Key Takeaways
- The mainstreaming of cryptocurrencies—and bitcoin, in particular—has accelerated since the onset of the Covid-19 pandemic. These digital assets have caught the attention of a broad range of financial market participants, driving the total crypto market capitalization higher by nearly tenfold.
- With bitcoin and its ilk facing significant challenges in meeting the functionality of traditional fiat currency, some investors have instead turned to crypto as a vehicle for speculation.
- While its limited supply has led some to see bitcoin as a store of value and potential hedge against inflation and the ongoing debasement of fiat currency, considering bitcoin in this context entails weighing the mostly theoretical benefits of a 12-year-old cryptocurrency against those gold has offered for millennia.
- First Eagle believes bitcoin's higher volatility, higher beta to equities and maturation-related uncertainties make it unlikely to be a binary substitute for gold at this stage of development.
The rise—and fall and rise and fall and rise—of bitcoin in recent years has dragged the universe of cryptocurrencies out of the shadows of the internet and onto the radars of a range of mainstream financial market participants, including central banks and federal monetary authorities, institutional investors and asset managers, merchants and electronicpayment providers, and smaller, less-experienced investors looking for a pathway to easy (digital) money. While First Eagle recognizes the potential for cryptocurrencies and similar innovations in a world marked by the continued debasement of fiat currency, we also are cognizant of the uncertainty inherent in existing forms of crypto at this point of development.
As investors focused on identifying attractive assets available for purchase at a "margin of safety,"1 we often have found ourselves bearing detached witness to the pockets of outsized enthusiasm that emerge in markets from time to time, whether it's Japanese real estate in the late 1980s, dot-com stocks in the late 1990s, financials in the mid-2000s or cryptocurrencies today.2 While each of these scenarios offered investors with impeccable timing the potential for profit, our focus on avoiding the permanent impairment of capital in support of long-term client outcomes dictates a more measured approach to asset selection.
For all of their broadening appeal, cryptocurrencies represent a very young asset whose behaviors across varying macroeconomic and market regimes are theoretical at best. While some of its backers have dubbed bitcoin "digital gold," in our view it currently is better described as an option on becoming digital gold. In contrast, actual gold has served as a store of value for millennia, and its unique risk-return characteristics have enabled it to maintain its real purchasing power over time across disparate environments and through numerous existential threats, providing investors a perceived "safe haven" in times of need.
KYC: Know Your Crypto
Like many grassroots movements bent on disruption, cryptocurrency comes with its own unique nomenclature. Though definitional nuances may differ depending on the source, below is a quick overview of some of the basic concepts discussed in more detail throughout this paper.
A blockchain is an anonymous, public record of digital transactions distributed and maintained across a peerto-peer network of unaffiliated computers (nodes). Driven by advanced encryption techniques and a system of well-aligned incentives among participant nodes, blockchains rely on consensus mechanisms—such as proofof-work or proof-of-stake—to verify and record individual transactions and thus preserve the legitimacy of the entire blockchain. Blockchain technology can be used to support a range of applications that require the efficient and secure storage and transfer of data, from securities trading to the sharing of personal healthcare information to elections. The first use case of blockchain technology to emerge at scale, was cryptocurrency (namely, bitcoin). Cryptocurrencies are digital assets that reside on and are secured by a blockchain. While some forms of crypto, including bitcoin, have a hard cap on their ultimate total supply written into their source code to promote scarcity, others allow for infinite expansion; generally, however, cryptocurrencies have mechanisms built into their protocols that control the rate of new issuance over time.
Coin refers to any cryptocurrency that is the product of its own standalone decentralized blockchain technology. Coins other than bitcoin fall under the umbrella of altcoins given their status as alternatives to the first mover; these include such cryptocurrencies as ether, XRP and dogecoin. Coins typically are intended to embody the properties of fiat currency—that is, to function as a medium of exchange, common unit of account and a store of value—to varying degrees.
In contrast, tokens are crypto assets that do not have their own underlying blockchain and thus are wholly dependent on an existing network; the Ethereum blockchain is the most popular platform for tokens. Tokens may have broad—and sometimes overlapping—functionality beyond that of a fiat currency substitute; for example, security tokens represent an ownership claim on a physical or digital asset, while utility tokens can be used to participate in a specific blockchain protocol. Tether, uniswap and chainlink are among the largest tokens by market cap.
Tokenization is the process of converting a physical or virtual asset into a digital unit that can be bought or sold. For example, stablecoins are a tokenization of currency; pegged to the value of another, more stable asset like fiat currency, stablecoins seek to mitigate the volatility typical of noncollateralized assets like bitcoins and altcoins. Non-fungible tokens (NFTs) are unique, indivisible digital assets used to prove the authenticity and ownership of collectibles like digital art and are also very popular in the online gaming world. Tokens also may be issued through initial coin offerings (ICOs) to raise capital for the production of decentralized applications (dApps). Rather than the centralized data servers upon which typical websites are run, dApps leverage blockchain technology to process data across distributed networks. Among the functionality dApps enable is decentralized finance (DeFi) through which developers seek to make a broad range of financial services—lending, insurance, trading, etc.—available over peer-to-peer networks. These services are executed by smart contracts, open-source blockchain protocols coded to be self-executing once certain prerequisites are met.
Nearly all digital asset trades are executed through centralized exchanges that serve as trusted intermediaries facilitating the purchase and sale of cryptocurrencies in exchange for fiat or other digital assets. Though cryptocurrencies never leave the blockchain, investors can interact with their digital assets through a wallet—a software program or dedicated hardware device. Wallets comprise a public key and a private key, codes that work together to securely store and manage the transfer of crypto assets.
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