Bitcoin, pristine collateral, and reserve asset – Part II
Jul 21, 2022
Bitcoin, an alternative to legacy reserve assets
The evolution of sound money technologies over time, from early systems of trading seashells and limestones to metals, coins, the gold standard, and contemporary government debt might be on the brink of an overhaul. Geopolitical tensions with the G7 seizing Russia’s foreign exchange reserves, pandemics, and raging inflation worldwide changed money. With the appearance of a new asset class led by Bitcoin, an interesting and never seen before cocktail originates that has the potential to reshape money and finance as we know it, in which Bitcoin could be a beneficiary. As Zoltan Pozsar, Credit Suisse’s global head of short-term interest strategy, puts it:
“We are witnessing the birth of Bretton Woods III – a new world (monetary) order centered around commodity-based currencies in the East that will likely weaken the Eurodollar system and also contribute to inflationary forces in the West” …
“After this war is over, “money” will never be the same again…
…and Bitcoin (if it still exists then) will probably benefit from all this.”
The current macro situation as a result of a variety of circumstances and their interdependencies exposed weaknesses of our financial system that is primarily based on debt and credit structures. With the sanctions on Russia and an estimate of more than half of their reserves frozen, the perception of reserve currencies like USD, EUR, or JPY altered as it was the first time a relevant economic and financial actor was seized by that magnitude.
Despite foreign currencies enabling the exchange rate of a country’s own currency to stay stable, it also leaves especially China being the largest foreign currency reserve holder in the world in a tricky position. With that, we might face a world with a sharper focus on outside money, like gold and other commodities as countries try to boost their reserves for independency. According to Pozsar, Bretton Woods III will be backed by outside money in a similar way as the first Bretton Woods era (1944–1971) was backed by gold while Bretton Woods II (1971–present) was backed by inside money (basically U.S. government paper). Gold or Bitcoin-backed currency regimes that can substitute the functions of fiat money that acts as reserve assets become more attractive and might offer dramatic upside. According to a report of VanEck, their framework for quantifying the impact of Bretton Woods III estimates gold prices of around $31,000 per ounce and Bitcoin prices of around $1,300,000 with even greater upside for greater strains on financial and monetary systems.
The Bitcoin standard and a brief history of reserves
Bretton Woods (named for the conference location in Bretton Woods, New Hampshire) aimed at monetary management and laid out the rules for financial relations between countries, created the International Monetary Fund (IMF), World Bank, and the World Trade Organization (WTO).
The first Bretton Woods system, now referred to as Bretton Woods I, was based on gold and dominated by the U.S. dollar, which was freely convertible into gold for $35 per ounce. The U.S. changed its currency in 1971 in order to make the dollar free-floating and backed it by faith in the economy, as well as by military defense and credit of the government. From there, Bretton Woods II was born, making the dollar the primary reserve currency, but in a system that mostly uses inside money and is largely debt-based.
Reserve assets provide credibility for the value of fiat currencies and are meant to serve as a store of value independent of volatile markets, allowing institutions to preserve their purchasing power over extended timeframes. Reserve assets as per the IMF balance of payments manual are currencies such as the U.S. dollar and assets, such as gold, that are readily transferable and used to balance international transactions. They must be comprised by:
- Foreign currencies: the most important official reserve
- Special drawing rights (SDRs): a proxy for obtaining e.g. foreign exchange from other IMF members
- Reserve positions with the IMF: reserves given to the IMF that are available
As foreign exchange aims to stabilize rates and promote efficiency in international trade, reserve currencies are typically acquired by central banks and major financial organizations. The U.S. Dollar has traditionally served as the standard reserve foreign exchange asset but faces threats to its stability as it continues to devalue in order to keep its position as the world's reserve currency. The emergence of Blockchain technology with Bitcoin on the forefront show potential to bring forth new innovations that could address some of the hazards connected with the current system and might become the cornerstone of the global financial system. What makes Bitcoin such a great solution to the current status and alternative to conventional reserve assets?
With gold being both durable and hard to produce, it’s offering a high stock-to-flow ratio, where supply is rather fixed, allowing goods to be steadily priced against it over time. Bitcoin beats gold on these criteria as its supply is known by design to be no more than 21 million Bitcoin. The ownership of Bitcoin is tracked in an immutable ledger. The network persists as long as there is the internet, and the digital coin is permanent. Furthermore, moving Bitcoin is significantly simpler than moving gold. Neutral reserve assets such as gold and Bitcoin are energy proxies that are tied to energy by mining production cost and storing. Regarding gold, a standardized metric named the All-in Sustaining Cost (AISC) aims to reflect the sustainable production cost of keeping the mine in business. It is currently resting at 70% of the gold price while Bitcoin’s production cost sits at 56% relative to its market price.
Overall, the properties that make Bitcoin valuable and a good reserve asset are cryptographically verifiable integrity, scarcity, security, verifiability, availability, and transferability that likely enhances global trade. Despite Bitcoin being able to satisfy all three functions of money, namely store of value, unit of account, and medium of exchange, it’s likely strongest property that is also agreed upon by Bitcoin proponents is its function as a store of value. By chasing that narrative, inefficiencies induced by Bitcoin’s robustness become trivial since Bitcoin’s weaknesses such as latency, TPS, power consumption, and scalability become non-issues for a neutral, supernational reserve asset. Similar to gold, Bitcoin might work as a hedge against inflation, carries no credit or counterparty risks, mostly features an inverse relation to the dollar, and can serve as a source of trust as it’s decentralized, permissionless, and trustless. With that, many of the hazards connected with the U.S. dollar system are possibly mitigated by Bitcoin.
Assets considered to be good inflation hedges hold or increase in value over time and are therefore considered a store of value. In order to act like a store of value, gold and Bitcoin bring important properties such as scarcity, accessibility, and durability. Both bitcoin and gold are sensitive to inflation, yet gold typically performs better during recessions. In contrast, even when the yield is increasing, Bitcoin seems to do better when the economy is stronger. As observed, Bitcoin prices appreciated under inflationary pressures within the last years but declined under heightened uncertainty. With that, Bitcoin has not really traded as an inflation hedge and neutral reserve relative to treasury bonds or gold in the recent down cycle, see Illustration 1 which compares gold and Bitcoin from the beginning of 2021 when the U.S. CPI started to climb. Regardless of Bitcoin’s role within decentralized treasuries though, Bitcoin has performed relative to crypto as a neutral reserve asset as it outperformed on the way down yet underperformed on the way up. That is one of the characteristics Bitcoin already showcased within the last cycles.
Illustration 1: U.S. CPI vs. Gold vs. BTC
Outside of the legacy system, Bitcoin is already leveraged as a reserve asset in decentralized infrastructures, especially with regard to stablecoins. For a more in-depth dive into stablecoins, we refer to our dedicated Decrypt titled (Un)stablecoins. As the future is likely a multitude of interoperable blockchains, users of Bitcoin as digital gold won’t necessarily worry about the technicals underlying the different chains or about the pegged derivative they use. For instance, more than 1.13% of the bitcoin supply is already wrapped on Ethereum through BitGo with more BTC hitting other blockchains continuously. A trend that is likely sustained considering the fears over the censorship resistance and collateralization of stablecoins. However, in the light of the merge scheduled for September, ETH is also a strong candidate for an important digital reserve asset within decentralized applications and DAOs as it already collateralizes stablecoins like Maker’s Dai. With the merge likely being a catalyst, ETH’s new monetary policy enabled by Proof of Stake (PoS) then offers a long-term security model, more security, and 5-10% staking interest while likely being deflationary post-merge.
Bretton Woods III
The most active central banks buying gold are no longer the traditional economic powerhouses such as the U.S., Germany, or France as they are mainly hodling the substantial holdings they already have. With about 8’100 t, or over 78 percent of its entire foreign reserves, the U.S. has the most gold. It is more than twice as much as Germany's stockpiles of more than 3’300 t, which places it second on the list and represents around 74% of its reserves. Russia and China recently ramped up their gold purchases within the last decade, yet still lag behind significantly. For instance, gold accounts for only 22% of Russia's reserves with 2’300 t, while China's holdings of slightly less than 2’000 t of gold account for only 3%. In Q1 2022, especially Egypt (44.06 t), Turkey (36.90 t), and Argentina (6.97 t) made significant additions to their holdings with each of them being hit by high inflation.
As data reveals, gold’s modern-day relevance as well as its enduring appeal are still present and might even come with some upside as the world seeks an overhaul of reigning monetary systems. Therefore, restocking gold as a national safe-haven asset strategy might be triggered by global spikes in government debts and further inflation that will likely yield an increase in Bitcoin’s supernational reserve asset adoption as a side effect.
Van Eck ran some numbers within their framework to properly value Bitcoin and gold as a global reserve asset in the emergence of a new gold or Bitcoin-backed currency regime revealing a potentially dramatic upside for both assets. To do that, they calculated implied gold prices based on the current reserves of various countries and their monetary supply, see Illustration 2.
Illustration 2: Implied gold prices by country
Impressively, the framework estimates gold prices of up to $31k per ounce for M0, $105k for M2, and potential Bitcoin prices of around $1.3m per coin for M0 and $4.8m for M2 if they were adopted to be a world reserve asset. Therefore, Bitcoin would offer an upside of around 33x for M0 while gold’s upside would still be 16x.
With ~6.3% of Bitcoin in treasuries, companies and countries increasingly leverage Bitcoin as a reserve asset and therefore decrease the available market supply. Overall, +$30b in BTC resides in treasuries of various entities, see Illustration 3. With 38 public companies holding Bitcoin on their balance sheet, they already amassed close to 262’695 BTC — about 1.25% of all Bitcoins and worth approximately $6.1b.
Illustration 3: Total BTC treasury distribution by category
As corporate buying shows signs of becoming a global trend after MicroStrategy kickstarted it, a lot of other companies such as Tesla or Galaxy Digital Holdings already joined the movement, reducing the available supply of Bitcoin significantly. If that movement keeps getting stronger, it makes sense to take a look at some numbers as the amount of Bitcoin that publicly traded companies hold as a reserve is only a tiny fraction of the corporate treasuries. For instance, the actual amount of cash held in reserves is in the trillions of U.S. dollars with nine companies in the S&P 500 sitting on close to $600b in cash and short-term investments, a potential massive buy pressure if aimed at Bitcoin. Moreover, also private companies, countries, and especially ETFs further reduce the liquid supply on markets, see Table 1, as they approach Bitcoin.
Table 1: Most important entities with BTC treasury holdings
Conclusion and Outlook
Bitcoin’s features make it not only a good collateral but also a pristine reserve asset. If combined, the potential market for Bitcoin and its corresponding upside is mesmerizing. Gold's merit as money and a reserve asset is outperformed by Bitcoin's material qualities. While Bitcoin already acts like a decent store of value regarding devaluing currencies, it has yet to live up to its narrative of being an inflationary hedge in times of uncertainty. However, with increasing adoption, which we already see signs of, and the current macro with lots of uncertainties, there is a case for Bitcoin becoming one of the most important and pristine reserve assets out there. By that, every entity be it public companies or countries must decide in years from now on where Bitcoin fits in their asset structure weighing in the substantial risk of being left behind if we’d hit adoption escape velocity.