A Comprehensive Look at Bearer Assets - Part 1

Almost every asset class is subject to some level of contention.

Investors often find themselves in endless discussions about whether a stock is priced too high, if bond yields align with the market conditions, or how oil will fare in the long-term future.

Yet, few assets spark as much debate as alternative currencies like gold and bitcoin. Some are so convinced of their value that they invest all they have in them, while others fail to see any value at all.

People like me take a more balanced approach, incorporating these controversial assets into a broader investment portfolio.

Because they neither produce cash flow like traditional businesses nor have measurable supply and demand like industrial goods, the valuation of assets like gold and bitcoin is especially contentious. The bull/bear gap extends widely not just to their current market price but also to their very justification as investable assets. Some enthusiasts are so convinced of their worth that they'll keep investing even during steep market declines, employing dollar-cost averaging strategies. Meanwhile, skeptics dismiss them as nothing more than "shiny rocks" or "virtual currency", choosing to keep them entirely out of their investment portfolios.

Interestingly, there was a period spanning four decades—from the 1930s to the 1970s—when Americans were prohibited from owning gold. In certain jurisdictions today, possessing bitcoin is also illegal. Governments often deem these assets as risky or destabilizing. It raises the question: How can something considered by some to be so inconsequential also be viewed as perilous? Items deemed worthless usually aren't subject to bans; they're typically ignored and allowed to fade into obscurity over time.

This article seeks to unravel the mystery behind their broad appeal. Rather than diving into specific price projections, my focus is on examining the driving factors behind their usage. If you're unfamiliar with the allure of gold or bitcoin, consider this piece your key to understanding why they hold value for many people.

After that, we can identify the economic scenarios where their prices are expected to increase or decrease, from an investment angle. This analysis will help elucidate their potential role in a well-rounded investment portfolio.

The idea of personal custody is uncommon.

It's quite rare to find financial assets that allow for long-term holding without the need for a centralized authority to oversee them. 

Most conventional assets, such as stocks, bonds, and cash accounts, are stored and managed by financial institutions, or are tied to centralized ownership databases.

Real estate stands out as the largest asset class you can technically maintain yourself, although it lacks portability, liquidity, and easy exchangeability. 

Collectibles offer self-custody but come with their own set of limitations, like lack of liquidity and fungibility, due to unique attributes like date, condition, or type. Gems face similar issues.

This leaves us with physical cash, precious metals, and cryptocurrencies as the exceptional asset classes that can be both self-managed and freely traded without a centralized or trusted intermediary. These assets are also unique for their liquidity, fungibility, and portability, setting them apart as a rare subset of money-like bearer assets.

When you consider it, creating a self-valuing, money-like asset is an extremely difficult task. If you and I wish to exchange a fungible value in any random amount without involving a third party—either online or offline—our options are astonishingly limited. While we often don't have an issue involving a third party (as in credit card transactions), the fact remains that if we wanted to bypass such intermediaries, we would have few practical choices.

Nearly all methods for exchanging value in a liquid and fungible manner necessitate the involvement of a centralized entity for verification or processing. This centralized party could potentially monitor or even block the transaction. The only notable exceptions to this rule are physical cash, precious metals, and cryptocurrencies. These unique asset classes allow for both self-custody and peer-to-peer transactions without requiring a centralized authority for validation or oversight.

Advantages and Disadvantages of Physical Cash

Physical cash tends to lose its value over time due to inflation targets set by global policymakers, commonly at 2% or above. The supply of fiat currency—money without inherent value or fixed supply—also expands over time. Unlike assets that gain organic acceptance, fiat currencies typically require governmental coercion for their usage. This can involve taxation on other asset types, requiring taxes to be paid exclusively in the state-sanctioned currency, or even imposing capital controls and bans on competing forms of money.

Contrary to the general rule that fiat currencies lack organic adoption, certain developing countries with weak local currencies serve as exceptions. Here, dollars or euros are commonly traded, either openly or in underground markets, and are considered more stable than the native options.

Take, for example, the Egyptian pound, which has had its share of instability. Egyptians witnessed their savings depreciate by nearly 50% against the dollar and euro almost overnight in November 2016, affecting a population of 100 million, whether their money was in a bank or not.

Over the last 100 years, even robust currencies like the Swiss franc and the US dollar have lost over 95% of their purchasing power. On average, most currencies have fared worse, depreciating by around 98-99%, with the weakest ones losing all their value.

Since the year 2000, the dollar has lost about 40% of its value when measured against the official consumer price inflation. 

The typical way to offset this is by depositing cash in a bank to earn interest, but even then, interest rates often fail to keep pace with inflation, particularly in high-inflation periods.

Long-term financial instruments like 10-year Treasury notes have also shown negative real returns during times when inflation severely devalued the currency, yielding as low as -4% to -5% annually if held to maturity.

Therefore, cash serves more effectively as a medium of exchange than a long-term store of value. It's generally stable for short-term use, especially in developed nations, but not advisable for long-term value preservation. This perspective is even more noteworthy considering that our current fiat-only system came into widespread use only in 1971.

While cash does involve a centralized authority—the government—it doesn't require that authority to facilitate transactions or hold the asset. Cash can be self-custodied and exchanged peer-to-peer offline, eliminating the need for a direct counterparty in transactions.

Advantages and Disadvantages of Precious Metals

Gold and silver have served as durable, fungible stores of value for millennia across different cultures. Gold's chemical stability and malleability make it ideal for crafting into standardized coins or bars, and its aesthetic appeal is perfect for jewelry. Unlike consumable commodities, gold's high stock-to-flow ratio positions it closer to a currency in terms of its supply and demand dynamics.

The durability of gold is so great that it would likely survive for hundreds of thousands of years even in the absence of human civilization, as illustrated by documentaries like “Life After People.” For instance, gold bars stored in the New York Federal Reserve would essentially remain unchanged even after being submerged and buried for ages.

Gold's annual increase in supply is about 1.5%-2%, roughly in line with global population growth. This low monetary inflation rate has allowed gold to preserve its purchasing power consistently. 

For instance, a one-ounce gold coin that could buy a quality outfit a century ago can do the same today. According to calculations from the World Gold Council, approximately one ounce of gold that has been mined exists for each individual on the planet.

Storing physical cash for several decades usually results in a significant decrease in its buying power. On the other hand, if you keep physical gold for the same length of time, it's likely to maintain most or all of its value, unless you purchased it at the peak of an infrequent gold bubble, such as those in 1980 or 2011.

That said, gold's purchasing power can fluctuate considerably over shorter spans like 5 or 10 years, potentially losing or gaining more than 25% of its value. Also, selling gold incurs taxes, and it generally trades at a premium when bought and at a discount when sold in the physical market, as intermediaries need to profit for market liquidity. Therefore, gold isn't practical for day-to-day transactions, unless nations choose to anchor their currencies to it. It serves best as a long-term store of value. There exist debit cards linked to gold accounts to facilitate its use as a medium of exchange, although this introduces the need for a trusted or centralized entity.

Holding large amounts of gold yourself comes with the risk of theft. While vault services offer a safer option for storing substantial quantities, this method ironically leads to centralization. Moreover, throughout the last century, several countries experienced instances of gold confiscation, where vaulted gold was seized from its owner. There are scarcely any places globally where one could have stored gold with a third-party vault a hundred years ago and successfully passed it down to their grandchildren.

Like gold, silver and platinum can serve as self-custodied stores of value. However, they function more as a cross between currencies and commodities, exhibiting lower stock-to-flow ratios and greater volatility. Platinum also faces less liquidity and higher transaction costs when bought and sold physically.

In summary, gold surpasses cash as a better long-term asset for self-custody. Many affluent individuals keep a modest amount of it as a form of emergency insurance.

In 2008, Satoshi Nakamoto amalgamated existing technologies and introduced his own innovations to develop the idea of digital scarcity. While there were earlier attempts that solved aspects of the problem, Nakamoto's approach was the first to successfully combine enough elements to achieve significant success.

Bitcoin operates as an open-source, decentralized public ledger. It employs a reward system that incentivizes miners across its dispersed network to authenticate transactions in return for fees and block rewards. Individuals use public and private keys to carry out transactions, avoiding the need for a centralized authority. The network is further verified by thousands of nodes, accessible to anyone with a standard computer and internet connection, which help counteract potential collusion among miners.

Much like fiat money, individual bitcoins or fractions thereof serve no industrial purpose beyond their potential as a means of payment and store of value. At its core, Bitcoin is a ledger that records the values tied to various addresses, and ownership of a private key grants you control over the coins linked to that specific address. While there are more technical details, such as UTXOs, that's the gist of it.

Your private key can be self-custodied in various forms—on paper, in a hardware wallet, etched onto a titanium plate, or even memorized via a seed phrase. You can also divide your key into multiple segments and store each segment in diverse ways and locations.

In contrast to fiat currencies, Bitcoin lacks a centralized authority that can alter its monetary policy, issue additional bitcoins, block transactions, or seize bitcoins from an address.

Differing from gold and cash, which are transactional only in the physical realm unless a centralized third party is involved, Bitcoin is native to the digital space. This enables online and cross-border transactions while retaining properties like self-custody and resistance to censorship.

This characteristic is what makes Bitcoin so divisive. At a cursory glance, Bitcoin and its crypto counterparts may appear to be without intrinsic value. However, when measured against fiat currencies in terms of features, Bitcoin generally outperforms them in all aspects except for its volatility. While lacking in industrial utility, the concept of a globally accessible, leaderless network focused on uncensorable transactions, all governed by a stringent monetary policy, makes it a compelling form of internet-based money. It has acquired value at an unprecedented speed, reaching milestones like 100 million users and a $1 trillion USD market cap more quickly than the internet or smartphones did.

Additionally, there are specialized USB drives designed to hold Bitcoin that must be physically destroyed to access the stored funds. These drives can be passed around like high-denomination currency notes and later be reintroduced to the online system when spent, acting as tangible bearer assets.

Image Source: OPENDIME

In a May 2021 conversation, Ross Stevens, Executive Chairman of NYDIG—a company that collaborates with institutions on Bitcoin-related services—highlighted Bitcoin's potential as not just a store of value but also a transformative financial tool.

According to Stevens, Bitcoin introduces two never-before-seen features: an electronic bearer asset and an open-source monetary network. This enables instantaneous, any-time financial settlements across the globe without fees, except for a nominal FX bid/ask spread.

Stevens explains how Bitcoin operates as the base layer in the financial landscape, similar to how physical cash works. It offers immediate, final settlement. Additional layers can be built on top of this, like Lightning, a second-layer solution that enables rapid transactions. In essence, you can convert your U.S. dollars into Bitcoin, move them instantly to the Lightning network, and send them anywhere in the world. The recipient can then convert it back into dollars or any other currency, essentially making it a fee-less, fiat-to-fiat transaction.

To illustrate the real-world impact of this technology, Stevens cited the example of El Salvador, where remittances constitute 24% of the GDP. Prior to the introduction of Bitcoin and the Lightning network through companies like Strike, sending money to El Salvador was a cumbersome process involving high fees and safety risks via services like Western Union. Now, the same transaction can be executed almost instantly and virtually without fees, making a significant difference in the lives of the recipients. Stevens pointed out that the adoption rate for this technology in El Salvador is growing rapidly, with tens of thousands signing up daily, proving its potential for large-scale, transformative impact.

Certainly, within weeks of its launch, Strike quickly ascended the ranks to become one of El Salvador's most downloaded apps. Remarkably, not long after that, El Salvador enacted legislation to recognize Bitcoin as legal tender, exempting it from taxation and requiring merchants to accept it for payments when feasible.

I had the opportunity to discuss Bitcoin's potential in emerging markets with Elizabeth Stark, CEO and co-founder of Lightning Labs, at the 2021 Bitcoin Conference on June 5. Mere hours later, during the concluding speech of the afternoon by Jack Mallers, El Salvador's president announced this groundbreaking policy shift.

One persistent challenge facing Bitcoin since its creation by Satoshi Nakamoto is the proliferation of alternative cryptocurrencies that dilute its market. While these "altcoins" aren't direct substitutes for Bitcoin, their existence and growing user bases can undermine Bitcoin's scarcity, thereby impacting its value proposition.

While having a few other viable blockchains for specific applications like smart contracts is acceptable, an overabundance of competing platforms creates a fragmented ecosystem. And because Bitcoin's software is open-source, there's no way to prevent anyone from creating a clone. Although these clones aren't recognized by Bitcoin's node network, they present an ongoing risk by potentially siphoning off users and market share.

This scenario is analogous to someone copying Wikipedia's text without being able to replicate its extensive hyperlink network or its active community of contributors. If enough such imitations appear and divert attention away from Wikipedia, they could, in theory, dilute its impact over time. Bitcoin has managed to navigate the challenge presented by altcoins for over 12 years, but it remains an ever-present risk.

To secure its long-term success, Bitcoin needs to sustain a strong network effect across various crypto market cycles, standing out against a backdrop of competing cryptocurrencies. Unlike nation-states that can enforce their fiat currencies, or gold, which faces little competition from other elements as a store of value, Bitcoin must rely on its inherent qualities, early adopter advantage, and the resulting network effects and security features that come from being the first and largest in its class.

Though some argue that Bitcoin's technology is dated and predict its eventual replacement by newer altcoins, it's worth noting that enduring technologies like TCP/IP and USB continue to serve as foundational infrastructure for the internet and data transfer, respectively. These technologies have sustained their relevance because they're reliable, adaptable, and have reached critical mass.

Though some argue that Bitcoin's technology is dated and predict its eventual replacement by newer altcoins, it's worth noting that enduring technologies like TCP/IP and USB continue to serve as foundational infrastructure for the internet and data transfer, respectively. These technologies have sustained their relevance because they're reliable, adaptable, and have reached critical mass.

In essence, when the goal is a decentralized, resilient system with widespread network effects, simplicity and stability are key. Even though a dominant protocol can potentially be unseated, achieving that becomes increasingly difficult once the protocol reaches a certain scale. Future innovations can always build upon these foundational protocols to extend their utility.

The Bitcoin base layer is updated slowly, with the latest update being a privacy and multi-signature update called Taproot. However, there is faster development on the secondary Lightning Network layer, and even more development in the broad ecosystem of apps, services, and hardware wallets that utilize the base layer and/or the secondary layer. Bitcoin's base layer is purposely lightweight and designed to be accessible to everyone. This means that even decades from now, anyone should still be able to run a full node.

Similarly, each of the three types of self-custodied assets (cash, gold, and bitcoin) has its own advantages and disadvantages. Ultimately, the best asset for each individual will depend on their specific needs and preferences.