Bitcoin: Technical Tour de Force, Rat Poison—or Both?

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Many a famous name has weighed in on the value, or lack thereof, of bitcoin. From Bill Gates—“I think it’s a technical tour de force”—to Warren Buffett’s partner and friend Charlie Munger—“I think it’s rat poison”—institutional CIOs can be excused for being confused about the validity of the crypto-currency.

First introduced in 2009 by pseudonymous developer Satoshi Nakamoto, bitcoin is defined as “a purely peer-to-peer version of electronic cash [that] would allow online payments to be sent directly from one party to another without going through a financial institution.” It has successfully established its place as a form of payment and cash exchange since then, earning the support of companies including Overstock.com, eBay, and Richard Branson’s Virgin Galactic. You can even buy tickets to the NBA’s Sacramento Kings games with bitcoins beginning March 1.

“It’s an incredible innovation,” says Jerry Brito, a senior research fellow at George Mason University’s Mercatus Center and an expert on bitcoin. “It solved the problem of double-spending without using a third party such as PayPal.”

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According to bitcoin.org, one can “mine” bitcoins by solving complex computer mathematical problems, exchange them at an online center, and make cash-for-bitcoins transactions at bitcoin ATMs. The system utilizes a ledger of transactions that provides users a certain level of anonymity, but all trades and deals are stored publicly on the network.

“We have proposed a system for electronic transactions without relying on trust,” Nakamoto wrote. Trust in people, in governments, and in the markets is irrelevant to bitcoins.

But, Is it Real?

Still, can we even call this crypto-currency a real currency?

Absolutely not, says David Yermack, a professor of finance at New York University’s Stern School of Business. “It’s really more of a speculative investment than a currency, like pet rocks in the ’70s and Beanie Babies in the ’90s. Bitcoins have captured the imagination of a small number of people, but it certainly doesn’t qualify as a true currency.”

One of bitcoin’s weaknesses as a currency is its inability to perform as a unit of account and a store of value—both major functions of money. According to Yermack’s research, bitcoin’s exchange rate volatility from January to November of 2013 was a whopping 133%, much higher than all major currencies. Gold, which has often been compared to bitcoins, recorded volatility of 22% in the same period.

He’s right—bitcoin prices are shaky.

When Mt. Gox, a major bitcoin exchange based in Toyko, suspended all withdrawals for “technical” reasons in early February, bitcoin prices took a major plunge, from $1,038 per unit on January 26 to below $700 on February 7. The price had dropped 8% overnight, a change inconceivable in other fiat currencies.

“One must conclude that holding bitcoin even for a short period is quite risky, which is inconsistent with a currency acting as a store of value and which greatly undermines the ability of a currency to function as a unit of account,” Yermack writes.

Peter Vessenes, chairman of the Bitcoin Foundation, feels differently. “It’s a new invention, a new asset class. It’s sort of a religious war in bitcoin-land: Is it money or is it a value store? I’ve seen it used more as a store of value than transactional money.” The foundation is a mouthpiece of the “currency” and largely works to legitimize bitcoins through standardization.

“There’s Nothing Behind It.”

Skeptics run wild in this bitcoin debate, however, questioning not only its use in today’s market transactions but even its fundamental principles. The crypto-currency is absent of any governmental backing, with no political ties and little impact from macroeconomic events. Instead, it’s only about computer algorithms.

“There’s nothing behind it,” says Jeffrey Christian, managing director of CPM Group, a commodities consulting firm. “Bitcoin is not a tangible asset, and its total construct is flawed. People have called it a gold-like commodity, but that’s also untrue. Gold has the faith of the market.”

Bitcoin’s complete independence from other fiat currencies and precious metals make it “ineffective as a tool of risk management,” says Yermack. “To hedge something, you need something that is negatively correlated with what you’re hedging against. Bitcoin is something different altogether. It can’t be sold short, and you can’t use derivatives such as forward contracts and swaps for bitcoins.”

Arguably, these qualities make bitcoins extremely risky—so risky that investing in bitcoins may be like “going to Bernie Madoff after he’s been arrested and asking him to manage your money,” according to Christian. “It’s a Ponzi scheme, a giant scam that will blow up and hurt a lot of people. I foresee a crisis this year.”

Yermack is similarly concerned, but says it may be inaccurate to call bitcoins a Ponzi scheme. “The supply for a fiat currency has to grow as fast as the economy to be effective. Without it, you face deflation. The fact that there’s only a limited quantity of bitcoins—21 million, with no expansion in supply possible after the year 2140—is a large structural economic problem. The bitcoin bubble could burst in the next two weeks.”

The Bitcoin Foundation’s Vessenes says it’s “stupid” to accuse bitcoin of being a financial bubble or a Ponzi scheme. “They just don’t understand it,” he says. “We’re expecting many consumer-oriented technologies to be built on the idea of bitcoins, all in an effort to legitimize it as a true alternative to a fiat currency. I’ve been seeing a lot of Silicon Valley money going in with great interest from venture capitalists. It’s only going to be bigger and better going forward.”

Bitcoin in Institutional Portfolios

Then could this digital “currency” play a role in an institutional portfolio?

Cameron and Tyler Winklevoss, of Social Network fame, think so. “I think bitcoin pretty much fits into the commodities bucket,” Cameron Winklevoss says. “It can definitely fit into an institutional portfolio depending on what kind of risk/reward profile the fund is going for.” The Winklevoss twins have been early proponents of the crypto-currency and currently own 1% of all bitcoins.

According to research conducted by Kim Oosterlinck, Marie Brière, and Ariane Szafarz of Université Libre de Bruxelles, investors could take advantage of bitcoin’s high volatility and implement a small proportion into their portfolio to “dramatically improve the risk/return trade-off of well-diversified portfolios.”

“We viewed bitcoin as any other asset class,” Oosterlinck says. “A very risky one that is not correlated with any other assets.” However, Oosterlinck emphasizes bitcoin’s extreme volatility and supremely high risk that could endanger a portfolio. “Investing in bitcoin alone would be suicidal,” he says. “Only a small portion is okay for now. It’s super risky, but the small correlation it has with other assets would help diversify a portfolio.”

To Scott Chan, CIO of Sacramento County Employees’ Retirement System, it may be too early to have this conversation. “It’s a novelty. I feel as though the technology is not yet robust enough to make bitcoins an investable asset.” His current interest is in how new technologies such as bitcoin and other crypto-currencies could disrupt the large and stable pie of monopolistic credit card companies. “Developed countries already operate on credit, and emerging or developing countries are moving into credit. And as the pie becomes larger, it’ll be interesting to see how bitcoin plays a role.”

The next move for bitcoin should be to secure its technology and financial underpinnings, Chan says. While it has the potential to offer superior protection over payment processors, it still lacks the stringent regulations and legitimization among big investors needed to be taken seriously.

So, is bitcoin a “technical tour de force”—or is it “rat poison”? In actuality, in can be both, and institutional investors are unlikely to forget one central lesson from the financial crisis: Just because something is technically remarkable doesn’t make it a good investment.

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With Russell Investments potentially on the block, all eyes are on this sector. The founder of Asset Management Finance and consultant to Alpha Strategic explains why asset owners could replace banks as the great financiers of asset management.

“Some large asset owners—the major pension and sovereign wealth funds—are actively looking for ways to invest more directly in infrastructure, real estate, and asset management. And it makes perfect sense. You have enormous amounts of institutional wealth being funneled down to asset managers on an outsourced basis, and yet there hasn’t been an effective alignment of transparency and economics. There is also continuing resentment of the high fees paid to outsourced managers. But alignment through ownership is difficult to do. Successfully investing in asset management likely involves key-man risk, concentration challenges, and a large-scale capital commitment. Prospective buyers also need to have the specialized skills to identify, execute, and monitor these investments. So it’s not something a lot of funds are equipped to do today. For example, a couple of years ago, Texas Teachers bought a stake in Bridgewater—one of the largest pension funds investing in one of the largest managers. It was a big transaction, and one that few institutions could have accomplished. That’s where going through a third party can help.

For asset managers, institutional buyers have a clear advantage. With private equity ownership, they’re going to end up on the auction block—whether it’s a good time or not. And that’s just the nature of the beast. At best, a sale is a distraction to the manager. At worst, it’s damaging. In contrast, institutional owners have a very long investment horizon, without these liquidity requirements—they are the ideal owner.

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The sellers in the best position have some unique offering, be it in active exchange-traded funds, liability-driven investing, or target date. We will see significant interest for products that large mutual fund companies or institutional managers can really pump through their distribution channels. Businesses packaging up liquid alternatives into ’40 Act products would be another example. The convergence of traditional and alternative assets—a theme many have seen coming for a long time—has been playing itself out in slow motion. Now demand from the retail market place has really picked up.

It’s difficult to find a very cheaply priced mergers and acquisitions (M&A) transaction in asset management, given improving economies and the overall health of these businesses. A lot of managers are going to know what their company is worth and have a value in mind. The M&A market in asset management has been a steady state of transactions recently. Over the last couple of years, much of the dollar volume has been driven by European banks’ divestitures: Robeco, Dexia, Credit Suisse, among others. A lot of this has played itself out. Since the financial crisis, European banks have narrowed their focus down to core strategies, and many have had to meet more stringent capital requirements. These businesses are very valuable assets.

Private equity (PE) shops, which are traditionally value buyers, have been quite active in facilitating those divestiture plays. The market values of publicly traded asset managers have also been very strong lately, and that tends to be a bellwether for PE activity. But private equity investors in this space ebb and flow. A select few are continuously active, including TA Associates and Carlyle, but for most it’s episodic. Still, the industry has been pretty successful fundraising lately, so they have some money to put to work.

There is also some renewed activity in buying funds-of-hedge-funds businesses. Carlyle bought Diversified Global in Toronto, for one. It’s a contrarian investment, I suppose. That said, there certainly are some good funds-of-funds—those that weren’t just asset gatherers, piling on structured products for the retail market and suffering the unwind that came after. Some funds-of-funds have the right focus on risk strategies tailored for their clients, and those can be of value.

But of all the trends I see in the asset management M&A space right now, the potential alignment of institutions and managers through ownership is certainly the most energizing.”