Bitcoin: An investment profile

Hedge against monetary and fiscal risks

Think of Bitcoin as a currency — one that’s issued by a computer network, rather than by a government or central bank. Bitcoin’s inflation rate is less than 1%, compared to Canadian historical inflation of 2.2% and Canadian money supply growth of 7.1%.² The expansion of a country’s money supply, particularly when growing at a faster rate than GDP, debases the value of currency. In turn, the money supply increases when governments spend more than they receive in tax revenues and finance the difference by issuing debt. This has become standard practice in Canada, the United States and other developed countries, especially after the global financial crisis of 2008–09.

In contrast, the supply of Bitcoin is set by code and cannot be arbitrarily increased. The total supply of Bitcoin is capped at 21 million tokens, about 19.8 million of which have already been mined. Bitcoin, like gold, represents a form of “hard money.”

Hedge against geopolitical risks

In its early days, Bitcoin behaved as an extremely high-risk asset, with crashes often much greater than any major stock market. As Bitcoin has matured as an asset class, it has remained very risky over the short term but has also shown some evidence of hedging geopolitical risk, in the aftermath of events such as the Russian invasion of Ukraine in 2022 and the U.S. regional banking crisis in 2023.³ However, this role as a hedge is relatively recent in Bitcoin’s history and is difficult to separate from other factors that may have affected Bitcoin’s price. Investors will likely need to see more data over an extended period to assess Bitcoin’s potential as a hedge against geopolitical risks.

Diversification

Bitcoin is a decentralized digital asset that is not tied to the fortunes of any government, institution or region. As such, Bitcoin’s returns have not moved in lock-step with those of financial assets, such as stocks and bonds. The correlation of Bitcoin to the S&P 500 has mostly varied between -0.50 and 0.50 over the last 10 years.⁴ In equity market declines, this correlation has increased to 0.75, or even higher on shorter timeframes. Bitcoin has never been tested with an extended equity market decline, like the technology crash of 2000–02 or the financial crisis of 2008–09.

Market risks

Bitcoin’s impressive performance came with extremely high levels of market risk. Bitcoin’s standard deviation (annualized volatility of daily returns) reached almost 100% in 2017 and has trended down to about 40%, still several times higher than major stock markets. Bitcoin has experienced 3 crashes of over 75% in the last 10 years, from which it took several years to recover in each case.⁶ Bitcoin’s past performance is almost illusory, since few investors would have been able to hold through the massive volatility and crashes to earn the long-term return.

Security risks

About 20% of Bitcoin is estimated to be in lost or stranded wallets, including where users have forgotten the password to their wallet.⁷ If a Bitcoin holder loses their password, there is no company to contact, no client service team to assist. This is a major risk of holding a digital asset.

Bitcoin has proven to be popular in romance and other scams, since payment is anonymous and irreversible. What’s more, cryptocurrency exchanges have been hacked on several occasions, including the $600 million hack of the FTX exchange in November 2022, the $570 million hack of the Binance exchange in October 2022 and the $473 million hack of the Mt. Gox exchange in 2014.⁸

Investors can mitigate these risks in two ways. The first way is to hold Bitcoin in a “cold storage” wallet that is kept offline and not connected to an exchange, safeguarding their passwords and remaining vigilant about security. This requires at least a moderate level of technical knowledge and a high level of risk and security management.

The second way is to hold Bitcoin through an ETF or mutual fund, where the fund company uses a custodian to store Bitcoin on behalf of fund investors.

Legal and regulatory risks

Bitcoin, as a new asset, has faced a wide range of legal and regulatory risks. Some developing nations such as China and India have tried to ban cryptocurrency trading, although not all measures have stuck. While it is difficult for a government to shut down a decentralized network, it can ban trading or ownership.

The ultimate legal risk for Bitcoin is a ban by a major government, such as the United States or European Union. As an example from history, the U.S. government banned the private ownership of gold in the 1930s, as demand for gold threatened to deflate the U.S. dollar during the Great Depression; the ban was not lifted until the 1970s.

Bitcoin has also faced numerous regulatory issues, including whether Bitcoin and other cryptocurrencies should be treated as securities or commodities; how custodians should account for Bitcoin held on behalf of clients; and whether Bitcoin is deemed to be a “qualified investment” in registered accounts. Currently in Canada, Bitcoin cannot be held in registered accounts, although Bitcoin ETFs and mutual funds can.

Overall, the lack of a regulatory framework for cryptocurrency in many developed markets has created risks and uncertainties for investors.

Environmental risks

Bitcoin mining requires intensive computing power, which uses electricity and contributes to carbon emissions. This has created concerns about Bitcoin’s environmental impact. The University of Cambridge’s Bitcoin Electricity Consumption Index estimates Bitcoin’s peak annual electricity consumption at about 150 terawatt hours (TWh), compared to global electricity consumption of about 176,000 TWh. Based on these estimates, Bitcoin consumes about 0.1% of global electricity.9 Bitcoin is also less carbon-efficient than the traditional financial sector, which emits 27 times more carbon than the Bitcoin network but serves relatively more users.¹⁰

What is Bitcoin?

• Bitcoin, a digital token stored on the Bitcoin network or blockchain, enables users to send money and store wealth without having to use the banking system or other financial intermediaries.
• Bitcoin miners expend significant energy and computational power to mine Bitcoin, a process that remains difficult over time.
• Bitcoin is a scarce digital asset, something that has not existed before.

Investment benefits of Bitcoin

• Hedge against monetary and fiscal risks: Bitcoin has a low inflation rate and limited supply, in contrast to the open-ended issuance of debt and currency by governments.
• Hedge against geopolitical risks: Bitcoin has shown recent evidence of hedging geopolitical risks, although investors will likely need to see more evidence to determine if this role is robust over time.
• Diversification: Bitcoin’s performance has included periods of low or negative correlation to the S&P 500, combined with periods of high correlation during equity market declines.
• Performance: Over the last 10 years, Bitcoin’s annualized return has exceeded 50%.

Investment risks of Bitcoin

• Market risks: Bitcoin is several times more volatile than major stock markets and has experienced three crashes of over 75% in the last 10 years.
• Security risks: Bitcoin holders have to be vigilant about the risks of storing Bitcoin, affecting both individual wallets and cryptocurrency exchanges.
• Legal and regulatory risks: Bitcoin is subject to a wide range of legal and regulatory risks, including the risk of a ban by a major government and the lack of a regulatory framework for cryptocurrency in many countries.
• Environmental risks: Bitcoin consumes about 0.1% of global electricity and is less carbon-efficient than the traditional financial system.
• Technology risks: Key risks to Bitcoin’s blockchain technology include a network attack and quantum computing.

References

¹ The Bitcoin network becomes more secure as blocks are added. Imagine the network is at block 1 and thousands of blocks are added over time. To undo block 1 would require undoing block 2, which would require undoing block 3 and so forth. A blockchain is nothing more than blocks — batches of transactions or other data — linked in a chain to other blocks.

² Bitcoin’s current inflation rate is less than 1%. This is calculated as the annual newly-mined supply, relative to all Bitcoin currently in circulation. Refer to The bitcoin halving: What is it? And why does it matter? Opens a new window.

Canadian money supply and inflation based on historical data from 2000 to 2023

• Canadian money supply, M2 (gross, unadjusted): Refer to Selected monetary aggregates and their components (formerly E1) Opens a new window.
• Canadian inflation (Consumer Price Index): Refer to Inflation Calculator Opens a new window.

³ BlackRock white paper, Bitcoin: A Unique Diversifier, September 17, 2024. Analysis of S&P 500, gold and Bitcoin during major geopolitical events.

⁴ BlackRock white paper, as previous. Six-month trailing correlation of Bitcoin weekly returns to S&P 500, January 1, 2015 to July 31, 2024.

⁵ Bitcoin returns, U.S. dollars.

⁶ BlackRock, Bitcoin volatility guide: Trends and insights for investors, July 11, 2024 Opens a new window..

⁷ New York Times, Lost passwords lock millionaires out of their Bitcoin fortunes, January 12, 2021 Opens a new window..

⁸ Cryptocurrency exchange hacks: Refer to The Largest Cryptocurrency Hacks So Far Opens a new window.

⁹ Analysis of Bitcoin’s energy usage: Refer to Bitcoin’s Energy Usage Isn’t a Problem. Here’s Why Opens a new window..

¹⁰ Carbon usage from Lyn Alden, as previous. The traditional financial sector serves 76.2% of the global population over the age of 15, based on 2021 data from the World Bank. Refer to List of countries by share of population with access to financial services Opens a new window.

¹¹ Number of computers or nodes connected to the Bitcoin network: Refer to What is a Bitcoin node? A beginner’s guide on blockchain nodes Opens a new window.

¹² Risk of 51% network attack: Refer to 51% Attack: Definition, Who Is At Risk, Example, and Cost Opens a new window.