Bitcoin Institutional Investor Analysis

LedgerMan, LedgerStat Capital1

Opening Premise

History has shown that there is a 100% chance that FIAT money fails. It is just a matter of time. Some currencies last for a decade, some a couple of decades and still others such as the US dollar or the British pound have lasted multiple decades before losing most of their value. The fact is, all government issued currencies have failed over time. According to Austrian economic theory, money is a an economic good like any other. It’s marginal cost of production is zero and that is why it always fails. The issuers of FIAT money always print more of it in order to try and solve other problems other than just being money. Whether it is printed for social welfare, to pay for wars to bail out banks or to manage markets, we are currently witnessing government issuers of paper money attempting to solve more of the world’s problems with printed money. This inevitably leads to its failure. History has also shown that those that understand this concept and allocate a specific portion of their portfolio to gold and rebalance annually have benefited. Their portfolios have substantially increased returns with less risk. Since bitcoin was introduced a decade ago, it is inheriting the characteristics of hard/sound money with its fixed amount and increasing stock to flow ratio. With the recent drop in bitcoin price combined with its improvement in fundamentals, we believe an institutional investor is compelled to at least “’do the work” on bitcoin to determine if there is a possibility that bitcoin can become “digital gold” and perform the role that gold has performed for so many years as the “hard money” alternative to government-issued paper money. Even if the chance of success is small, a tiny allocation may still be warranted given its expected value. For example, a 20% chance of bitcoin taking a 10% market-share from gold over the next decade would be 20%*10%*$7.5 trillions = $150 billion market cap compared to its current $60 billion. There are plenty of markets and use cases for bitcoin that lead to much higher expected values, the most important point is that bitcoin actually has all of the characteristics necessary to be the best money the world

1 For more information visit www.ledgerstatcapital.com

Bitcoin Institutional Investor Analysis

has ever seen and the mere possibility of this happening demands that one must do the research and determine for yourself what the possibilities are.

It is our view, that Bitcoin is the most revolutionary technological development since the industrial revolution. The Bitcoin White Paper made the term “digital scarcity” a reality and thus made it possible to have such thing as digital money. This development will continue to revolutionize monetary economics. If our analysis is correct, Bitcoin could become the most widely used form of “money” and it has the potential to become the numeraire in monetary economics. That is, the standard by which all other money is valued. This is a large claim but, it is a very real claim because Bitcoin, due to its fixed supply of 21 million units and strict monetary policy of issuance, has already become the hardest form of money ever invented by mankind2. History shows that mankind has always sought to place its excess capital or savings in the hardest form of money, or where it will be treated best. This is a fundamental human trait, and is captured in Gresham’s Law which states that “bad money drives out good”. Or said another way, people will spend money that they believe is depreciating and will save or hoard money that they believe is increasing in value. As a superior form of money (in terms of its characteristics) we believe Bitcoin will increase in value for years to come.

Bitcoin is already on the path of evolving from an internet collectible to a Store of Value. If that is true. You can’t afford not to do the work. The Bitcoin Standard, by Saifedean Ammous is a great place to begin to learn about bitcoin, however Saifedean spends the first 8 of 13 chapters talking about money, what it is and society’s need for hard money. He approaches bitcoin from an Austrian perspective and concludes that for a society to advance, it needs hard money and that bitcoin is the hardest form of money the world has ever seen. If this is true, and because there is a non-zero chance that bitcoin succeeds, an individual can’t afford to say it is “too tough” or “I’ll pass on this”. If a better form of money comes along, the old money dies and the impact on those holding onto the old money are financial

2 Credit for this observation goes to Saifedean Ammous, author of The Bitcoin Standard: The Decentralized Alternative to Central Banking. 2018. New Jersey, John Wiley & Sons.

ruin. Conversely, the early adopters have the opportunity to be rewarded for their willingness to do the work.

“Bitcoin is not a currency for a government; it is a global currency for the people.” Wences Casares

A Brief History of Money

The history of money does not begin, a mere five-thousand years ago with the introduction of gold in place of barter. I credit Nick Szabo in his article Shelling Out as introducing me to the notion of money as speech and that anthropological studies show carvings going back one hundred thousand years communicating value amongst each other through ledgers. Over time those ledgers which were meant to keep track of who owes what to whom evolved into easier forms of exchange. Approximately fifty-thousand years ago, depending on your location in the world, man used beads/shells/glass/rai stones to pass/keep/store the ledger amongst their particular tribe. At its core, money remained a ledger and the entries upon that ledger were secured by scarcity of the item securing that slot. The most important characteristic of money is obviously scarcity, without scarcity, anyone can print more slots on the ledger which would be ruinous for that money and for that society (just look at our own society post 2008 bail-outs). Other features became important within the society for trading, for milestone events like birth, marriage and for generational transfers. This ability to communicate more effectively has adapted over time. Eventually, it appears as though about five thousand years ago gold/silver emerged as a means to communicate value between tribes and among nation states.

Characteristics of Money

Source: Vijay Boyapati. Medium.com

These precious metals served the purpose of being both universally recognizable and scarce. The metals were also durable, portable and divisible which helped hasten their ultimate acceptance. However, about 500 years ago, money needed to be more easily divisible and portable so a market developed for warehouse receipts and other forms of institutional issued paper that was backed by a claim on real physical gold. This second layer on top of gold was not perfect. There were times when the issuer printed more claims than actual gold and there were collapses, but these paper notes had incredibly useful features that the market decided were worth that risk. Most countries had their own currencies that were backed by gold. These gold-backed paper notes served as money until about 19143. Below is the history of FIAT currencies since that time period. It is one of complete failure relative to gold.

3 The Bitcoin Standard, Saifedean Ammous

Just as in the past, when society’s need to communicate value more effectively was met with a new form of money, similarly, I believe that the central banks and governments which control our present fiat monetary system are notorious for distorting the ledger or otherwise “print money” in order to serve other purposes other than as a Store of Value. These other uses become enormous and cumbersome and eventually crash the system as we witnessed in the epic failure of the financial system in 2008. Subsequently, the monetary experimentations have become more dangerous and widespread. Fortunately, there is another experiment that was started at the same time that is now 10 years old called bitcoin. It is a harder form of money with a higher stock to flow ratio than even gold. In addition to scarcity, bitcoin is better than gold in most of the remaining features.4 It also offers that it is censorship resistant. It is my expectation that privacy, fungibility

4 The Bitcoin Standard, Saifedeane Ammous

and ease of use will improve with time. This brings us to the Store of Value. When people choose not to spend or consume and thereby save money they want their savings to be in a form that will hold its value over time. This is where the present-day case for Gold and Bitcoin is very interesting. As we all know Government issued money is continually being diluted and thus loses value or purchasing power over time. It appears as though the bubble in all asset prices is a direct result of savers being forced out of dollars and into other forms of speculation in order to store value. Historically, when thinking about savings people have had a choice about what form of monetary good to hold. The two classical choices have been fiat currencies and gold. Bitcoin adds a third choice. A digitally scarce asset that is a superior form of money.

There are no guarantees that this will not fail, but there is certainly a Lindy effect that is at play here, and after ten years of success, the network is growing and getting stronger and with each passing day that it survives, the probability of its success actually improves.

Background and Philosophy

Bitcoin is an advanced protocol which allows value to be securely transferred over the internet on a peer to peer basis with no need for a trusted third party. Bitcoin is money for the internet. This completely global currency is available to anyone at any time.

“Bitcoin’s monetary policy is a simple mathematical formula that limits its ultimate supply to 21 million units, bestowing the characteristic of scarcity upon each bitcoin.”

Every Bitcoin transaction is verified by the bitcoin miners and recorded on a distributed ledger which is recorded by approximately 12,000 nodes. This decentralized, peer to peer digital ledger is an immutable account of every transaction that has ever occurred in Bitcoin. This creates a “truth machine” that has been operating successfully for the past ten years with no violations to its ledger. It is a breakthrough technological leap that has the potential to revolutionize monetary economics. The advancement that Bitcoin provides is that it solved the Byzantine General’s Problem through proof of work and in doing so solved the double spend problem. This breakthrough protocol was combined with other innovations such as distributed digital ledgers, blockchain technology, economic incentives and mathematically assured scarcity to create an immutable method of transferring digital credits and debits. Launched in 2009, the Bitcoin network is now distributed worldwide and the blockchain record of all Bitcoin transactions since inception is contained on more than 12,000 digital servers. For over ten years, millions of individuals have used Bitcoin to transfer value and the blockchain now contains over 400 million transactions and has not been hacked or compromised. The number of Bitcoin users and “use cases” has grown steadily and there are now over 30 million Bitcoin wallets worldwide. There is a strong trend of adoption and use as demonstrated by the fact that the number or wallets increased by 89% last year.

There are several important features of Bitcoin which make it unique. First, it is decentralized and peer to peer. There is no need for a middleman. No other

monetary system has this feature. Huge sums can be transferred privately, directly between parties without a bank or brokerage firm. Second, and most important, it is “hard money”. Because the maximum number of Bitcoin that can ever be created is 21 million there is a natural deflationary characteristic to using Bitcoin as money.

“Unlike fiat currency which can be printed and distributed to infinity there will never be more than 21 million Bitcoins.”

This scarcity makes Bitcoin a very attractive currency for long term savings or as a store of value. In this respect it has been compared to gold and its adopters often refer to it as “digital gold”.

The development of Bitcoin reminds us of the development of the internet. A large part of its value will be derived from the “network effect” described in Metcalf’s Law. The internet and Bitcoin become exponentially more useful and valuable with each incremental user.

“Bitcoin is the native money of the internet. Its current and most important use case is as a Store of Value.”

The Lightning Network and other second layer protocols will continue to evolve and allow for better payment solutions which will further increase adoption as a Medium of Exchange.

In our opinion, the investment case for Bitcoin is compelling. First, its recognition as the first and most secure digitally scarce asset will continue to be adopted as a Store of Value as more and more individuals, family offices, and financial institutions embrace the monetary characteristics of Bitcoin. Presently there are over $700 trillion of financial assets in the world. The current market value of all the Bitcoin in existence is less than $80 Billion (price $4,000). If even a small fraction of that $700 Trillion decides to diversify into Bitcoin to take advantage of its unique characteristics, its value will multiply many times. In the meantime, the infrastructure is being built to develop it as a medium of exchange. With over $4 trillion dollars traded daily in the foreign exchange currency markets and $14 trillion dollars traded in the asset markets this adoption promises to be an enormous opportunity. Over time, its mathematically assured scarcity and

immutable ledger system will be looked upon as a global asset that all other assets can be easily and uniformly priced against, a Global Unit of Account.

Nearly every other form of “money” that has been used by mankind has been subject to dilution or an increase in supply. Because the supply of Bitcoin is limited it has been compared to gold, and some even call it “digital gold”. However, this is not a correct comparison because Bitcoin is in fact even harder than gold. It is harder in two ways. First, there are a limited number of Bitcoins. There is not a limited supply of gold. We still mine gold and the supply of above ground gold is always increasing. An interesting feature of bitcoin is that as bitcoin becomes more valuable, there is a greater incentive to mine bitcoin. In this case mining bitcoin cannot create any additional supply but merely allows miners to commit more resources to the network that makes the ledger more secure. So, the higher the bitcoin price, the greater the incentive to secure the network.5

There are risks to bitcoin

Bitcoin is a new system. It is built by humans using computer technology and therefore it cannot be considered entirely risk free. What are the risks? In our opinion there are two principal risks. The first is private key theft. Remember that in the Bitcoin network, transactions cannot be reversed. Bitcoin is like a “bearer bond” and if you have the private key to an address you control that bond. If someone gets your private key they can steal your Bitcoin. It is a real risk and it has happened. Unless you hold your Bitcoin securely in what is called “cold storage” you are at risk of key theft. Even in cold storage there is some risk. If you lose the Private Key to your Bitcoin then those coins are lost forever. The security and custody issues surrounding holding Bitcoin as an investment might be considered one of the larger risks. LedgerStat Capital has developed systems to minimize and eliminate these risks. It is these custody-related risks that are the cause of most recent delay in institutional adoption of bitcoin

The second risk is the risk in the code and the network. The Bitcoin network has been operating for ten years and there are over 30 million wallets in existence.

5 The Bitcoin Standard, Saifedean Ammous

The Bitcoin blockchain contains over 400 million transactions since inception and every 10 minutes or so a new block is created. The network has never crashed or been inoperable. At busy times the transaction speed will slow down and transaction fees will increase, but the network has never stopped working. There are hundreds of Bitcoin core developers working on the network to grow it and to add functionality. In the early going Bitcoin was an experiment. Because it has operated for so long without trouble we believe that the risk of a network problem is low, but it is not zero. Bitcoin may still fail.

Adoption and Value

Like any other economic good that is traded in multiple marketplaces the price of Bitcoin is constantly fluctuating and is driven by supply and demand. Presently (November, 2018) there are 17,084,662 Bitcoin in existence and at a price of $4,000 per coin the entire supply is valued at $80 Billion. In a recent 24- hour period $3.8 Billion of value was traded, or roughly 5% of the supply.

There is little doubt that growth in the value of each Bitcoin will be driven by more and more people concluding that Bitcoin is a form of savings that they want to hold. When Bitcoin first launched in 2009 only technology geeks and very early adopters were willing to pay cash for a Bitcoin. However, as the word spread and more people became involved the demand for each Bitcoin increased. More Bitcoin brokerages opened up and additional Bitcoin wallets were opened. Initially the growth in users and growth in price was modest. As the schedule below shows, 2017 was a break out year for Bitcoin awareness and the Bitcoin price.

Bitcoin Average Monthly Price 2016 – 2018

Behind the price appreciation is more people worldwide deciding to purchase or hold Bitcoin. To do so you need a Bitcoin wallet or a Bitcoin brokerage account. The schedule below shows the consistent wallet growth which has taken place since 2012.

Also, keep in mind that each Bitcoin wallet address may represent more than one person. The schedule above shows that in early 2018 there are roughly 30 million Bitcoin addresses worldwide. So, herein lies the interesting investment thesis. We have a new form of money. It has characteristics that make it superior to other forms of money (to be fair it also has risks compared to other forms). It has been consistently adopted and has been working for ten years. Only a small portion of the world has purchased any of this money. However, there has been consistent adoption over the past few years. In our experience an economic trend in motion tends to persist, unless something catastrophic interrupts it.

If more and more of the world’s capital or money migrates toward Bitcoin as a vehicle for storage of wealth and savings, there is only one conclusion that we can reasonably draw about the future price of Bitcoin. It will be higher. Perhaps materially higher.

Ownership and Future Value

In our opinion we are still in the very early stages of Bitcoin adoption. Less than 1% of the people in the world own Bitcoin, however ownership is growing rapidly. We are reminded of the adoption of the internet in 1994 and the rapid growth that followed. The area is still confusing, the brokerages do not work very well, there is a lot of bad information and there is a lot of hype. But, beneath all of this there is a sound technology which provides genuine advantages over the existing system. In his seminal book, The Bitcoin Standard, Saifedean Ammous talks about how gun powder changed the nature of warfare. Axes arrows and spears were just not as effective once gun powder was discovered. Although adoption took time and as late as WW I there were still bayonet charges. We see a parallel here. To our way of seeing it Bitcoin is a very superior Store of Value money. It cannot be printed or corrupted by governments. This is a HUGE benefit. It is also completely private which has very important implications. As more and more people come to see and appreciate the benefits, the demand for Bitcoin will increase. We do not know how fast the process will occur or how long it will take. But, we can envision a future where Bitcoin is a very meaningful portion of the savings base of the world.

Some people look at Bitcoin’s current price of roughly $4,000 and think they have missed the upside. They look at the people who bought at $300 or $1,000 and

think they are too late. We strongly disagree. We think that in the future people will marvel at those who bought at $4,000. We find it interesting how few people hold meaningful balances of Bitcoin. Here are some statistics which show what we mean:

Bitcoin addresses worth over $10 million: 1,780

Bitcoin addresses worth over $ 1 million: 8,761

Bitcoin addresses worth over $100,000: 155,011

Bitcoin addresses worth over $10,000: 729,013

Bitcoin addresses worth over $1,000: 2,410,332

Bitcoin addresses worth over $100: 6,491,881

Bitcoin addresses worth over $10: 16,478,292

In the context of a world that has 15,000 billionaires and 25 million millionaires there are not many people who hold meaningful positions in Bitcoin. If wealthy people come to believe that Bitcoin is a good investment then these numbers will grow significantly, and with a fixed supply the price will have to adjust upward. Bitcoin is a new monetary good. It is also an investment. We believe that it will hold its value because the supply is limited. It would take a sustained decrease in demand for it to lose long term value. Given the trends that are in place we think this is unlikely. Because of the adoption curve and the substitution affect we think there is enormous upside in the price of Bitcoin. As more and more people recognize its unique properties and purchase some its price will increase.

Market Value of Bitcoin

As we said, Bitcoin is a monetary good and an investment. The total market value of Bitcoin today is $80 Billion. Let’s put this in the context of other investments and forms of money. Presently the worldwide market for gold is $8 Trillion. If the Bitcoin market were to grow to be the size of the gold market the value of each Bitcoin would be $380,000 per coin. Worldwide there is $30 Trillion of currency in circulation. Worldwide the stock markets are $75 Trillion in value. The worldwide

bond markets hold $120 Trillion in value. The worldwide money supply is $80 Trillion. It is impossible to know if Bitcoin will become ubiquitous or will be a specialized niche form of money. It seems unlikely to us that is disappears. Even if it only plays a niche role its value will be much higher than today’s price. If it becomes widely adopted we have seen serious analysts who estimate that one Bitcoin could be worth as much as $1 million. If it were to become the true form of base money it could be worth as much as $10 million per coin using today’s money supply figures.

We have no idea how this will unfold and what the end point will be. However, we do know that the trend is

s in our favor, this form of money represents a breakthrough and an improvement over other forms of money, and that it is highly likely that it will be more valuable as the years roll by.

By our estimation the upside optionality is so great that only mistake an investor can make is to have an allocation of zero. The downside is 1x your investment (only likely if the network implodes) and the upside is between 10 and 100 times your investment. Investments with a proven trend of momentum and an upside skew that looks like this are very rare and hard to find.

Bitcoin as a “digital asset” class

6 Morgan Creek

Summary

History has shown that fiat currencies fail 100% of the time. Portfolios that reflect that risk by owning a portion in gold, and more recently bitcoin have dramaticly improved their returns while reducing the riskiness of their portfolios. Now is a great time to buy gold and at least do the research on bitcoin because gold has never been cheaper relative to financial assets and bitcoin is down over 80% from its highs. The fundamentals keep strengthening, institutions will have custody solutions from Fidelity, and global utility and growth continues.