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Exploring Bitcoin As an Asset Class EXPLORING BITCOIN AS AN ASSET CLASS A THESIS Presented to The Faculty of the Department of Economics and Business The Colorado College In Partial Fulfillment of the Requirements for the Degree Bachelor of Arts By Martin Gaspar March, 2018 EXPLORING BITCOIN AS AN ASSET CLASS Martin Gaspar February, 2018 Economics Abstract Bitcoin, a digital currency created in 2009, has garnered significant attention over the last couple years for its outsized returns and its significant volatility. However, since it is such a relatively new and controversial asset, many investors remain tepid to invest in it for they do not know how to approach Bitcoin as an investment. I believe this is because investors are unfamiliar with Bitcoin’s unique characteristics and do not realize the extent that Bitcoin, and its markets, have matured since its inception. Consequently, I hypothesize that Bitcoin holds enough features to be considered a legitimate asset class. In this paper, I explore Bitcoin’s potential as an asset class through several established criteria for something to be considered an asset class. I examine how well Bitcoin’s characteristics fulfill those criteria by comparing it to other established asset classes and analyzing their correlations, volatility, and risk-adjusted returns, among other statistics. I find that Bitcoin fulfills most of the criteria for an asset class, but must further develop in some areas before it is appropriate for every kind of investor to invest in it. KEYWORDS: (Bitcoin, Asset Class, Investing) JEL CODES: (Code, Code, Code) ON MY HONOR, I HAVE NEITHER GIVEN NOR RECEIVED UNAUTHORIZED AID ON THIS THESIS Signature TABLE OF CONTENTS ABSTRACT ii 1 INTRODUCTION ……………………………………………………………… 1 2 AN OVERVIEW OF BITCOIN 2.1 History of Bitcoin ......................................................................................... 4 2.2 How Bitcoin Works ...................................................................................... 6 3 THEORY 3.1 Properties of Assets and Assets Classes ....................................................... 11 3.2 Bitcoin’s Properties as an Asset Class .......................................................... 14 3.3 Exploring Bitcoin with the Three Superclasses ............................................ 18 4 DATA & ANALYSIS 4.1 Diversification Benefits: Correlation ............................................................ 21 4.2 Portfolio Utility ............................................................................................. 28 4.2.1 Volatility ............................................................................................. 28 4.2.2 Returns ................................................................................................ 32 4.2.3 Sharpe & Sortino Ratios ..................................................................... 33 4.3 Liquidity ....................................................................................................... 34 4.4 Drivers of Value ........................................................................................... 35 4.5 Regulation ..................................................................................................... 37 4.5.1 Legality ............................................................................................... 37 4.5.2 Fair Markets ........................................................................................ 38 4.5.3 Investor Protections ............................................................................ 40 4.5.4 Hacking Risk ...................................................................................... 41 5 CONCLUSION …………………………………………………………………. 44 6 REFERENCES …………………………………………………………………. 49 7 TABLES & FIGURES ....………………………………………………………. 61 Introduction Infamous for its extreme volatility, Bitcoin, a peer-to-peer payment system as well as a digital currency, has gained significant attention in recent years as users and speculators have driven the price for one Bitcoin into the thousands of dollars.1 Introduced in 2008 by the mysterious Satoshi Nakamoto, Bitcoin was worth mere pennies when the first Bitcoin exchanges opened in 2010, according to news site CoinDesk’s Bitcoin Price Index (Nakamoto 2008). As recently as November 8th 2017, one Bitcoin was worth as much as $7,882 (Lee, 2017). In its earliest days, mostly payment professionals and libertarians took note of Bitcoin, seeing its potential for transforming digital payments and its benefits as a decentralized currency. With its price continuing to soar, investors are scrambling to understand the potential of the Bitcoin network and determine how much each Bitcoin could be worth. Despite the lucrative allure of Bitcoin, its shady history and complexity keep Bitcoin in a gray zone for investors. Those who believe it is the currency or payment system of the future have hurriedly invested in it. Larger players, such as institutional investors, have remained cautious of it, citing the risks of speculating on a volatile digital currency not backed by a government, noting that Bitcoin’s trading behavior is outside their investment guidelines (Acton & Kharpal, 2017). This could be in part because money managers are often reluctant to accept non-traditional assets as legitimate 1 It is important to note the distinction between in capitalization of Bitcoin. Uppercase Bitcoin refers to the payment system, network, or concept as a whole. Lowercase Bitcoin refers to individual Bitcoins as a unit of account. However, the two will be used interchangeably for the purposes of this paper. 1 (Kritzman, 1999). Yet with the market capitalization of Bitcoin now exceeding $100 billion, according to CoinDesk, Bitcoin is quickly growing too big for even its most outspoken skeptics to ignore (CoinDesk, 2017). According to the financial media, there are several barriers holding Bitcoin from going mainstream and accessing retail and institutional investors. Some of these barriers concern the limited ways to hedge Bitcoin, including the limited derivatives market for it. One recent development on this front is that the Chicago Mercantile Exchange (CME) and Chicago Board Options Exchange (CBOE) rolled out Bitcoin futures contracts in December 2017 (Urban & Russo, 2017). Another barrier is government scrutiny—many regulators are still unsure how to approach Bitcoin. In September 2017, China, one of the largest markets for Bitcoin in terms of exchange volume, banned cryptocurrency exchanges, effectively outlawing the sale of digital currencies such as Bitcoin, causing the price to plummet (Osipovich, 2017). Despite the dramatic move, the price of Bitcoin fell before recovering and has continued to reach all-time highs since then. Both of these recent developments suggest that Bitcoin may be here to stay despite such obstacles. These events are encouraging for the future of Bitcoin, and many believe it is only a matter of time before Bitcoin becomes accepted as a real asset class. When this occurs, Bitcoin will be within the investment guidelines of many money managers, who will begin to trade it alongside other established asset classes, such as equities and bonds. This would be a remarkable event, given the frequent skepticism Bitcoin has enjoyed since its inception. In this paper, I explore if Bitcoin can be considered a legitimate asset class. First, I will give a brief history of Bitcoin and describe how it works. Then, I will examine the 2 criteria required for something to be considered an asset class, and analyze the extent that Bitcoin matches those criteria. To test if Bitcoin fulfills those criteria, I will examine its correlation and risk-adjusted-returns with other asset classes. I will also compare its volatility to the volatility of other asset classes to get an idea of what level of risk- tolerance investors would require to be inclined to invest in Bitcoin. Moreover, I will review the number of Bitcoin transactions and Bitcoin users to see if they are driving Bitcoin’s value. I will also analyze Bitcoin’s liquidity and current regulatory state. Lastly, I will examine my results and conclude to what extent Bitcoin can be considered an asset class. If Bitcoin matches most of the criteria for an asset class, it is likely that institutional investors will soon begin to invest in it. This would grant Bitcoin significant legitimacy, and likely lead to greater adoption and lower volatility in the future. 3 An Overview of Bitcoin History of Bitcoin Bitcoin was invented by Satoshi Nakamoto, widely assumed to be a pseudonym, who released a white paper on it in 2008 (Nakamoto 2008). There are several indications that Nakamoto was inspired to create Bitcoin in response to the Great Recession that arose due to centralized institutions, such as banks (Antonopoulos, 2017). In 2009, Nakamoto helped release the first Bitcoin client and started mining the first ever Bitcoins (Popper, 2016). Over the next couple years, Satoshi became less and less involved in the project, and eventually stopped all communications with developers in 2011 (Antonopoulos, 2014). As a result, there still is much speculation about who Satoshi Nakamoto could be, and whether they are still alive today. It is important to note that despite creating the Bitcoin system, Satoshi does not control it. The Bitcoin network runs on open-source code, meaning that anyone can view the code and propose changes (Antonopoulos, 2014). Bitcoin began to garner significant media attention during the 2012-2013 financial crisis in Cyprus, when the price
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