Episode 13 – Cryptocurrency

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Hello, everybody. Thank you for tuning in to Market Perspectives, a Mercer Advisors podcast where we provide a data-driven, common sense perspective on the economy, on markets, and on investing. I’m John Walker, regional Vice President with Mercer Advisors, and I’m co-hosting today with Don Calcagni, Chief Investment Officer at Mercer Advisors. Don, thanks so much for joining me.

I’m looking forward to this. It’s going to be fun.

Today, we’re going to tackle Bitcoin, Bitcoin ETFs. And for context, the SEC recently approved new ETFs that were coming to market, and our first dose of Bitcoin ETFs hitting the broader investment landscape here. And of course, as you can imagine, we’re getting a lot of questions, Don, on whether folks should invest in Bitcoin and if this is something that should be a part of their overall portfolio strategy as a part of their financial plan. So our goal today is to give as balanced view as much as possible, but Don, I’m really excited to get your insight into this new emerging player in the market.

Maybe what would be helpful to start is take a step back a little bit, and maybe start by helping differentiate the difference between Bitcoin, digital assets, crypto assets, blockchain. There’s so much jargon and terminology in this space that is a little foreign to many folks. Could you help us start by really understanding what the difference is between some of these different types of investments?

Absolutely, John. And let’s begin with digital assets. That’s probably the easiest one to define. Digital assets is really just an umbrella term that refers to crypto assets, to stablecoins, any sort of tokens.

You might have heard of NFTs. Those are non-fungible tokens. Anything that is native to a blockchain. So it’s a very broad umbrella term.

John, I totally agree. There’s way too much jargon in this space.

We’re in the space, Don, and I have a hard time keeping track of all of the differentiating between some of these things. It’s in the news a lot, so it can get very, very confusing. And I don’t know that all the terms are always used properly by those in this space, so it’s really helpful to understand that. I’ll put it in air quotes. What about crypto, Don?

So crypto assets really refers to what we call digitally native assets that are issued using a blockchain. These are assets that utilize cryptography, peer-to-peer computer networks, and what we refer to as a public ledger. This is a digital ledger that the network uses to regulate, to limit, for example, the generation of new units, in this case, perhaps Bitcoin. That ledger is also used to verify transactions between two parties who perhaps are exchanging assets using this particular cryptocurrency. It’s really meant to be a secure record of ownership such that you do not have to rely on a third-party intermediary.

And one of the things we’ll discuss here, John, is that proponents of cryptocurrencies will argue that this is a good thing, the lack of an intermediary. We can explore the pros and cons perhaps to that argument, but that’s what crypto assets are. I do think it’s important that we define blockchain. Blockchain is the one common denominator that these assets have in common. And this term is thrown around a little bit haphazardly. And I would argue that many of the folks who are using this terminology don’t actually understand it. Blockchain is the technological backbone of this digital ecosystem.

So cryptocurrencies, tokens, they’re all utilizing a blockchain. A blockchain is a distributed database, meaning it doesn’t live in one place. It lives in the cloud on multiple computers. It’s distributed.

It’s shared amongst the nodes of the network. All the different computers that are on that network are really the record of the blockchain. That is the blockchain. So that’s the idea.

It is a database. A blockchain stores information in a digital format that is secure, and it is decentralized. Again, we’re going to come back to that argument as to whether or not this decentralization is a good thing or not.

But it is decentralized. This is really the core innovation of blockchain technology. In that, it supports the construction of this secure, trusted record that helps create trust among parties to a transaction without having to go through that third-party intermediary.

And as I’ve seen it explained, Don, the value that blockchain is supposed to provide is that security. It’s an enhanced security because of that decentralization. I’m excited to argue the pros and cons of that and really see if it delivers, but what about specifically how we started here with Bitcoin? Where does Bitcoin fit into all of this chain?

Bitcoin is the world’s leading and most widely adopted cryptocurrency. It’s mined. It’s stored. It’s transferred among participants on this decentralized peer-to-peer network via this public ledger that we call the blockchain.

So Bitcoin is not blockchain, and blockchain is not Bitcoin. Bitcoin utilizes a blockchain to govern the issuance of new units, to record transactions, and so on and so forth. But Bitcoin is by far the most popular cryptocurrency in existence today. And John, today there are more than 20,000 cryptocurrencies in existence.

So we have seen a staggering increase in the number of cryptocurrencies over the past decade.

That is a staggering number and tremendous growth in this space. But I think it’s really important to underscore whilst many people use the terms interchangeably, Bitcoin and blockchain are not synonyms for each other. Bitcoin is a cryptocurrency that leverages blockchain technology. They are not the same thing. There are countless other cryptocurrencies that also leverage blockchain technology in their existence as a part of how they operate.

Absolutely. I think the key innovation of the digital asset evolution over the past decade, John, is really this concept of the blockchain. And today, many financial institutions, many central banks around the world are already using blockchain technology to create, to enable more secure financial transactions for consumers. So it’s become widely adopted not just by Bitcoin and other cryptocurrencies, but by existing legacy financial institutions.

Yeah. And I think there’s a business case being made for how blockchain can be leveraged in far greater depth than it is currently. And so, Don, I guess that leads us to our next question that we get, which is how does one assess whether investing in Bitcoin is a good idea for you? Is there a business case to be made for leveraging crypto assets more broadly? How would you address that?

I think that’s one of the most important questions. Anytime you’re evaluating an investment, John, you have to understand what is the business case for this particular business. What specific problems does the business solve for consumers, to be very granular? Why exactly should we give up exchange, transfer our hard-earned US dollars for these units of a cryptocurrency? Why should we do that? And so I think the first argument, John, that I hear is that it’s highly secure. And we just spent some time discussing the security that the blockchain offers.

And I think there’s some legitimacy to that. We live in a world where digital security is absolutely paramount. And I do think that there is a strong claim to be made. I’m not an expert in coding or cybersecurity. From what I understand from consultants that we’ve worked with, the blockchain technology is a significant advancement in security.

Now, to be fair, I do think–

If we look at the other side of this argument for a moment, I think that claim is perhaps overstated. So, to be fair, if we actually look at the data, just in December, just last year, North Korean hackers stole about $3 billion over the past six years.

So through the end of December, if we look back six years, the North Koreans–

This is not the world’s most technologically advanced society. They have managed to steal $3 billion worth of cryptocurrencies over the past six years.

For context, Don, if we offer to the families that we work with, that we were interested in investing in ABC Bank, and it became apparent that ABC Bank had lost $3 billion to hackers over the last decade. I feel like there’d be some skepticism from those clients saying, maybe this is not the right fit for me. It’s important to look at both sides of this coin to say there are proponents who say this is incredibly secure, and then there’s real data that says, yes, and it is still not completely safe, like, anything. There has been very high-profile breakdowns in the encryption that have led to theft.

Exactly, John. Let me give you a few more data points. Since July of 2011, we have seen over 800 recorded thefts of Bitcoin totaling almost $50 billion US dollars worth of Bitcoin. So think about that over the past, let’s call it 12, 13 years, we have seen $50 billion worth of Bitcoin has been stolen. That represents about 6% of all bitcoins in existence. So let’s turn that on its head. If 6% of all US dollars were stolen, I think, to your point, that would give us a lot of pause with respect to investing our wealth in a given currency, given the level of theft that is so rampant.

And, John, to take it one step further, there’s no insurance for Bitcoin. Think of we have the Federal Deposit Insurance Corporation. Many custodians, like Schwab and Fidelity, they carry additional excess liability insurance policies to protect depositors accounts, to protect our IRAs, our 401-Ks, our investment accounts. We don’t have that with Bitcoin. And I think evidence of that is the failure, the collapse of the FTX crypto exchange in late 2022.

I think that’s really important to underscore, too. Many of the institutions that we’re familiar with, the banks that house our deposits, the custodians that we might use to manage our investments, there are protections in place for you as the consumer that don’t exist in this marketplace. And I know we’re not here to peddle fear, Don, but it really is important that we give a pretty candid assessment of this claim that there is greater security available here.

There could be, and there’s a good case to be made for that, but it’s right to be healthily skeptical a little bit. Part of that value that cryptocurrencies also provide, and I know we mentioned this earlier, is that this concept of being decentralized, that there’s no need for an intermediary. How do you assess that claim? What does that really mean for consumers?

First off, to argue that this is a good thing implies that centralization is a bad thing. And I think that’s an interesting argument. I think all of us would agree there are times when the government is perhaps too intrusive in our lives, whether that be when you’re doing a real estate transaction or something else. And so I’m not here to argue that the government should be increasingly involved in our lives. I would probably argue the opposite, but there are many times when having a central bank, for example, having an intermediary, is a good thing.

For example, when you purchase a piece of real estate, you typically will wire funds to an escrow account, a trusted intermediary that will hold on to those funds in trust until we go to settlement. So there are times when I would argue it’s a good thing. We want the central bank to manage the economy. We want the central bank to ensure that the monetary base is healthy and secure for all of us across the economy. So again, I’m not really sure that this is a feature of Bitcoin or any cryptocurrency that I think is a good thing.

I think this is probably a good thing for certainly groups that are involved in more nefarious activities, perhaps, and they want to escape the discerning eye of government and regulators. But I think for those of us who are buying real estate, and making significant transactions, and live our lives in a specific currency, that having some intermediaries and having government oversight, I would argue, I would think that’s actually a good thing.

And again, much like the security question, you can make a pretty compelling argument on both sides here for what it does. What about this claim that it’s a reliable store of value, unlike many of the currencies that we are familiar with? How do you assess that claim?

So, John, let’s evaluate this claim that it is a reliable store of value. Let’s just look at the US dollar. We know we’ve seen some inflation in the US dollar here over the past couple of years. We’ve all witnessed that.

So our dollars have been devalued a little bit over the past couple of years. But let’s look at Bitcoin. Bitcoin has been notoriously volatile. If we just look at what happened in Bitcoin between November of 2021 and November of 2022, Bitcoin lost 75% of its value in that 12-month period.

By any objective measure, John, that is not what it means to be a reliable store of value when the value of your bank account of your savings account goes down 75% in value, so you can’t make the claim, I don’t think, when you look at the actual real-world evidence, that Bitcoin by any measure is a reliable store of value.

Anything where through no control of your own in something that’s supposed to be a safe place to store your assets, that would either increase or decrease that significantly, it’s a pretty tough business case to make to say that’s a reliable store of value. But there are proponents of Bitcoin and crypto that say it has other value in the banking space beyond just that, that it helps those folks today who are maybe unbanked in the current economic landscape we’re in.

I think this is probably one of the stronger arguments. I’ve traveled extensively throughout the developing world, where financial institutions are less established and it is harder for the world’s poor to work with financial institutions. And so it’s harder for them to open accounts. It’s harder for them to transfer money back home to support loved ones. And so I think this is an interesting use case for crypto assets broadly.

For example, if you go to sub-Saharan Africa or if you go to Central America, everybody seems to have a smartphone. Despite their high expense, everybody seems to have a smartphone. And so what that means is these folks conceivably could have a digital wallet. They could actually own digital assets, they could own Bitcoin, and they could transact using Bitcoins and not have to open a financial account at a financial institution. So I think it’s an interesting argument.

It certainly is, but I will play devil’s advocate here and say, as someone who began his career in the financial services industry working in banks, there is a part of the banking industry that is also there to protect the consumer and to protect from illicit activities. And if I’m hearing you correctly, while it does increase access, there really is no regulatory environment to ensure that the management of this cryptocurrency is prohibiting some of those illicit activities. Is that a fair characterization?

I think it is. And I think this is one of the tragedies that impacts the world’s poor more than others, and that is they are easily taken advantage of by financial institutions, by more nefarious actors. And so, for example, let’s just say you have a digital wallet on your phone, and that’s where you hold your Bitcoin assets. What happens if you lose your phone? What happens if you lose your password to your digital wallet? What happens if, perhaps, you are forced to transfer those digital Bitcoin dollars to somebody else?

And so you’re right. I think not having that centralized government oversight, I do think, opens up the world’s poor to be a target for those who would look to abscond with their wealth.

That is a really tough pill to swallow when you talk about assessing this and its value. What about the other part of this accessibility, is that many proponents argue that it’s a more efficient form of payments, because it brings down transaction costs, or, to your point, it’s more available globally. How do you assess that claim that it’s more efficient as a vehicle for payment?

I hear this all the time. Candidly, I think this argument could not be more wrong. And the reason I say that, if you just look at what it costs to transfer your US dollars into Bitcoin or from Bitcoin into US dollars, John, you’re going to pay a pretty hefty transaction charge. Just this morning, I was looking at the fee grid to do that.

I personally do not own Bitcoin, but I was just curious what would the transaction charge be. It starts at 3%. Everywhere I was looking, it starts at 3%. That’s pretty significant.

To give up 3% of your wealth just to transfer it into a different currency is pretty significant.

To take it a step further, if you are a US citizen, and you own Bitcoin, and you decide to transfer that Bitcoin into US dollars, John, there’s another very significant transaction cost called a capital gains tax that you will have to pay to the Internal Revenue Service because that is a taxable transaction. There’s no tax, no capital gains tax when I simply use my US dollars.

Depending on your family’s tax situation, that could be pretty significant, that capital gain could be pretty significant, particularly if it’s added to the cumulative gains that you get through other investment vehicles, real estate, etc.

So to your point, that really does punch a pretty big hole in the idea that this is a more efficient form of payment. There’s significant cost that doesn’t exist using US currency as an example. So I think we’ve done a fairly good job of assessing what this is, how it works, and what potentially the pros and cons are of the cryptocurrency itself, of Bitcoin itself.

But given that context on when we get asked this question, because we get asked it all the time, how do you decide if cryptocurrency makes sense in your portfolio? How do you assess that? What should people be thinking about as they consider this as an option?

Let’s just assume for a moment that you’ve accepted this argument that cryptocurrencies are going to fundamentally transform how economic activity happens on planet Earth. Let’s just assume we accept that, OK? I think we just punched some holes in that, but let’s assume that argument has validity. If you’ve accepted that, then the next order of business is you need to decide which of the more than 20,000 cryptocurrencies in existence should you invest in. Would you just pick one, would you pick all of them, or somewhere in between? And what’s the investment rationale for that selection?

How do you decide, G, I want to invest in Bitcoin? Well, why not Ethereum? Very popular cryptocurrency called Ethereum. And there’s a zillion others, like I said.

So you have to first decide which cryptocurrency do you want to invest in. You then need to ask yourself–

Let’s just assume it’s Bitcoin, and you’ve said, “OK, I’m going to invest in Bitcoin.” You then need to ask yourself, OK, at what price should I invest in Bitcoin? This morning it’s trading at $43,000 for one Bitcoin. Is that price too high?

Is it too low? Is it priced just right?

This is one of the biggest challenges with digital assets, John, is there is no way that I know of that any financial experts know of to appropriately determine the price of crypto assets. Unlike, for example, McDonald’s. McDonald’s earns profits. It pays a dividend.

We know what McDonald’s market share is. We don’t have that information for Bitcoin. Bitcoin does not pay a dividend. You’re not going to earn 5% on your Bitcoin right now like you will if you were to buy short-term US Treasury bonds using your US dollars.

So it’s really hard to figure out what’s the right price. Is the price right? Nobody knows.

And I think that’s such a great point to illustrate here. You lead a significant team here at Mercer Advisors of analysts. And there’s globally thousands upon thousands of analysts in our industry that really look under the hood of companies. They analyze their earnings, they analyze what their projections are, they get quarterly reporting on what that looks like. They understand the debt structure of the company. And so many details that are publicly available for publicly traded companies to really understand is the value appropriate based on what we know.

And Bitcoin provides, from what I’m hearing you say, very little, if not any at all, to help us ascertain whether this is a good value or not.

Remember, it’s a decentralized cryptocurrency. There’s not even anybody to talk to, John. We don’t even know for sure who actually created Bitcoin. It just popped onto the scene 13, 14, 15 years ago.

So there’s no management team to assess. It’s not even clear at any one point who owns the majority of Bitcoins. We know who owns the majority of McDonald’s shares. This is all public information because the Securities and Exchange Commission requires that information be disclosed.

Again, part of the value of having some sort of centralized regulator to help ensure that we are getting high-quality information on something that we are considering investing in. We don’t have that with Bitcoin or any cryptocurrency for that matter.

And even if I take all of that and I say I still want to go forward. I’m still comfortable. I’ve made certain assumptions, and I am OK with this risk. How much of their portfolio should investors be thinking about when it comes to putting this into their overall portfolio allocation?

Yeah. John, and that’s one of the most important questions that most investors fail to ask themselves when they’re thinking about investing in any investment. You may like a particular company, you may like Bitcoin. It all comes back to what we call, how do you think about position sizing? How much of your portfolio would you allocate to it? And so let’s just look at Bitcoin as if it were a company, for example. All the bitcoins in existence today are worth about $800 billion.

In the S&P 500 index, it would rank just above Tesla. And so if you were to build a portfolio and you were to weight Bitcoin just as you would any other US stock in your portfolio, it means that you would probably have about 1.5%

of your portfolio in Bitcoin. But that’s if you only had a US-based portfolio. If you had a global portfolio, it would be about half of that. So let’s say 3/4 of 1% would be the appropriate amount that you would put in Bitcoin, if we were looking at Bitcoin as if it were a stock, a global stock, or a US stock.

And I think for those folks listening, Don, they might be shocked to think of it in that regard, or might say, “I think I have a fair bit more of that in my portfolio.” Less than 1% is likely not how many people are allocated today, but I think it is in part because it’s not viewed maybe in the same regard as other investments are through the lens that we view investments. So, Don, we share a lot around how Mercer Advisors approaches things, and how it’s predicated on a really cogent financial plan, and how we take our fiduciary oath to our clients incredibly seriously.

It is a commitment that we are going to put their interests before our own. So with that, as the lens that we’re viewing Bitcoin and other currencies, how do you and our investment team assess this as a part of a portfolio?

I think it’s important for our listeners to understand that as a fiduciary, we are trusted stewards of our clients wealth. And what that means is that we have a very, very high standard that all investments have to meet before we seriously consider including them in a portfolio. And one of the most foundational fiduciary requirements, John, for any investment, is to recommend only those investments where our clients have crystal clear, ironclad investor protections. You need to be able to enforce your claims of ownership in a court of law.

If you own stock in McDonald’s, if you own bonds issued by Ford Motor Company, you have a legal claim on the assets of those companies. With cryptocurrencies, it’s not clear that you have a legal claim on anything. Remember, it’s a decentralized network. We don’t even know who owns the majority of the Bitcoins in existence. So to me, that’s one of the most foundational requirements that cryptocurrencies fail to check that very basic box in terms of having legal rights, legal ownership to an underlying asset. Second, John, we just touched on this a few moments ago. It’s unclear to us whether Bitcoin is overpriced or underpriced.

We have no valuation framework. Bitcoin does not pay a dividend. It doesn’t pay an interest rate. It doesn’t earn revenue like McDonald’s, or Ford Motor Company, or any other company that we might consider owning. So without that information, John, without having clear investor protections, without having a clear framework that we can use to put a price on the asset, in our view, it doesn’t meet some of the most basic requirements for inclusion in a client’s portfolio. So for those reasons, we’re out.

Yeah, I’ve heard hope is not an investment strategy. Hoping that someone in the future will pay more for something that you own today isn’t really a plan. Right, Don? And that’s certainly not how we assess growth of the equities market. So I’m hearing lots of things that I just want to reiterate. It’s not really clear that investors actually own anything when they own cryptocurrency. There’s no tangible asset, unlike stocks, and bonds, and real estate.

There’s no delineated legal clear investor protections in place if you own this, and it’s really unclear how it’s valued. So bring it home for us, Don. What is the overall assessment of this as a place in your portfolio for us today at Mercer Advisors?

Yeah, and I think it’s important to communicate that we will continue to closely monitor the evolution of the crypto space. I think this is a really fascinating development. I personally am more interested in the blockchain technology and its different applications to other industries, perhaps medicine, in addition to finance. So we’re going to continue to monitor this particular space.

I think it’s important–

I say this to every member of our team, let’s keep an open mind on cryptocurrencies. And that includes Bitcoin. There may eventually be an argument where we can properly value Bitcoin.

Is it overpriced? Is it underpriced? We may in the future have investor protections that are put in place by the US Federal Reserve, or the Securities and Exchange Commission, or the US Treasury Department. We don’t have those today. So I think it’s important to keep an open mind. Look, the investment thesis that we have today, it could change, but, John, our thesis today is that Bitcoin and cryptocurrencies do not meet some of the most fundamental basic requirements that we have in order to ethically argue that it should be included in our client’s portfolios.

Well, there it is, Don. Should you have any questions, please feel free to reach out to your advisor here at Mercer Advisors. I’m John Walker with Don Calcagni. Thank you for listening, and we look forward to seeing you next time.

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