Goldman Sachs Report: Can Bitcoin Work as an Institutional Asset Class?

Gold” in the digital age.

While interest in cryptocurrencies has been on the rise among credible investors, cryptocurrency prices remain extremely volatile and traditional financial institutions, including us, have been launching new crypto products and services, with cryptocurrencies certainly at the forefront of people’s minds. We first covered Bitcoin in 2014 and covered cryptocurrencies more extensively in 2018, exploring the potential and risks of the crypto ecosystem.

In the midst of recent volatility, Goldman Sachs began looking at whether crypto assets could be considered an institutional asset class and interviewed several industry insiders, including Galaxy’s Michael Novogratz, NYU’s Nouriel Roubini, Grayscale’s Michael Sonnenshein and Goldman Sachs’ Mathew McDermott, in addition to Goldman Sachs’ exchanges with former SEC counsel Alan Cohen, Dan Guido of Trail of Bits and Michael Gronager of Chainalysis exploring regulatory, technical and security barriers to its further institutional adoption.

Michael Novogratz’s view is that “the number of institutions involved in cryptocurrencies has now reached a tipping point. From major banks to PayPal and Square, among others, participation is growing and the clear and unequivocal signal is that cryptocurrencies are now an official asset class.”

According to Michael Sonnenshein, CEO of Grayscale, institutional investors are now generally aware of digital assets, and investors are increasingly attracted to assets with scarcity like Bitcoin as a hedge against inflation and currency devaluation, diversifying their portfolios in pursuit of higher risk-adjusted returns. A faster and stronger rally in crypto assets in 2020 will only make investors more comfortable with them as a resilient asset class.

Zach Pandl, Co-Head of Global FX, Rates and Emerging Markets Strategy at Goldman Sachs, largely agrees that Bitcoin has the potential for widespread social adoption due to its strong brand advantages and other features such as security, privacy, transferability and the fact that it is digital, making it a valuable store of value for future generations.

Goldman Sachs commodities analyst Mikhail Sprogis and Jeff Currie, head of global commodities research, on the other hand, believe that cryptocurrencies can act as stores of value, but only if they have other practical uses, and they believe that ethereum has the greatest potential to become the primary digital store of value.

The NYU Stern economics professor, Nouriel Roubini, has a completely different view, and does not believe at all that something that has no income, utility or relationship to economic fundamentals can be considered a store of value, or arguably an asset. Despite the recent crypto mania, he remains skeptical of the willingness of most institutions to expose themselves to the volatility and risk of cryptocurrencies.

Mathew McDermott, Global Head of Digital Assets at Goldman Sachs, explains why Goldman Sachs is re-entering the cryptocurrency space in two words: client demand (different clients showing interest in cryptocurrencies); client type (from asset managers looking to diversify their portfolios to an increasing number of high net worth clients looking for more crypto use cases, to hedge funds looking to arbitrage by going long and short). short to arbitrage hedge funds), reflecting the fact that these clients still have difficulty accessing the market directly today. So Goldman Sachs intends to go out and make some products or services for these clients.

This report looks at the prospects for cryptocurrencies on the one hand, and some of the major obstacles to further institutional adoption of crypto assets on the other.

Crypto Assets: A Surge in Size

Goldman Sachs Report: Can Bitcoin Work as an Institutional Asset Class?

Strong year-to-date performance for bitcoin and ethereum

Other cryptocurrencies have seen more of a rally

Goldman Sachs Report: Can Bitcoin Work as an Institutional Asset Class?

Average Daily Volatility of Crypto and Other Assets Total Active Addresses in Bitcoin and Ether Networks Reach 2018 High

Goldman Sachs Report: Can Bitcoin Work as an Institutional Asset Class?

Bitcoin, Ether, Gold Market Cap

70% of bitcoin and 85% of ethereum are in profit

Tracking Bitcoin’s volatility
The following chart shows Bitcoin’s price volatility trajectory and key timeframes from 2013-2016 and 2017-2021.

Goldman Sachs Report: Can Bitcoin Work as an Institutional Asset Class?
Goldman Sachs Report: Can Bitcoin Work as an Institutional Asset Class?

Note: Market pricing as of May 19, 2021

Sources: CoinDesk, 99 Bitcoin, Bloomberg, various news sources, Goldman Sachs Global Risk Report.

The following highlights share the detailed views of one of them, Zach Pandl, Co-Head of Global FX, Rates, Emerging Markets Strategy at Goldman Sachs.

Bitcoin as a Macro Asset
Zach Pandl, Co-Head of Global FX, Rates, Emerging Markets Strategy at Goldman Sachs, believes that institutional investors should view bitcoin as a macro asset, similar to gold, going through a social adoption phase.

While bitcoin is now being adopted by a wider range of institutions, many sophisticated investors still struggle to understand why a digital asset should have any value at all – let alone a market size of more than $500 billion. And because of the parabolic price rise and high retail participation, many see the cryptocurrency phenomenon as a classic speculative mania or “bubble. Whether or not bitcoin will prove to be a good investment over time, this perspective is still too narrow. Bitcoin is a medium currency that is beginning to function – primarily as a “store of value”. Almost anything can serve this purpose as long as it gains widespread social adoption, and Bitcoin is making meaningful progress along this path.

The Need for a Store of Value

To understand Bitcoin, it’s best to start with gold. Gold plays a unique role in the global financial system. It is both a useful commodity and a “store of value” asset, similar to a currency. However, unlike traditional monetary mediums, it is not issued by governments, nor is it denominated in any commodity or asset trade. In fact, gold can be used as an alternative reserve currency instrument in adverse global situations when investors are unsure of the safety of traditional assets or fiat currencies (e.g. due to inflation or the risk of confiscation). In the foreign exchange market, gold behaves like an “inverse currency”: prices tend to fall when the fundamentals of major currencies improve, and tend to rise when the fundamentals of major currencies deteriorate. Over time, the most important driver of nominal exchange rates is the relative inflation rate between the two economies. Because gold has a quasi-fixed supply, its nominal value tends to rise in line with the inflation rate in the major markets. These correlation and store-of-value properties make gold a very useful diversifier in investment portfolios.

Initially, gold was likely to be used as a monetary medium due to its elemental properties. Gold and copper are the only metals that do not turn gray in their natural state, and they have fascinated humans since ancient times. Gold is also relatively dense, forgeable, and malleable, and unlike many other metals, it does not tarnish, rust, or corrode. These characteristics have cemented gold’s use as a monetary instrument throughout human history.

But the use of gold today has as much to do with inertia as it does with its physical properties. After all, the dollar is also a means of preserving value, and it is made of paper. Money, like language, is a social tool – it is closer to a concept than to a thing. Money is a social tool that facilitates commerce, just as language is a social tool that facilitates other aspects of our lives. Having a currency that is not issued by a sovereign government is useful to society. But the particular medium used for that purpose is to some extent arbitrary. Throughout history, a wide variety of items have served the purpose of money depending on the needs of location and time – as bitcoin enthusiasts and cryptocurrency historians like to point out. Classic examples include the tobacco-based monetary standards of the early American colonies and the frequent use of cell phone airtime as currency throughout Africa. Gold functions as money today primarily as a product of history, not because it is actually the best medium for meeting society’s need for a store of value.

Goldman Sachs Report: Can Bitcoin Work as an Institutional Asset Class?

Gold plays an important diversification role in investment portfolios

When inflation accelerated in the mid-20th century and investors sought ways to protect the real value of their assets, gold was the natural choice. At the time, the world’s major currencies were pegged to gold through the Bretton Woods gold exchange standard via the U.S. dollar, and prior to the Great Depression, most currencies, as well as most U.S. Treasury bonds, were backed directly by gold. The U.S. government provided the official price of gold in dollars, which changed only twice in the nearly two centuries between the 1890s and the 1970s. In the 1960s, under the gold exchange standard, gold traded above its official markup was the most obvious way to observe the pressure to devalue the dollar. In short, for much of the post-World War II era, there was a strong link between the price of gold, currency stability and the real value of money – making it an obvious inflation hedge for investment portfolios.

But the link between the dollar and the price of gold was severed 50 years ago when President Nixon ended the convertibility of the dollar with gold in August 1971. As a result, a generation of asset holders grew up in a world where there was no strong link between gold and cash. So, when the need for a store of value assets arises, will they go looking for something else?

In Public

This is where Bitcoin comes in. Any alternative medium needs to be secure, private, have a fixed or quasi-fixed supply, and be transferable, preferably outside of the traditional payment system. In our modern, globalized society, a large portion of social interaction and commerce happens online (especially among young people), so it may also need to be digital. But, most importantly, it needs to have the potential to be adopted by a wide range of societies – anything can be money, if it has it. Bitcoin is therefore a viable alternative value medium to gold and, due to its wider social adoption, is currently the best candidate among cryptocurrencies with a similar structure.

In a state of (economic) equilibrium, an unstable store of value like Bitcoin would not be very useful. But cryptocurrencies are still in their infancy; it’s best to think of today’s price as reflecting some probability that Bitcoin or other tokens may gain more adoption in the future, when their prices could be very high. As a result, small changes in those probabilities could cause today’s price to fluctuate significantly. Bitcoin investors speculate that it will eventually gain near-universal acceptance as a non-sovereign currency and reap high returns (and high volatility) in the process.

Goldman Sachs Report: Can Bitcoin Work as an Institutional Asset Class?

Today’s Bitcoin Price Reflects the Potential for Wider Adoption of Crypto Assets in the Future

the key ingredient to Bitcoin’s success – widespread social adoption – has now crossed a number of significant thresholds: Tesla, the sixth largest company in the S&P 500, has Bitcoin on its balance sheet; Brevan Howard, a prominent macro hedge fund, has begun investing in cryptocurrencies Coinbase is now listed on Nasdaq. And other blockchain networks, notably Ether, are developing decentralized banking platforms, Facebook is expected to launch its stablecoin Diem later this year, and many central banks are exploring distributed ledger technology for their own digital currencies. In the long run, Bitcoin’s success as a store of value remains an open question – its consumption of real resources over time could be a detriment – but for now, social adoption of cryptocurrencies appears to be moving forward.

Bitcoin as a Macro Asset

Bitcoin has also matured enough that its price behavior is similar to that of other macro assets. For example, the Federal Reserve said at its March 17 meeting that most policymakers do not expect to raise interest rates until after 2023 – later than financial markets expect. Macro assets reacted to the “dovish policy shock” in the traditional way: short-term Treasury yields fell, the yield curve steepened, the dollar fell and stock prices rose. Bitcoin rises, just like gold, but with about four times the volatility.

Goldman Sachs Report: Can Bitcoin Work as an Institutional Asset Class?

Bitcoin Moves Almost Identically to Gold on the Day of the Fed Meeting on March 17, 2021

This is how investors should approach bitcoin. Gold is a commodity that functions as a currency and behaves like one. Bitcoin is exactly the same, although it is a digital commodity created through cryptography rather than a physical commodity found in the earth’s crust. From a market perspective, the main difference between these two assets is that Bitcoin is going through a one-time social adoption phase – which may or may not succeed. When social adoption rises, bitcoin should offer higher returns compared to gold. When social adoption declines (due to unfavorable regulatory changes, for example), bitcoin may offer lower returns compared to gold. Due to the speculative nature of the asset class and the high degree of uncertainty in valuations, investors should be prepared for prices to outpace fundamentals in both directions. While bitcoin’s value has generally appreciated over time, there have been several waves of excessive speculation that have closely followed the selloff.

Technical issues aside, the current macroeconomic outlook appears to favor storing assets of value, whether physical or digital. The Fed has adopted a more ambitious labor market target of “broad and inclusive” full employment and appears to be more tolerant of above-target inflation than it has been recently. Our economists expect real cash yields in developed market economies to remain negative for the next few years. Stock market multiples are at historically high levels. Many developing countries will struggle to cope with the fiscal fallout from the COVID-19 crisis in the coming years. In this environment, demand for assets that protect purchasing power should remain high unless investors are able to find alternative sources of real returns.

Goldman Sachs Report: Can Bitcoin Work as an Institutional Asset Class?

March Core Inflation, Federal Funds Rate, Real Interest Rate Change

Posted by:CoinYuppie,Reprinted with attribution to:
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