Today, bitcoin is idiosyncratic to traditional financial markets. Unlike bonds, equity and property, bitcoin’s returns are uncorrelated with economic growth, inflation, or risk premia. Bitcoin is related to these variables insofar as unsound money makes sound money more attractive, but no observable correlation exists. As a result, it can be tricky to position bitcoin in a portfolio that allocates according to various economic and financial regimes. Wresting at this conclusion is a mistake, though. Bitcoin’s self-reinforcing network effects could imply that no stable equilibrium exists. The inability to neatly measure value relative to traditional financial markets cannot dictate obliviousness to this technological revolution. TLDR: You cannot pigeonhole bitcoin. Different asset allocation frameworks are required.
Adoption appears speculative but the foundation is fundamental
Since bitcoin is not driven by our measures of economic growth, inflation or risk premia, many assume that it is driven by speculation alone. That is partially true, but it is not the full truth. Bitcoin has fundamentals that drive usage, value, price, etc. The halving is a key component, which determines bitcoin’s monetary policy for the next 4 years. The reduction in inflation rate at the halving, pushes the price higher and sets off the adoption cycle. There is undeniably a speculative component to adoption cycles but, at its root, the cyclical shift is fundamentally driven. Additional network fundamentals include new addresses, hashing power, transaction volumes, nodes, etc.
Network effects create a reinforcing cycle of capital inflows
Bitcoin is maturing and adoption is growing, but this does not imply its idiosyncratic nature will disappear. As the network grows, the network itself becomes more valuable. Not just from a market capitalisation perspective. A bigger network implies more merchants, more users, more nodes, and more miner hashing power. This growth makes the network more powerful, secure, tradeable, and useful, which in-turn encourages new capital inflows.
A stable equilibrium could be unachievable because new capital begets new capital.
The adoption trend is unstable and non-linear
The combination of a powerful technology, human emotion, speculation, and the halving cycle implies that the adoption trajectory is non-linear. Digital scarcity is powerful and could drive a technological revolution equivalent to the printing press, steam engine or spinning wheel so a non-linear impact is unsurprising.
Peculiarly, bitcoin is liquid, listed on exchanges and tradeable 24/7 in all corners of the globe, which is unlike other technologies. Listed markets are powerful, exacerbating human emotion. At times people over-estimate the potential of bitcoin; at times greed fosters frenzied buying; and at times fear fosters frenzied selling of a technology some people did not fully understand.
Despite this volatility, over time, adoption continues. Unstable and with periods of regress, but the adoption trend is entrenched.
Is stability a pipedream?
With unstable adoption cycles, bitcoin may never hold clear correlations to traditional financial markets and economies. Bitcoin could continue to grow on the side, sucking in more capital. There will be more users, merchants, investors, and companies in the bitcoin economy. But the process may be too chaotic and unstable to observe clear relationships to the traditional economy. It may look like a speculative blur from the outside.
In bitcoin, bitcoin is fundamental
Relationships have emerged between bitcoin participants in their new economy – bitcoin fundamentals. We can observe these relationships through the network fundamentals I listed before.
Looking at the world from a bitcoin perspective, as a holder of the asset, investor in the ecosystem and proponent of its principles, bitcoin is fundamental. In this world view, traditional financial markets are idiosyncratic. Some would go as far as to call traditional financial markets, legacy financial markets.
As bitcoin adoption grows, the number of people looking at the world through the bitcoin lense grows. One day bitcoin will be fundamental and legacy financial markets will be idiosyncratic. It will not be a binary cross-over from one regime to the next. Some people, families, communities, and companies have already transitioned. Some have yet to transition, some are on the fence and some will leave this earth before taking the plunge. But the transition towards digital internet money is underway. The destination seems crazy now, but in hindsight it will seem obvious.
For specific asset allocation frameworks to overcome the challenge presented in this article, I recommend reading: