What is Bitcoin and Why Does it Appeal to Investors?

Cryptocurrency is a term for digital or virtual currency that can be exchanged for goods and services. There are many types of cryptocurrencies, but the most popular type is bitcoin. At their core, bitcoin and other cryptocurrencies are sets of software protocols for generating digital tokens and for tracking transactions in a way that makes it hard to counterfeit or re-use tokens. Bitcoin, introduced in 2008, was designed as a digital version of cash that could operate outside the control of governments or central banks. Its software runs on a network of linked but independent computers, and that decentralized structure makes it ideal for moving money quickly and cheaply across borders.

The initial price of bitcoin, set in 2010, was less than 1 cent. It finished 2020 at $28,966, more than quadrupling over the year. Bitcoin’s rally beyond $35,000 kicks off 2021 on a high following above expectation institutional interest with banks and hedge funds now aggressively seeking to expand their bitcoin holdings.

These days, Bitcoin has drawn millions of dollars from certain hedge funds and companies like MicroStrategy and Square, while PayPal lets consumers use bitcoin to pay for goods and services. The largest U.S. cryptocurrency exchange, Coinbase Inc., plans to conduct an initial public offering in 2021. The recent price surge could reflect recognition by the financial community that so-called cryptocurrencies -- digital forms of money -- can be useful, and that bitcoin may fill the role of gold as a hedge against inflation.

Zero and negative yields for some traditional assets are driving more hedge funds and other companies to pour cash into bitcoin, which, despite being highly volatile, has appreciated substantially over the long term. While nay-sayers have long said that bitcoin’s value will drop to zero, many have recently had to revise their thinking -- simply because enough people seem to believe in bitcoin. “Making bitcoin a significant part of your portfolio would increase your risk substantially,” says Eswar Prasad, a trade-policy professor at Cornell University who is writing a book about digital currencies. “But a marginal amount seems worthwhile given recent dynamics.”

As a scarce resource, gold has traditionally been a hedge against inflation. Governments can speed up their treasuries’ printing presses and thereby debase their currencies, but gold miners theoretically cannot flood markets at the same rate. Part of bitcoin’s appeal lies in the fact that it is not controlled by governments or their monetary policies, and that its supply is limited even more strictly than gold. Bitcoin’s internal protocols help slow down the mining of new coins, and production will cease entirely at 21 million coins. With the vast spending by governments and central banks in response to the pandemic raising fears of inflation after economies recover, more attention is being paid to bitcoin as “digital gold,” even as inflation remains muted.

The total market value for bitcoin is just under $600 billion, far below the market cap of the biggest individual stocks, like Apple Inc., currently worth more than $2 trillion. It is also well below the total market value of the gold market, which was about $11.9 trillion at the end of 2019, according to the World Gold Council.

Investors who bought at least 1,000 bitcoins — worth roughly $23 million at the December 18, 2020 price — and have had an account open for less than a year drove significant demand since September, according to data firm Chainalysis. These accounts together bought half a million bitcoins, or $11.5 billion worth, in the past three months (as of December 18, 2020).

The new demand has helped fuel cryptocurrency’s rally to an all-time high, according to Philip Gradwell, chief economist at Chainalysis.

The surge in demand from wealthy Wall Street investors marks a sharp turn-around from bitcoin’s first run-up three years ago. The 2017 rally was largely driven by retail investors, many of whom bet on bitcoin and other smaller cryptocurrencies out of speculation. Bitcoin became a household name when it first neared $20,000 that year. It crashed soon after, losing 80% of its value in the following months.

Bitcoin crossed $23,000 for the first time ever in the third week of December 2020, and advanced more than 300% in 2020.

The price resurgence in 2020 in part has been fueled by well-known Wall Street billionaires publicly backing bitcoin. Analysts say that gave confidence to otherwise skeptical, mainstream investors.

Bitwise’s 10 Crypto Index Fund went live on December 10, 2020, making history as the first publicly traded crypto index fund in the US. 2020 was a big year for bitcoin’s retail and institutional investors. Companies like Coinbase and Fidelity cater to these groups respectively, but there’s a middle ground of wealth managers—people who manage the wealth of millions of Americans—waiting to be tapped into. Bitwise’s fund is designed to expose these millions of Americans to crypto via their investment portfolios. As of December 16, 2020, the company is already looking after $162 million worth of assets and trading volume is hovering at just under $100 million. Bitwise CIO Matthew Hougan has identified this wealth management space as an untapped, but major area of promise for the cryptocurrency space. “In the US it’s about a $15 trillion market, it’s a market that’s aggressively moving towards crypto at this very moment, and that’s what our products are designed to serve,” Hougan added.

Famed macro investor, Michael Novogratz, was an early adopter of the space, having founded his cryptocurrency firm, Galaxy Digital, prior to the last bitcoin peak. This time around, other heavy weights from the macro space, Stanley Druckenmiller and Paul Tudor Jones, have both invested in the cryptocurrency and highlighted its potential as a hedge against inflation. Alan Howard similarly emerged as a large backer of the asset class. Meanwhile, Square, MicroStrategy and Mass Mutual have used their own balance sheets to buy cryptocurrency. Square and PayPal have also added the ability for clients to buy bitcoin, which has opened up the market to millions of new buyers.

“We are seeing institutional capital flowing in at the fastest pace in the history of our business, and it is being deployed by some of the world’s largest institutions and some of the most famous investors,” Michael Sonnenshein, managing director at Grayscale Investments, told CNBC in a phone interview. Flows into Grayscale’s publicly traded Bitcoin Trust have increased roughly 6x from a year ago, he said.

Many institutional investors are using investment vehicles like Grayscale’s Bitcoin Trust as a means of buying into bitcoin. According to JPMorgan, more than $3 billion has flowed into the Grayscale Bitcoin Trust since mid-October while gold ETFs have bled $7 billion.

Another example is MassMutual, a stalwart of America’s insurance industry that is now embracing Bitcoin. “MassMutual was formed when Millard Fillmore was the President in the US in 1851, and now they own $100 million in Bitcoin,” Hougan said.

Guggenheim filed to reserve the right for 10% of its $5.3 billion Macro Opportunities Fund to invest in the Grayscale Bitcoin Trust. Meanwhile, a new bitcoin offering of Skybridge Capital now is up to $310mm in assets.

According to a recent article published in the Financial Times, institutional capital has now started to arrive in scale into bitcoin, and demand for bitcoin could soon outstrip supply.

Coindesk confirmed that UK-based asset manager Ruffer had accumulated some £550m of bitcoin since November 2020, representing some 2.7% of the firm’s AUM. Ruffer’s move is now being widely interpreted as the beginning of a major portfolio diversification trend into bitcoin. It seems institutional money can no longer afford to ignore it.

For a long time, institutional investment in bitcoin was hampered by strict investment mandates and regulatory compliance. Now that bitcoin has been formally recognized by many regulators, and regulated accordingly, this issue is far less of an obstacle than it used to be.

For some, government responses to the Covid-19 pandemic have provoked nightmarish imaginings of a future in which the world slips towards authoritarianism —and civil liberties cannot be taken for granted. For those of such bent, bitcoin’s anonymous security acts as a hedge against the worst of dystopian realities. It might be an extremely expensive and energy-intensive solution, but at least it provides a rationale for bitcoin’s existence.