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Gold, Game Theory, and Bitcoin

Debate continues to develop separating digital currency (crypto) from fiat money (central bank currency, i.e. dollars). Blockchain-based finance enabling immediate transfer and settlement in digital currency, on the one hand, seems inevitable as central bank-based currency deteriorates. Yet, central banks back fiat currency worldwide with substantial reserves of global agreed-upon value (within a certain range of convertibility).

Central bankers seem to be winning this argument. For example, Bitcoin has dropped over 50% in just a few weeks, and its ability to be a medium of exchange diminishes daily. China is cracking down on Bitcoin mining just as its central government wishes to issue its own digital currency backed by its central bank – perhaps a harbinger of many things to come in other developed large economies. Digital dollars in digital euros are already on the table.

As crypto (digital assets in general other than those backed by a central bank) swings wildly, there appears to be no serious collateral damage. Many more traditional bankers are dismissing crypto as a mere sideshow in the financial markets. But, this dismissive attitude is mistaken.

It’s a Focal Point, Not a Currency

Gold is built on a collective belief in its value. There is nothing fundamentally “inherent” in the price attributed to gold other than an agreed-upon value. The same is true with Bitcoin and other crypto. In fact, it’s fair to say that all asset prices are fundamentally based on the collective belief about value regardless of some perceived upon “inherent” value.

The pervasiveness of crypto as it exits a somewhat self-contained digital world and has institutional investor attention forming a basis for far-reaching financial transactions establishes it more as an economic force much more than a financial sideshow.

Game Theory contends that people act collectively if they believe others are doing the same. Essentially, the theory holds that many situations provide a clue, called a “focal point” around which people coordinate their actions, even if there is no explicit agreement to do so. As John Maynard Keynes has said, picking investments is much like guessing the winner of a beauty contest. It is not a matter of what you think, but it is predicting who most people think the winner should be. This is how markets move and it is based on a fundamental tenet of game theory.

The Bubble

Gold stands out as an illustrative example. The investment case for gold is best explained as coordination among cooperating parties. Gold has a value because, collectively, people agree that it does. Gold’s value is enhanced by its scarcity and longevity, but there is still nothing inherently valuable there if there is no collective agreement about that value. In other words, it is “a 6000-year bubble” that is unlikely to burst anytime soon. The collective belief about gold will not suddenly change.

Crypto, in general, and Bitcoin, in particular, are similar. While displaying ingenious technology (the two most popular crypto assets are Bitcoin with software nothing less than brilliant, and Ethereum, which may be both more clever and have a more compelling user case). While Bitcoin can be used in transactions, its notoriety and scarcity make it a natural “focal point.” Arguably, as with gold, there is a case to be made that crypto can be a powerful hedge against fiat money inflation, especially when the world’s central banks seem hell-bent on printing as much currency as possible regardless of potential hyperinflation effects. After all, that worked so well in Germany in 1921.

Simply because these consequences haven’t occurred, and may not occur in our modern global economy, it does not mean that hedging against this potential consequence doesn’t make sense.

Connections and Gyrations

As crypto’s volatility becomes increasingly extreme, it may have the appearance of being unconnected with the rest of finance. But this is misleading because a closer look shows a different trend emerging. Crypto pricing and gold valuations are already interacting.

Funds are flowing into ETFs that invest in gold, and are moving in and out of Bitcoin futures and ETF’s. Institutional investors are considering crypto, gold, and other investment options increasingly interchangeable. In fact, gold is being used as a hedge against crypto, and as crypto rises in value, funds are flowing into gold, and vice versa. In other words, financial interconnections are beginning and are knocking down walls to institutional investors who view crypto as a viable hedge, as well as a potential long-term valuable asset. Institutional investors are now combining a broader set of inflation hedges to include crypto, and are also becoming long-term asset holders.

Volatility will continue more intensely and more frequently for crypto assets, but other investment alternatives, as well. The overall distribution of digital assets and the ease with which they can be bought and sold will only exacerbate this. But that does not mean crypto is not becoming better established within the institutional world, and, as with any other more broadly distributed investment vehicle, becoming more stable and predictable.

How Much, Again?

That is not to say that the wild gyrations we have seen in crypto will matter less. In fact, a lot more money is involved in crypto – more than $2.5 trillion in market capitalization

as of May 2021 dropped to $1.5 trillion by the first week of June 2021. That massive loss is not insignificant, even though prices are edging back up. Perhaps most importantly, there may be a floor to crypto valuations at which there is more broad-based institutional acceptance. In any event, as the market capitalization of crypto approaches $2 trillion dollars again, it is an emerging asset class that cannot be ignored.

More to Come

Cryptocurrencies are not foundational institutional investments. They are still speculative assets subject to wild swings that are less connected to the broad financial markets and more interconnected with the whims of Twitter and Reddit silliness. But, increasingly, a focal point of belief is developing and signaling a shift to a broader appetite among investors and institutions. Beliefs matter.

Crypto may not be a 6000-year bubble, but game theory and institutional investor activity indicate it is not a temporary flash.