Foreword: You may not be aware — particularly if you live in the United States— but the global economy is now entering uncharted territory as negative interest rates become reality in Europe and elsewhere. Suddenly the financial media (sponsored in no small measure by global banks) are working overtime to ‘educate’ the masses as to why the practice of paying your bank to hold your cash makes perfect sense. (They conveniently forget to mention that they will immediately lend your money to other customers, but good luck getting negative rates as a borrower!) Amidst this insanity, I will attempt to explain whether it makes sense for both professional and retail investors to own Bitcoin and other digital assets as a hedge against the inevitable destructive force of negative interest rates. TL;DR: The answer is ‘yes, it does make sense!’ However, it’s important to understand the reasons why. For that, let’s continue… ============================= After trading it for the past six years, Bitcoin has become such a dominant theme in my life that I often forget how short that timeframe really is. In fact, Bitcoin and the broader cryptoasset class have only ever existed in an era of economic expansion. At some point we will reach an inflection point, and I believe that we are now approaching that at the pace of the proverbial fly against a Ferrari’s windshield. When the inevitable recession finally occurs, many of our current theories about Bitcoin’s durability and use-cases will — finally — be tested. Bitcoin’s unveiling in 2009, before the chaos of the previous year’s financial crisis had passed, coincided with the start of one of the longest sustained bull runs in modern history. This new class of crypto assets was designed to act as an inflation-proof store of value, with censorship-resistant features that would prevent central bankers and politicians from manipulating its supply and value to print their way to prosperity at the expense of savers. It is no coincidence that Bitcoin has experienced jaw-dropping gains in value, and captured the entire world’s attention, even as the political class has continued an unprecedented decade-long experiment to ‘stimulate’ the global economy through currency manipulation and capital controls. Yet despite their increasingly frantic efforts, inflation in the developed world has not only failed to materialize. In fact, we now find ourselves on the brink of broad-based deflation on a global scale, potentially surpassing levels not seen since the Arab oil embargoes of the 1970s. Rising BTC value is highly correlated with rapid growth in negative-yielding debt. Source: Bloomberg, T Rowe Price To be clear, I am not forecasting that deflation is imminent — least of all here in the United States. However, as a professional investor who has high conviction in Bitcoin’s viability as “digital gold”, that is to say as an inflation-resistant store of value, it is important to consider the implications of a deflationary environment for an asset class that has never experienced one. This is certainly true in light of the past few days, when Germany issued a negative-yielding 30-year Bund and the President of the United States declared the Chairman of the Federal Reserve an “enemy” for adopting an (allegedly) insufficiently dovish policy. What would be the impact of deflation on Bitcoin — which is, by nature, a deflationary asset? As perceived ‘risky’ assets, will demand for cryptoassets increase as investors move out on the risk curve in search of return? Are there other features of crypto assets that are of particular relevance? And, even though crypto was designed to be a global, borderless asset, will the market response be consistent globally? Thinking Linearly Within our fund, my partner and I are followers and disciples of Oaktree’s . As one of the greatest thinkers in the investment world, Marks is perhaps best known for his attempts to consider second- and even third-order consequences of external factors and policy decisions within his investment process. With that in mind, here are some of the truths that we consider to be self-evident in the emerging world of crypto: Howard Marks In a deflationary world, where dollar- or euro-denominated investors have no fear of inflation in their base currency, the case for holding assets like gold or Bitcoin will be reduced. Deflation reduces demand for inflation hedges. To what extent this will impact price is impossible to judge, especially when considered in combination with additional factors (see below). However, this will surely impact the thinking of institutional asset managers who control that now-famous ‘wall of money’ that crypto bulls are counting on to drive prices higher. 2. The flip side to this is that even in a deflationary environment, NIRP is going to convince many investors — perhaps foolishly — that the time is nigh to buy risk assets (e.g. junk bonds, WeWork IPO, cannabis stocks). However, Negative Interest Rate Policy (NIRP) increases demand for alternatives to cash. For those who view Bitcoin as a risk asset, and for those who view it as a hedge against inflation, the conclusion will be the same — it will be time to smash the ‘buy’ button. Coming soon to your local bank. Source: Reddit 3. Even though Bitcoin has emerged as 2019’s star performer in crypto, it is not the only potential beneficiary in an economic downturn. It seems equally clear that — that class of digital assets designed to maintain parity with a fiat currency or basket of fiat currencies — are also likely to gain enormous traction. Stablecoins stand to benefit. stablecoins There are dozens of stablecoin projects today, with a wide range of quality. That being said, we believe that certain high-quality stablecoins may trade above par on a sustained basis. If we had to pick two, our favorites are Trust Token’s TrueUSD [disclosure: I personally (not through my fund) invested in TT’s Coinlist offering last year] and Circle’s USDC.* Stablecoins will become coveted if (1) as is beginning to happen in Europe, banks charge you interest or fees to keep your money on deposit; and (2) your mattress does not strike you as a suitable storage mechanism for your hard-earned currency. In a world where banks bill you for storing your cash (only to lend it out at much more profitable rates), stablecoins offer a new alternative that could prove massively disruptive to the banks’ latest scheme via the ability to safely hold an appreciating currency without paying for the privilege. In this scenario, the utility of your local bank is limited to the security that it provides through an old-fashioned safe deposit box where you can store your hardware wallet. The irony and humor of this eventuality is thick. This may sound simplistic, but the fact remains that high-net-worth individuals would happily forego modest deposit insurance coverage (if it is even available) to avoid large fees and the prospect of a bail-in if things go south. The fiasco that greeted depositors of Cyprus banks in 2013 is a stark reminder that governments will not hesitate to confiscate the wealth of their constituents in a crisis — that is, if they can access it. 4. On the other hand, the majority of alt-coins — cryptocurrencies and the broader universe of digital assets beyond Bitcoin — will likely see a very different fate. In short, the most charitable thing we can say about alt-coins is that they face a challenging future . Most alt-coins are going to zero (there, we said it). as an investment We are not universally bearish, as there will undoubtedly be some winners. We expect at least one privacy-focused token — most likely Monero or ZCash — to perform well, and perhaps a handful of utility tokens that demonstrate utility and a compelling reason to hold them long term, rather than simply acquiring and rapidly disposing of them at the time of use. actual We also believe strongly that dApps — decentralized applications, or any application that runs on a peer-to-peer network, instead of a single server — will eventually thrive, however it less clear to us how many of them will ultimately require native tokens. In reality, most alt-coins owe their existence to Bitcoin’s success, and the era of ultra-low interest rates and asset price inflation that we have seen over the past decade. To paraphrase Warren Buffett — which we do sparingly, given his overtly negative opinion on crypto — a deflationary environment will be the ultimate opportunity to see who has been swimming naked after the tide goes out. For the many alternative cryptoassets that possess no intrinsic value or meaningful use case, that would unequivocally include their HODLers. Of course, for those of us who like to actively trade these assets, the impending train wreck will in itself be a great opportunity. 5. The momentum behind Central Bank Digital Currencies (CBDCs) is about to accelerate dramatically. Their use-case is obvious. They are an opportunity for governments to circumvent domestic commercial banks — which in many emerging and frontier economies are barely functional — and ‘helicopter-drop’ money directly into the hands of consumers. Centralized sovereign currencies are coming — mostly bad, but also good. Additionally, CBDCs can enable governments to further stimulate their economies by taking interest/fees on these holdings just like a commercial bank might do. If you think this sounds like a utopian outcome, you should consider just how much control these schemes will place in the hands of totalitarian governments like China’s. While the growth of CBDCs will require substantially more time to play out, and may ultimately reduce demand for stablecoins in the medium term, we believe that their market adoption will ultimately prove to be a huge positive for the cryptoasset class as they serve to introduce and acclimate the general public to digital assets. This view, of course, is broadly similar to that which has been recently articulated by many commentators on the merits of Facebook’s Libra cryptocurrency. Whether Facebook’s ethics-free approach to business is better for the market than heavy-handed central bank policy is another matter altogether. This movie could be the next ‘Reservoir Dogs’ (i.e. where all of the characters are villains)… Second-order effects In adopting a “Marks-ian” thought process, we surmise that there are a host of potentially even more significant second-order implications for cryptoassets if a deflationary environment comes to pass. 1. In our view, many Western, and in particular US-based, investors lack an appreciation of what life is like in emerging markets. The two of us have a combined total of over twenty years living and working in developing economies. Things that we in the US take for granted — a relatively stable currency, rule of law and cultural norms that limit the ability of banks or the government to engage in outright theft — are simply absent for the majority of people worldwide. Bitcoin demand will be driven from emerging markets — not the United States. Put simply, we believe it is no coincidence that Bitcoin’s most effective early evangelist was an Argentine, Wences Casares, and that leading crypto mining equipment manufacturers such as Bitfury and Bitmain were founded by individuals from the former Soviet Union and China. These individuals are all too familiar with places where the foundation for sustained freedom and prosperity did not exist. Why is this important? A deflationary spiral in the West may not translate to a deflationary spiral in emerging markets. In fact, it could trigger the opposite. Such a descent into deflation would almost certainly destroy Western consumer activity, particularly for discretionary imports from emerging markets, as the incentive to save suddenly presents itself. Emerging economies would rapidly tank, and their central banks would duly engage in vigorous bouts of money printing to attempt to prop up domestic demand. Dollar-denominated loans would become more difficult for emerging markets to service — a disaster for countries like Turkey and Mexico. A crisis of confidence would unfold with respect to their local currencies, and investors would race for the exits. Hyperinflation would almost certainly follow. Even if events do not play out precisely in this manner, the fragility of developing economies will be difficult to understate if global economic chaos ensues. Many of the IMF’s favorite debtors are simply one-trick export-oriented ponies with limited domestic demand drivers, and populations who have been burned more times than they can count. People with this life experience are VERY sensitive to economic changes and will take action immediately if they sense they are descending — once again — into an economic vortex. As for their response, well that’s fairly simple: . In the developing world, if you are an individual consumer or small- business owner, your ability to actually buy and hold dollars or euros on deposit is limited. And even if you could, you would be compelled to hold them in the same domestic banks that you don’t trust in the first place and that are getting crushed by the economic woes that you’re seeking to avoid. Don’t believe me? Talk to a Russian over thirty years of age, or a Cypriot over twenty. Good luck buying physical gold from your local jewelry shop; the lines out front will be nearly as long as those trying to withdraw funds from failed British bank Northern Rock in 2007. they will seek safe havens where they can find them I was working on a London trading floor in 2007 when Northern Rock went bust. I will never forget the panicked look on its depositors’ faces as they queued up to retrieve what they could. So then, what options will be available to anyone with an internet connection? And the obvious answer is: digital assets like Bitcoin. And while the notion of buying stablecoins in the developing world may make a lot of sense, our suspicion is that this concept may, bizarrely, seem too foreign to people for whom Bitcoin is at least a known commodity. Our bet: should deflation emerge throughout the West, the global economic crisis it produces will spark unprecedented buying demand for Bitcoin in the emerging world. 2. . While we believe strongly that Bitcoin, in the long-run, is the ultimate safe haven asset — a better form of gold — the fact remains that today it has a bifurcated identity in the minds of investors. Depending on your worldview, it is either: Bitcoin holds advantages for its fans and skeptics a. A highly volatile and risky asset that offers no utility other than as a tool for speculation. This is what we would characterize as the critics’ view (best known to readers of the Financial Times); or b. Digital Gold: An inflation proof store of value: what we consider the proponents’ view 3. . There is in fact a further third piece to the puzzle that is not necessarily inconsistent with either of the above but also is critical to Bitcoin’s identity as an investment: the relatively lower correlation, and in several instances a high negative correlation, when compared to other assets. Lower correlations offer distinct benefits for any well-managed portfolio The below chart tracks BTC’s performance relative to the S&P 500 on the days of the latter’s biggest moves in 2019 year-to-date: Source: Coinbase, FRED, Kosmos research There is no discernible pattern in BTC’s price action during a significant move in the S&P 500. This offers intrinsic appeal for anyone constructing a portfolio and seeking to optimize risk-adjusted returns. Money managers with professional experience stretching back to 2008’s global financial crisis remember all too well that supposedly uncorrelated traditional assets suddenly found their correlations trending rapidly higher as the bottom caved in. It is possible that Bitcoin may behave similarly during the next crisis, and offer little or even no diversification, however we would argue that to own at least a small relative position in Bitcoin is the ultimate asymmetric bet in this market; the cost of taking that bet is minimal, and the potential upside if it proves uncorrelated is significant. Therefore, these various elements of Bitcoin’s identity should be appealing to sophisticated investors, even amidst a deflationary environment. Conclusion In summary, it is not at all clear that a deflationary environment will necessarily eliminate institutional investor appetite for Bitcoin in the West and, in fact, second and third order effects in emerging markets may well generate a substantial aggregate increase in Bitcoin demand as people there seek readily available, liquid safe-havens. Moreover, while a worldwide economic meltdown is hardly something we’re rooting for, there are some potential salutary benefits for digital assets beyond strengthening Bitcoin, namely a clearing of the decks with respect to dubious altcoin projects that give the asset class a bad name together. An additional indirect benefit may also be the advent of government sponsored CBDCs that will ultimately introduce the widest possible audience to cryptoasset technology, and set the stage for long-term mass adoption. *As always, DYOR! (Do Your Own Research) ======================================= I work at Kosmos Capital Management , which actively trades the emergent class of digital assets. Follow me on Twitter @kvirgil ======================================= DISCLAIMER: Nothing in this column is intended as investment advice and you definitely should not interpret it as such. Don’t rely on my advice, or for that matter anyone else’s advice, when making investment decisions. Doing your own research is the key to success in any market. =======================================

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