In 2008, in the middle of the global financial crisis, Satoshi Nakamoto published a white paper describing the bitcoin protocol. The bitcoin blockchain then came into existence on January 3, 2009 when Nakamoto created the genesis block — the first block of the blockchain. All subsequent blocks contain data from the previous block as an input, thus forming an unbroken chain representing all transactions that have occurred in the past.
The genesis block, having no previous block, instead contained this line of text:
The Times 03/Jan/2009 Chancellor on brink of second bailout for banks
This line of text refers to an article published by The Times, the newspaper of record for the United Kingdom, and hints that Nakamoto’s motivation behind creating bitcoin was due to the fallout from the financial crisis.
The financial crisis highlighted the major flaw in our current system of fiat currencies — it’s all based on trust. Central banks must be trusted to respond prudently to macroeconomic conditions and not debase the currency. Policymakers must be trusted to be fiscally responsible and maintain the creditworthiness of the government’s sovereign bonds. Banks and other financial institutions must be trusted to lend responsibly and not take unnecessary risks. Bitcoin addresses this flaw by eliminating the need for centralized institutions and the need for trust — instead, everything is based on cryptographic proof.
Bitcoin is still evolving rapidly and market participants aren’t quite sure yet whether bitcoin’s primary utility derives from its properties as a currency that facilitates low cost, secure, and anonymous transactions without a centralized institution or if its utility derives from its properties as a safe haven asset. This post is interested in examining the second possibility: bitcoin as a safe haven asset and how effective it is as a hedge against tail risk, financial instability, banking crises, currency devaluation, hyperinflation, and geopolitical events.
In my previous post, I argued that bitcoin deserves a place in a passively-managed, long-only portfolio because it is uncorrelated with all major asset classes. In this post, I examine bitcoin’s response to several macroeconomic and geopolitical events.
Bitcoin’s Response to Cypriot Banking Crisis
On March 16, 2013, Cypriot policymakers announced a plan to solve the country’s banking crisis which involved confiscating a small percentage of ordinary citizens’s deposits to bailout banks and implementing strict capital controls. Ordinary citizens were faced with the possibility of losing 6.75 percent or more of their deposits.
The following Monday, bitcoin rose from $45 to $55 on speculation that forced haircuts and capital controls could be considered in the bailout plans for other countries within the European Union. During this time, the eurozone was still in the midst of dealing with the region’s debt crisis with many countries trading with high credit default spreads and high interest rates on their sovereign bonds. Strong demand for bitcoin was seen from countries most directly linked to Cyprus, including Greece and Spain.
Below, I plot the price of bitcoin, price of gold using the ETF GLD, U.S. equities using the ETF SPY, and the U.S. 10-year bond yield. In response to the Cypriot banking crisis, there was a classic flight-to-safety where investors sell higher risk assets like equities and buy safer assets like gold and U.S. treasuries.
In this case, bitcoin also rose in concert with gold and U.S. treasuries. This is not surprising since if policymakers are thinking about confiscating your bank deposits, it makes sense to try to hide your cash somehow. But this incident represents one of the first times that investors began to see bitcoin as a safe haven asset. Previously, bitcoin was seen more as a novel way to facilitate trust-less transactions.
Bitcoin’s Response to Greek Default Fears
On June 27, 2015, the Greek debt crisis escalated as policymakers withdrew from bank bailout negotiations. Soon afterwards, Greece temporarily shut down its banks and implemented strict capital controls in an effort to contain the crisis.
When financial markets opened again on Monday, June 29, bitcoin rose along with other safe haven assets while equities declined. Bitcoin continued with a strong rally afterwards (although gold didn’t) and there was strong anecdotal evidence that the rally was fueled by Greek citizens interested in protecting their assets.
The escalation of the crisis continued for several weeks as progress in bailout talks was limited but was finally resolved on July 13 with an agreement on another bailout program. This coincides with the sharp rally and decline in bitcoin prices at the time, demonstrating bitcoin’s ability to serve as an effective hedge against financial crises, even in a localized market. Interestingly, gold did not rise during this time.
Bitcoin’s Response to Brexit
On June 23, the United Kingdom held a referendum on the United Kingdom’s membership in the European Union and the majority of British voters voted to leave.
In the weeks prior to the vote, there was significantly increased trading volume and bitcoin rose from around $600 to $765. Bitcoin ended up giving up the majority of its gains in the days before the vote as investors thought that Brexit was unlikely based on latest polling numbers. During this time, gold and bitcoin were highly correlated with the implied odds that the United Kingdom would leave based on the lines on betting websites.
When Brexit was confirmed, bitcoin again rose in response to the news in concert with other safe haven assets while almost all equity markets around the world and currencies in the eurozone declined sharply. This confirmed bitcoin’s status as a safe haven asset in the eyes of many investors and demonstrated how effective a hedge it is when centralized institutions fail.
Bitcoin’s Response to Trump Election Win
On November 8, 2016, the United States held its presidential election and Donald Trump was elected president, shocking investors around the world. In the immediate hours following the election, the classic flight-to-safety movement in financial markets in the above examples played out.
Investors quickly reevaluated the implications of Trump’s win and global equity markets actually rose the following day. But the intraday movement in bitcoin again demonstrates its safe haven properties as well as how efficient the bitcoin market has become in absorbing new information.
Bitcoin is the Ultimate Save Haven Asset
Looking at these historical cases has given me increased conviction that bitcoin (or cryptocurrencies in general) deserve a place in a passively-held, long-only portfolio. I strongly recommend an allocation of between 1 to 5 percent. It probably makes sense to own other cryptocurrencies other than bitcoin at this point since there is a real risk that an altcoin displaces bitcoin as the leading coin if bitcoin cannot solve its internal debate on the best way to scale the blockchain.
Here are some additional closing thoughts.
First, bitcoin is a safe haven asset, but it is different from other safe have assets like gold, U.S. treasuries, the U.S. dollar, Swiss franc, and Japanese yen. I examined many other examples in the past where flight-to-safety occurred, mainly in response to macroeconomic events and changes in expectations for future monetary policy. There is very little evidence that bitcoin responds in a predictable way to these events. Gold is primarily driven by changes in real yields, but I found very little evidence that bitcoin responds in the same way. My interpretation is that bitcoin is not mature enough of an asset class yet to have meaningful changes to macroeconomic conditions. This confirms my findings that bitcoin has very little correlation to other asset classes.
Second, bitcoin is a true hedge of black swan-type events, particularly events where centralized institutions fail. This goes back to the design philosophy of bitcoin of why it was created and how it can function without any centralized institutions or trust. When financial institutions fail or political institutions and policymakers fail, bitcoin responds very favorably.
Third, bitcoin’s volatility is beneficial from a portfolio construction perspective. If it’s volatile and negatively correlated to risky assets in times of crisis, that’s very desirable. I wrote a post on how to implement a simple risk parity portfolio which expands on this subject.
Fourth, since bitcoin was created, the world has been fairly stable, with volatility well below historical averages and equity markets around the world trending upwards with few exceptions and few corrections. Another crisis will happen in the future, either financial or political. If a significant enough crisis occurs, I would expect cryptocurrencies to rise significantly and become a legitimate asset class.
Overall, I strongly recommend some exposure to bitcoin and altcoins. As a practical matter, you should create an account at multiple exchanges now since it takes several weeks to build a meaningful position. Exchanges require identification confirmation and there are usually transfer limits that prevent you from accumulating quickly.
The code for this post can be found on my Github.
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