Bitcoin, an alternative to legacy reserve assets

The evolution of sound money technologies over time, from early systems of trading seashells and limestones to metals, coins, the gold standard, and contemporary government debt might be on the brink of an overhaul. Geopolitical tensions with the G7 seizing Russia’s foreign exchange reserves, pandemics, and raging inflation worldwide changed money. With the appearance of a new asset class led by Bitcoin, an interesting and never seen before cocktail originates that has the potential to reshape money and finance as we know it, in which Bitcoin could be a beneficiary. As Zoltan Pozsar, Credit Suisse’s global head of short-term interest strategy, puts it:

“We are witnessing the birth of Bretton Woods III – a new world (monetary) order centered around commodity-based currencies in the East that will likely weaken the Eurodollar system and also contribute to inflationary forces in the West” …

“After this war is over, “money” will never be the same again…

…and Bitcoin (if it still exists then) will probably benefit from all this.”

The current macro situation as a result of a variety of circumstances and their interdependencies exposed weaknesses of our financial system that is primarily based on debt and credit structures. With the sanctions on Russia and an estimate of more than half of their reserves frozen, the perception of reserve currencies like USD, EUR, or JPY altered as it was the first time a relevant economic and financial actor was seized by that magnitude.

Despite foreign currencies enabling the exchange rate of a country’s own currency to stay stable, it also leaves especially China being the largest foreign currency reserve holder in the world in a tricky position. With that, we might face a world with a sharper focus on outside money, like gold and other commodities as countries try to boost their reserves for independency. According to Pozsar, Bretton Woods III will be backed by outside money in a similar way as the first Bretton Woods era (1944–1971) was backed by gold while Bretton Woods II (1971–present) was backed by inside money (basically U.S. government paper). Gold or Bitcoin-backed currency regimes that can substitute the functions of fiat money that acts as reserve assets become more attractive and might offer dramatic upside. According to a report of VanEck, their framework for quantifying the impact of Bretton Woods III estimates gold prices of around $31,000 per ounce and Bitcoin prices of around $1,300,000 with even greater upside for greater strains on financial and monetary systems.

The Bitcoin standard and a brief history of reserves

Bretton Woods (named for the conference location in Bretton Woods, New Hampshire) aimed at monetary management and laid out the rules for financial relations between countries, created the International Monetary Fund (IMF), World Bank, and the World Trade Organization (WTO).

The first Bretton Woods system, now referred to as Bretton Woods I, was based on gold and dominated by the U.S. dollar, which was freely convertible into gold for $35 per ounce. The U.S. changed its currency in 1971 in order to make the dollar free-floating and backed it by faith in the economy, as well as by military defense and credit of the government. From there, Bretton Woods II was born, making the dollar the primary reserve currency, but in a system that mostly uses inside money and is largely debt-based.

Reserve assets provide credibility for the value of fiat currencies and are meant to serve as a store of value independent of volatile markets, allowing institutions to preserve their purchasing power over extended timeframes. Reserve assets as per the IMF balance of payments manual are currencies such as the U.S. dollar and assets, such as gold, that are readily transferable and used to balance international transactions. They must be comprised by:

• Foreign currencies: the most important official reserve
• Special drawing rights (SDRs): a proxy for obtaining e.g. foreign exchange from other IMF members
• Gold
• Reserve positions with the IMF: reserves given to the IMF that are available

As foreign exchange aims to stabilize rates and promote efficiency in international trade, reserve currencies are typically acquired by central banks and major financial organizations. The U.S. Dollar has traditionally served as the standard reserve foreign exchange asset but faces threats to its stability as it continues to devalue in order to keep its position as the world's reserve currency. The emergence of Blockchain technology with Bitcoin on the forefront show potential to bring forth new innovations that could address some of the hazards connected with the current system and might become the cornerstone of the global financial system. What makes Bitcoin such a great solution to the current status and alternative to conventional reserve assets?

With gold being both durable and hard to produce, it’s offering a high stock-to-flow ratio, where supply is rather fixed, allowing goods to be steadily priced against it over time. Bitcoin beats gold on these criteria as its supply is known by design to be no more than 21 million Bitcoin. The ownership of Bitcoin is tracked in an immutable ledger. The network persists as long as there is the internet, and the digital coin is permanent. Furthermore, moving Bitcoin is significantly simpler than moving gold. Neutral reserve assets such as gold and Bitcoin are energy proxies that are tied to energy by mining production cost and storing. Regarding gold, a standardized metric named the All-in Sustaining Cost (AISC) aims to reflect the sustainable production cost of keeping the mine in business. It is currently resting at 70% of the gold price while Bitcoin’s production cost sits at 56% relative to its market price.

Overall, the properties that make Bitcoin valuable and a good reserve asset are cryptographically verifiable integrity, scarcity, security, verifiability, availability, and transferability that likely enhances global trade. Despite Bitcoin being able to satisfy all three functions of money, namely store of value, unit of account, and medium of exchange, it’s likely strongest property that is also agreed upon by Bitcoin proponents is its function as a store of value. By chasing that narrative, inefficiencies induced by Bitcoin’s robustness become trivial since Bitcoin’s weaknesses such as latency, TPS, power consumption, and scalability become non-issues for a neutral, supernational reserve asset. Similar to gold, Bitcoin might work as a hedge against inflation, carries no credit or counterparty risks, mostly features an inverse relation to the dollar, and can serve as a source of trust as it’s decentralized, permissionless, and trustless. With that, many of the hazards connected with the U.S. dollar system are possibly mitigated by Bitcoin.

Assets considered to be good inflation hedges hold or increase in value over time and are therefore considered a store of value. In order to act like a store of value, gold and Bitcoin bring important properties such as scarcity, accessibility, and durability. Both bitcoin and gold are sensitive to inflation, yet gold typically performs better during recessions. In contrast, even when the yield is increasing, Bitcoin seems to do better when the economy is stronger. As observed, Bitcoin prices appreciated under inflationary pressures within the last years but declined under heightened uncertainty. With that, Bitcoin has not really traded as an inflation hedge and neutral reserve relative to treasury bonds or gold in the recent down cycle, see Illustration 1 which compares gold and Bitcoin from the beginning of 2021 when the U.S. CPI started to climb. Regardless of Bitcoin’s role within decentralized treasuries though, Bitcoin has performed relative to crypto as a neutral reserve asset as it outperformed on the way down yet underperformed on the way up. That is one of the characteristics Bitcoin already showcased within the last cycles.

Impressively, the framework estimates gold prices of up to $31k per ounce for M0, $105k for M2, and potential Bitcoin prices of around $1.3m per coin for M0 and $4.8m for M2 if they were adopted to be a world reserve asset. Therefore, Bitcoin would offer an upside of around 33x for M0 while gold’s upside would still be 16x.

Bitcoin Treasuries

With ~6.3% of Bitcoin in treasuries, companies and countries increasingly leverage Bitcoin as a reserve asset and therefore decrease the available market supply. Overall, +$30b in BTC resides in treasuries of various entities, see Illustration 3. With 38 public companies holding Bitcoin on their balance sheet, they already amassed close to 262’695 BTC — about 1.25% of all Bitcoins and worth approximately $6.1b.

As corporate buying shows signs of becoming a global trend after MicroStrategy kickstarted it, a lot of other companies such as Tesla or Galaxy Digital Holdings already joined the movement, reducing the available supply of Bitcoin significantly. If that movement keeps getting stronger, it makes sense to take a look at some numbers as the amount of Bitcoin that publicly traded companies hold as a reserve is only a tiny fraction of the corporate treasuries. For instance, the actual amount of cash held in reserves is in the trillions of U.S. dollars with nine companies in the S&P 500 sitting on close to $600b in cash and short-term investments, a potential massive buy pressure if aimed at Bitcoin. Moreover, also private companies, countries, and especially ETFs further reduce the liquid supply on markets, see Table 1, as they approach Bitcoin.