Bitcoin Whitepaper

By Henry Pizzutello

Chief Investment Officer

The current economic landscape characterized by slower economic growth, higher debt burdens, and divergent monetary and fiscal policies are favorable for increased adoption of digital currency. One of the biggest issues facing industry today is the regulatory changes that are increasing the cost of compliance. The rapid changes in digital technology are helping to solve these problems and manage this risk, both on an industrial and personal financial scale. Demographically, there are large global population trends underway, driven by the increasing importance of Asia and the emerging market economies, and by the next generation of investors in developed countries entering their prime earnings years.

As the Federal Reserve and other central banks continue to print more and more money amid the ongoing pandemic, there has been increased interest in bitcoin as an alternative currency. One of the primary “advantages” to bitcoin is that it is not subject to fiscal policy or monetary manipulation, which has been a concern regarding future trade policies. Additionally, central bank stimulus to combat the economic damage caused by the pandemic has raised the very real threat of increased inflation in the future. While this is not an issue today and for the near-term future, the increased investor attention to gold and to digital currencies suggest that it is not something to be ignored. However, even gold, which has traditionally been an asset held to combat inflation, suffers a form of inflation as miners dig more of it from the ground – something that is not a problem with a fixed supply of ultimately just 21 million bitcoins.

What is Bitcoin?

Bitcoin is a digital currency that was created in January 2009 by the pseudonym group Satoshi Nakamoto following the housing market crash. Bitcoin offers the promise of lower transaction fees than traditional online payment mechanisms and is operated by a decentralized authority, unlike government-issued currencies. There are no physical bitcoins, only balances kept on a public ledger that everyone has transparent access to. That ledger, called blockchain, is verified by a massive amount of computing power. Bitcoins are not issued or backed by any banks or governments, nor are individual bitcoins valuable as a commodity.

• Open Source: Anyone can participate in the network. • Secure: Bitcoin uses blockchain technology, which is used to keep an online ledger of all the transactions that have ever been conducted, thus providing a data structure for this ledger that is quite secure and is shared and agreed upon by the entire network. Every new block generated must be verified by each node before being confirmed, making it almost impossible to forge transaction histories. This is because addresses involved in any bitcoin transaction are permanently and publicly available on the blockchain.

• Transparent: All transactions are recorded and publicly viewable on the bitcoin blockchain from anywhere in the world. Information like multiple transactions originating from one wallet or data leaks from custody solutions or exchanges can almost always trace back to one’s identity.

• Irreversible: Transaction amounts cannot easily be changed or reversed once added to the blockchain.

• Finite supply: Bitcoin has a maximum supply cap set at 21 million units and is equipped with a disinflationary supply mechanism. With 17.97 million already in circulation today (~86%), it is estimated that the total bitcoin supply will be mined around the year 2040.

One of the most important technology concepts behind bitcoin is blockchain, which has the potential to develop new technologies across a wide range of business applications. While blockchain is an extremely complicated process, the basic premise of the technology could be thought of as a giant spreadsheet that shows the complete transaction history and location of every bitcoin. Every 10 minutes, the spreadsheet gets updated as an additional "block" of new transactions is added. Picture that as someone opening up the spreadsheet and adding thousands of new transactions to it. That's a new "block." A blockchain is merely a chain of new blocks. The key question is how this “spreadsheet” is maintained and how can security be regulated. If someone can “edit” the spreadsheet, they would be able to make updates to change the balances of bitcoin. That's the job of bitcoin miners. They are computer networks with massive power that run software to support the bitcoin network and keep it operating smoothly. These miners do not keep this running for free – they are able to be paid in bitcoin if they are able to solve the complicated math required to solve the blockchain requirements – essentially to keep it updated. When all bitcoin has been mined, the miners will no longer receive block rewards since there are no more coins to be generated. They will only earn from the transaction fees to be collected from every confirmed transaction. Miners can continue securing the network since they will still earn from the said fees.

How Does Bitcoin Have Value?

Historically, commodities or precious metals were used as methods of payment because they were seen as having a relatively stable value. Rather than require individuals to carry around cumbersome quantities of cocoa beans, gold or other early forms of currency, however, societies eventually turned to minted currency as an alternative. Currency is usable if it is a store of value, or, put differently, if it can reliably be counted on to maintain its relative value over time and without depreciating. Some types of currencies rely on the fact that they are "representative," meaning that each coin or note can be directly exchanged for a specified amount of a commodity. However, as countries left the gold standard in an effort to curb concerns about runs on federal gold supplies, many global currencies are now classified as “fiat.” Fiat currency is issued by a government and not backed by any commodity, but rather by the faith that individuals and governments have that parties will accept that currency.

Scarcity: The key to the maintenance of a currency's value is its supply. In the case of fiat currencies, most governments around the world continue to print money as a means of controlling scarcity. This is different from bitcoin, which has a flexible issuance rate which changes over time. When Bitcoin was launched in 2009, developer stipulated in the protocol that the supply of tokens would be capped at 21 million. It is expected to reach full supply in October 2040.

Divisibility: Successful currencies are divisible into smaller incremental units. 21 million Bitcoins is vastly smaller than the circulation of most fiat currencies in the world. Fortunately, Bitcoin is divisible up to 8 decimal points. While the U.S. dollar can be divided into cents, or 1/100 of 1 USD, the smallest divisible unit is just 1/100,000,000 of 1 bitcoin – about 1/1000 of one cent at current price.

Utility: Individuals must be able to reliably trade units of the currency for goods and services. One of the biggest selling points of bitcoin has been its use of blockchain technology in transaction facilitation. Importantly, the flexibility of blockchain technology means that it has utility outside of the cryptocurrency space as well.

Transportability: Currencies must be easily transferred between participants in an economy in order to be useful. In fiat currency terms, this means that units of currency must be transferable within a particular country's economy as well as between nations via exchange. Bitcoin is transferable between parties within minutes, regardless of the size of the transaction with very low costs. The process of transferring money in the current system can take days at a time and have fees.

Durability: To be effective, a currency must be reasonably durable. Coins or notes made out of materials that can easily be mutilated, damaged, or destroyed, or which degrade over time to the point of being unusable, are not sufficient. A dollar bill, while sturdy, can still be torn, burned, or otherwise rendered unusable. Digital forms of payment are not susceptible to these physical harms in the same way. For this reason, bitcoin is tremendously valuable. That's not to say, however, that bitcoin cannot be lost. If a user loses his or her cryptographic key, the bitcoins in the corresponding wallet may be effectively unusable on a permanent basis.

Counterfeit Difficulty: Just as a currency must be durable, it must also be difficult to counterfeit in order to remain effective. If not, it would be easy to disrupt the currency system by flooding it with fake bills, thereby negatively impacting the currency's value. Thanks to the complicated, decentralized blockchain ledger system, bitcoin is incredibly difficult to counterfeit. Doing so would essentially require confusing all participants in the Bitcoin network, no small feat.

One of the biggest issues is bitcoin's status as a store of value. Bitcoin's utility as a store of value is dependent on its adoption as a medium of exchange. In the early stages of its history, the current value of bitcoin had been driven primarily by speculative interest. This is likely to decline as bitcoin continues to see greater mainstream adoption.

Move toward Mainstream

Eight years ago, cryptocurrency was the domain of computer programmers. Three years ago, it was seen as a speculative investment by many to “get rich quick”. However, as the market has developed, we are seeing more and more institutional engagement, and significant steps towards mass adoption and worldwide acceptance. As this trend continues and cryptocurrency grows and matures as an asset class, bitcoin is likely to become an increasingly important part of every investor’s portfolio.

Integration into mainstream apps and scaling are good signs. We have seen companies like Square announce that they are working their Lightning Network into bitcoin wallets. Asia represents the bulk of global growth in payments, driven in large part by the explosion in third-party (nonbank) and mobile providers, with the most rapid growth in China and India. Cashless economies work and increase financial inclusion. For example, China has suggested that the transition to a mostly cashless economy can be managed at a large scale. Payments remains one of the clear use cases for blockchain, as well as supply chain (companies like Cargill and Bumble Bee Foods already use blockchain), secure transfers (medical records for companies like CVS), and custodial services (biggest being the Depository Trust Corp that supports the investment industry). In May 2020, JPMorgan signed bitcoin exchanges Coinbase and Gemini onto their banking platform after a lengthy vetting period, which will lead the way for more widespread adoption. This was especially important because JP Morgan had been a vociferous critic of bitcoin just three years earlier. On July 22, the Office of the Comptroller of the Currency ("OCC"), the Department of the Treasury agency that regulates the U.S. banking system, released a letter explaining that it could take "custody" of cryptocurrencies on behalf of their customers. This would be a very positive development as it is another step in the process of “legitimizing” the asset class. The implication of this OCC letter could mean that bitcoin becomes a fungible currency so that every bank in America would let you swap between dollars and bitcoin instantaneously.

Business Applications

Trade / banking transactions: Money center banks / global securities firms like Goldman Sachs (GS) and JPMorgan Chase (JPM) have entire teams and buildings dedicated to confirming and spot-checking the trades and transactions their firms make. This is estimated to cut costs by 25-50%

Independent payments platform: Visa / MasterCard - blockchain is being rolled out as a way to validate identities and detect fraud, in line with Know Your Customer rules.

Credit: Payment processing companies like Visa, MasterCard and PayPal are using the blockchain technology as a way to reduce fraud and costs.

Fraud Protection: Used to formalize commercial relationships through smart contracts. This promises to revolutionize the insurance industry by helping to automate processes, facilitate smooth claims, and cut insurance fraud

Insurance/Identity: Nationwide Insurance is trialing a proof-of-insurance blockchain solution that would allow law enforcement and other insurers to verify insurance coverage in real-time.

Travel: The popularity of Airbnb shows how consumers are more than happy to cut out the middleman and go straight to hosts for accommodation. With blockchain, you don’t even need an intermediary platform like Airbnb to facilitate the transaction – the blockchain would handle it all. TUI Group is also investing in blockchain technology in travel, with an eye on eventually eliminating the need for intermediaries like Expedia.

Why Put Bitcoin in an Investment Portfolio?

The main reason to include an asset in a portfolio is if it can generate higher expected returns with the same level of risk or keep expected returns constant while lowering risk. Assets like gold, which traditionally have an inverse correlation to equities—they tend to rise when equities decline in times of stress—are a good example. Bitcoin or cryptocurrency assets have traditionally had very little correlation to gold. Part of the explanation for this is that until fairly recently, bitcoin has not been considered an investment class for many investment managers. However, during the recent pandemic crisis, the correlation to gold rose dramatically. This speaks very strongly to the public perception of bitcoin as a potential safe haven during times of market turbulence. This diversification and negative correlation to risk is an attractive portfolio combination.

Confirming this thesis, in August 2018, Aleh Tsyvinski, the Arthur Okun Professor of Economics at Yale, published a study of bitcoin’s role in an investment portfolio.

One of the main findings of the study was that the volatility-adjusted return of bitcoin was incrementally positive to the overall portfolio, and cryptocurrency should be about 6% of every portfolio in order to achieve optimal construction. The study indicates that even a modest 1% allocation has diversification and return benefits. As recently as two years ago, this idea would have been laughable. The volatility of 2018 discouraged most investors from taking bitcoin and other digital assets seriously. However, as viability and adoption has increased since then, bitcoin has exhibited a positive trend even with higher volatility.

The chart above illustrates this trend. The red line shows $10 invested weekly into the Dow Jones Index vs $10 invested into bitcoin from February 2017 to February 2020. This also confirms the Yale study regarding the risk/reward characteristics.

There have also been studies done that show how portfolios fared with different allocations of digital assets. The table below shows that even a small allocation of digital assets has increased return while only marginally increasing the overall volatility.


September 25th, 2013 – June 30, 2020

However, since the price of bitcoin increased from $129 to $9,153 over the evaluation period, critics could argue that these investment results would not be predictive of future portfolio improvements. This is a very valid argument, although the results do show that the portfolios did not show materially increased overall volatility, even at a 5% allocation.

We would argue that more recent results would be a better metric to judge the effectiveness of bitcoin allocation in an overall portfolio. We ran a similar analysis using a Global 60/40 portfolio with a 2% and 5% allocation to Grayscale Bitcoin Trust (GBTC). Looking at different time frames of 3 years, 1 year and 6 moths, we found the following:

While numerous conclusions can be made from the above data, it is clear that in each time period, the inclusion of bitcoin through GBTC provided greater returns, with the same or less overall risk. Interestingly, the larger 5% allocation, while seemingly more risky, actually provided greater portfolio returns, with lower max drawdown and lower volatility during the period encompassing the severe market decline earlier this year.

(1) Source: Bloomberg, Performance is shown from September 25, 2013 through June 30, 2020. Annualized figures are based on 252 trading days. “Global 60/40” consists of a 60% allocation to the iShares MSCI ACWI and a 40% allocation to the Vanguard Total International Bond ETF. “Digital Assets” consists of an equal-weighted mix of Bitcoin (BTC), Bitcoin Cash (BCH), Ethereum (ETH), Ethereum Classic (ETC), Litecoin (LTC), Stellar Lumens (XLM), XRP (XRP), Zcash (ZEC), and Zen (ZEN). THE GLOBAL 60/40 + 1%/3%/5% DIGITAL ASSETS RESULTS ARE HYPOTHETICAL AND ARE NOT BASED ON ACTUAL RETURNS OR HISTORICAL PERFORMANCE. DIGITAL ASSETS HAVE HISTORICALLY EXPERIENCED SIGNFICANT INTRADAY AND LONG-TERM PRICE SWINGS AND PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Component asset weights are held constant over the period. The Sharpe Ratio is calculated as the annualized excess return of the portfolio over the 3-month US T-Bill divided by the standard deviation of excess returns. Ratio improvement is calculated by taking the Sharpe Ratio of the Global 60/40 + 1%/3%/5% Digital Assets Portfolios and dividing each by the Sharpe Ratio of the Global 60/40 Portfolio

(2) Source: Hidden Performance is shown from on a rolling 3 year, 1 year and 6 month time period from September 18, 2020. Annualized figures are based on 252 trading days. “Global 60/40” consists of a 60% allocation to the iShares MSCI ACWI and a 40% allocation to the iShares Core US Aggregate Bond ETF. “GBTC” refers to the Grayscale Bitcoin Trust. THE GLOBAL 60/40 + 2%/5% GBTC RESULTS ARE HYPOTHETICAL AND ARE NOT BASED ON ACTUAL RETURNS OF A MANAGED PORTFOLIO. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Component asset weights are held constant over the period. The Sharpe Ratio is calculated as the annualized excess return of the portfolio over the 3-month US T-Bill divided by the standard deviation of excess returns. Total Return/Max Drawdown and Volatility are based on historical prices of the underlying assets.

In the relatively short time they have existed, the correlation of major a

In the relatively short time they have existed, the correlation of major asset classes and currencies to digital assets has ranged from slightly negative to slightly positive, showing little-to-no correlation. As a result, digital assets may be considered a diversifying component within multi-asset class portfolios. As the chart above shows, digital assets are only a tiny fraction of the overall financial asset picture. As financial markets and industries continue the adoption of bitcoin and cryptocurrency technology into the mainstream, the attractiveness of bitcoin in the overall portfolio allocation will continue to grow.

Key Investment Considerations:

· Long-term, bitcoin correlations with traditional asset classes remain low.

· Short-term, the market sell-off induced by the COVID-19 pandemic increased bitcoin correlations with traditional asset classes—particularly gold, potentially hinting at bitcoin’s increasing safe-haven status.

· A small bitcoin addition to a 60% equity/40% bond blended portfolio significantly reduced portfolio volatility during the recent market sell-off.

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