We might think Bitcoin would be the last thing anyone would use to hedge anything, given its massive volatility. As it continues to evolve, this might not be a crazy idea after all.
Cryptocurrencies at least have the potential to hedge other things such as other currencies or stocks, simply because its market isn’t dependent upon the same forces as these other financial products are. One of the ideas behind them is that they are fully market dependent, unlike hard currencies which depend on macroeconomic factors which are subject to cycles and other independent influencers.
Sometimes currencies can be subject to forces like hyperinflation which can cause them to lose a lot of value. The collapse of the German paper mark during the period of 1921-23 was a classic example of this. If you had a trillion paper marks in 1921, the value of all this money became reduced to a single gold mark just two years later.
Germany even printed trillion-mark bills during this time, and if a trillion marks was now only worth what a single mark was a couple of years ago, this became necessary. People were seen with wheelbarrows full of money going to the store, as it took that much to buy their groceries. To buy one U.S. dollar worth of anything, it took 4.2 trillion paper marks at the worst of this.
While that may not have been convenient, the worst part of this mess by far is seeing all of your wealth held in this currency evaporate. To give you an idea of the scale of this, U.S. GDP was 86 billion in 1923, and if subject to this massive hyperinflation, would be worth less than a penny.
That all happened long ago, but we have a more recent example of a huge enough magnitude to see people’s life savings disappear, in Venezuela. Between 1973 and 2019, inflation in Venezuela has averaged 4374%. This is not a currency that you could ever have accumulated wealth because what you save each year would just continue to evaporate and you could never get ahead.
In recent times, we’ve seen inflation rates as high as 329,000%, and in just a few years of this, this can turn enough money to buy a house into just enough to buy a doormat. There is no point of saving at all in this environment because you lose so much money each year to inflation that it becomes completely pointless.
What you do instead is put your money into something else, like gold for instance. What is curious about Venezuela these days is that a lot of people are actually fleeing to Bitcoin to protect their wealth. Even though Bitcoin’s reputation has been somewhat scarred over this time, its scars are mere blemishes compared to what has happened to the Venezuelan bolivar.
It’s easy enough to have your money in another currency when inflation runs way too high, but when people get paid in the local currency, this is rife with huge problems. Even if this was made very easy, with currency exchanges on every street corner, it is not hard to imagine what would happen to a currency if everyone just exchanged it for U.S. dollars all the time. Its value would plummet even further from this due to all the selling of the currency.
Buying gold would seem like a lot better solution, but people don’t trade in gold. If you turned your paycheck to the minimal amount of gold it would buy, you now have to worry about how you are going to spend this, and using gold for this just isn’t practical and far from it actually.
What is so appealing about Bitcoin is that it actually can be used practically, not as practically as hard currency but certainly much more so than precious metals. People can get paid in Bitcoin and buy things with it and this allows people to escape the hyperinflation to some degree at least.
Bitcoin’s Main Purpose is to Speculate, But Gold is Like That Too
For the rest of us, who don’t have to worry about such things very much, Bitcoin is far too impractical to be used as a replacement currency generally, but it still can serve this purpose as a store of wealth like gold does.
Thus far, Bitcoin has just served as a speculative investment, and we’re talking a level of speculation that we have never seen before with an asset widely available. While in theory, Bitcoin and other cybercurrencies can hedge against currency risk, unless we’re talking about a currency that is even more volatile than Bitcoin is, this involves taking on more risk, not hedging it.
During both the rise and subsequent fall of Bitcoin, and especially during its fall, the overall risk of Bitcoin investment wasn’t clearly defined at all. While few people expected it to drop to nothing, there were some who were worried about a truly massive decline and we had no history or backstop to guide us.
Gold only goes down so far because it does have a certain intrinsic value, although speculation does add a lot to this. We also have a long history of gold trading to reference, and while the risks of gold investing are still pretty high, we generally have at least a decent notion of what they may be at any given time.
This was not the case with Bitcoin back then, and given that it has no intrinsic value, there’s really nothing stopping it from collapsing completely apart from investor sentiment turning at some point, where the buyers create enough upward pressure to keep it from going too far down.
We now have at least a bit of history with Bitcoin, where it did fall a long way but the sky did not fall, and Bitcoin has matured quite a bit lately. It’s still very volatile but more within somewhat predictable ranges.
It is no secret that a lot of Chinese have invested in Bitcoin, and while there may be better hedges against the yuan, the Chinese government prevents this sort of hedging. Even Bitcoin has come under some pretty big restrictions there but this has not stopped a lot of people from putting a lot of their money in Bitcoin of late.
This was especially evident during the yuan’s recent plunge, although it has been declining in value for quite some time now and Chinese fleeing to Bitcoin as a safer haven is nothing new. However, this time the moves were correlated enough for some to think that this may be an example of Bitcoin actually being used as a currency hedge, which not long ago seemed like a simply crazy idea.
It still might be crazy but perhaps less so than it used to be. However, if people are afraid of the yuan dropping by amounts like 10%, this is rare for the yuan but of a magnitude that is commonplace with Bitcoin.
This play is obviously not about offsetting currency risk per se, it is more a combination of hedging and speculating, and if we look at it this way, it might make some real sense. If you are bullish on Bitcoin and your currency is in decline, the currency part of it can be a bonus.
Bitcoin has performed very well over the last 4 months, and tripling in value in 4 months is indeed good performance, spectacular performance actually. There are people who crow that their stock positions have increased this much in 10 years and are delighted with this, and we’re talking about an annualized return over this time with Bitcoin that is 30 times greater.
Is Bitcoin Becoming the New Gold?
Bitcoin is now regarded by some as functioning similarly to gold, but as much as gold has shone over this time, Bitcoin has shined with a far greater luster. People fled to both gold and Bitcoin during these latest developments on the trade front, but those who went with Bitcoin simply made a lot more money.
These correlations develop as we use these other assets as an alternative when things don’t go our way so much, and when enough people do this when other assets such as currencies or stocks decline, the move becomes more correlated and therefore reliable.
Bonds are a much purer hedge than gold is, even though there is plenty of speculating with bonds as well. The idea with putting your money in treasuries though is mostly to park your money in a safer place, and bonds are much safer than stocks, but gold is even less safe than stocks. Bitcoin is the least safe of any of these assets by far.
People will buy gold when competing assets aren’t performing as well, and depending on what is going on with gold, a bear market with the main assets can be a bull market for gold if the situation is right. Gold functions as both a speculative instrument and a hedge during these times, and those who seek to just use it as a hedge without paying attention to how good a speculative investment it may be can pay a big price for their inattention or ignorance.
Comparing Bitcoin to gold is actually pretty valid, because neither of these assets are really pure hedges, at least they should not be used this way, and they both derive their power as a replacement investment from their ability to move in the opposite direction of what is sought to be hedged, even though this does depend on their actually moving the way we want them to.
We can even bet on them both going down by using futures, where there is no up or down per se but instead opposing sides of trades, with one always betting that the price of the asset will rise and one always betting that it will fall.
The value of investments lies in the combination of their performance and reliability. Bonds are very reliable but their performance potential is minimal, stocks are fairly reliable and have better potential, gold can be fairly reliable at times and also perform pretty well at times, and Bitcoin has massive performance potential but is the least reliable of the bunch by far.
Each of these assets may have their place depending on the appetite for gains and the risk tolerance of investors, and Bitcoin’s role may be increasing and set to increase even more as it stabilizes more. One day, we may even see much bigger migrations to Bitcoin during flights to safety, perhaps even surpassing gold one day among alternative investments, although neither will ever touch bonds because people move to bonds during this time for actual safety, not just to move to something else that may have a better price outlook right now.
Bitcoin as a flight to safety in times of market underperformance may seem like an outrageous idea, but it’s one that is starting to emerge and one day may indeed be pretty popular. Bitcoin will probably always be a lot more volatile than gold or similar assets, due to its very nature, but some people thinking that Bitcoin is heading toward becoming the new gold may not be as far off as we might think.