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Special Series: Institutional Investment in the Bitcoin Market

Part 3: The scarcity of Bitcoin as a hedge against inflation

In an environment of inflationary fears caused by the COVID-19 pandemic, geopolitical uncertainty and higher traditional asset prices, Bitcoin is an alternative asset that is increasingly being used as an effective hedge against inflation by professional investors.

As the world economy recuperates, economists and analysts anticipate higher inflation rates than in previous years. Inflation predictions have already caused increased volatility and uncertainty in traditional and digital asset markets.  For example, in the US in May inflation jumped to its highest rate since 2008 as the world’s largest economy strongly rebounds from the coronavirus crisis.

In the Eurozone, inflation surged beyond the European Central Bank’s (ECB) May prediction and hit its highest level in almost three years.

A recent study shows striking results that support the idea that Bitcoin could be used as a viable hedge against inflation. The researchers found that changes in the price of Bitcoin cause changes in the forward inflation rate. However, the opposite direction of causation was not observed. According to the paper, Bitcoin’s returns are positively correlated with future inflation expectation rates, and tend to lead this indicator.

Higher inflation has been enhanced by central banks aggressive monetary stimulus since the 2008 global financial crisis. Although the crisis is more than a decade old, the same basic policies are still in place.

Central bank balance sheets keep expanding. With the COVID-19 crisis, central banks have kicked money printing into an even higher gear. The US Federal Reserve’s balance sheet has breached $7 trillion, which is comparable to the ECB’s €7 trillion. Central banks seem to have chained themselves to the public markets and feel forced to step in each time stocks drop meaningfully. The unnatural consequences of this behaviour are becoming more and more obvious and attached to the surge of inflation and loss of fiat currency purchasing power.

Given this scenario, a number of public companies, institutions and professional investors are considering or have already invested in cryptocurrencies as a hedge against inflation. Thirty-three public companies collectively hold over 200,000 bitcoins, according to data from CryptoTreasuries. Together, these represent 1.07% of the total supply of bitcoins in circulation and are equivalent to $8.1 billion based on the price on 15 June 2021. Among these companies are: Meitu (OSL client), MicroStrategy, Tesla, Galaxy Digital Holdings, Voyager Digital, Square and Marathon Digital Holdings.

The main reason Bitcoin and its peers are seen as a viable hedge against inflation is due to Bitcoin’s inherently disinflationary nature. Bitcoin was created with a built-in scarcity property that caps its supply to not more than 21 million bitcoin units. Unlike fiat currencies, Bitcoin’s money creation is set in code and will not change. As the number of bitcoins left to be earned continues to decrease, we are seeing the network and its ecosystem grow.

Most new entrants are institutions and professional investors that are allocating some of their portfolios into Bitcoin and other digital assets, e.g. Ethereum, because these investments offer good risk-adjusted returns compared to other assets as can be seen in the chart below.

The future of the realm of the digital asset industry looks very promising with many new applications and technologies being developed. Currently, there is a global wave of new Bitcoin Exchange Traded Funds (ETFs) being introduced to the market. This kind of product eases significantly the entry barrier for many types of investors, especially the larger and more sophisticated institutions. Other product innovations, such as Security Token Offerings (STOs) and other digital securities, are also expected to gain ground in the coming weeks and months.

Bitcoin has some key advantages over traditional assets. It is truly liquid, fungible, easily accessible from anywhere in the world, and trades 24/7. Unlike fiat currency, Bitcoin has no authority or central bank making decisions on its supply. In an era of increasing worry about inflation, Bitcoin is positioned as an effective alternative and a hedge against inflation.