The Node Ahead #24

Regulatory Update and Is Bitcoin Still an Inflation Hedge?

Onramp Invest

August 9th, 2022

Welcome back to The Node Ahead, a cryptoasset resource for financial advisors.

Welcome back to The Node Ahead, a cryptoasset resource for financial advisers. Every other week, we discuss the latest crypto news and the potential impacts it may have on you and your clients.

In this edition, we will review:

  • Stablecoin and Crypto Taxation Update
  • Bitcoin as an Inflation Hedge

In our last newsletter, we broke down how the SEC’s refusal to approve a spot bitcoin ETF and its preference to regulate through enforcement rather than providing a clear set of rules has caused more harm than good. Soon after our newsletter went out, Senator Pat Toomey published a letter accusing the SEC of failing to provide regulatory clarity that could have prevented much of the recent turmoil in the crypto industry. We don't know if Senator Toomey reads this newsletter or not, but it’s great to see policymakers recognize the harm the SEC has caused.

One other major announcement worth highlighting. Asset management giant Blackrock has partnered with Coinbase to provide institutional investors access to crypto trading, custody, prime brokerage, and reporting capabilities. The endorsement from the world's largest money manager (with over $9 trillion in assets) is yet another sign that interest in the asset class continues to grow. “Our institutional clients are increasingly interested in gaining exposure to digital asset markets” Joseph Chalom, global head of strategic ecosystem partnerships at BlackRock, said in a statement.

Stablecoin and Crypto Taxation Regulatory Update

Stablecoins are one of the most likely areas within the crypto industry to see increased regulation soon. Due to their rapid growth and Facebook’s attempt to create its own private stablecoin, regulators started to take notice towards the end of last year. So much so that the US House Committee on Financial Services held a hearing on stablecoins back in February of this year. During that meeting, representative Maxine Waters highlighted the main concern Congress seems to have, namely that “many of these so-called stablecoins are not, in fact, backed fully by reserve assets. Moreover, due to speculative trading and the lack of investor protections could even threaten U.S. financial stability.” The recent collapse of Terra and its algorithmic stablecoin UST, has only increased Washington’s urgency to regulate this sector of the industry.

The most likely piece of legislation to get passed first is a non-partisan bill put forth by Democrat Maxine Waters and Republican Patrick McHenry. This bill reportedly requires stablecoin issuers, like Tether and Circle, to maintain 1:1 reserves of their stablecoins in circulation and would also limit the types of assets that could back these stablecoins. The bill also would give banks the ability to issue their own stablecoins and allow the Federal Reserve to oversee any nonbank issuers.

However, the bill was recently delayed by Treasury Secretary Janet Yellen, who raised concerns over how the bill addresses custody of digital assets. The two sides were unable to come to an agreement in time for the committee meeting and now the bill has been pushed until after the August recess. In a recent statement, Maxine Waters said, “Although the Ranking Member, Secretary Yellen and I have made considerable progress towards an agreement on the legislation, we are unfortunately not there yet, and will therefore continue our negotiations over the August recess.” Given this delay and the looming mid-term elections, it is likely this bill will not pass this year but should be a hot topic once the elections are completed.

The second regulatory update from the past couple of weeks has to do with reducing the tax burden for small crypto payments. A new bill called the Virtual Currency Tax Fairness Act was introduced by Republican senator Patrick Toomey and Democratic senator Kyrsten Sinema that would make all transactions up to $50, or any trade earning up to $50, tax-exempt from capital gains. Crypto users would no longer be required to report these small transactions to the IRS. Though $50 isn’t much, it’s an encouraging step in the right direction.

Finally, a new bill from the Senate Agriculture Committee has been filed that would assign the Commodity Futures Trading Commission (CFTC) direct oversight of the crypto markets. Democratic senator Debbie Stabenow and Republican senator John Boozman co-authored the bill which would require exchanges and brokerages to register with the CFTC, not the SEC. This is now the third bill proposed this year that would classify cryptoassets as commodities and give the CFTC regulatory oversight of the industry.  We have yet to have any formal legislation proposed that gives oversight authority to the SEC suggesting that the overwhelming preference within Washington right now is for the crypto industry to fall under the purview of the CFTC rather than the SEC (which maybe explains Gensler’s desperate attempts to expand the scope of his own agency now before Congress steps in).

Both the tax bill and the CFTC bill are very similar to the provisions in the Responsible Financial Innovation Act introduced earlier this year by Republican senator Cynthia Lummis and Democratic senator Kirsten Gillibrand. It’s also worth highlighting that most of the crypto bills proposed over the past year, including these two most recent ones, have been brought forth by a team consisting of both a Democrat and a Republican. Crypto has always been non-partisan and has aspects that appeal to both sides of the aisle.  It’s likely that crypto will eventually become an issue not divided between democrats and republicans, but rather “Pro-Crypto” and “Anti-Crypto” parties.

Bitcoin as an Inflation Hedge

The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by consumers for a basket of goods. It is also the most common metric for measuring inflation.  Since the start of the year, CPI has risen to 9.1% as of June, which is the highest it’s been in over 40 years. During that same time span, bitcoin’s price has fallen roughly 51% causing many to question the narrative of bitcoin as a viable hedge against inflation.

Source: Glassnode, US Bureau of Labor Statistics

Before we can analyze whether bitcoin is a viable inflation hedge, we need to start with why the narrative exists in the first place. The short answer is that bitcoin’s monetary policy is the exact opposite of every government-backed fiat currency that exists, including the dollar. Whereas the US government can print an “unlimited” amount of dollars, bitcoin has a capped supply of 21 million coins. Whereas the amount of newly created dollars has been increasing over time, bitcoin’s supply issuance gets cut in half every four years. Furthermore, because bitcoin’s supply issuance is programmatic, we know with a high degree of accuracy when every new bitcoin will be issued between now and the year 2140 (the year the last new bitcoin will be released). Compare that to the dollar where we do not have clarity over the next 12 months let alone the next 100+ years. Whereas a small group of unelected officials decide behind closed doors how many dollars to print and when bitcoin’s supply issuance decision is written in code and transparent for all to see. But most importantly, whereas the US government can change its monetary policy whenever it likes (and does so frequently), bitcoin’s monetary policy is constant and cannot be changed by a single entity.

It’s clear that bitcoin’s monetary policy is in direct contrast to that of fiat currency. Hence, it stands to reason that it should act as a hedge against fiat debasement.

And that's the key, bitcoin is an excellent hedge against the debasement of the dollar (or any other fiat currency). However, the definition of the term “inflation” has expanded from currency debasement to include any price increase that impacts consumers or businesses. While printing more money does cause purchasing power to decrease, it’s not the only thing that can cause price increases. 

Let’s return to the often-used inflation metric we highlighted at the start. CPI is simply a measurement of the change in price for consumer goods. Anything that causes prices of consumer goods to rise will be reflected in CPI.  But here is the thing: price increases can be caused by either an increase in demand or a decrease in the supply of consumer goods and bitcoin is only a hedge against one of those causes. 

Let’s start with demand-driven inflation. As a government prints more money, more cash is available to spend on goods and services within an economy.  If, however, the output of those goods and services doesn’t also increase, then demand will outpace supply and prices will rise. Hence, if the money supply increases at a faster rate than the economic output, the result is inflation due to an increase in demand. This is what people typically refer to when they claim “bitcoin is an inflation hedge” even though what they really mean is “bitcoin is a hedge against monetary expansion.”

However, prices could also rise due to a decrease in the aggregate supply of goods and services.  If the supply of raw materials experiences a sudden decrease (ie: severe weather conditions wiping out crops) or production of a good decreases (ie: lockdowns due to a global pandemic), then the cost of those raw materials will rise. In turn, the production cost of the final product will also rise, and very often those costs will be passed onto the consumer resulting in inflation. A famous example is the oil crisis in the 1970s when OPEC increased the price of oil while demand for oil remained constant. The result was the price of finished goods also increased. 

While bitcoin acts as a hedge against inflation caused by loose monetary policy, nothing about bitcoin is a hedge against the supply of raw goods dropping or production decreasing. Hence, bitcoin is not a hedge against supply-driven inflation forces. 

This brings us to today. The increase in CPI over the last year or so has likely been caused by a combination of both monetary expansion and supply issues. We will leave it to people much smarter and more well-versed in macroeconomics than us to debate which factor has had a greater impact on the recent rise in CPI.  But the truth is today’s inflation is likely due to a mix of both factors. On the demand-driven side, the Fed printed a record amount of money in a short period of time.  It’s also true that the supply side has contributed to the inflation we are currently experiencing. The shutdown due to COVID resulted in less production of goods. In addition, the Russia / Ukraine war has disrupted the supply of raw materials such as oil (Russia is the 3rd largest oil producer in the world), wheat (Russia is the 3rd largest wheat producer in the world and Ukraine is the 8th), corn (Russia and Ukraine combine for 17% of the worlds corn production), fertilizer (Ukraine is Europe’s largest supplier of ammonia which is a key component of fertilizer) and more. The ongoing war has caused a drastic reduction in a number of key raw materials in the global economy leading to price increases (have you been to the gas pump recently?).

As we just described, bitcoin would be a hedge to only the money printing part of the equation, not the supply-driven issues. In theory, this explains why bitcoin can still be a reliable hedge against currency debasement even though bitcoin’s price has fallen while CPI has risen.

Now, that's all well and good in theory, but we need to test this hypothesis and see what the data says.  If our theory is true, bitcoin’s price should increase when the Fed decides to print money and fall when it starts to tighten.  And in fact, that's exactly what the data shows.

In a recent post, economist Jan Wustenfeld compared bitcoin’s price to M3 rather than CPI in order to determine if bitcoin is in fact a hedge against monetary inflation. M3 is a measure of the money supply in an economy. Thus, by using M3 as our comparison, we can focus solely on how bitcoin reacts to monetary inflation rather than using CPI which has other factors embedded in it that could distort our findings.  

In early 2020, M3 shot up as a result of the stimulus-response to the pandemic. Not long after, bitcoin’s price also exploded upwards. In mid-2021, M3 started to flatten out for a short period of time and that corresponded with bitcoin’s fall in price. When M3 started to grow again in the back half of 2021, bitcoin rebounded in price. Similarly, when the Fed tightened its policy earlier this year and M3 began to decrease, bitcoin once again fell in price.

Source: Glassnode, FRED

Jan then took his analysis a step further by highlighting the percentage change from the previous year in which the correlation is much more prevalent. As we can see in the chart below, as the year-over-year change in M3 grew, bitcoin’s price followed shortly thereafter. The percent change in M3 peaked in February 2021 and in March, bitcoin’s percent change peaked as well. As the growth of M3 declined in the back half of 2021, bitcoin’s price followed suit. Recently, as the Fed has tightened its monetary policy, and hence M3’s growth has precipitously declined, so too has bitcoin’s price. 

Source: Glassnode, FRED

Whereas bitcoin’s price doesn't appear to be correlated with CPI, it does appear to have a fair amount of correlation with M3. The data suggests that bitcoin is in fact a good hedge against monetary debasement. The reason bitcoin isn’t necessarily a hedge against CPI is that CPI is reflective of more than just monetary expansion, it includes other factors that contribute to price increases that bitcoin may not be a hedge against.

If this is true, it should also be reflected in bitcoin’s performance. For that, we need to go back to March 2020 when Congress passed the CARES act injecting $2.2 trillion of economic stimulus into the economy.

Source: federalreserve.gov

Since that time, bitcoin is up 254%. That's after the craziness of this year and includes the 70% drawdown bitcoin has experienced since its all-time high in November. The bottom line is bitcoin has outperformed every other asset class since the COVID policy response in March 2020. According to the data and bitcoin’s performance during periods of loose monetary policy, it’s hard to argue against bitcoin being a hedge against inflation caused by monetary debasement.

There is one other important factor to take into consideration with regards to CPI and that is time. It takes time for newly created money to make its way into the economy and have an impact. Hence, CPI is a lagging indicator. In comparison, BTC trades 24/7 and reacts to the Fed’s expansion and tightening of monetary policy much faster.  Because of this, bitcoin price had already risen before inflation started showing up in the CPI numbers. In other words, bitcoin tends to front-run CPI. As CPI started to climb higher, the Fed’s policy changed and predictably, bitcoin’s price fell even though CPI was still rising.  Again, there will be some time lag between the Fed’s recent actions and the impact it will have on CPI but bitcoin will react far quicker. Though it’s impossible to know the future, there is good reason to believe that if the Fed changes course later this year or next year and resumes quantitative easing measures, bitcoin will likely react positively to that news before the impact is reflected in CPI. 

Bitcoin’s absolute scarcity and predictable supply issuance is the best hedge against the monetary expansion of the US dollar and every other central bank-issued currency.  However, it is not necessarily a hedge against inflation caused by supply shortages. Between the time lag of CPI and the fact that recent price increases have been caused by a mix of monetary expansion and supply shortages, many people have drawn the wrong conclusion as of late.  However, as soon as you understand why bitcoin is such a good hedge and analyze the data, the conclusion becomes much more obvious.

This leads us to one final thought. If you believe that central banks will continue tightening and the Fed will decrease its balance sheet over the course of the next few decades, then owning bitcoin probably doesn't make sense. However, if you believe that this recent tightening is a short-term trend and that central banks will revert to their continued policy of monetary expansion (like they have been doing ever since we went off the gold standard in 1971), then bitcoin is likely to do extremely well in the coming years and decades.

In Other News

A recent study by Deloitte found that nearly 75% of all retailers plan to accept crypto as payment in the next two years.

Mobile wallet Slope, which stored users' private keys in plain text on a centralized server, was hacked which resulted in $4.5m worth of Solana being stolen from more than 8,000 wallets.  

Robinhood's crypto unit has been fined $30 million by the New York State Department of Financial Services (NYDFS), which alleges that the company violated anti-money laundering and cybersecurity regulations.

The SEC Chair, Gary Gensler, wants crypto exchanges to segregate market making from custody services.

The European Central Bank released a working paper highlting how bitcoin and the Lightning Network can improve cross-border payments.

The SEC’s cryptocurrency confusion.

The IRS updated the crypto question for the 2022 tax return form to include gifts.

Disclaimer:  This is not investment advice. The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. Nothing contained constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments in this or in any other jurisdiction in which such solicitation or offer would be unlawful under the securities laws of such jurisdiction. All Content is information of a general nature and does not address the circumstances of any particular individual or entity. Opinions expressed are solely that of Brett Munster and do not express the views or opinions of Blockforce Capital or Onramp Invest.

 

 

 

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