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Bitcoin and gold: Risk versus resilience in the 21st century

When considering a safe-haven asset it is important to ascertain what we are protecting against. Known high-probability risks within a system, or low-probability high-consequence systemic risks that interconnected with other systems? Intelligent investors should consider the difference between risk and resilience, and look at the market from a systems perspective.

In today’s extraordinary environment many market axioms are being violated. Positive correlations between disparate asset classes, gold and the US dollar strengthening together, trillions of dollars of negative-yielding debt, and malfunctions in the money markets. These are some of the many abnormal events occurring in today’s financial system.

In this introductory article to an upcoming quantitative BNC Research series (Gold Vs Bitcoin) we assess how in trying to bring stability to a complex financial system, central banks have compounded risks in nearly all asset classes threatening the equilibrium of the entire financial system, including gold. The frequency of abnormal market events suggests an approaching tipping point.

blx gold vol

Although undeniably a more volatile asset with just 10 years of data to draw on, we propose that in the event of a crash – with inflationary consequences – Bitcoin may be a greater benefactor and a more adaptable asset than gold in the emergent new regime for the following reasons:

**(i) **It is self-sovereign with low barrier to entry/no custodial fees **(ii) **its digital nativity aligns with 21st demographics and the changing paradigm towards digital value **(iii) **its digital malleability allows the building of digital companies, and apps, and can protect personal data on the world’s most secure network **(iv) **the breakdown of public trust in institutions, including central banks which hold a large amount of the world’s gold and (v) it is relatively autonomous from the legacy financial system

Part 1. We assess the interdependent risks built into financial markets and consider the resilience of gold and Bitcoin as safe havens within that complex system.

Part 2. We consider a new emerging paradigm of value, as the trust in money as a store of value continues to erode. This article will be followed by a quantitative investigation into the resilience of Bitcoin vs gold as a safe-haven asset from cascading effects in the financial system.

Part 1. Complex Systems

Complex dynamics is the study of systems that are often in non-equilibrium states. These systems are made up of many nonlinear interactions and dependencies between its different parts – and arise from spontaneous order in nature and society such as organisms, ecosystems, human cells, the economy, and society generally. However, complexity theory is the opposite of today’s prevailing financial models which are all premised on equilibrium models of the economy.

Financial markets share the three characteristics of complex dynamical systems, as defined by the Stockholm Resilience Centre:

  • highly unpredictable, due to their non-linear relationships / interactions
  • contagion effect, things can spread very quickly
  • modularity, although the whole system is well-connected, parts of the system are more connected within than between, which may help its resilience.

Using forest fires as a demonstration of complex dynamics, in spite of our success at reducing their frequency, the size and devastation caused by forest fires has increased over the years. What has since been discovered is that human interference in suppressing the frequency of forest fires has resulted in more acres of forest being lost to fire.

The primary reasons for this are the lack of diversity in pine forests that are planted for their timber efficiency but lack resilience, and because preventing fires allows invasive species, which grow faster, to outcompete the more resilient species, which are the older slower-growing species. This makes the forest less resilient and less able to recover from fires.

Risk versus resilience: The kindling builds up

When considering a safe-haven it is important to consider what we are protecting against – probable known risks within a system or low-probability high-consequence systemic risks?

What is a systemic threat?

According to the International Risk Governance Center a systemic threat arises when “systems […]are highly interconnected and intertwined with one another,” and disruption in one area triggers cascading damage to other nested or dependent nodes. A system is less resilient to these systemic threats the more closely interconnected it is with other systems.

The loss of resilience in the financial system can be seen in the declining central bank interest rates since the 1980s as the rate has failed to recover its former strength after each recessionary shock.

fed funds fed debt
Before the mid-80s, the Feds Fund rate (blue line) and Federal debt (red line) moved relatively in sync, keeping the government’s debt growth stable, as both FF rate and debt generally came down during recessions. But since the end of the gold-standard, it has been easier and cheaper for the US government to increase the money supply by lowering the interest rate and taking on more debt, particularly during recessions.

Just as forest fires are a regenerative process that clears out dead wood and leaves only the more resilient trees behind, eventually increasing overall resilience, our economic system can be understood in the same way. However, because a true reset has been avoided for several decades, and has been falsely supported by QE and bank bailouts, this has resulted in many ‘zombie companies’ growing even larger. It is due to this that many are seeking resilience in a new safe-haven for the 21st century.

Although the terms are sometimes conflated there is a fundamental difference between the two. While the metric of risk measured by volatility in financial markets considers the risk exposure before an event occurs, systems theory considers the resilience of how well a system prepares before and recovers after high-impact shocks that are entwined in other complex systems.

According to the OECD, resilience is risk preparedness, risk absorption, and risk adaptation to black swan events, or in other words ‘threat agnostic’.

On the other hand, risk management strategies (in the financial markets, hedging, safe havens, diversification or options strategies) can be effective for relatively low-impact shocks.

Systemic market risk and loss of resilience

In the legacy markets, there is growing concern that passive investing and exchange-traded funds (ETFs) have created bubbles and distortions in equity markets, all but eliminating price discovery and falsely suppressing volatility. The threat has even been likened to collateralized debt obligations (CDOs), the derivatives that precipitated the GFC.

The latent risks of these ETFs are that the institutions which create, underwrite, and custody them – are all counterparties to each other for the derivatives they have on their books. In other words, the fund management industry is highly interdependent and has grown ‘too big to fail.’

The eight largest asset management shops in the US have amassed $22t in assets under management, up from $8t in 2006, according to research by asset manager Fasanara Capital. This can be partly attributed to the positive feedback loop of rising asset prices led by trend-following funds and managers, resulting in a highly correlated and concentrated level of risk in global stock markets and particularly in the asset management industry.

“We find that, over recent years, measures of market diversity and resilience fell in lockstep with measures of entropy, all the while as size rose to record levels. Entropy in the ETF market decayed at an average rate of 4.5% per year in the last ten years, and its trend-line has almost reached 2008 levels.”

— Fasanara Capital

The FSB (Financial Stability Board) has warned of a “liquidity mismatch” between fund investments and redemption — essentially ETFs create an illusion of liquidity for assets as the number of funds has far outgrown the number of stocks underlying them and the ability to sell (or redeem) them during a mass sell-off.

Bitcoin’s relative autonomy from the wider financial system could make it a safe-haven from shocks emanating from that system as there are weaker connections that would result in cascading shocks. While Bitcoin has its native risks, these are largely independent of the legacy financial system.

Bitcoin as portfolio resilience

What characterizes a system’s resilience is its ability to absorb shocks and also to quickly adapt to a new equilibrium after a regime change. As for Bitcoin’s resilience, we propose Bitcoin’s ability to bounce back (via its price recovery rate) from a Black Swan event, will be greater than gold due to its unique 21st-century qualities.

If data is the oil of the new economy then Bitcoin, perhaps the world’s most secure and expensive data network, appeals to the developers and tech entrepreneurs building the apps and software of the new internet (Web 3.0).

Rather than being simply ‘digital gold,’ Bitcoin has become perhaps the most resilient and valuable information and data network in the world. In this sense, Bitcoin should be more adaptive and resilient to regime changes in the 21st century as it is natively digital, fungible, liquid, and portable – traits we believe are more desirable and will become more valuable than the aesthetics of gold jewelry.

As such, it is a feature that Bitcoin has no ETF, central bank and little institutional exposure – as this reduces its cross-ownership and interconnections with other parts of the financial system which should increase its resilience in the event of a systemic shock.

Gold’s interdependencies in the financial markets

Gold, on the other hand, is highly interconnected to the ‘legacy’ markets as it is owned by central banks and by investor portfolios, both public and private, and dozens of derivatives funds and ETFs — and as we will argue, it can backfire as a safe-haven strategy.

Gold funds are wrappers around a risky asset which introduces more intermediaries between the buyer and the asset than if one was to simply buy the asset outright.

For example, the value of the largest gold ETF, the SPDR Gold Share (GLD), depends largely upon physical gold held in vaults in London, and systemically important financial institutions, the fund vendor State Street Global Advisors, the trustee Bank of New York Mellon, and HSBC as the custodian of the gold. If any of those major (highly interdependent) institutions were to fail the value of the fund’s shares could go to zero, just as some of the short volatility funds did during the VIX spike shock this year.

gold holdings distribution

Also, not all funds are constructed the same. ETFs can either be fully-backed by the physical asset (GLD) or a mix of paper and physical. The fully-backed model has some obvious obstacles, there is only so much free-floating gold supply that can be bought but an unknown amount of demand for the gold fund, which can introduce price dislocations between the spot and the fund’s NAV (ordinarily brought back in line by arbitrageurs). The fund can only grow to a certain size before it distorts price.

Why then do most people buy gold? Most investors will never need or want to own physical gold but will simply hold a paper derivative as a portfolio instrument.

With hundreds of gold derivative products (ETFs, ETNs, futures, options, etc.) gold is also firmly ensconced in the global derivatives market which, at a conservative estimate, has a capitalization around $544t, and at an upper estimate is $1.2 quadrillion. For comparison, the capitalization of all the world’s stock markets is around $80tr and all of the gold in circulation (187,200 tonnes according to the World Gold Council) has a market capitalization of $10tr (when valued at a price of $1,500 per ounce).

The ratio of paper versus physical gold has long been a controversial issue in the gold and silver markets with many insisting that the outsized derivatives markets enables speculators to manipulate prices. This is also becoming an issue in the Bitcoin market, which has seen a huge influx of derivatives, particularly futures, products on crypto exchanges and traditional marketplaces such as CME and ICE’s Bakkt market. The notional trading volumes in the futures market is now suspected of exceeding the spot market, however, to what extent is difficult to determine due to leverage, double-counting and spoof volumes on exchanges. ChainAnalysis estimated $23b was traded in crypto derivatives through to Q3 2019.

Bitcoin is still in a relatively early stage of derivative evolution while the sheer size of the legacy derivatives market has compounded systemic risk by increasing the interdependence of the world’s major financial institutions which all play roles in issuing, insuring, underwriting, and holding custody of the derivative products – making them counterparties to many of the same risky assets they hold on their books. When systems are highly interdependent it increases the node connectivity which increases cascading effects emanating from a system blow up.

In the tumultuous months leading up to the Lehman Bros collapse in 2008, and the global financial crisis, gold dropped sharply for almost an entire year, presumably due to people liquidating positions and covering margin calls and selling by large institutions including central banks — a cascading effect.

At the onset of the GFC in early 2008, gold (XAU/USD) initially sold off and declined over 40%, shown by the trendline, not what would be expected of a ‘safe haven’ asset at the beginning of a crisis.

Even though gold made a strong recovery in the years after the GFC it also coincided with a strong recovery in the S&P index which has continued climbing to all-time highs.

gld spx correlation
*Both gold (blue line) and the S&P 500 rallied in tandem from the trough of the GFC in 2009 to recovery in 2013. Since 2013 the S&P has outperformed gold.

The coinciding crash and recovery in both gold and the SPX over such a long time-frame suggests gold wasn’t acting alone as a safe-haven but benefited from a broad lift in liquidity from quantitative easing which, in turn, lifted wider market confidence.

Whether this pattern will repeat in the next recession or be even more accentuated is unclear. However, it is an example of the unreliability of gold as a safe-haven when it is so intrinsic to the system it is meant to be protecting against.

Part 2. A changing paradigm of value

Rather than money reverting to a hard-backed standard, money is becoming globalized and it is unlikely there will ever be a return to a ‘gold standard’. Instead, the paradigm of value is changing to the digitization of value.

The margins on the cost of money production have been widening for central banks over the decades as the Treasury has diluted the content of metal (silver and nickel) in coins and even changed the standard of the printed paper money. In 2018 the Federal Reserve printed $243m of USD for a cost of $800m — or 0.3% of the face value.

Gold is held by all central banks as a form of non-sovereign base money as it is the one true globally accepted unit of settlement.


When fiat money is fully digitized and central banks issue their own digital currency the cost and ease of money production will be slashed again. This could allow for even greater fiscal spending as advocated by proponents of Quantitative Easing and Modern Monetary Theory (MMT). Monetizing government debt as per the proposition of MMT would be entirely more plausible and even logical with a central bank digital currency (CBDC) as the government would have real-time data on all economic activity.

The concept of value is undergoing a paradigm shift as a new generation native to the world of digital value emerges as the dominant global demographic. Millennials and Gen Z. These digital natives grew up with the internet, online banking, credit cards, Magic: The Gathering, gaming, and virtual currencies. As a result, this new generation of consumers understands value as more of an abstract concept, and not something that must be physical or held.

This generation will shape the future of money and perhaps define the next reserve currency. In the early 20th century a global narrative emerged that rather than having currencies pegged to gold as a reserve currency (the gold standard) they should be backed to both gold and silver. The premise being that a gold peg hindered economic growth as countries couldn’t expand the money supply beyond what value of the gold they held and often the peg had to be dropped, especially in times of war. A gold-silver combo would be more flexible and allow for more monetary expansion.

Trust is eroding in money and financial institutions

As money is a promissory note we can use it as a proxy for trust in a system. If interest rates are the price of money (for which return you are willing to lend it) then negative and zero rates have the effect of diminishing trust rather than bolstering it. Using the ‘alternative money’ narrative of gold its price can be viewed also as the breakdown of trust in legacy money.

tips and tnxThe price of gold (XAU/USD) in blue against the performance of inflation expectations (RINF) or US Treasury inflation-protected securities (TIPS) in orange shows a sharp divergence since the end of 2018. For years the price of gold and inflation expectations have tracked closely together.

Despite its reputation as providing protection against inflation, since the Great Depression, the annual return on gold has been 3% after inflation, compared to 8% for the Dow Jones. The narrative of gold as a safe-haven asset against market turmoil is an enduring one in investment folklore going as far back as the middle ages when gold was used in trade rather than paper money issued by kings who were prone to being killed and defaulting on the notes.

Despite the narrative of strong economies today the rally price of gold doesn’t reflect inflation protection but signals a breakdown of trust in money, politics, and economics.

In the first six months of the year, central banks bought a record $15.7b in an effort ‘to diversify’ from USD which signals distrust among central banks, just as the turnover of gold coins increased during times of war and distrust in monarchies.

Bimetallism for the 21st Century: Bitcoin and Gold?

The concept of ‘bimetallism’ arose in the 1890s which called for a monetary-system based on both gold and silver, rather than just the gold standard that prevailed for centuries. This term rose in frequency particularly after the 1893 depression, as the tie to a scarce physical asset limited the amount of money and credit supply needed to lift economies out of the trough.

A similar spike in interest has emerged with search terms for Bitcoin since 2012, driven by price speculation but also other narratives including calls for a new autonomous financial and monetary system, financial sovereignty, anarcho-capitalism, debt-free money, and ‘digital gold’.

The longer that Bitcoin exists, the stronger the Lindy effect becomes. In the meantime, the narratives will continue to evolve. In terms of pandemic models the story of Bitcoin has already gone ‘viral’. According to Prof Robert Shiller’s work on narrative economics search terms for Bitcoin have reached a similar fever pitch to bimetallism in the 19th century.

Source: Prof Robert Shiller

Just as the calls for bimetallism arose during the late 19th and early 20th centuries, a period of many wars in Europe and the US, some of the ‘macro drivers’ for Bitcoin have been geopolitical turmoil, such as Brexit and trade war headlines, etc.

What is most remarkable, is that in the space of just 10 years, Bitcoin has gone from obscure online cryptography chatrooms to sharing headlines in global media alongside the Federal Reserve, interest rates and calls for a new global monetary system not based on debt. The network has grown in value from zero to hundreds of billions of dollars in the same time frame.

Narratives spread the same as a virus epidemic. Could the interest in Bitcoin and systemic tensions reach new heights to propel Bitcoin as a safe-haven for the 21st century?

Conclusion: Preparing for a regime change

It is important to consider ‘regime changes’ from a systems perspective as the build-up of passive investing bubbles, cross-ownership of assets and high correlations between markets adds to systemic threats. A regime change occurs after a system reaches a tipping point that triggers an abrupt change of state to a new equilibrium in the system.

Many potential tipping points are lurking in the global financial system. That fact that today’s global sovereign debt bubble (as well as climate costs) is comprised of $14 trillion in negative-yielding bonds represents uncharted territory.

Rather than being simply ‘digital gold’ – Bitcoin has become perhaps the most resilient, valuable information and data system in the world.

Every year the Bitcoin network exists it grows in resilience. Bitcoin is constantly under attack and adapting to these new threats with updates to the base code makes it increasingly resistant to attack. There are numerous features in its decentralized design that prepare it for a systemic shock. This is the opposite trend to the financial system as a whole.

This article will be followed by a quantitative investigation into the resilience of Bitcoin vs gold as a safe-haven asset from cascading effects in the financial system.


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