Bitcoin is a Hedge Against System Failure

With the fallout of the COVID-19 pandemic causing increasing economic uncertainty, people are searching for ways to protect their money. Bitcoin, which is often regarded as ‘digital gold’, could serve as a hedge against system failure.

Fears over rising inflation, fiat currency devaluation, and political crises are continuing to rise across the world, leading many to look to Bitcoin as more than just an investment but as a hedging instrument. 

It’s no secret that Bitcoin has attracted widespread criticism, especially with regards to the energy consumption of its proof-of-work protocol. However, enthusiasts have maintained that its ability to function as a store of value far outweighs the costs.

Bitcoin as digital gold

Bitcoin has been touted as a digital equivalent to gold, a natural resource that has been used as a store of value and a hedge against governmental collapse for millennia. During the medieval period, gold was used as a currency in cross-border transactions because governments were unable to keep their fiat currencies stable.

Since then, gold has been used as both an investment asset and a hedging instrument against the collapse of government-backed currencies. 

As a peer-to-peer electronic cash system, the Bitcoin network doesn’t require the support of governments to operate, much like gold when it was first used. More importantly, most hard assets such as gold and silver hold their value because of their limited supply, which is also Bitcoin’s most important property. 

Bitcoin is a deflationary asset because its supply is finite. Only 21 million Bitcoin will ever be mined and as of October 2021, 18,845,868 Bitcoins (89.74% of its total supply) has already been mined. As concern continues to grow around fiscal policies towards money printing, Bitcoin’s limited supply only puts it in an ever-stronger position as a hedging asset.

Bitcoin’s value in struggling economies 

Bitcoin’s usefulness is best seen in parts of the world where the national currency has become unstable. This type of system failure could be due to issues such as a government breakdown or hyperinflation eroding the value of a country’s currency. Historically, gold was used as a hedge against currency decline. Now Bitcoin is filling the void as it has the additional benefits of being easily transportable, cheap to securely store, and effective in areas without the infrastructure necessary to support traditional digital payments.

In several emerging markets battling currency devaluation, individuals are purchasing cryptocurrency as a means to protect their money. This has been particularly evident in African economies, for example, Nigeria, where many residents have turned to cryptocurrency to protect their savings as the ‘naira’ continues to lose value. In Nigeria, the bitcoin market is booming more so than ever before, even after a government ban.

According to Nasdaq, Bitcoin’s trading volumes rise in markets struggling with high inflation and unstable banking systems, even when the price of Bitcoin falls. During Bitcoin’s year-long decline from December 2017 to December 2018, trade volume dropped by roughly 70% in countries with low inflation but rose by 60% in high inflation markets. 

These arguments alone don’t guarantee Bitcoin’s long-term efficacy as a hedging instrument, however, they demonstrate that the cryptocurrency is proving to be an attractive financial solution when conventional systems are in trouble. 

Limitations of Bitcoin

The biggest criticism of Bitcoin’s use as a hedge against system failure is how closely its performance appears to mirror the traditional markets. Gold is favored as a hedging instrument because historically it has proven to successfully absorb economic turbulence in the bond, equity, and oil markets.

Broadly speaking, the price of gold increases when interest rates decrease which is why it’s valuable during economic downturns. However, it’s been argued that Bitcoin prefers a strong global economy. 

A recent statistical study on Bitcoin’s performance during the COVID-19 outbreak looked at Bitcoin’s ability to behave like gold. It found that as stocks fell, their correlation with gold stayed the same. On the other hand, Bitcoin became more closely correlated to the equities market as the economic downturn worsened. 

Similarly, on 13 July 2021, the price of Bitcoin fell by 2% alongside a dip in stocks on the same day. This followed the release of US CPI data showing the biggest one-month inflation increase in 13 years between May and June, leading to further doubts about Bitcoin’s role as an inflation hedge. That said, during the recent downturn bitcoin consistently outperformed gold and it continues to do so.

Many have argued that fear around risky assets, such as cryptocurrency, is in fact to blame for sell-offs during equity market declines, which more reflects general market behavior than Bitcoin’s value as an asset. After all, bitcoin is the founding member of an entirely new asset class, so volatility is to be expected.

Is buying Bitcoin a good hedging strategy? 

As with any asset, Bitcoin isn’t without its weaknesses. Bitcoin is unique because its value is based entirely on people’s interest in holding it. It’s not intrinsically tied to other assets or specific markets in the same way that oil or real estate is. For that reason, although we’ve seen Bitcoin being used as an inflation hedge already, particularly in emerging markets, its long-term worth as a store of value remains to be seen. However, as adoption increases and fear continues to be dispelled around cryptocurrency, it seems ever more likely that its value is only set to grow in the long term.

It’s worth noting however that no single asset is guaranteed to protect you from any form of system failure. Investing in cryptocurrency requires a high risk tolerance so diversification is generally a good idea and you should always consider your personal long-term goals when investing your money in cryptocurrency. 

Finally, remember, that as always this guide doesn’t constitute financial advice and you should do your own research and consult a financial advisor before making a high-risk investment.

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