Digital Assets: Your Guide to Investing and Trading in the New Crypto Market

By Jonathan Hobbs

CRYPTO IS GOING MAINSTREAM. WHAT SHOULD YOU DO ABOUT IT?

"Pretty much essential reading for those who have been tempted to dabble in trading but never quite had the confidence." - Cointelegraph.com

Bitcoin and digital assets have come a long way since the "bubble" popped in December 2017. While many investors have left the crypto market since then, the industry has been quietly building behind the scenes. Fast forward to today and a new digital asset market has emerged, with crypto prices once again on the rise. Crypto trading and investing are no longer just for techno-savvy early adopters. With each passing day, digital assets become more crucial for mainstream investors to consider.

In his latest and third book, Digital Assets, Jonathan Hobbs, CFA, provides a compelling case for adding bitcoin and crypto to your broader investment strategy. But perhaps more importantly, he focuses on how you can manage risk in a market that never sleeps, and not get 'wrecked' by the extreme volatility that crypto trading and investing so often entails.

If you are a long-term investor trying to buy crypto or a trader wishing to exploit opportunities in the most volatile asset class in the world, Digital Assets will be your compass to navigate this new and revolutionary market.

• Language: English
• Publisher: Jonathan Hobbs
• Release date: Apr 13, 2021
• ISBN: 9781005927370

Jonathan Hobbs

Jonathan Hobbs has been actively involved in the investment industry for the past 15 years. He graduated in Finance and Economics from the University of Cape Town, South Africa in 2006, and he holds the Chartered Financial Analyst ® designation. Jonathan has worked at Morgan Stanley, HSBC, and M&G Investments, where he specialised in valuing complex assets. His articles and market commentary have featured in Cointelegraph, ETF Strategy, and the London City AM.In 2017, Jonathan left his work in the city to become a full-time entrepreneur, author, and investor. It was then that he founded the Stopsaving.com investment education blog and wrote his first book, 'Stop Saving Start Investing: Ten Simple Rules for Effectively Investing in Funds'. In July that year, Jonathan became fascinated by bitcoin and digital assets. So much so, that by April 2018, he had already written his second book, 'The Crypto Portfolio: a Commonsense Approach to Cryptocurrency Investing'. This led him to consult on the investment strategy for digital asset hedge fund Ecstatus Capital in 2018, before serving as the firm’s chief investment officer for a time. He now independently advises financial institutions on the various nuances of digital asset investing, and has just finished his third book: 'Digital Assets: Your Guide to Investing and Trading in the New Crypto Market'.Jonathan strongly believes that nobody can predict the future of financial markets. For this reason, he simplifies his approach to investing with basic investment rules and strategies that work well over time. In his personal portfolio, he invests in stocks, bonds, mutual funds, start-up companies, gold, silver, and (of course) crypto. He lives in London with his wife and son.

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Introduction

If you want to get a good night’s sleep, don’t check the price of bitcoin in the middle of the night.

I learned this lesson when I woke up around 1 AM on 13 March 2020. I had been sleeping restlessly because of what was going on in the world at the time. I was also in a bitcoin short position.

March 2020 was a bloodbath for global stock markets. At one point, the S&P 500 US stocks index was down by over 25 per cent for the month. This was after it had already fallen by nearly 10 per cent the month before. The pandemic and lockdowns that followed caused huge uncertainty in the markets. And markets do not like uncertainty.

Bitcoin was not immune from the panic of Covid-19. From the start of the month until the time I woke up that morning, it was down 55 per cent. But then something extraordinary happened—I never went back to sleep after I saw it.

In less than an hour, the bitcoin price pumped nearly 40 per cent from below $4,000 to over $5,400. Bitcoin would not be dying this night, I thought, as I witnessed the panic turn to greed in a matter of minutes. Buying pressure stepped in here in a big way.

I started writing this book in the summer of 2020. Back then, bitcoin was priced at around $10,000. It is now February 2021 and the price is above $50,000. The question you might now be asking yourself is, can it go higher still? The short answer to this question is, yes it can. The long answer is laid out in part one of this book.

Bitcoin (and by extension, other digital assets) could prove to be extraordinary investments in the years to come. But make no mistake, there will be twists and turns at every corner. Part two of this book will help you navigate these.

I hope this book broadens your understanding of this new and revolutionary digital asset market, and that you walk away armed and ready to profit from it in some way.

To your investment success,

Jonathan Hobbs, CFA

Part 1: Why Digital Assets?

One

The Empty Promise of Cash

‘We have gold because we cannot trust governments.’

US President Herbert Hoover, 1933.

My investment philosophy is based on one overriding truth: nobody, and I mean nobody, can consistently predict what the market will do next. Not me, not you, and definitely not your local investment guru. The market has a mind of its own. It does what it likes, when it likes. The sooner you accept this fact, the better investor you will be.

With that being said, I do believe some investment themes have a far greater chance of playing out over long time frames than others. The most prominent theme today is one we will cover at length in this book—that of infinite money printing. We now have a situation of too many dollars chasing too few goods. Whether those goods are bitcoins, stocks, ounces of gold, properties, or packets of chewing gum, economics 101 expects those goods to become more expensive over time. If the supply of cash is unlimited, and the supply of goods is limited, then you will get less bang for your buck in the future. This makes cash a risky way to store your wealth.

Economics is not the only field of study behind this claim. History shows us that when governments control money, the results are always the same: money loses value. To understand why this happens, we must first look back in time at how money has evolved.

This story begins about 5,000 years ago, in ancient Mesopotamia, when people recorded financial transactions on slabs of clay. In The Ascent of Money, Niall Ferguson compares these to modern paper banknotes—in that each of them represented a financial promise to those who owned them. For example, one of these clay slabs that still exists today translates to Amil-mirra will pay 330 measures of barley to the bearer of the tablet at harvest time.¹ The £20 note I have in my wallet says, I promise to pay the bearer on demand the sum of £20. With my £20 note, I have more freedom as the bearer to choose what I want to buy than the bearer of Amil-mirra’s 330 measures of barley. But my £20 note is still a promise, nonetheless. For a promise to mean anything, you must trust the person or entity making it.

Money has come a long way since those ancient Mesopotamian days, with gold and other precious metals playing an important role in this journey. For thousands of years, gold could be exchanged for goods and services of similar worth. In Babylonian times, a farmer could buy a sheep for around two and a half grams of gold.² At today’s gold price, that is valued at roughly $150. One American farming website, iamcountryside.com, points out that a modern-day sheep usually costs between $200 and $250.³

Today I can buy a quality loaf of freshly baked bread for about £4 from my local artisan bakery. If I wanted to buy 350 of these loaves, it would cost me £1,400—which is about the price of an ounce of gold as I write this. In Babylon, 350 loaves of bread would also cost about an ounce of gold. In Roman times, the same ounce of gold could buy a toga fit for a senator. In the times we are now living in, it could buy a politician a suit in London.

Unlike the paper money of modern times, gold is not a promise. It is a finite substance that has been a universally recognised store of value for thousands of years. The human race has trusted in gold for several millennia, which is why it still holds its purchasing power today.

Gold’s physical characteristics have made it a great store of wealth. For one thing, it is shiny and nice to look at. It is also a highly durable metal. Unlike iron or steel, which rust easily, gold does not degrade in water or air. Finally, gold is a malleable substance. It can be melted down at 1,064 degrees Celsius (this will vary amongst different gold alloys) and reshaped into golden coins of a standard weight. Silver and bronze, which have slightly lower melting points of around 960 and 950 degrees Celsius respectively, can also be melted and minted into coins in this way.

Coin minting first started around 600 B.C when the Lydian Empire became the world’s first government to issue coins made from precious metals.⁴ The Lydian Stater was made out of electrum (a naturally occurring alloy of gold and silver found in Lydia’s rivers) and stamped with the heads of lions, bulls, and rams. The ancient Greeks had gold and silver coins for different cities, each with a god or hero on the one side, and a symbol of their city on the other. The Romans also had standardised precious metal coins of gold, silver, and bronze.

Before the invention of coins, it was a lot harder to buy things with bullion. People would carry around pieces of gold and silver that were each worth random sums of money. But now, they had coins of the same sizes, weights, and substances. This meant that goods and services could have fixed prices. The coins were also fungible as each type of coin carried the same value, regardless of who last owned it.

Coins made from rare precious metals are inherently valuable. For example, a gold or silver coin can be melted down and turned into jewellery. This, however, is not the case with modern currency coins made from cheap base metals or banknotes made from paper. And yet paper forms of money have been used for a surprisingly long time. According to the Guinness Book of World Records, the ‘flying money’ used in the Tang Dynasty in China from 618 A.D. to 907 A.D.⁵ was the first example of this phenomenon. Flying money took the form of paper documents, which were used exclusively by government officials and the wealthy elite as paper receipts to reclaim deposited funds. These papers could not be exchanged between individuals, which is why they were not yet true paper currency. Then, in the 11th century, Chinese merchants started printing ‘Jiaozi’ papers. People could trade these among themselves and exchange them for copper coins, tax exemption certificates, silver, and gold.

The government of the Song Dynasty later saw the value and efficiency of paper ‘promissory notes’ (financial instruments containing a written promise) and declared them legal tender. They also took charge of the money printing press and inscribed something like those who are caught counterfeiting will be decapitated on each paper note.⁶ After some years, the government-issued paper notes of the Song lost their value to extreme inflation. And eventually, people stopped using them as money. Each note was a written promise of a claim on a certain amount of coins. But the Song government broke those promises by continuing to print more paper notes than they could afford to.

The Song’s monetary collapse was not to be outdone by that of the Romans. During the reign of Emperor Nero,⁷ the Romans began a series of aggressive debasements of the silver denarius and gold aureus coins to fuel the growth of their empire. As time went on, each coin contained lesser precious metal content—until they were mostly made of cheap base alloys. This ended in hyperinflation, as merchants demanded more coins to exchange the same amount of gold and silver for their goods and services.

History shows us that any currency based on a government promise of some kind (rather than having an intrinsic value like gold) will eventually inflate away. And any type of money that can be printed or debased without limits sooner or later becomes worthless. Money needs to be scarce, or at least hard to come by, in order to hold its value. This suggests that modern-day currencies are poor long-term stores of wealth.

The German mark, Argentinian peso, and Zimbabwean dollar are some of the better-known examples of hyperinflation in recent history. While each of these nations had its own problems at the time, they all printed massive amounts of currency to help them tide over economic challenges. In all cases, this led to an over-supply of currency followed by extreme inflation, with more currency chasing the same amount of goods and services. The prices of those goods and services, therefore, went up in paper money terms. We can see several other examples of this in Table 1.1.

TABLE 1.1 Cases of high inflation for different countries pre-2000.

Source: goldonomic.com⁸

The Rise and Fall of the Gold Standard

In the early 1800s, England became the first country to directly link the value of its currency to gold and silver.⁹ This made it possible for pound sterling notes or coins to be exchanged at the bank for fixed quantities of precious metals. As the 19th century progressed, so did global trade and with it, the discovery of more bullion. Other European countries began ‘pegging’ their currencies to gold, and by 1900, most developed nations were on the gold standard. This worked out quite well for global trade and politics until World War I.

In times of war, countries tend to spend more. But back then, each country’s spending was limited by the amount of gold they held in their vaults. To counter this problem, the Bank of England and a few other central banks temporarily suspended the gold standard in 1914.¹⁰ This allowed them to create more money than they could before. The United States remained on the gold standard during the war, albeit only partially…

The US Federal Reserve bank (Fed) was created in 1913 to provide the US with a safer, more flexible, and more stable monetary and financial system.¹¹ The Fed’s first act was to grant its twelve reserve banks across America the power to print more money. To accommodate this, the Fed no longer needed to back its currency with a 100% gold reserve ratio—they agreed that 40% would do just fine.¹² Now, a $1 bill could be exchanged at the bank for only $0.40 worth of gold.

By the end of World War II, more than half of the world’s known gold supply belonged to the US. The US profited immensely by supplying its allies with military equipment during both world wars. All of this was paid for by their allies in pure gold. At this time, the US, now flush with gold, had also lent out a huge sum of dollars to other countries. There were now enough dollars circulating the globe to make it the world’s official reserve currency. And this is exactly what happened in 1944 under the Bretton Woods agreement, when the world agreed to add an extra middleman to the gold standard—this came in the form of the US dollar. Global currencies were now pegged to the dollar, which was backed by gold at $35 an ounce.¹³ This meant that most countries (apart from the US) were now on an indirect gold standard.

Under Bretton Woods, central banks around the world could exchange their dollars for gold held with the US treasury on demand. But over time, other countries became weary of the dollar’s influence and questioned whether it was all it was touted to be. This caused many countries to demand back their gold at the same time. But the world’s largest economy did not have sufficient gold in its reserves to match these demands. This is because the Fed had printed more dollars than it had available gold.

Just like the Song Dynasty and the Roman Empire before them, the US government had broken a promise it had made about what was backing its paper. Now under growing pressure, President Nixon ‘temporarily’ suspended all conversions of dollars into gold in 1971. But there was nothing temporary about this.

The Money Printer Goes Brrr

The fiat currencies we use today are backed by the promises of governments, as opposed to something physically valuable. The £20 note I have in my wallet, for example, is a promise by the Bank of England that they have my back. I can go to Tesco and buy £20 worth of groceries with it. The cashier at the checkout will accept it as money because the UK government says so. This sounds simple enough at first, but dig deeper and things can start getting hazy in no time…

Fiat currency is ‘printed’ by central banks at will. Since most money is digital nowadays, printing refers to the addition of numbers to digital accounts. The underlying process behind this involves a complex series of bond auctions, interest rates, and fractional reserve requirements. This allows central banks to expand or contract the money supply in order to help steer the economy through good times and bad. Of course, in this day and age, expansion is far more fashionable than contraction!

At the risk of turning this book into an economics masterclass, there is one major point about this process that you must understand: when central banks print more money, this creates brand new government debt. This is because governments must borrow every penny of new money that enters the system. They do this by taking out loans in the form of government bonds. These bonds are auctioned to large banks and asset managers, who then have the legal right to receive future interest payments from the government according to the terms of these loans.

Because the banks and asset managers now own the bonds, they can sell them to whomever they like. The central bank then buys these bonds from them using the money it creates out of thin air. In the short run, more cash enters the system to accelerate the economy. But in the long run, more debt ends up being created that must eventually be paid back by the government. Unfortunately, that government debt is then passed on to taxpayers like you and me. This comes in the form of direct tax hikes or (as we will shortly explore) the indirect tax of inflation.

For the sake of simplicity, consider the economy to be a bus; interest rates would then be the accelerator and a central bank would be the bus driver. When the bus slows down, the bus driver presses his foot down on the accelerator to speed up the bus. When interest rates go down, the money supply expands. With more money in the system, the economy can be sped up (theoretically) in the short term as more people have access to credit and liquidity.

Since the 2008 financial crisis, central banks have been pressing the accelerator down harder than ever before. To begin with, they did this to stop the banks from going under, using Quantitative Easing (QE). QE is what you get when a central bank is Dominic Toretto in The Fast and The Furious—and he is pressing the nitric oxide combustion button for extra speed.

If central banks had not done QE in 2008 and 2009, we may have had a much deeper recession than we actually did. But as the economy slowly recovered, the money printing pressed on regardless. Then 2020 happened, and the money printers went brrr…a

Figure 1.1 shows how QE has increased the Fed’s ownership of assets by about $6 trillion since the 2008 financial crisis.¹⁴ You will notice on the chart that QE4 makes QE1, QE2, and QE3 look rather small. QE1 was the Fed’s response to the 2008 financial crisis. QE4 was the Fed’s response to the Covid-19 crisis. Remember—more QE means more money printing and more government debt—not a good thing! What will the Fed’s response be to the next crisis? Or future crises that might stem from all this QE?

FIGURE 1.1 US Federal Reserve's total assets

Source: Board of Governors of the Federal Reserve System (US)

QE addiction is not just an American problem—it is happening all over the world. In the UK, for example, the rate of QE has also been increasing much faster of late. The Bank of England did £200 billion of QE in 2009.¹⁵ By 2016, this had grown to £445 billion. Then in 2020, when the pandemic hit and businesses were forced to shut their doors, the UK economy needed help. Consequently, the Bank of England printed another £450 billion. This was more than all the QE they did from 2008 until 2016.

Not to be beaten by the Brits across the pond, the European Central Bank announced a €750 billion emergency pandemic bond purchase program in March 2020.¹⁶ In the Land of the Rising Sun, the Bank of Japan was the first central bank ever to use QE back in the early 2000s. It has been buying about 80 trillion yen's worth (roughly $700 billion) of assets per year since 2014.¹⁷

Why Governments Need Inflation

We keep hearing about ‘inflation targets’ in the news. What’s the fuss about these targets? Recall that every time a central bank buys more government bonds, more currency is created. Simultaneously though, more debt is also owed to the central bank by the government. As mentioned before, the government could raise taxes each year to shore up more cash to try and pay back the central bank. But in a modern democracy, who is going to vote for a government that raises taxes to pay off its debt?b

Let’s assume we live in a world awash with inflation and I lend £100 to my mate Jeff. When Jeff repays me—let’s say in one year from now—the money will be less valuable. I could go to Tesco and buy fewer groceries with it than I could before I lent it to him. This would be a bad deal for me. But for Jeff, it is a great deal as the real value of his debt has gone down—despite him owing me that same £100.

Just as it would get Jeff off the hook for some of his debt, inflation would lower the real debt burden of your government—a few extra billion (or trillion) dollars of debt might be more manageable that way. This is why governments do not just want inflation, they need it. Therefore, they will throw every money printer they have at it until they get it.

If inflation is the carrot for debt-ridden governments, deflation is the stick. Deflation (the opposite of inflation) is when the purchasing power of your money increases. In this case, Jeff would get a raw deal by borrowing £100 from me because the real value of his debt would go up one year from now. By that same logic, deflation would be catastrophic for governments in large debt, whose real debt burdens would spiral out of control.

As we can see, deflation is a debt-ridden government’s worst nightmare. Governments, therefore, have huge incentives to create inflation. I would not bet against them here. Ironically, by keeping too much of your wealth in the ‘safety of cash’, you could be gambling with your financial future.

How Inflation Is Measured and Why It Is Wrong

Most countries measure inflation using some form of Consumer Price Index (CPI). The CPI is a standard measure of the average cost of a basket of goods and services at a point in time. This basket includes things like food, household bills, transport, electronic goods, education, clothing, furniture, and so on. When the CPI goes up, the general cost of living goes up and in effect, the purchasing power of your cash goes down. Changes in the CPI each year, therefore, are used to calculate the inflation rate. Figure 1.2 shows US inflation rates based on changes in the CPI for urban consumers in the US since 1913.¹⁸

FIGURE 1.2 Annual percentage US inflation rate (1913 - 2020)

(based on average annual US CPI for all urban consumers)

Data source: bls.gov

As shown on the chart, the US inflation rate has ranged from as high as 18 per cent to as low as negative 11 per cent (a negative inflation rate implies deflation). Using this data, the average yearly US inflation rate comes to about 3 per cent from 1913 to 2020. The chart also suggests that inflation has been more stable since 1985. On the surface, this may seem like a good thing for urban cash savers. But the average CPI inflation rate was still just over 2.5 per cent from 1985 until today.

Albert Einstein once famously said that compound interest is the eighth wonder of the world. He had a point there—compound interest is