Why is Bitcoin not a suitable investment for Sampo?

Bitcoin is a so-called cryptocurrency that has attracted growing enthusiasm since its creation in 2008. More and more parties have recently begun to recommend its suitability as a small part of a well-diversified investment portfolio. On these grounds alone, Bitcoin could be expected to have potential for further positive value development if its demand indeed increases. So why doesn't Bitcoin fit into Sampo's investment portfolio?

Valuation of investments

When estimating the expected return of an asset, it is useful to distinguish the cash flows of the asset from the factors that affect the valuation of these cash flows. The basic premise for any investment is that its value is built on the cash flows it generates over its life cycle. An investor can also get value from an investment asset if she manages to sell this asset to another party at a higher price than what she has originally paid for it. However, this may not be the result of an increase in the expected cash flows generated by the asset itself. In addition to the cash flows generated by the asset, its market valuation is affected by the factors by which these cash flows, which will only be received in the future, are converted to present value. These factors include, besides the general level of interest rates, also risk premia, which are added on top of risk-free interest rates and depend on the level of systematic risk in the asset itself. Risk premia are driven by the general market sentiment together with structural market factors, ultimately by supply and demand.

For Bitcoin, none of this seems very relevant, as it does not in itself generate any kind of cash flows, unlike equities, bonds, and real estate in the form of dividends, interest payments and rental income. Bitcoin is therefore not a cash flow -generating asset, and hence over time, Bitcoin itself can’t be expected to generate any sort of returns. Indeed, the prospective return expectations placed on it are based on speculation, reckoning that others are looking to buy more of it and its market price would thus rise, allowing it to be sold to another eager buyer.

Items without cashflows

Of course, there are items in the world that have value even if they do not generate cash flows. Factors of production, such as natural resources, infrastructure and production equipment, can be seen as part of the actual investment project, which, of course, is intended to generate cash flows for the investor. But items that do not generate cash flows and still have value for the buyer include especially items such as services and consumer goods. Their value is based on the utility gained from consumption - they are not bought for the purpose of generating returns on investment. If consumer goods that have been purchased are not consumed, their value can be expected to decrease as the item in question decays over time.

But there are also non-cash-generating imperishable items that are not intended for consumption and at the same time have an indisputable and lasting value, such as e.g. art, gold and cash. It is obvious that their value isn’t based solely on speculation. However, these items can’t be expected to generate a real rate of interest, i.e. a return in excess of inflation, as they do not generate any cash flows that would represent a return. The return on cash doesn’t match even the rate of inflation, as inflation erodes at its value by definition. But the real value of art and gold as imperishable objects could be expected to be preserved as long as these objects have a permanent use case and thus a permanent use value.

Bitcoin cannot be consumed or used as a factor of production or to make anything concrete like jewellery, for example. It is also difficult to see that Bitcoin would produce a similar kind of enjoyment for its buyer as art does. How could a value higher than zero be justified for Bitcoin at all?

Bitcoin as a medium of exchange 

A natural comparison for cryptocurrencies is in fact funds on a bank account, or money, in the euro area the euro. Bitcoin does not have the status of a legal tender, meaning that no one can oblige another party, such as a counterparty or a creditor, to receive a payment in Bitcoin. However, it acts as a medium of exchange and as means of payment in some online stores, online services and physical stores, and of course, between those who are willing to make and receive a payment in Bitcoin.

Money is a liability to the central bank and owed to its holder. Money is a liability on the central bank's balance sheet and matched by assets in the form of securities investments and gold. At the time of the gold standard, the central bank promised to exchange banknotes for gold at a fixed exchange rate. Today, the gold standard has been abandoned and the objective of the central bank is simply to maintain the purchasing power of money, or its real value, instead of exchanging money for gold, in other words, to keep inflation low. 1)

The central bank has the means to achieve this as it is able to control prevailing market interest rates and to influence commercial bank lending. Indeed, the central banks in developed countries have been successful in stabilizing the value of money in recent decades, with inflation remaining low, in the view of some, too low. 2)

There are no guarantees or commitments by anyone for Bitcoin to retain its value, as there are for money. Bitcoin is nobody’s liability to anyone, and no party is committed to guaranteeing the stability of its value. Indeed, the value of Bitcoin has been highly volatile over its life cycle. This makes it a poor medium of exchange - it is difficult for a buyer or seller to know in advance how many Bitcoins (or parts of it, satoshi) are needed to pay for the object in the transaction.

Bitcoin’s suitability for Sampo as an investment 

Recently, also many incumbents in the financial markets have begun to view Bitcoin as an inflation-hedge 3) and plausible investment asset. Such perspectives can easily be seen to reflect a general mistrust in the monetary economy and in the monetary policy pursued by central banks during recent years. In addition, Bitcoin is surrounded by a hype regarding its blockchain 4) technology, which, however, cannot be justified in terms of the non-existent cash flows it generates or its poor characteristics as a medium of exchange. Unless the anonymity offered by Bitcoin is seen as providing value for illegal use cases. From this perspective, however, Bitcoin cannot be recommended to be a part of a responsible investor’s portfolio. In addition, the amount of energy consumed for “mining” Bitcoin currently exceeds, for example, the entire energy consumption of Finland, meaning that it is not suitable as part of responsible investments from this point of view either.

According to the prudent person principle laid down in Solvency II and in the Insurance Companies Act in Finland, insurance companies may only invest in assets the risks of which they can identify, measure, monitor, manage, control and report properly. The company must take these risks into account when assessing its overall solvency needs. An insurance company is required to invest its assets in a way which ensures their security, convertibility to cash, returns, and accessibility. Bitcoin does not meet these requirements applicable to Sampo as the ultimate parent company of an insurance group.

1) The value of so-called fiat (Latin “let it be done”) money is not based on its convertibility to gold, for example, but on the credibility of the monetary policy pursued by the central bank in preserving the real value of money.

2) In recent years, it has often been read that central banks are pumping more and more money into the markets. However, central banks do not give away money to anyone, but exchange their own liabilities for the liabilities of others - either by buying government and corporate bonds or by lending to banks against securities collateral. In addition, central bank refinancing operations do not affect the real economy or inflation without the efforts of commercial banks to expand their lending. When a central bank buys securities and thus increases the supply of money, only the amount of commercial bank deposits held in the central bank (so-called central bank money) increases. In other words, from the point of view of consumers and businesses, the supply of money will not increase at all as a result of central bank measures alone. Indeed, central bank money is a closed system, and money can’t leak out of it to consumers and businesses without commercial banks increasing the amount of loans they grant to consumers and businesses. The low level of inflation in the 2010s has been partly explained by the moderate growth of commercial bank lending. However, during the Covid-19 pandemic, the amount of loans raised by businesses and consumers has started to grow faster. During recent months, this has raised concerns of a possible acceleration in inflation. Manufacturing capacity in the pandemic-weakened economy has been lost, and some fear it will be incapable of responding to a surge in demand following the end of the lockdown measures imposed by the authorities, which would lead to an increase in the level of prices.

3) see e.g. Bitcoin – At the Tipping Point, Citi, March 2021

4) a blockchain is a decentralized, and oftentimes public, digital ledger