Discover why digital assets are the ultimate insurance policy. The current macro environment is scary and getting scarier.
Evidence of systemic risk and stress in the broader financial markets are suggesting that we are approaching a breaking point. Serious investors are recognizing that they are exposed to more risk than previously imagined and are looking for ways to hedge their exposure.
To understand what is currently happening, it is important to discuss the flaws in our financial system, how we got here and why we might be at a different point than at other times in the past.
First of all, our global financial system is becoming increasingly centralized. Powerful central banks, large financial institutions, and intergovernmental organizations who shape monetary policy and guide the economy contribute to many global challenges and risks we face today. These seven major flaws in our centralized financial system are:
- Billions unbanked: Globally, about 1.7bn adults are without an account at a financial institution or through a mobile money provider
- Low financial literacy: Just one-third of people show an understanding of basic financial concepts
- High cost: Globally, fees per transaction average seven percent per transaction
- Low trust: Only 57 percent of people trust the financial services industry, and 40 percent of Americans trust the government
- Skyrocketing inequality: The top one percent own 47percent of household wealth- and top 10 percent hold roughly 85 percent of all household wealth
- Currency manipulation, instability and censorship: Countries like China, Venezuela and Turkey have all experienced varying degrees of currency manipulation
- Systemic risk: With financial power concentrated among just a few select institutions, such as central banks and “too big to fail” companies, it means that one abject failure can decimate an entire system, like the 2008 subprime mortgage crisis.
But, in order to reform our current system, we must examine the basics of the financial system, how it works and why we have it in the first place. And, like so many stories, it is best to “Begin at the beginning," And for our story, that beginning is trade and the creation of money.
What is the role of money?
Initially, money solved the issues with complex trade.
- Trading goods of different sizes. Let’s say eggs for a house.
- Trading goods in different locations. If you want to trade one factory for another, but they are not in mutually desirable locations, then no trade will happen.
- Trading goods of different levels of perishability. Let us say apples for a car. It is difficult to collect enough apples to trade for a car before the apples begin to spoil.
But as society developed and became increasingly complex, other qualities of money became desirable and are listed below:
Today, we use the terms currency and money interchangeably, but they are not synonyms. Our current, government-mandated currencies fill the role of money with one major exception: “Store of Value”.
While “store of value” is only one of the core functions of money, the lack of storing value leads to far-reaching and pervasive consequences across society- though these may not be immediately felt.
When money is a good store of value, it is referred to as “sound money” or “hard money”. A money’s ability to hold its value allows participants in the economy and investors to evaluate decisions for their merits, without being concerned with the deterioration of its value. This process of thoughtful investment is what fuels the progress of society.
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On the other hand, unsound money, or money that loses its value, has the opposite effect. It warps the relationship between savings and investment by encouraging people to spend now rather than investing in the future, as an equal amount of money will be worth less in the future. The slower the deterioration, or inflation, the more insidious and harder to detect. When inflation is extreme, people run to exchange their increasingly worthless money for real goods. We saw this in Weimar Germany in the 1930s.
And more recently in Venezuela.
This results in the collapse of the economy and is often accompanied by societal chaos. Again, see Venezuela with its civil unrest, mass migration, and spiraling murder rate.
For thousands of years, gold has served as money because of its high stock to flow ratio. That is, no matter the demand for gold, you can only mine so much, and it is impossible to create more. Anyone would agree that if alchemists could create gold from base metals, it would immediately cease to be a store of value.
But gold is not the money we have as our “store of value” today- it is the fiat currencies of various governments, which can indeed be conjured out of thin air. The reserve currency of the world, the US Dollar, has lost 90% of its purchasing power since superseding the British Pound in 1944.
Hardly the store of value needed to base sound investment decisions on.
The unsoundness of fiat currencies both encourages and is accompanied by ever-increasing financialization of the economy. At its core, the financial system only needs to serve four functions:
- Value exchange - Making payments
- Intermediation - Transferring resources between savers and borrowers
- Risk transfer - Pricing and allocating certain risks
- Liquidity - Converting assets into cash without undue loss of value
You want these functions achieved with as little cost and complexity as possible.
What we have, instead, is a Frankenstein monster of complexity:
And this machine is served by an increasingly large portion of the economy:
This is a system that has grown exponentially larger than the underlying real economy and is a breeding ground for catastrophic and unpredictable risk.
But why now?
Many agree this problem has been building for some time, and there have been many prophets of doom constantly predicting the collapse. What is different about the current environment that suggests we are coming to the end of our game of musical chairs?
Overall, the system is starting to show stress and exhibiting characteristics indicative of instability. There have been major currency failures and devaluations in countries like Venezuela and Turkey. While they are not major economies, instability usually begins in the periphery.
The escalating trade war between China and the U.S. is evidence that the world is shifting from an expansive, grow the pie, cooperative strategy to a competitive, enlarge your piece, type of mentality. The fantastic Ben Hunt’s The Silver Age of the Central Banker goes into more detail about the move from cooperation to competition and how it affects central bank policy —introducing more instability, both financial and geopolitical, into the system. These developments often lead to conflicts that can spark shooting wars, and we now see tinderboxes the world over: Hong Kong, the Straits of Hormuz, Venezuela and the list goes on.
Finally, and often overlooked, is the mounting political instability within countries. Ray Dalio’s research team at Bridgewater tracks this phenomenon with their Developed World Populism Index, which is now as high as it was at the outbreak of World War II.
And this may be the most critical factor of all. When crises have been averted in the past, it has taken tremendous political will and cooperation from opposing political parties. As the centers have deteriorated and people have moved further into their extreme camps, it is becoming more and more unlikely that we will be able to solve the mounting problems within the financial system through traditional, democratic governmental processes.
How to Approach Systemic Risk as an Investor?
To understand how to guard against, and even profit from, the risks in our financial system, we should consider Black Swans and Antifragility- two concepts developed by the author, trader and overall gadfly Nassim Taleb.
A black swan is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences. Black swan events are characterized by their extreme rarity, severe impact, and the practice of explaining widespread failure to predict them as simple folly in hindsight.
This is important because complex systems, like our financial system, are a breeding ground for black swans. The more complex and interconnected a system becomes, the more prone to black swans and the greater their potential impact.
The other just as important Taleb concept is antifragility and antifragile investments. These investments are not just resistant to shocks and chaos but actually, increase in strength or value from them. Think convex, asymmetric payoffs like options and insurance policies.
Bitcoin and digital currencies, when viewed as a life raft from the current financial system, may be the most antifragile investment in history. Bitcoin solves the problem of creating scarcity in the digital age and has the potential to restore monetary soundness.
And this is the point. Our current financial system is on track to produce the ultimate black swan event and the best way to play it is having an allocation to Bitcoin and digital assets.
Insurance Policy Before the Fire
But the door is closing and the time to put these plans in place is now. The macro lights are flashing red: Fed interest rate policy, global trade slowdown and increasing equity volatility. The geopolitical environment is even more tenuous. In a matter of weeks, Hong Kong has gone from one of the global financial centers to be on the verge of martial law enforced at the barrel of a gun by the People’s Liberation Army of China. We are starting to see increased demand for a digital, safe-haven asset.
There are very few things outside the financial system that have the potential for asymmetric returns in a global risk-off event, and crypto is one of them. Consider digital assets like Bitcoin to be your financial system fire insurance policy. A little bit can go a long way, and you hope you never have to use it — but to be without could be devastating.
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