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With Inflation on the Rise, Which Cryptocurrencies Can Provide the Best Hedge?

Aug. 2, 2021, 7:01 AM

As the pandemic winds down, and the world opens back up, we’re seeing a surge in spending and inflation that hasn’t been witnessed since 2008. Nothing gets fans of the gold standard more excited than reports of 4.2% inflation and congressional spending bills in the trillions of dollars.

With the growing concern around inflation, can cryptocurrency begin to fill the traditional role of an inflationary hedge in your portfolio, especially as oil stocks become morally untenable, real estate skyrockets, and gold stagnates? And if so, are some cryptocurrencies better designed than others? And, what about the tax implications, any chance this could be tax advantageous?

To begin answering this question, it’s worth considering the use case for U.S. dollars. That sounds somewhat ridiculous on its face—after all, everyone knows what the dollar is used for. But when you look beyond the price headlines of Bitcoin and Doge—the cryptocurrencies you hear about every day—there are code and systems there designed to serve a purpose. The U.S. dollar is no different—it was designed to be inflationary, to be printed and spent by the U.S. government, and to decrease in value if held, because spending is a positive driver of the economy and deflationary cycles are infinitely worse than inflationary pressure.

But this begs an important question—what use case was Bitcoin designed to address? If you haven’t heard the story, in the first block ever minted on the Bitcoin blockchain by Satoshi himself, the following verbiage was included: “Chancellor on Brink of Second Bailout for Banks”—this was in reference to a newspaper article from the U.K. about a British bank bailout.

Obviously, the designers of Bitcoin were against the unlimited printing of fiat and set out to build a deflationary asset. It’s worth repeating that—Bitcoin wasn’t an emergent phenomenon like paper money and early Templar credit systems. It was a designed system of checks and balances, discussed at great length, contemplated deeply, and built for a specific economic purpose. As crazy as it may sound, Bitcoin was designed to arbitrage electricity into a deflationary asset, and over time it has proven to be exceptionally good at this effort.

Before we get into other cryptocurrencies and the specifics of how to incorporate them into your portfolio, there’s one important consideration—just as fund managers and individuals have moved to divest from oil stocks, should cryptocurrency be similarly avoided?

While sensational headlines comparing Bitcoin to the power usage of small countries are common, it’s not quite that simple. Compared to oil stocks which are based on the fossil fuel economy, cryptocurrencies are tied to the electricity economy. That’s a subtle, but incredibly important distinction—in fact, the cheapest unsubsidized electricity in the world right now is green—hydroelectric in Oregon, solar in the Sahara, wind in India, and geothermal in Iceland—the list goes on.

But, green energy has one huge problem—you can’t line up supply with demand. With a traditional natural gas plant, you turn generation down during the day and up at night—you match your supply to the demand. Until we can control when the wind blows, or build orbiting solar stations, green energy just doesn’t really line up with our demand curves.

Now, there are different ways renewable plants deal with this issue—most stop operating during lower demand cycles to save on maintenance costs, but some use exotic energy storage systems. This may include something as “simple” as large Tesla batteries at the South Australian Neoen wind farms, or as ingenious as using hydroelectric power to pump water back uphill like in the Rocky Mountain Hydroelectric Plant in the U.S. Systems have even been designed to pump air into underwater bladders to later be used to power turbines.

While it may sound counterintuitive, cryptocurrencies are beginning to fill the role of energy storage. Afterall, Bitcoin was designed to turn electricity into a deflationary asset. And, while Bitcoin miners may be exploiting local power subsidies in China, regulation and policing will quickly deal with that.

My company for example, Bitwave, deals with taxes and accounting for cryptocurrencies at businesses, and the most successful cryptocurrency miners we see are people that are incorporating cryptocurrency into power arbitrage—using low-cost renewables, or off-cycle fossil fuel plants to mine when there’s excess power, and spinning down their mining operations as energy costs go up. In this way, not only can cryptocurrency become green, but it can also actually become a critical part of subsidizing green electricity by allowing plants and farms to run at a profit regardless of demand.

Does this mean Bitcoin is incredibly clean today? Of course not—but, take this into consideration as you make investment decisions.

So, should you bring a cryptocurrency into your portfolio as an inflationary hedge? Yes, but like anything in life, there are considerations. First, not all digital assets are designed for the same purpose. While Bitcoin was designed to be deflationary (only 21 million bitcoins will ever exist, and every four years the number of Bitcoins mined per day halves), other cryptocurrencies have no hard max. Dogecoin, for instance, is mined at an alarming clip, has no set max, and was just created as a bit of a joke.

Ethereum also has no hard cap, but its use case is very different. It wasn’t designed as a deflationary store of value, it was designed as a global computer. Eth itself is the “gas” you pay this global computer to do your calculations. That means, as the demand for this global computer goes up, so does the demand for Eth.

It’s important to note, however, that this doesn’t make it an inflationary hedge—which inherently is an investment that you think will gain value. So, if you’re looking to hedge, Bitcoin is the most similar asset to gold or oil, in that it’s just simply a way of converting time and energy into a single asset.

That doesn’t mean you should ignore Ethereum, Bitcoin Cash, Dash, or any other crypto, but just be aware of what you’re looking for in an investment. Crypto is as diverse as the stock market, and while a bet on Bitcoin smells a lot like a bet on gold, a wager on Ethereum is a lot more like buying stock in Netflix—you’re taking a stance that usage of the network will go up.

OK, now here’s where the taxes come into play—for all the great things about digital assets, the taxes on this stuff can be tricky. First, the IRS treats crypto as an asset, so when you acquire it, you pick up a cost basis, and when you sell it, you’ll have a capital gain or loss. There are some really interesting points around there though—if you’re mining, staking, or otherwise earning crypto, when that new crypto hits your wallet, you’re actually supposed to recognize that as income!

There are a few industries where it’s really common to recognize asset transfers as income, but I always hark back to the time when one farmer would trade a pig to someone in exchange for painting their house. In that case, you’re supposed to recognize one pig worth of U.S. dollars as income and pay income tax (perhaps the IRS takes bacon). The income you recognize is then your new cost basis for the asset—so, whatever the fair market value of painting a house is, or whatever CoinMarketCap says Bitcoin is worth.

Should you bring Bitcoin into your portfolio, even in light of having to pay taxes and massive price fluctuations? Well, I can’t give you financial advice, but I certainly think it makes sense, and many of the companies we work with do too. Additionally, you could always buy gold that has been tokenized onto the blockchain? So, why not try both!

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Pat White is co-founder and CEO of Bitwave, an enterprise digital asset management platform.

Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.

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