What the Heck is the Golden Rule? Have Cryptos replaced Gold?

This post is Part II of our Copper/Gold Ratio series. The Copper/Gold Ratio plays a significant role within the BT Market Risk Indicator and gives us a read on the day-by-day cyclical economic activity. We covered the macro drivers of Copper in our previous post.

In today’s post, we will cover the cyclical/structural drivers of the Gold price, as well as examine if Decentralized Cryptocurrencies such as Bitcoin or Ethereum (or Ether) may have replaced gold as a safe-haven asset and/or will protect investors against fiat monetary inflation/currency debasement.    

We will cover the following sections: 

Part 2

1. History of Gold Usage in the Financial System
2. Demand and Supply of Gold
3. The Golden Rule! Our Current Financial World Order
4. Have Cryptocurrencies replaced Gold as a Store of Value?
5. BT Machine Learning Models – Gold, Ether, and Bitcoin

1. History of Gold Usage in the Financial System

• Gold has benefitted from diverse sources of demand: as an investment, a reserve asset, jewelry, and a technology component. It is highly liquid, has no one’s liability, carries no credit risk, and is scarce, historically preserving its value over time. It is a store of value.  Gold has been the ultimate safe-haven asset to withstand economic recessions, inflation spikes, and credit risk concerns. Central banks have been net purchasers of gold since 2010, ending a multi-decade streak of net gold sales that had persisted since the end of the Bretton Woods system in the early 1970s. Investors tend to sell copper and invest in gold in times of economic/geopolitical crisis and hence the Copper/Gold Ratio declines.
• The open secret in the financial world (in a fiat currency world order) is that governments discourage the use of gold as money for their citizens and promote its use of fiat currency through the banking system, but they hold in it through their reserve assets at their central banks. Alan Greenspan once said deficit spending (or debt-driven growth) is simply a scheme for the hidden confiscation of wealth (via inflation). Gold stands in the way of this insidious process. It stands as a protector of property rights.  Generational memories of high inflation and how the value of paper currencies can be destroyed, generational memories of war, and upheaval (i.e. Germany) have driven the importance of gold in times of crisis and emergency. 

Three Monetary Systems have Lasted Multiple Millennium

For thousands of years of human history there have been 3 different monetary – see Table 1 as Ray Dalio has covered in his book The Changing World Order – Why Nations Succeed and Fail.  When the country needs more money/credit to deal with debt or fund wars or respond to a pandemic or crisis, it will move from Type 1 to Type 2 or Type 2 to Type 3 so that it can print more money and devalue the currency including reducing interest rates against real assets which may have different levels of relative scarcity such as real estate and commodities (i.e. resulting in increases in nominal value).  

If too much debt is created in the Type 3 currency (i.e. fiat currency) and trust and credibility of investors and citizens fall, and investors and citizens will get out of cash or spend it quickly as it no longer functions as a store of value. To regain creditability the currency would need to move from Type 3 into a Type 1 which is backed by hard assets (i.e. gold or silver) or a commodity with limited inflation or high scarcity. China the country that invented the world’s first fiat currency has moved back and forward between the different monetary systems over the last 1500 years (see Table 2 below).

Table 1: Different Monetary Systems – Hard Money to Fiat Money

Table 2: Transitions across Different Types of Monetary Systems in Chinese History

Back to the current financial system and US dollar reserve currency regime as we have seen similar themes play out. Before 1971, foreign currency reserves were effectively backed by gold (a Type 2 system), either directly under the gold standard or indirectly through the US dollar standard.

Despite the severing of this link in 1971 (Type 3 system), the US dollar and US Treasuries backed by the full faith and credit of the United States has continued to play a central role in the international monetary system during the latter part of the 20^th century due to the country’s economic strength and the stability of its political and judicial system.

The key factor to driving gold prices since 1971 has been the lack of debasement via inflation as annual supply growth of gold (above ground stock) which has been about 2% per year relative to money supply growth of 6%…more on this later. Gold’s scarcity relative to fiat currency derives its value.  

Fiat money can be printed in unlimited quantities to support monetary policy, as exemplified by the quantitative easing measures in the aftermath of the Global Financial Crisis (GFC). In recent years, the rapidly increasing global money supply and a low to negative rate environment have fostered an optimal environment for gold to outperform global sovereign debt, such as US treasuries, and track the global money supply. Gold has been more negatively correlated with equities in extreme market selloffs than commodities and US treasuries. As a result, gold is viewed as a safe-haven asset as a hedge against equity market drawdowns, and currency/sovereign bond devaluations/defaults.

Table 3: Gold vs. M2 Money Supply

Sanctions and US dollar payment system

• The US dollar’s global dominance gives the US a powerful tool to enforce sanctions on people, institutions, and countries. The pervasive nature of the US dollar payments system along with its dominance in international transactions has enabled the US broad powers to impose economic and financial sanctions on other countries.

• The US has enforced sanctions by restricting foreign governments, institutions, and individuals from using US dollars in international finance so that they are unable to receive payments for exports, pay for the purchase of goods, or own US-dollar denominated assets. Some view this as weaponizing the US dollar which started under the Clinton administration in the 1990s.

• Central Banks in countries that have been threatened with sanctions (i.e. Russia, China, Iran, etc.), have begun to hold higher gold reserves, so that they may continue to make payments by circumventing the US dollar payment system and these sanctions. These sanctions may have also led to further strategic alliances (Russia, China, and Iran) and trade agreements which may weaken the USD system in the future…more on this later. Private decentralized cryptocurrencies have also been used to move money outside of the US dollar payment system and sanctions as well.  

Gold Investment Characteristics

Credit (or default risk) and negative real rates sustained over a long period are the largest risks faced by bond investors. Gold provides a safe haven to investors with the following characteristics (see Table 4).   

Over the last hundred years, many countries even those thought to be safe, and liquid for bondholders, have experienced sovereign debt defaults (see Table 5), resulting in permanent loss of capital. Gold is held in central bank reserve assets as it is the only asset free of default risk.

Table 4: Gold Investment Characteristics

Diversification	Correlation with other assets 0.1 on average
Tail Risk/Safety	Effective Tail risk hedge including sovereign debt defaults and restructuring
Liquidity	Liquidity higher than German bunds, British gilts, US Treasuries
Currency Hedge	Negative correlations with fiat currency, especially with USD
Inflation//Deflation	Performs well rising price inflation and strongly in deflationary times

Table 5: Notable Sovereign Debt Defaults and Restructurings

2. Demand, Supply, and Reserves of Gold

• Now that we’ve looked at the history of gold in the monetary system, let’s take a look at some of the structural drivers of demand and supply of gold and where it is locally from a geographical perspective. Demand comes from 4 main areas – Jewelry, Technology, Investment, and Central Bank reserves with a significant demand coming from emerging markets led by China and India representing about 50% of overall world demand (see Table 8). Structural growth drivers are at play here as highlighted in Tables 6 and 7.  

• Supply is mainly driven by mine production and recycling of gold (see Table 9). Mine production tends to grow at roughly 2% per year (similar to the inflation target for Central Banks around the world) which may be a legacy holdover from the Type 2 monetary system in 1960/the 1970s.

Table 6: Global Market Demand for Gold 2010-2021

Table 7: Gold Structural Drivers

Table 8: Demand Geographically Diverse but skewed more towards Emerging markets (China and India) representing 50% of the global demand

Table 9: Global Gold Supply – Increases about 2% per year

Table 10: Consumer Demand and Mining Production by Country

Though the global monetary system is in Type 3 (no backing by commodity), gold still plays a significant role in reserve management for the central banks, representing upwards of 60% of total foreign exchange reserves for advanced countries such as the U.S., Japan, and Europe. 

The top 20 countries that hold gold in their Central Bank portfolios represent about 85% of total gold held by central banks globally, Central Bank reserve managers highlight gold’s performance during times of crisis as to why they continue to hold in their securities portfolios – see Table 11.

You will notice that the US holds 23% of global central bank gold, which is consistent with GDP as % of Total World GDP, however, is much less than the 70% of world supply at the Bretton Woods, yet continues to yield significant control of the financial system as much of trade is done in US dollars.

Table 11: Central Bank Reserves – about 20% of Total World Gold Supply

Table 12: Central Bank Reserves – Performance in Times of Crisis top reason to hold gold

Heightened economic and political risks – Central Bank FX Reserves

Central Banks are heavily exposed to the risks associated with advanced economy debt including:

• The long-term impact of the COVID-19 pandemic on monetary and fiscal policies
• Rising global inequality, which has fueled social unrest and the rise of populist parties
• Greater polarization of political parties, which increases the likelihood of large policy shifts from one administration to the next
• Deteriorating budget positions and aging populations
• Growing trade disputes and protectionist policies
• Increasing challenges to central bank independence around the world and the threat of sovereign debt being monetized
• An increased threat of competitive currency wars.

Anticipation of changes in the international monetary system

Structural factors also seem to underlie central banks’ interest in gold including the following:  

• Economic power is shifting from West to East and gold is moving in this direction. China is now the world’s largest economy on a purchasing-power-parity basis. It is the largest trading nation in the world and has the third-largest sovereign debt market.
• In recent decades, China has become a key driver of global growth, and is expected to play a major role for years to come. We note that gold is also flowing from West to East from dominant powers to emerging powers. We have seen this type of outcome playing out in previous changes to the monetary system – Dutch to British and British/US – see Table 16 – Lifetime of Empires.
• The reconfiguration of the global economy and China’s rising global footprint is expected to have an impact on the international monetary system. China has already taken steps to internationalize its currency by introducing several measures to promote renminbi cross-border settlements. More on this in the Golden Rule section.

China’s Impact on the Gold Market

Over the past two decades, China has become the world’s leading gold market. As both the largest gold consumer and producer in the world, China plays a key role in the global gold market.  Despite being the world’s number 1 gold miner, it relies on imports to meet local gold demand. Approximately 60% of China’s annual gold supply is sourced from imports and western markets have played an important role, as they account for roughly 50% of the imports.   

In Table 13, we show the process in which gold goes from mining to the UK (largest importer of gold via London Bullion Market Association or LBMA) for trading and on to Swiss refineries to end-user demand in China. LBMA sets Good Delivery standards for trading contract settlement (400 troy ounces). London is by far the largest global center for Over-the-Counter (OTC) transactions followed by New York, Zurich, and Tokyo. LBMA accounts for roughly 45% of global gold market liquidity. Western markets control much of the global gold market liquidity through the combination of the COMEX (NY) and LBMA and North American ETF trading represent about 80% of global gold market liquidity as of January 2022.

China’s major import markets are Australia, the UK, and Switzerland. The UK is also the world’s largest importer of gold and is Switzerland’s 2^nd largest trade partner with respect to gold. Australia, the US, Canada, and Mexico have significant gold mining and reserve capacity and are net exporters of mined gold traveling through the UK and Switzerland, at almost 600 tonnes annually, satisfying Chinese and Indian consumer demand for gold. The general trend has been gold has been moving from West to East over the last 30 years. (See Table 14).

Table 13: Transportation from Western Market to China

Table 14 – Select Western Market Global Net Exports of Gold – 1994 to 2020

India’s Impact on the Gold Market

The drivers of gold demand in India are many and varied. Cultural affinity, long-held tradition, and festive gifting play a significant role. With India’s deep affinity for gold, Indians have historically turned to this asset as a means of preserving their wealth – and increasing its value over time. However, India is unusual. Even though the country is one of the leading sources of gold demand worldwide, there is almost no domestic production, as almost 90% of India’s gold supply is imported. As such, when demand rises, imports tend to rise in sync. This can, at times, have a significant effect on India’s trade balance and current account. India generally speaking, imports from Western markets via Switzerland and Africa via UAE and Ghana.

Switzerland

Most of the gold produced in the world transits physically through Switzerland, and in particular Ticino. Four of the world’s major refineries of gold are located on Swiss soil. In an average year, Switzerland refines about 70 percent of world gold.

United Arab Emirates

As late as 1996, the UAE did not even appear among the world’s top one hundred gold-importing countries. Two decades later, the UAE ranked among the top four, above Hong Kong and the United States. The customs data provided by governments to UN Comtrade, a United Nations database, shows the UAE has been a prime destination for gold from many African states for some years.  Dubai’s role as a financial center and its lax regulation of the gold trade, favorable geographic position between Asia and Africa, and access to free trade zones have all contributed to Dubai’s growing reputation as a node of corruption.

Concerns about Dubai’s role in the illicit bullion trade have grown in recent years after reports that regulatory loopholes allow gold linked to conflict and money laundering to trade there. The city is the destination for 95% of the gold originating from east and central Africa, according to United Nations data, and that region is considered high risk due to the presence of armed groups.

Now that we have covered the structural drivers of demand and supply on a worldwide basis, let’s take a look at Gold’s influence on financial markets and the current world order. 

3. The Golden Rule! Our Current Financial World Order

The first Golden Rule is the principle of treating others as one wants to be treated. However, when we talk about the world order/financial system and look back at history, whoever has the gold makes the rules.

A lot of the architecture and imbalances via trade in today’s financial system can be traced back to the choices made at the end of World War II and the relative positions of the countries back then. It was clear during World War II that a new international system (“Bretton Woods”) would be needed to replace the Gold Standard after the war ended. Let’s review how we got to where we are today.

Type 2 Monetary System – Bretton Woods: The design for it was drawn up at the Bretton Woods Conference in the US in 1944. US political and economic dominance necessitated the US dollar being at the center of the system. The massive 20,000 metric tonnes of gold accumulated by the US Treasury (roughly 70% of the world’s gold supply) at the time provided confidence in the success of the Bretton Woods framework.  The Bretton Woods system was drawn up and fixed the US dollar to gold at the existing parity of US$35 per ounce, while all other currencies had fixed, but adjustable, exchange rates to the US dollar. Unlike the classical Gold Standard, capital controls were permitted to enable governments to stimulate their economies without suffering from financial market penalties. The dominant power at the time of crafting Bretton Woods, the UK, and British Pound Sterling was the world’s reserve currency, however, the UK was on its downward arc, in its lifetime as an empire – see Table 16 for further information.

A couple of summary facts of relative positions of global powers at the time:

	US	UK
Gold Position	Held ~70% of the world gold	Used up all gold reserves during WWII
Net investment Position	Largest Net Creditor – Lender of the Marshall Plan (repair infrastructure after WWII in Europe).   Collectively-owned more foreign assets than foreigners owned US assets	Net Debtor – needed debt relief following WWII
Trade Position	US wanted to break UK dominance of world trade. Emerging superpower.	The UK was the lead trader at the time and the dominant military superpower. GBP was the reserve currency of the world.

Type 3 Monetary System – Petrodollar: In August 1971, President Nixon announced that the US would end on-demand convertibility of the dollar into gold for the central banks of other nations. The Bretton Woods system collapsed and gold traded freely on the world’s markets. USD maintained its supremacy as the world’s reserve currency through the petrodollar – see the last article for further information. The current system is backed by the full faith and credit of the US.

A Paradox – Fiat Currency, Credit Cycles and Gold in a Type 3 Monetary System

So if gold is no longer at the centerpiece of the monetary system why do central banks continue to hold almost 20% of all of the world’s gold ever mined? A simple answer, the fiat currency system can be volatile as a result of credit cycles, and gold has performed well historically as a safe-haven investment in times of crisis.   

Conceptually, gold is linked to the end of credit cycles. Credit cycles start with the monetary authorities. When the money supply is inflated and interest rates lowered artificially, naturally unprofitable projects appear profitable, the structure of production is overdrawn, and more debt is taken on. Money is created through the credit creation process through the banking system.  As a credit cycle ends, the unprofitability of many of these businesses becomes apparent as they systematically fail to meet their projected performance. This often results in mass liquidations, layoffs/unemployment, and recession. To offset the lower amount of private credit creation during the recession, sovereign debt is issued to reduce the time a country may spend in recession by bringing debts and interest payments back in-line with cash flows. See Table 15 to see how this has played out over time in the US.   

Consequently, investors grow concerned about volatility during a recession, and gold frequently rises in value. Gold is the store of value in a credit-based system.

The rules of the credit-based system are documented and applied through the Basel Framework via the Basel Committee on Banking Supervision (BCBS) which aims to strengthen the regulation, supervision, and risk management of banks globally. The BCBS was created in 1974 (around the time of the movement to the Type 3 Monetary System) and comprises central banks (i.e. who hold the gold) and bank supervisors from 28 jurisdictions.

These rules maintain the current system and create fiat currency via the credit creation process. The rules also provide a large number of buyers (i.e. banks) for sovereign debt held as high-quality liquid assets (HQLA) in their liquidity portfolios and considered the most liquid and are of the highest quality in times of stress. 

Table 15 – U.S. Business Cycles – Debt is higher and Interest Rates are lower each cycle

Let’s fast forward to the current day. We see that the architect of the current regime continues to benefit from the exorbitant privilege the US dollar has afforded, however, times have changed for the US and appears to be on the downward slope of its arc which many reserve currencies experience given the buildup of excess debt in their systems – see Table 16 below.  

Table 16: Lifetime of Empires

We see that after operating in the Bretton Woods system, the collapse and subsequent emergence of Type 3 monetary system, Great Financial Crisis (GFC) and COVID-19 Crisis, in Table 17 we note that the US looks very similar to the UK after WWII and China appears very similar to the emerging US power after WWII.

Table 17: Lifetime of Empires – Reflecting on Emerging Power and Dominate Power (Current Day)

	China	US
Gold Position	May control 65% of the world’s gold via strategic alliances (see below) and appears to have amassed 20,000 tonnes of gold (similar to the US in Bretton Woods world order).	Holds about 20% of the world’s gold
Net investment Position	Net Creditor – Lender of the Belt and Road Initiative which represents the largest project of its kind globally comprising 60-70% of the world’s population.    Japan and Germany are also net creditors.	Net Debtor – potentially need debt relief following COVID-19 or will run negative real rates to inflate away the debt. Widening trade deficit.
Trade Position	China has broken US dominance of world trade and wishes to de-dollarize via digital RMB and build infrastructure and trade routes through Belt and Road Initiative. Emerging superpower.	Outsourced a large portion of its manufacturing base when compared to peers such as Japan and Germany.   Dominant military superpower. No longer dominate trade position. COVID-19 demonstrated weakness in the supply chain.   The US Military will continue to enforce the US Dollar’s use as the Global Reserve Currency

De-dollarization one commodity at a time – Internationalization of the Renminbi (RMB) and possible linkage to gold?

• We note that through the lifetime of empires, through the downward arc, the dominant superpower usually loses its exorbitant privilege (run twin-deficits) via reserve currency status (i.e. weakens as a result of excess debt as compared to productive capacity). We have covered in earlier posts, that over the last 20 years there has been a decline of US dollars within the FX reserves of global central banks, however, remains at ~60% of reserves currently (far greater than the US GDP as % of World GDP). We are seeing further de-dollarization via trade agreements (albeit slowly) and expect to see this continue going forward.

• China is the largest importer of oil. We are starting to see de-dollarization in oil being priced in renminbi (yuan). A significant boost to the internationalization of the RMB has been its use in trade in oil, with countries like Russia, Iran (China’s two most important oil suppliers), and Venezuela already accepting the RMB payment for oil deliveries, and China making the yuan more attractive by ensuring that it is fully convertible into gold on the Shanghai and Hong Kong markets. This is another significant step toward de-dollarization – the slow but steady move from a system with a single world reserve currency to a multipolar world in which the euro and yuan play supporting roles alongside the US dollar.

• China is pursuing several goals at once: developing its financial center; strengthening its currency, the renminbi (yuan), in international trade; and expanding its economic dominance in Asia. The aim is to gradually bring the renminbi on a par with the US dollar and the euro. This goal is a long way off; as only a very small part of international reserves held by Central Banks is currently held in the RMB (Chinese national currency) at around 2% which is equivalent to Canada which has 1/8^th the size of the economy.

• However, China has improved its position through clever maneuvers in the oil and gold trade. Let’s review what has occurred:  

• 2013: China no longer accumulates US bonds in its central bank reserves. Currently holds about $1 trillion or 4% of total US Treasuries outstanding.

• 2014: China launched a gold fixing in yuan (The Shanghai gold benchmark) given its clout in the global gold market (a year after it become the largest consumer). The gold reserves of the central banks have been considerably increased in some countries in recent years, which may indicate how many tokens a state has to offer at the negotiating table of a new world monetary order. Since the GFC, the PBOC central bank has added 1,350 tonnes of gold to its reserve.  

• 2018: Oil trading in the Chinese national currency was laid as they introduced oil futures dubbed the “Petroyuan” contract traded on Shanghai International Energy Exchange, which accounted for ~11% of global trade volume as it grabs market share from New York and London. China imports oil from a wide variety of sources, including Russia, Angola, Saudi Arabia, Iraq, Brazil, Iran, and Venezuela. Some of these countries have US sanctions against them (such as Russia, Iran, and Venezuela) and others may prefer gold to dollars, which is why conversion of yuan to gold based on the Shanghai gold benchmark was important to execute before the introduction of the oil futures contract.  
  • There are geopolitical implications here as this helps advance the China-Russia partnership in Eurasia, Africa, and the Middle East, as the US is moving away from the Middle East in recent years (i.e. Syria and Afghanistan).
  • Russia is now accumulating gold in its central bank, given the potential danger that the Western financial system has posed Russia in the wake of American sanctions, and more particularly the financial devastation faced by Iran when the US forced the SWIFT inter-bank settlement system to ban Iranian transfers in all other currencies. 
  • China and Russia have been expanding bilateral trade in their currencies for years and already conduct at least a quarter of cross-border business in rubles and yuan.

Bilateral Swap Agreements and Gold – A Possible Bretton Woods 2.0?

Similar to our analysis on copper, we have attempted to map relevant bilateral central bank liquidity swap arrangements and Gold with the U.S. Federal Reserve and People’s Bank of China (PBOC), as the existence of these agreements tends to be for strong allies and important trade partners and may be particularly important in understanding who controls the gold in a multi-polar world.   

Our gold estimates are based on Gold production, Central Bank Reserves, and net imports and exports since 1994 to get a sense of gold held in each jurisdiction/strategic alliance. We expect that future trade may be based on a multi-polar as the US and China look to decouple their interests due to strategic competition. It is difficult to get a handle on how much gold China may have given that:

• Trade data is incomplete: China does not report gold imports and exports on a consolidated basis. We have used UN Comtrade data which is from voluntary disclosures of the countries in which export gold to China/Hong Kong. We have started to track this data starting in 1994.    

• Official Reserves: This only includes gold held by the People’s Bank of China (PBOC) (Central Bank). Consistent with other emerging market central banks, they have added to their gold reserves since the Great Financial Crisis. Also, as China is a large holder of US dollar assets, if it was accumulating a large reserve of gold, it would not want to undermine the US dollar in the process of doing it by holding it in the officially reported Central Bank reserves. Gold may be accumulated in other State-owned businesses or possession of the People’s Liberation Army and the Communist Party. This gold is not officially reported but may be inferred by the accumulation of net imports or domestic production.  

• Beginning in 2002, private holdings of gold by citizens were allowed as the Shanghai Gold Exchange (SGE) was set up by the PBOC to permit the public to buy gold. State media and Banks have encouraged investment through Gold Accumulation Plans as a store of value. Gold is synonymous with money in Chinese culture and has been a preferred form of saving for generations. Banks also take gold as collateral for loans.

• World’s leading producer of gold (became the leading producer in 2007) and does not export gold to the rest of the world and became the world’s largest consumer in 2013. Almost all gold acquired by China remains in China. Chinese refined bars are rarely seen in Switzerland, the West’s principal refining center.
• Financial Center and Gold Exchange: China now hosts the world’s most important bullion spot/futures exchange in Asia (~9% of Global Gold market liquidity), has set itself up as a rival to London (LBMA). There may be evidence that gold is being used to back the China government bond market as well. However, western markets (US and UK) still control about 80% of global gold market liquidity.

Is China Developing a Financial Center linked to Gold?

Since opening up its bond market to foreign investors in 2010, it appears that total returns in China Government Bonds and Gold have been roughly the same. We give Louis Vincent Gave of Gavekal, credit for this observation. In Table 18, we show the China Government Bond-to-Gold Ratio and you will note that it roughly stays within 1 standard deviation over time, effectively backing their bonds (yield) with gold (safety). If this is true, this may add creditability to their bond markets on a relative basis to improve investor demand for bonds given the safety of gold.  Also, as real rates have been negative for western countries since the GFC, if China bonds offer positive real rates, this may boost demand for CGBs relative to German Bunds or US Treasuries.

Table 18: CGB to Gold Ratio – Mean Reversion Tendency

Table 19: Estimated Gold Holdings by Country

In Table 19, we have estimated that China’s holdings are roughly 21,000 tonnes or 11% of the overall world gold supply. However, by taking a look at strategic alliances, it appears that China may control almost 65% of the global gold supply via trade/Belt and Road Initiative and bilateral swap agreements.  

We looked at the importance of bilateral swap agreements in the previous posts. These swap agreements stabilize markets when markets become stressed in a fiat currency regime (i.e. debt becomes too much and more than cash flows to repay principal and interest). It also allows us to categorize countries across strategic/trade alliances.

Swap lines keep plenty of currency available during times of stress so that countries can continue to trade and secure important raw materials for manufacturing and production. In a fiat currency system, liquidity is necessary to keep financial markets functioning smoothly during crises.

We observe that while these swap arrangements are typically reserved for trading partners that are exporting key goods/services into either US or China, we note, that the China-only swap line countries skew heavily towards having a larger proportion of copper production (with generally larger trading relationships) on an annual scale which may help bolster domestic production in periods of liquidity stress going forward.

We note that the existing split between the US and China is much more balanced when looking at Bilateral Liquidity Swap Arrangements (BLSWAPs) in Chart 20 assuming that current strategic alliances holdup.

However, despite not having a bilateral swap arrangement with the PBOC, several countries are members of the Belt and Road Initiative and Free Trade Agreements exist (Peru) which may secure the supply of gold from these countries for China in exchange for infrastructure/further economic development/movement of people and goods – See Table 21 for further information.

By combing the BRI and BLSwap alliances, this would bring China closer to controlling the physical gold market via strategic alliances almost 65% of the world’s gold reserve – which is the number the U.S. had when it original drafted the rules of the game in Bretton Woods/Petrodollar World Order. This is a significant observation in our opinion.  

Table 20: Quantifying Total Gold Reserves and Bilateral Swap Lines (US Fed /PBOC)

Table 21: Significant Mining Production and BRI countries

It should be noted, that looking at annual production and net exports in Australia, the US, Canada, and Mexico, represent 75% of the mining annual production in BRI countries in Table 21, and in a situation of pegging the RMB to a tangible good such as gold, domestic production in these Western markets may be re-routed away from China and focused on domestic accumulation/protection of reserves. This would reduce China’s control in the physical gold market. 

Furthering the RMB Internationalization through technology and linkage to Gold – A possible New Monetary Order?

• Central bank digital currencies (CBDCs) open possibilities for easy bilateral trade and settlement without going via the US dollar detour to purchase commodities or financial assets. Digital currencies may also be tokenized with real assets.

• Under a central bank digital currency, direct credits and debits could replace stimulus checks and taxes. It would be the vehicle through which modern monetary theory could be fully implemented – with the central bank becoming tax collector and funder of all government operations.

• Tokenization refers to the process of issuing a security token that represents digital ownership of a real, tradeable asset and is recorded on an immutable blockchain. In theory, any asset can be tokenized. By digitizing tokens, assets that were once illiquid can now be considered liquid assets. By purchasing digital assets on the blockchain, you can purchase gold closest to its spot price and reduce unnecessary transport logistics. And purchasing a digital fraction of gold means you no longer need to physically break up a gold bar that alters its value.

China appears to be further ahead of most Central Bank in deploying a CBDC – see Table 22. Unlike China, the West has been debating, planning, testing. The key difference with a CBDC, relative to other decentralized digital currencies such as Bitcoin or Ether, is that a Central Bank has absolute control over the rules and regulations which will determine the use of the Central Bank’s liability and will have the technology to enforce it. This gives the central banks more power and control over the economy in real-time as money is programmable and could be created or reduced in a few keystrokes in unlimited quantities.  

Table 22– Central Bank Digital Currency Development

So where is China at with its Central Bank Digital Currency? Could this be the End Game for the US Dollar?

• The PBoC has already launched their CBDC with aspirations to soon be used in international trade settlements and eventually even used as legal tender in jurisdictions outside China and between third-party countries. This has been introduced to the rest of the world through the Beijing 2022 Olympics. We could see that greater adoption of digital yuan may be used in trading with other countries as well. 

• China may even retain control over their capital and financial accounts while internationalizing their digital renminbi through trade in the BRI initiative which covers roughly 60% of the world’s population. Given that China controls much of the world’s trade and has strategically secured most of the world’s raw materials over the last 25 years, this could be a way to dethrone the USD.

• A Possible End Game for USD or New Monetary Order?  But for the digital RMB to be trusted in a world of runaway inflation (asset/price) in the current USD fiat system, it may be important to restore creditability in the financial system and provide an anchor through scarce commodities (such as gold) or a basket of commodities. Keyes originally proposed a similar concept coming out of WWII known as Bancor backed by a basket of commodities, moving from a Type 3 currency system to Type 2, like we have seen throughout history when creditability in the system needs to be restored.

• The restoration of creditability in the financial system away from debt-driven growth has also driven the interest in decentralized cryptocurrencies to restore sound money in the last 15 years coming out of the Great Financial Crisis, more on this later.

• There are several hurdles to this end game (if this is even the end game). However, by having strategic control of the physical market for gold via its trade and infrastructure deals, China can threaten to use it to destabilize the US dollar and financial system, without destabilizing the RMB. This may be potentially devastating, and used carelessly could trigger an economic collapse in Western capital markets, wreaking financial and economic havoc in the US and other advanced nations.

• However, given that trade is global and interwoven, China will never be wholly independent from trade with the West, and severe financial and economic damage to the West may potentially create a feedback loop to China’s trade arrangements/strategic alliances. This is the reason that we believe, that China has yet to use its potential control of the physical gold market as an economic/financial weapon. Also, given that China also relies on western markets (Australia, US, Canada, and Mexico) today to import gold to meet current demand, this supply chain could be re-routed in such a case, reducing China’s control over the physical market. Though China has been building a financial center in Shanghai, western markets still control about 80% of global gold market liquidity through existing channels (US and UK).    

• Gold also provides insulation from periodic financial volatility and crisis associated with the fiat currency system. Under a monetary order where electronic digits representing currency can be created out of thin air in unlimited quantities, the best hedge (gold or cryptocurrency) is the opposite – tangible, scarce, and portable wealth. China is potentially accumulating gold to diversify its exposure away from the US dollar, given the knowledge of aging empires and currency depreciation or potential future US sanctions. 

• There may be hesitation of wide adoption by democratic nations in trade in the digital RMB due to concerns around individual property rights, cybersecurity, and rule of law despite a gold-backed currency from China given the rule by the Chinese Communist Party.  

• Rather than dethroning the USD, we believe the most likely outcome for the digital RMB is that in a multi-polar world, it would support existing trade arrangements, in which the euro and RMB play supporting roles alongside the US dollar, is the likely future. These three digital currencies potentially support, the three trading blocs that have begun to emerge: 1) North America on the US dollar, 2) a European Bloc tied to Euro, and 3) Pacific, Middle East, and certain South American countries tied to RMB. We already have started to see some of these lines drawn and this is partially reflected in the bilateral swap arrangements we have covered earlier.

• Another possible path, is a new monetary world order that is anchored to something tangible such as gold (gold-backed digital currencies via several central banks aligned with these trading blocs). The IMF has special drawing rights (SDR) that create international reserve assets. The value of the SDR is based on a basket of five currencies—the U.S. dollar, the euro, the Chinese renminbi, the Japanese yen, and the British pound sterling. Further digitizing this concept may be a potential path forward.

What about Bitcoin or Ethereum could they replace gold or fiat currencies as a store of value and payment currency? More on this later….

4. Have Cryptocurrencies replaced Gold as a Store of Value?

• Before we answer the question, we should start with what exactly are cryptocurrencies and how does one derive value from a cryptocurrency?

• The most liquid and common cryptocurrency for outright direct exposure is Bitcoin, which is a potential “digital gold” asset. There is also growing interest and liquidity in Ethereum, a blockchain-based computing platform, whose native currency, Ether, is required as “fuel” to power the decentralized apps or decentralized finance on its network—akin to a “digital gas.

• Decentralized cryptocurrencies let a consumer own and control value and send it anywhere around the world. It does this by providing a way for a large number of people, who don’t trust each other, to agree on a ledger of accounts (a blockchain) without the need for a trusted intermediary (such as a bank).

• Cryptocurrencies are open to anyone and no one has the authority to change the rules. The rules, like its scarcity and its openness, are written into the technology. The technology is programmable as well. It’s not like traditional finance where governments can print money or change the rules or confiscate your gold, or banks or financial institutions can shut down markets.

• One particular emerging area, Decentralized finance (DeFi) is an emerging financial technology based on secure distributed ledgers similar to those used by cryptocurrencies – see Table 23 below. The system removes the control banks and institutions have on money, financial products, and financial services. Ethereum is a smart-contract blockchain focused on building a secure, decentralized environment to host applications of all types. In the past year, decentralized finance (DeFi) and non-fungible tokens (NFT) have taken the stage to show the world the possibilities that can arise from blockchain technology.

• The common theme among all use cases will be the need for users to own and spend Ethereum’s native asset. The native asset is to the network what gas is to a car. So by building more applications on the Ethereum network and introducing more blockchain wallets, one may expect a network effect as more customers use Ether to conduct more and more transactions.

Table 23 – Decentralized Finance vs Traditional Finance

DeFi	Traditional finance
You hold your money.	Your money is held by companies.
You control where your money goes and how it’s spent.	You have to trust companies not to mismanage your money, like lending to risky borrowers.
Transfers of funds happen in minutes.	Payments can take days due to manual processes.
Transaction activity is pseudonymous.	Financial activity is tightly coupled with your identity.
DeFi is open to anyone.	You must apply to use financial services.
The markets are always open.	Markets close because employees need breaks.
It’s built on transparency – anyone can look at a product’s data and inspect how the system works.	Financial institutions are closed books: you can’t ask to see their loan history, a record of their managed assets, and so on.

So Can we Actual Say that Bitcoin and Ether have replaced Gold?

• It may be too early to tell if cryptocurrencies have replaced Gold as the Store of Value or Safe Haven asset. We do not believe this is the case given the interest in gold by several central banks and the growth of ETFs in recent years. Also, we have tested this empirically through our Machine Learning modeling as well and have found that there is limited evidence to support this claim. See the BT Model section for further information.

• Given the volatility and lack of current usage as a payment currency and lack of widespread sovereign adoption and central banks currently look at digital fiat currencies, and general regulatory uncertainty (and in some countries an outright ban such as China) we do not see either Bitcoin or Ether emerging as a global reserve currency at this point.   

• However, both Gold and Bitcoin/Ether have shown that are the antidote to monetary inflation/currency debasement within a fiat currency system.

• As Incrementum has noted, Gold and Bitcoin are like cousins in that Gold is a prime physical asset, whereas Bitcoin is a prime digital asset, which investors may appreciate for similar reasons. In Table 24, you can see that Gold and Bitcoin have similar characteristics.

Table 24: Characteristics of Gold, Fiat, and Bitcoin

• The relative scarcity of Gold and Bitcoin and lower inflation relative to annual monetary inflation given both assets value. Real Estate is also known as ‘Concrete Gold’ also benefits from relative scarcity, (though suffers from the lack of portability in a crisis) which will be a subject of a future post. Buying back common stock is a similar concept by making cash-generating available shares to be bought by future investors increasingly scarce in a world that is expected to have more fiat currency in the future.   

• In Table 25, we show the on the left side (stock-and-flow) which shows the annual production to total reserves, both at roughly 58 years. On the right side, the current annual inflation of Gold and Bitcoin is around 2% (which interestingly is consistent with the annual target for consumer price inflation adopted by central banks), which is far lower than money supply increases through the fiat currency system which is roughly 7-10% per annum.

• The annual inflation rate of Bitcoin is set to be less than 1% in 2024-2028 (see table 26 as future supply is pre-determined), increasing the stock to flow to 121 years (only 21 million Bitcoins available supply), making it a scarce asset in a world awash with fiat currency. The current value of Bitcoin is roughly 10% of gold’s market cap.

Although these decentralized cryptocurrency markets remain small markets relative to the most liquid markets in the world, we believe crypto markets are now large enough to allow for positions in sizes relevant to institutional investors – see Table 27 for Bridgewater’s estimate of relative Liquidity of markets institutional investors play in.

Table 25: Relative Scarcity gives Value to Gold and Bitcoin in a World of Expanded Money Supply

Table 26: Bitcoin Future Supply is largely Pre-determined and Stands at ~10% of Gold’s Market Cap

Table 27 – Bridgewater Associates Estimate of Liquidity across Institutional Markets

Bridgewater Associates has noted that there are several barriers for institutional investors, cited in surveys are about the nature of the asset class (e.g., it is volatile, hard to value, etc.), and others are more structural (e.g., custody issues and regulatory uncertainty). This development is expected to spurn further interest in these assets and further support reduced volatility over time.

5. BT Machine Learning Models – Gold, Ether, and Bitcoin

So after examining all the evidence from above, we set out the model digital assets on a similar feature set in which we built our previous BT Gold model to determine if indeed Ether or Bitcoin did replace gold in 2021, given that some investors feel that Gold did not perform the way it was expected to with high inflation prints over the last few months.

Before jumping into the data science and feature sets, we wanted to review the 12-mth returns of Bitcoin (BTC/USD), Ether (ETH/USD), Gold, and NASDAQ-100 Index (QQQ). The NASDAQ-100 Index includes the 100 largest non-financial companies listed on the NASDAQ based on market cap. Given the Fintech nature/blockchain technology of Ether and Bitcoin, we thought that there may be some correlation with the NASDAQ-100 returns over time – and we were right.  

A couple of summary observations – See Table 28 for the Summary:

• We note that BTC and ETH tend to track each other well over time at roughly 0.94 correlation. Returns and Risk as measured by volatility appear like a leveraged version (10-to-1) of the QQQ.
• QQQ, BTC, and ETH tend to track each other reasonably well at 0.60
• BTC/ETH vs Gold were more tightly correlated before March 2020 and correlation has moved negatively
• Does not appear that either BTC or ETH have replaced Gold as a store of value.
• Adding a small position of BTC or ETH to a well-diversified portfolio with Gold may further add diversification risk-adjusted returns.
• Our initial view before modeling is that BTC and ETH are not replacements for Gold, though, there is limited data to test the hypothesis given that returns for BTC start in 2011 and ETH 2015.

Table 28 – 12-mth Rolling Returns/Risk and Correlations for Select Assets

Machine Learning Models – Gold, BTC, and ETH

Each assets’ return was tested against the 12-month change in the features in Table 29 below. The training monthly datasets (80%) and the out-of-sample testing periods (20% of data) are included in Table 29 below. 

Table 29 – BT Model Feature Set and Features with High Model Value (in Green)

BT Gold Model Summary:

The rate of 12-month change in the gold price (in $US dollars) appears to be strongly correlated with the rate of change with an R-squared of 0.91 in the out-of-sample period 2018-2021 along with the following features (see Table 31):

• Central Bank Gold to Total Reserve Asset Ratio
• Select G20 Total Reserve Assets
• The U.S. Household Balance Sheet Allocation to Gold relative to Stocks and Bonds based on ETF holdings – see Table 30 below
• U.S. Real 10Y/30Y interest rates
• Price of Oil and U.S.CPI
• Select G20 BT Credit Impulse/Commercial & Industrial Lending in the U.S.
• Safe-Haven Asset (Japanese Yen/weakness in USD(DXY))
• U.S. Economic Policy Uncertainty measured by EPU

Table 30: Monthly ETF holding – World ETF Holdings represents 2% of Global Supply and North America represents 50%

Table 31: BT Gold Model Output

BT BTC/USD Model Summary:

The rate of 12-month change in the BTC price (in $US dollars) appears to be strongly correlated with the rate of change with an R-squared of 0.47 in the out-of-sample period 2018-2021 along with the following features (see Table 32):

• Network Effect as measured by the number of Blockchain wallets and Hash Rate (Table 33)
• Select G20 BT Credit Impulse/Commercial & Industrial Lending in the U.S.
• Safe Haven Asset (weakness in USD(DXY))
• High Yield Credit Spreads (Tightening represents risk-on)
• Equity Market Returns as measured by NASDAQ-100 Index (QQQ)

Table 32: BT BTC Model Output

Table 33: Blockchain Wallets and Hash Rates

• The crackdown by China in May/June 2021 impacted the prices by outlawing mining taking 50% of bitcoin’s hash rate dropped off the global network (see Table 33). Hash rate is an industry term used to describe the computing power of all miners in the bitcoin network.

• Regulators deemed all crypto transactions (both crypto-to-fiat and crypto-to-crypto), trading, and investments as illegal, whether executed via local or foreign platforms. This includes all bitcoin, Ethereum, and tether transactions.

• Chinese nationals who work in marketing or tech support roles for foreign exchanges are subject to legal prosecution. Authorities have set out plans to ban crypto mining by severing investment in the sector, increasing electricity costs, and blocking new companies from entering the industry. This is consistent with the government introducing their own CBDC currency for wide use in 2022.

BT ETH/USD Model Summary:

The rate of 12-month change in the ETH price (in $US dollars) appears to be strongly correlated with the rate of change with an R-squared of 0.47 in the out-of-sample period 2020-2021 along with the following features (see Table 34):

• Network Effect as measured by the number of Blockchain wallets
• Select G20 BT Credit Impulse/Commercial & Industrial Lending in the U.S.
• Safe Haven Asset (weakness in USD(DXY))
• High Yield Credit Spreads (Tightening represents risk-on)
• Equity Market Returns as measured by NASDAQ-100 Index (QQQ)

Table 34: BT ETH Model Output

Table 35 – BTC vs US dollar Trade-weighted Index

As we noted in our last post, commodities (including cryptocurrencies) and the U.S. Trade-weighted dollar appear to be negatively correlated – see Table 35. The Trade-weighted dollar index strengthens as the U.S. Fed raises short-term rates slowing the pace of cryptocurrency price growth), and tends to decline with larger U.S. budget/trade deficits/lower Fed Funds rate, which is supportive of higher cryptocurrency price growth – see Table 35.

The current monetary policy stance is tilted towards increasing the USD with reducing monetary support over the next 12 months, which may not be a positive environment for crypto prices going forward if history is our guide.

Overall Conclusions:

• Intuitively Gold, BTC, and ETH based on underlying characteristics may be thought of as direct substitutes to protect investors against currency debasement through fiat currency inflation and potentially a safe-haven asset to hedge equity market risk.  However, upon further empirical testing, these assets are not correlated, and using similar feature sets for each asset, did not help predict asset returns in the out-of-sample periods. We are interpreting these results with caution, given the limited data/limited life of BTC/ETH we have used to extrapolate results. We have noted as the number of blockchain wallets increases, the rolling volatility of 12-mth returns has decreased as the assets mature.

• Returns appear to be correlated to technology-focused equities as measured by the NASDAQ-100 Index (tends to be a high beta asset) and acted like a levered version of the index (10-to-1). BTC/ETH do not appear to hedge equity market risk as a safe-haven investment such as gold. Returns have been high for BTC/ETH in 2020/2021 a risk-on/high beta equity environment in which central banks/governments added substantial monetary and fiscal support including quantitative easing which adds significant tailwinds to many assets.

• There is limited data on how BTC and ETH may perform in a risk-off/lower beta period given the limited historical life of these assets. We expect the next 12-24 months to be a risk-off period in which we may see a higher Fed Funds rate and reducing central bank balance sheets through quantitative tightening. Cryptocurrency assets tend to be negatively correlated to the USD Trade-weighted index and in the near term, we expect more restrictive monetary policy to increase the USD trade-weighted index if history is our guide. In Table 36, we note that the NASDAQ-100 outperformed BTC, ETH, and Gold during the previous period of Quantitative Tightening (October 2017 to September 2019) though volatility was higher across all assets as compared to the total measurement period October 2016 to October 2021. 

Table 36 – Quantitative Tightening – October 2017 to September 2019

• Some investors believed that gold did not perform as expected in 2021 as asset returns did not react to higher-than-expected inflation in the US. Some investors believed that higher allocations to cryptocurrency assets may have replaced gold as a store of value/safe-haven asset. However, empirically speaking, the BT Model performed extremely well during the out-of-sample period with an R-squared of 0.91, which suggests that gold performed just as expected.      

• It may be too early to tell if cryptocurrencies have replaced Gold as the Store of Value asset. We do not believe this is the case given the interest in gold by several central banks and the growth of ETFs in recent years. However, there is limited data to test the hypothesis given that returns for BTC start in 2011 (106 observations) and ETH 2015 (62 observations). We expect with further institutional investor allocation to cryptocurrencies may add further pricing disciple and risk management in the future.
• Real assets with scarcity such as Real Estate/Land, Bitcoin/Ether, and Commodities (Gold) should be part of a well-diversified portfolio and expected to perform well in an environment with increasing fiat currency.   

Appreciate any questions or feedback you have or other research topics you may suggest.

Please contact us at beowulftreasury@gmail.com.

BT