Key Wealth Institute

Cryptocurrency Basics:
Blockchain, Bitcoin, and
Betting on the Future
by Justin Tantalo, CFA, Senior Lead Research Analyst
 Key Wealth Institute

Part 1: Bitcoin and blockchain basics

Bitcoin was introduced on October 31, 2008, in a short message from Satoshi Nakamoto1 sent to an
obscure mailing list of cryptography enthusiasts:

The humble message linked readers to a nine-page white paper, where Satoshi outlined the Bitcoin
peer-to-peer payment framework and introduced a set of solutions to overcome the shortcomings of
previous attempts at decentralized digital cash. The message represented the birth of a revolutionary
technology — the decentralized digital blockchain — and, on that blockchain bitcoin, the world’s first
cryptocurrency.

Who was Satoshi Nakamoto?

We still don’t know. “Satoshi Nakamoto” was an alias used by the person (or persons) who developed
Bitcoin. The mystery around Satoshi is an intriguing side story in Bitcoin that could remain unsolved
indefinitely: It’s been more than 10 years since Satoshi Nakamoto was last active online. The most
credible theories of Satoshi’s identity center on a small group of cryptography and computer science
experts, some of whom have passed on since Bitcoin went live in January 2009.
What we do know from Satoshi’s writings is that he/she/they were likely motivated by a distrust of
the fractional reserve currency system that underpins modern monetary policy. The fractional reserve
system places trust in a centralized monetary authority that ultimately controls money supply. Satoshi
believed that sound money could be created using cryptography and transparent code rather than
central banks and politicians who might be subject to whims of the moment. Coincidently (or not), the
timing of Bitcoin’s launch (January 2009) coincided with the depths of the Great Financial Crisis and the
ultra-unorthodox monetary response to it. Satoshi embedded a message into the first block of Bitcoin:
“The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.”

http://www.metzdowd.com/pipermail/cryptography/2008-October/014810.html
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Defining Bitcoin
First, some terminology. The word Bitcoin — slightly confusingly — refers to two separate but related
concepts. It refers to both the blockchain network and the cryptocurrency that trades on that network.2
Other blockchain protocols such as Ethereum differentiate the network (Ethereum) from the currency
(ether) with less ambiguity.

What is Bitcoin?
Bitcoin is a decentralized, digital blockchain network that allows peer-to-peer transfer of value
(bitcoin) without the need for permission or trusted intermediary. A bitcoin is not simply a file
that is sent from one user to another, since the sender could keep a copy while also spending
it (i.e., double spend). Instead, the Bitcoin network keeps track of all historical transactions on
a distributed ledger to accurately reflect who currently holds bitcoins.

Ledgers, ledgers everywhere!

Banks, central banks, security brokers, remittance services, and countless other intermediaries make
up our modern-day centralized financial infrastructure. Collectively these entities maintain interconnected
ledgers of who owns what and who owes what: They implicitly reflect historical transactions made between
parties. It’s a complicated web of centralized ledgers that is costly to maintain, but the plumbing works.
Digital blockchains like Bitcoin, on the other hand, operate as decentralized distributed ledgers where
network participants propose, validate, and record transactions without a centralized, trusted intermediary.
In Bitcoin, all transaction data is stored on a blockchain. A blockchain is a ledger record of every
historical transaction in the network, since day one, where “blocks” of data (transactions) are “chained”
to previous blocks such that the blockchain tells a single, immutable story of how current balances
came to be. The ledger is append-only, which means that data or transactions can only be added in
subsequent blocks. Cryptographic verification is used to ensure that transactions in historical blocks
cannot be altered without breaking the sanctity of the chain.

How it works.
The Bitcoin blockchain is software maintained concurrently on thousands of independent nodes (servers)
distributed globally. Anyone can operate a node on something as basic as a personal laptop. This
distributed architecture makes Bitcoin both hard to shut down and secure, since a rogue or malicious
node with false transaction data will have its record disregarded by the consensus of the thousands of
other nodes. Consensus is the ultimate truth.
Each node maintains its own copy of the Bitcoin blockchain which is updated with a new block every
10 minutes or so. Let’s walk through a simple example to better understand the process.

A differentiation is sometimes made: “Bitcoin” with an upper-case “B” refers to the blockchain network protocol, while “bitcoin” lower-case “b” refers
2

to the cryptocurrency itself. Think of a railroad analogy: the goods (bitcoin) travel on the rails (Bitcoin).

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Suppose Alice would like to send two bitcoins to Bob. Alice creates a transaction request using Bob’s
public address, signs the request digitally using her private key that only she knows, and broadcasts
her proposed transaction to the network of nodes. All newly proposed transactions like Alice’s are
distributed to each node. Cryptography is then used to verify that Alice sent the message and that the
two bitcoins are in fact hers to send.
Alice’s transaction only becomes “official” when it is included in the next block of the blockchain. This
last step requires a consensus-building mechanism amongst nodes so that each of them has the same
record with the same cadence. Consensus-building is undertaken by a specialized participant called a
Bitcoin miner.

Understanding a bitcoin transaction

Source: CBInsights

Anyone can mine Bitcoin.

Miners race against each other to be first to solve a computationally challenging cryptographic puzzle,
because with that solution (called “proof-of-work”), they win the right to package awaiting proposed
transactions (including Alice’s) into the next official block in the blockchain. The successful miner is
entitled to newly minted bitcoin as a reward for solving the puzzle and formally creating the next block.3
All nodes update their blockchain once a new block is mined by a miner; in the above schematic, Bob
officially takes custody of his two bitcoins in block 105.
Bitcoin miners play an important role in building consensus and maintaining network integrity. The
incentives they face steer the blockchain to include only the set of transactions which have been verified
as legitimate (digitally signed and unspent coins). How so? A miner who solves the cryptographic
solution but proposes a block with a fraudulent set of transactions will have their block rejected by the
network of nodes (due to unrecognized transactions), which leads to failing to achieve consensus and
forgoing their associated reward of newly minted bitcoin.
Every Bitcoin came into existence through the mining process just described. To close out our example,
Alice may have originally acquired those two bitcoins she sent to Bob in one of three ways:
1. She mined them
2. She purchased them with fiat currency like US dollars or other cryptocurrency at a crypto exchange
3. She acquired them in exchange for goods or services (i.e., accepted payment in bitcoin).
These are the three ways one can acquire bitcoin: mine them, buy them, or trade for them.

3
Mining rewards are currently 6.25 BTC per block. Rewards started at 50 BTC per block in 2009, but halve every four years.

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Digital scarcity
Satoshi Nakamoto appreciated that for users to adopt Bitcoin, it needed to be grounded in sound money
principles. Establishing trust would be difficult if an unlimited supply of bitcoin could be conjured up in
a discretionary manner, a weakness Satoshi believed to be inherent with fiat money. To address this,
the protocol dictates that new bitcoin awarded to miners follows a known trajectory with ultimate supply
capped at 21 million bitcoins.
The supply of bitcoin is scheduled to grow at a decelerating rate until sometime in the year 2140, when
all 21 million bitcoins that will ever exist will have been mined.4 As of mid-2021, approximately 18.7 million
bitcoin have been mined.
Bitcoin introduced the world to the concept of digital scarcity — a digital good with verifiably limited supply.

History of Bitcoin Supply (Millions)

25.0

20.0

15.0

10.0

5.0

0.0
09

09

10

10

11

11

12

12

13

13

14

14

15

15

16

16

17

17

18

18

19

19

20

20

21
n–

l–

n–

l–
n–

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n–

l–

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l–

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l–

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l–

n–

l–

n–

l–

n–

l–

n–

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n–

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Ju

Ju

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Ju

Ju

Ju

Ju

Ju

Ju

Ju

Ju
Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja
Source: Coinmetrics

Is bitcoin money?
Livestock, salt, shells, cloth, leather, coins of copper, silver, and gold have all been used as money at
some point in history. Is bitcoin (or other cryptocurrencies) the future of money? Maybe.
Money is a complex, societal construct. Some of history’s brightest economists have written treatises
on money that span hundreds of pages. We won’t take that liberty here. But to approach this question
objectively, we remind ourselves of the three textbook roles of well-functioning money. Money should act
as 1) a medium of exchange, 2) a unit of account, and 3) a store of value. It turns out that when viewed
using this objective lens, bitcoin is a relatively weak form of money. Consider:
Bitcoin as a Medium of Exchange:
• Money should be widely accepted in exchange for goods and services. US dollars are widely accepted
because those dollars are widely accepted elsewhere. That circle of trust is exceptionally important for
a medium of exchange. Bitcoin, although growing, are not yet widely accepted as a form of payment.
• Scalability issues. The Visa payment network handles an average of 1,700 transactions per second.
Bitcoin can accommodate approximately seven transactions per second. There are side-chain or
“layer two” solutions that can improve scalability, but using bitcoin to purchase a cup of coffee is not
likely anytime soon.

Beyond 21 million bitcoins, miners will be incentivized by transaction fees paid by senders.
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• Bitcoin settlement is final. A credit card transaction can be reversed through a chargeback. There is
no such discretion in Bitcoin, and it is impossible for a payer to unilaterally reverse a transaction, even
if justifiable because of error or fraud. With Bitcoin, all transfers are final, including mistakes.
Bitcoin as a Unit of Account:
• Money should be fungible and divisible into smaller units. Here, bitcoin scores well as 1) all coins
are equal and fungible, and 2) a coin can be divisible into a hundred-millionth unit called a “satoshi”
(0.00000001 BTC).
• A unit of account needs price stability. Bitcoin is still far too volatile to reliably price goods. There are
some goods which can be purchased in bitcoin today, but these transactions are usually priced first in a
hard currency like US dollars, then wrapped with the equivalent bitcoin price tag at the final transaction.
Bitcoin as a Store of Value:
• A store of value refers to money’s ability to retain its purchasing power across both space and time.
• A good store of value over space (geographically) was first defined by neoclassical economist Stanley
Jevons as “Something which is very valuable, although of little bulk and weight, and which will be
recognized as very valuable in every part of the world...”.5 Since bitcoin lives on a decentralized global
network, it scores exceptionally well as a portable asset that stores value, arguably the best in history.
•H
 owever, money should be a good store of value over time too. Bitcoin’s volatility can easily be forgiven
when prices are rising, but there have been three drawdowns of 80% in the past 10 years. The high
volatility materially limits the attractiveness as a store of value. Historically, stores of value during
economic and political duress (when they are needed the most) have been volatile given high levels of
uncertainty and risks of punitive capital controls. Given Bitcoin’s more limited history and much higher
volatility, other assets such as gold may be more palatable for a broader range of people.
Bitcoin has scalability issues and a volatility profile that makes it a weak form of transactional money.

A better analogy for Bitcoin might be “digital gold.” Gold and bitcoin are both liquid,
volatile, bearer assets whose incremental supply is verifiably constrained. There are
superficial parallels too: Both bitcoin and gold are mined into the market, and bitcoin
is even popularly portrayed as a golden coin, with an engraved B.

Gold Bitcoin
Finite supply Supply increases about 2% per year. Supply increases less over time, with a terminal
limit of 21,000,000 coins.
Liquid markets Gold has a highly liquid market with a huge Bitcoin, like gold, appears to have highly liquid
variety of participants and contracts. markets, including futures contracts.*
Uncorrelated Correlations with other assets are typically Price behavior is still evolving, with correlations
low, especially in times of economic distress. increasing more recently.
Inflation hedge Past inflationary episodes have shown gold Finite supply is attractive, but the asset remains
tends to perform well in such environments. untested given its limited history.
Global acceptance Gold is a globally recognized store of value, Bitcoin is banned in a number of countries and
held as reserve assets by most central banks. is widely regarded with skepticism by authorities.
Use in goods Gold is commonly used in high-tech Bitcoin has no uses outside its value as an asset.
manufacturing and jewelry.

Source: Invesco
*Bitcoin trades 24/7, resulting in periods of relative liquidity. This appears to be especially true on Sundays, resulting in greater price volatility on these days.

Money and the Mechanism of Exchange, (New York: D. Appleton and Co. 1876)
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Part 2: Crypto assets in a portfolio

Bitcoin is a cleverly designed peer-to-peer Consider the uncertainty of this question through
payment network. But how does its technology the lens of bitcoin’s historical price range. It’s
and growing adoption translate to price? In other enormous. At the bottom of the range, the
words, what is a bitcoin worth? 10,000 bitcoins that Laszlo Hanyecz paid for
two Papa John’s pizzas in 2010 implies a price
Bitcoin has no obvious intrinsic value. Any
of less than $0.01 per bitcoin. At the top end of
theoretical model or narrative on the fair value
the range, in early 2021, one bitcoin traded for
of bitcoin requires a good dose of abstraction.
approximately $65,000. From less than one cent
Unlike traditional assets like stocks, bonds, and
to $65,000 with exceptional price volatility along
real estate, bitcoins do not have a stream of cash
the way, it’s clear that even the wisdom of the
flows that can be discounted. How then should
masses struggle with bitcoin’s fair value.
one think about bitcoin’s price and/or fair value?

Bitcoin Price USD (Log Scale)

$100,000

$10,000

$1,000

$100

$10

$1

$0
Jan–11

Jun–11

Nov–11

Apr–12

Sep–12

Feb–13

Jul–13

Dec–13

May–14

Oct–14

Mar–15

Aug–15

Jan–16

Jun–16

Nov–16

Apr–17

Sep–17

Feb–18

Jul–18

Dec–18

May–19

Oct–19

Mar–20

Aug–20

Jan–21

Jun–21
Source: Coinmetrics

Market participants have proposed various frameworks to understand bitcoin’s price. We review a few
of the most compelling here:

Relative to gold
Bitcoin’s conceptual parallel to gold has been extended to valuation. If one considers gold as a financial
asset and store of value and ignores its use in jewelry, electronics, and dental work, then comparing
gold’s total capitalization to bitcoin could be informative. The World Gold Council estimates that
~200k tonnes (or metric tons) of gold have been mined throughout history. Because gold is practically
indestructible, we can assume that it is all still held somewhere. That gives gold a market capitalization
of approximately $12 trillion (at $1,750/oz). Using June 30, 2021, price (approximately $35,000/BTC),
Bitcoin’s market cap of $650 billion values the asset at 5% of gold. Some gold-based valuation models
also adjust for bitcoin’s substantially higher volatility. If volatility is incorporated, then the relative market
cap to gold is materially higher.

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Bitcoin Relative to Gold (Total Market Cap)

10%
9%
8%
7%
6%
5%
4%
3%
2%
1%
0%
11

12

13

14

15

16

17

18

19

20

21
–1

–1

–1

–1

–1

–1

–1

–1

–1

–2
–

–
ay

ov

ay

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ay

ov

ay

ov

ay

ov

ay

ov

ay

ov

ay

ov

ay

ov

ay

ov

ay
M

M
N

N
Sources: Coinmetrics, World Gold Council

Bitcoin in relation to an exogenous market Network Effects: Metcalfe’s Law

price like gold is one way to approach valuation.
An alternative group of models attempt to
$100,000 10,000,000
understand bitcoin’s price endogenously, or its
1,000,000
price in relation to internal variables. Three of

Transaction Pairs, Millions

$10,000
Price Per Bitcoin, USD

these models are presented below. 100,000

$1,000 10,000
Model #1: Using Metcalfe’s Law.
$100 1,000
Metcalfe’s Law suggests that the value of any
100
network is nonlinearly proportional to the number
$10
of users on it (value = users2). In other words, the 10
value of a network is equal to the square of its $1 1
user base. 2011 2014 2017 2020

Closing Price, USD (LHS)

Consider a simple telephone network with two
Transaction Pairs (RHS)
users. It has some value, but with three users
it has more than twice that value, since more
Value of a Network = # of Nodes2
than twice as many combinations of calls can
be made on it. Sources: Bitcoin price and its marginal cost of production: support for a
fundamental value by Adam S. Hayes, CFA, and Metcalfe’s Law as a Model
Proponents of this framework see Bitcoin as for Bitcoin’s Value by Timothy F. Peterson, CFA, CAIA. Model recreated using
estimates from Cambridge University Centre for Alternative Finance and data
a payment network with growing adoption. from CoinMetrics.io. Data as of 31 May 2021. Past performance does not
Invesco evaluated this model using transaction guarantee future results.

pairs to proxy Bitcoin’s user base and plotted Charting produced by Invesco.

it against bitcoin prices over time.

The challenge with this model is that Metcalfe’s value (economic utility) of the Bitcoin blockchain
Law is rather vague about the definition of network? The difference matters. Email as a
value. Does it refer to the value (price) of a network has exceptional value (utility), but it also
single bitcoin in dollars? Does it refer to the has a comparatively low price.

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Model #2: Stock-to-Flow.

The Stock-to-Flow (S2F) model was first disseminated in 2019 by pseudonymous Bitcoin enthusiast
“Plan B.” The model hypothesizes that a scarcity factor (SF = stock/flow) explains price levels. Gold, for
instance, has a scarcity factor of approximately 66x (existing stock of ~200 thousand tonnes, annual
flow of three thousand tonnes), meaning that it takes approximately 66 years of current gold mining
production to double outstanding gold supply.
Bitcoin has a dynamic scarcity factor that increases over time as the new supply of bitcoin created by
the mining process halves every four years. An increasing scarcity factor was thought to drive prices
higher. Plan B fit a predicted value estimate through statistical regression, which is presented below.

Stock-to-Flow Model (Log Scale)

$1,000,000 $1,000,000

$100,000 $100,000

$10,000 $10,000

$1,000 $1,000

$100 $100

$10 $10

$1 $1

$0 $0

$0 $0
09

11

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18
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Ja

Stock-to-Flow Model (BTC = 0.4*SF^3) BTC Price (USD)

Sources: PlanB, Coinmetrics

The Stock-to-Flow model hypothesizes that a scarcity factor (SF = stock/flow) explains price levels.

The S2F model had exceptional out-of-sample success early on, which thrust the model and the author
firmly into the spotlight. More specifically, when the model was released in March 2019, bitcoin was
trading at less than $4,000. The model predicted that post the May 2020 halving of mining rewards,
from 12.5 per block to 6.25, the price of bitcoin would be close to $70,000, reflecting a higher scarcity
factor. A nearly 20x implied return was a bold prediction indeed. And it was surprisingly prescient: The
price of bitcoin rose more than 15x to $65,000 by early 2021.
Academics tend to dismiss the S2F model on the grounds of the efficient market hypothesis. They
argue that the future supply trajectory of bitcoin is known in advance, and thus it should already be
priced in. In fact, bitcoin supply has almost no uncertainty to it (it’s transparent code). Fluctuations in
demand, which are variable, should thus matter more than widely understood incremental supply. In
short, academics dismiss the S2F model as a classic case of mistaking causation for correlation.

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Model #3: Marginal Cost. Embodied Costs of Production

The final model to note was proposed by Adam
Hayes, who borrows from neoclassical economics
and suggests that the price of bitcoin might be
related to its marginal cost of production, or at
least provide a floor. The marginal cost of bitcoin
comes in the form of energy and computing
equipment that miners use, since that is the
process by which new bitcoins enter the system.
Haye’s thesis is this: The higher the cost of mining
bitcoin, the higher its price should be.
The challenge with this model is that unlike
traditional commodities, incremental supply of
bitcoin does not respond to expanded mining
capacity. Bitcoin’s protocol automatically adjusts Electricity Cost of Hash Rate
the difficulty of the cryptographic mining puzzle Cost of Production =
Bitcoins Mined Per Day
such that regardless of network-wide hash-rate
(i.e., mining capacity), a new block is created on Sources: Bitcoin price and its marginal cost of production: support for a
average every 10 minutes. The math adjusts and fundamental value by Adam S. Hayes, CFA, and Metcalfe’s Law as a Model
for Bitcoin’s Value by Timothy F. Peterson, CFA, CAIA. Model recreated using
the puzzle gets harder to solve. Since no amount estimates from Cambridge University Centre for Alternative Finance and data
from CoinMetrics.io. Data as of 31 May 2021. Past performance does not
of computing power can change the rate of guarantee future results.
incremental bitcoin supply, marginal cost arguably Charting produced by Invesco.
converges to price, not the other way around.

Haye’s thesis says that the higher the cost of mining bitcoin, the higher its price should be.

Investors have long struggled to describe or predict the price of unproductive assets whose cash flows
cannot be simply discounted. Warren Buffett, arguably the most-famous investor in history, is well
known for being uninterested in gold precisely because it yields nothing, and suggests that the asset is
not useful outside of “going long fear.” In his 2011 letter to Berkshire Hathaway shareholders, he wrote:
“What motivates most gold purchasers is their belief that the ranks of the fearful will grow.”
The reality is that there is no theoretical model that reliably captures bitcoin’s price. No reliable model
indicating whether its price is low, fair, or expensive. Bitcoin has value because humans ascribe it value.
Like gold. And just like gold, there is no endgame with bitcoin’s price discovery; it will continue to be a
volatile reflection of speculation, fear of inflation, fear of missing out, risk of regulatory intervention, risk
of technological obsolescence, and ultimately, buyer’s sentiment.

Bitcoin in a portfolio
Institutional and private investors are increasingly incorporating bitcoin and other crypto assets into their
investible opportunity set. The asset class is relatively new and volatile, but high risk-adjusted returns have
commanded attention. In this segment we’ll review the characteristics of bitcoin in an investment portfolio.

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We’ll start by stating the obvious: Bitcoin is an exceptionally volatile asset. The standard deviation of
returns for bitcoin averaged 75% over the past five years. That is more than twice the volatility of crude
oil, 5x the volatility of gold and US equities (S&P 500 Index), and more than 20x the volatility of US
investment-grade bonds (Barclay’s Aggregate Bond Index).

Annualized Return Volatility (Trailing 12m)

140%

120%

100%

80%

60%

40%

20%

0%
Jan–16 Jul–16 Jan–17 Jul–17 Jan–18 Jul–18 Jan–19 Jul–19 Jan–20 Jul–20 Jan–21

Bitcoin Traditional 60/40 BBgBarc US Agg Bond Index

BBgBarc US Treasury Index S&P 500 Index Brent Crude
Gold

Sources: Coinmetrics, Morningstar

Drawdowns in bitcoin prices are shown in the figure below. Over the past 10 years, bitcoin has lost
nearly 80% of its value on three separate occasions. Enthusiasts have even coined an acronym for it:
HODL — hold on for dear life. In each of those drawdowns prices rebounded to record new highs over
the coming years.

Bitcoin Price Drawdowns

0.0%
-10.0%
-20.0%
-30.0%
-40.0%
-50.0%
-60.0%
-70.0%
-80.0%
-90.0%
Sep–11
May–11

Jan–21
May–12
Sep–12

May–13
Sep–13

May–14
Sep–14

May–15
Sep–15

May–16
Sep–16

May–17
Sep–17

May–18
Sep–18

May–19
Sep–19

May–20
Sep–20

May–21
Jan–12

Jan–13

Jan–14

Jan–15

Jan–16

Jan–17

Jan–18

Jan–19

Jan–20

Bitcoin

Source: Coinmetrics

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Despite this history of volatility and aggressive drawdowns, bitcoin’s returns have more than
compensated, resulting in a stream of historically high risk-adjusted returns. The trailing one-year Sharpe
ratios are shown below. As a reminder, the Sharpe ratio compares an asset’s excess returns (over the
risk-free rate) to its volatility (standard deviation of returns). Higher is better.

Sharpe Ratio (Trailing 12m)

5.0

4.0

3.0

2.0

1.0

0.0

-1.0

-2.0
16

16

16

16

17

17

17

18

18

18

19

19

19

20

20

20

1
–1

–1

–1

–1

–2

–2
n–

n–

p–

c–

n–

p–

c–

n–

p–

c–

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c–

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p–

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ar

ar

ar

ar

ar

ar
De

De

De

De

De
Ja

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Ju

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Se

Se

Se

Se

Se
M

M
Bitcoin Gold Traditional 60/40
S&P 500 Index Bbg-Brcly US Treasury Index Brent Crude Oil
Bbg-Brcly US Aggregate Bond Index

Sources: Coinmetrics, Morningstar

Bitcoin return correlations with traditional assets for the past decade are shown in the matrix below.

60% FTSE BBgBarc FTSE FTSE S&P S&P

BBgBarc BBgBarc FTSE S&P S&P
Bitcoin All World + US Russell Dvlp Nareit Bloomberg GSCI GSCI
US Agg US S&P 500 Emerging GSCI GSCI
USD 40% US Corporate 2000 Mrkts All Equity Commodity Brent Industrial
Bond Treasury Markets Gold Softs
Bonds (IG) High Yield (ex US) REITs Crude Metals
Bitcoin USD 1.00
60% FTSE All World + 40%
0.11 1.00
US Bonds (IG)
BBgBarc US Agg Bond 0.00 0.11 1.00
BBgBarc US Corporate High Yield 0.12 0.85 0.20 1.00
BBgBarc US Treasury (0.04) (0.27) 0.88 (0.23) 1.00
S&P 500 0.14 0.95 (0.07) 0.77 (0.41) 1.00
Russell 2000 0.12 0.84 (0.15) 0.75 (0.47) 0.89 1.00
FTSE Dvlp Mrkts (ex US) 0.11 0.96 (0.03) 0.80 (0.39) 0.88 0.80 1.00
FTSE Emerging Markets 0.04 0.87 0.09 0.78 (0.27) 0.74 0.68 0.85 1.00
FTSE Nareit All Equity REITs 0.00 0.73 0.35 0.69 0.03 0.69 0.65 0.63 0.59 1.00
Bloomberg Commodity 0.03 0.58 (0.09) 0.61 (0.33) 0.52 0.52 0.60 0.63 0.37 1.00
S&P GSCI Brent Crude 0.06 0.55 (0.15) 0.66 (0.42) 0.53 0.56 0.59 0.48 0.28 0.73 1.00
S&P GSCI Gold (0.11) 0.19 0.41 0.19 0.34 0.06 0.01 0.15 0.29 0.14 0.40 0.08 1.00
S&P GSCI Industrial Metals (0.02) 0.53 (0.07) 0.47 (0.27) 0.46 0.48 0.55 0.65 0.32 0.71 0.48 0.35 1.00
S&P GSCI Softs 0.03 0.43 0.04 0.42 (0.17) 0.35 0.35 0.44 0.50 0.37 0.65 0.44 0.24 0.45 1.00

Sources: Coinmetrics, Morningstar

The slightly negative correlation with gold is worth noting. If the narrative is that bitcoin is “digital gold,”
shouldn’t the correlation be higher? Or positive? One potential explanation is that as an investment
substitute for gold, bitcoin may be drawing incremental demand and capital away from bullion.

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Overall, bitcoin has negligible return correlations with traditional assets.

Analyzing bitcoin’s price volatility using the Venn risk model designed by Two Sigma confirms the
idiosyncratic nature of bitcoin’s volatility. Less than 10% of volatility can be explained by common
factors. The remaining 90%+ is residual and unexplained, which is consistent with the low correlations
shown in the matrix on the preceding page.

Factor Contributions to Risk

What percent of total risk is driven by each factor?

Investment
Equity 2.53%
Credit 0.39%
Commodities 0.70%
Emerging Markets 1.00%
Local Inflation 1.00%
Local Equity 0.11%
Equity Short Volatility 0.39%
Fixed Income Carry 0.35%
Foreign Exchange Carry 0.27%
Trend Following 0.70%
Low Risk -0.02%
Quality 0.46%
Value 0.02%
Crowding 0.11%
Residual 92.00%
-100.00% 0.00% 100.00%
Two Sigma’s factor selection methodology excluded 4 insignificant factors.

 Negative  Positive  Insignificant Value  Residual

Sources: Two Sigma Venn, Coinmetrics

Assets with high risk-adjusted returns and low correlations with stocks and bonds are the holy grail in
modern portfolio theory. Including these assets in a diversified portfolio pushes out the efficient frontier
and increases the benefits from diversification. The challenge, of course, is determining whether the
high and uncorrelated historical returns of bitcoin persist.
The “easier” forecast to make is that one should expect correlations with traditional assets to rise over
time as institutional adoption of bitcoin and crypto assets increase.

Allocation sizing
Digital assets are new to most portfolios. Investors should consider the risks involved, which we discuss
in the next section, but recognize that these assets represent the next layer of a digital transformation
that’s been taking place over the past 30 years. It’s been a costly theme for investors to ignore.
An investment in bitcoin (or any digital asset) should be sized appropriately in a portfolio. Bitcoin’s low
correlations with traditional assets help, but ultimately the only real mitigant to 75% volatility is to size the
allocation accordingly. And for the avoidance of doubt, while bitcoin is statistically uncorrelated to most
assets, it is not a portfolio hedge. During meaningful drawdowns in risk assets, bitcoin declines too.

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Bitcoin During S&P500 Drawdowns (10%+)

0.0%
-10%
-20%
-30%
-40%
-50%
-60%
-70%
-80%
-90%
May–11

Oct–11

Mar–12

Aug–12

Jan–13

Jun–13

Nov–13

Apr–14

Sep–14

Feb–15

Jul–15

Dec–15

May–16

Oct–16

Mar–17

Aug–17

Jan–18

Jun–18

Nov–18

Apr–19

Sep–19

Feb–20

Jul–20

Dec–20

May–21
Bitcoin S&P 500 TR USD

Sources: Coinmetrics, Morningstar

For investors who manage risk using benchmark tracking error, we examined the impact of adding bitcoin
to a portfolio of traditional assets. We start with a traditional “60/40” portfolio benchmark composed of
60% MSCI ACWI Index and 40% Bloomberg Barclays US Aggregate Bond Index.

Stocks Bonds Bitcoin Tracking Error

Traditional 60/40 portfolio 60.0% 40.0% 0.0% –
Traditional plus 1% BTC 59.4% 39.6% 1.0% 1.1%
Traditional plus 2% BTC 58.8% 39.2% 2.0% 2.2%
Traditional plus 3% BTC 58.2% 38.8% 3.0% 3.3%

The five-year backtest suggests that bitcoin weight, then they might consider $1 of digital
adds tracking error in roughly equal parts to assets for every $75 of equities in their portfolio.
its allocation. In other words, a 2.0% allocation A neutral weight to digital assets for a 60/40
to bitcoin added 2.2% tracking error to the investor would then be 0.8%.
neutral 60/40 portfolio. This relationship may be
Sizing an allocation to bitcoin with a focus
somewhat overstated due to skewed historical
on risk management allows investors to gain
upside volatility, but it helps frame the sizing
exposure to digital assets without overly relying
question using relative risk.
on future price forecasts. In our view, most
A second approach to portfolio sizing is cap investors would be well served to limit their
weighting. Consider that global listed equities overall exposure, and any allocation of 5% or
were valued in aggregate at roughly $75 trillion more should be reserved for those with outsized
in June 2021. Digital assets like bitcoin and ether risk tolerance and deeply rooted conviction in
were valued at roughly $1 trillion during the the future of digital assets. The table on the
same period. If an investor were to use relative next page describes the various approaches to
market prices as a crutch to determine neutral gaining exposure to the asset class.

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Asset Approach Notes

Crypto Exchange For traditional retail investors. Web and mobile apps can be used to buy and sell various
crypto assets. Convenient, but security varies depending on the custody protocol which
varies by exchange platform.

Private Fund For accredited investors or qualified investors. Most popular with HNWI. Typically passive
exposure to underlying digital assets. Can be active.

Public Fund (ETFs) In certain jurisdications, like Canada, bitcoin and ether ETFs are available. The SEC
in the United States is currently evaluating applications for crypto asset ETFs traded
on American exchanges.

Direct Custody Large institutional investors may choose to bypass collective investment vehicles
by establishing a direct custody relationship with specialist crypto custodians.

CME Futures Bitcoin futures trade on the Chicago Mercantile Exchange. The synthetic exposure
bypasses potential issues with digital asset custody, but adds trading and roll costs.
Capital gains tend to be difficult to defer when rolling futures.

Venture Capital Funds Typically for qualified investors. Venture capital firms will invest in newer digital assets
and/or start-ups in crypto infrastructure.

Sources: Bitwise, CFA Institute

Many investors with exposure to digital assets provide seed capital or early stage equity to
simply hold the most prominent coins, like entrepreneurs to help scale their businesses.
bitcoin and ether. Some might complement this Some of the most prominent VC firms have
with exposure to smaller, less-established coins had tremendous success backing crypto
and tokens, which are more volatile but have businesses and have established dedicated
the potential for excess returns should they gain crypto investment teams and funds. The
more prominence. investor demand is there too: In June 2021 one
well-known VC firm raised a $2.2 billion crypto-
Beyond coins and tokens, some qualified investors
dedicated fund, which is an impressive vote of
gain exposure to blockchain opportunities
confidence given the nascency of the sector.
through venture capital (VC) funds. VC funds

Part 3: Risks
Bitcoin is risky.
We’ve referenced bitcoin’s annual price volatility north of 75%, more than 3 – 5x as volatile as other
traditional risk assets like equities and commodities. If one accepts that price volatility represents risk, an
argument could even be made that bitcoin and similar digital assets are the riskiest of all investments.
Some investors disagree that price volatility represents risk. For them, risk is the potential for permanent
loss of capital. Bitcoin has that too.
The risk for permanent loss in bitcoin centers on custody and typically comes from errors in self-custody
or crypto exchange hacks.

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Recall that bitcoins are secured by private keys Most small holders of bitcoin store their private
that control a Bitcoin address. For bitcoins keys in a digital wallet hosted by a crypto
that are self-custodied (i.e., held outside exchange. Each exchange differs in protocol,
an exchange), the private keys are the sole but typically a user has recourse should they
responsibility of the asset owner and are often lose access to their wallet or forget their
stored in digital wallets. Those wallets containing password by contacting the exchange. This
private keys can be lost or passwords forgotten. access redundancy has obvious value, but it
Chainalysis, a blockchain-analysis firm based also introduces another point of failure since
in New York, estimates that up to a fifth of all exchanges can be run by malicious actors or
bitcoins are stranded due to lost private keys. hacked by them. Users have lost access to their
A vast majority of these coins have not been bitcoin through exchange hacks in the past.
transferred since the days when bitcoin was sub-
$10, which partially explains the carelessness.6

Exchange Date Bitcoin Lost Value, at Time of Theft Value ($35,000/BTC)

Mt. Gox February 2014 840,000 $460.0 MM $28.6 B

Bitfinex August 2016 120,000 $68.0 MM $4.0 B
AfriCrypt June 2021 69,000 $3.6 B (reported) $2.8 B
Thodex April 2021 unknown $2.0 B (reported) $2.0 B
Bitfloor September 2012 24,000 $250.0 MM $816.0 MM

Source: Various

In the institutional and fiduciary space, specialist digital custodians have entered the market. They
store bitcoin for large investors in “air-gapped” or “cold-storage” hardware wallets, which are physically
disconnected from the internet or any wireless device in buildings with high degrees of access control.
Keeping bitcoin keys stored in this fashion reduces the threat from hackers.

51% attack
A 51% attack refers to the risk in proof-of-work blockchains (such as Bitcoin) that a miner or group of
miners gains enough hash power to take control of 51% or more of a blockchain mining network, thereby
allowing it a mechanism to double-spend coins. The risk is acute for smaller blockchains with few miners
supporting the network. An attack has not happened in Bitcoin since network inception, likely because
the network’s collective hashing power has been far too large to attack. Hardware costs (est. $5-10
billion), chip shortages, and enough electricity to power a small country stands in front of would-be
attackers. That said, state-sponsored commandeering of existing mining capacity cannot be ruled out.

An attack has not happened in Bitcoin since network inception, likely because the network’s
collective hashing power has been far too large to attack.

Consider the case of James Howells, who stored private keys to 7,500 bitcoins on a hard drive that was accidently thrown out in 2013. He offered
6

25% of the $300m bounty to the city council in Newport, Wales, for permission to search the since shuttered landfill site. The city declined.

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Regulatory risk
Destabilizing regulation is the biggest risk faced by Bitcoin and the broader digital asset ecosystem.
It would be a mistake to conclude that since blockchains are permissionless, decentralized, and global,
they operate with regulatory immunity. Regulation is very much possible; the largest on-ramps and off-
ramps to crypto assets are centralized exchanges, and they require banking relationships, which in turn
are heavily regulated in each country.
The focus of regulators so far has centered on:
•  axes/AML/Terrorism Funding: Law enforcement agencies globally have increased their attention
T
on crypto assets, including Bitcoin, to stem its use to evade taxes, launder proceeds from criminal
activities, or fund terrorists. Blockchain technology represents an interesting combination of attributes
for those who “follow the money.” Bitcoin is pseudonymous in that all transactions ever made on
the blockchain are available for anyone to review or scrutinize. The challenge for law enforcement is
understanding the beneficial ownership of sending/receiving addresses. KYC (know-your-customer)
procedures at crypto exchanges helps connect the dots.
• Securities Laws: Bitcoin is interpreted as property in the United States, but other tokenized assets
can look and act very similar to traditional securities. Tokens can be created to represent fractional
ownership like stocks and REITs, to represent loans, or even contract-for-differences derivatives
(CFDs). The Securities and Exchange Commission has used public advisory statements, testimony,
and enforcement actions to remind participants that regardless of the platform, securities law applies.
Investors should expect the regulatory environment surrounding crypto assets to broaden. Regulation
tends to lag technology. Recall that the first law related to the internet in the US was enacted in 1996,
well past its early adoption. In the Telecommunications Act of 1996, lawmakers emphasized the role
of private investment and markets as the best route to promoting innovation. If the same philosophy is
embraced with digital assets and blockchain technology, one should expect the balance of regulation
to support innovation.
On the other hand, if advances in decentralized blockchain technology create a risk of financial
market destabilization, then one should expect a stronger response from regulators. It is unlikely that
governments will tolerate decentralized digital assets to meaningfully compete with fiat currencies.
If digital assets such as stable coins begin taking market share from fiat currencies for everyday
transactions, then regulatory risk would likely increase. Ultimately, regulatory risk is path dependent.

Investors should expect the regulatory environment surrounding crypto assets to broaden.

Environmental impact
Blockchains like Bitcoin that run on proof-of-work protocol consume significant amounts of electricity.
The electricity is used by miners in their race to solve the cryptographic puzzle, which is rewarded
with fresh issuance of bitcoin. Network electricity demand is useful in making it costly for a malicious
actor to mount a 51% attack, but in a world focused on reducing carbon emissions it represents a real
problem. Bitcoin enthusiasts argue that the economics incentivize miners to go where there is stranded
electricity, which is usually renewable (e.g., hydro), but the environmental impact of proof-of-work
blockchains is undeniable.

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The Cambridge Centre for Alternative Finance (CCAF) estimates that Bitcoin consumes
approximately 0.5% of global electricity, or nearly the equivalent of the energy consumed
in the Philippines or the Netherlands.

Unknown unknowns
Bitcoin and blockchain are new technologies with new terminology and a steep learning curve. Investors
considering adding an allocation to bitcoin or any other digital asset should remember that public
equities have been around since the Dutch East India Company was founded more than 400 years
ago. Bonds are even older. The asset price behavior and range of possibilities in traditional assets are
understood far better than nascent digital assets, which have been around for less than 15 years.
While the future possibilities for digital assets are virtually endless, a fully informed investor should realize
that there is equally impressive downside risk. We advise investors to tread carefully, understand the
possible risks, and for active strategies, partner only with the highest-quality managers.

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Appendix:
Beyond Bitcoin: Ethereum, and the second layer of digital assets
Blockchain is a decentralizing technology that can be used for any application which relies on time-
stamped, verifiably trusted data. Bitcoin focuses exclusively on transfer of value, but that is just one of
the many use cases that blockchain can support. Vitalik Buterin and Gavin Wood recognized this early,
and in 2013 they began working on Ethereum, which was envisioned to be a blockchain platform that
could be used for applications beyond money.
Ethereum is a more-complex protocol than Bitcoin. It too includes a native token (ether) like bitcoin, but
it also includes a decentralized Ethereum Virtual Machine (EVM), which is in essence a shared computer
that can execute code. The combination of the two components allows developers to create malleable
“smart contracts.”
Smart contracts are code that can execute conditional actions using the blockchain to maintain integrity
and transparency. For example, a smart contract might be programmed to execute simple travel insurance:
• If Alice’s flight is delayed by more than 30 minutes, escrowed ether (Ethereum’s native coin) is
automatically disbursed to her as insurance proceeds.
• If Alice’s flight departs on time, her escrowed insurance premium is automatically transferred to the insurer.
Ethereum is a platform that can bring Alice and an insurer together in a decentralized way, where trust is
placed in the blockchain and smart contract instead of traditional counterparties and brokers. The code,
along with an oracle (external data source), determines to which party the locked money will be released.
The technology has benefits for both sides of the transaction. Alice may be happier that a wider array
of insurance is available at potentially lower premiums as more of the process is automated. And our
hypothetical insurer, who may be a start-up or even an individual investor looking for uncorrelated returns,
is happy that it can participate in the market now that blockchain lowered the barriers to entry. Ethereum
provides the trust, decision-making protocol, and payment network to settle smart contract transactions.
With the flexibility of smart contracts, a developer can use blockchain technology in a myriad of use
cases. Ethereum is the mortar, and the developers bring the bricks.
Our hypothetical insurance example above is an example of Decentralized Finance (DeFi). As of
H1-21 there are more than 100 functional DeFi tokens disrupting traditional finance in asset-backed
loans, decentralized exchanges, and derivatives, with over $50 billion of value locked (i.e., smart
contracts engaged).

DeFi Token Category Total Value Locked (B)

Aave Loans $10.8
Curve Finance Decentralized Exchange $7.9
Maker Loans $6.9
Compound Loans $6.8
InstaDApp Asset Management $5.9
Uniswap Decentralized Exchange $5.7

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DeFi Token Category Total Value Locked (B)

yearn.finance Asset Management $3.8
Liquity Loans $2.9
SushiSwap Decentralized Exchange $2.7
Flexa Payments Network $1.4

Source: DeFi Pulse, https://defipulse.com/

The DeFi Tokens listed above operate entirely on the blockchain. Interestingly, almost all these
applications used the blockchain to undertake an “initial coin offering” to finance their start-up. Initial
coin offerings (ICOs) can be used to “tokenize” corporate equity, and trade on a blockchain just as
bitcoin does, mimicking the public listing of a stock. More than 1,500 token offerings have taken place
in the past five years, raising north of $20 billion. The table below details some of the similarities and
differences between an ICO and an IPO.

ICO IPO

Owner-related motivations Diversification of the ownership, facilitation of acquisitions, and increasing valuation

Company-related motivations General investment needs (currency for acquisitions, stock liquidity), monitoring and certification
requirements by analysts, marketing, image, and public relations

Monitoring and certification requirements by the

Securities and Exchange Commission markets (SEC)

Degree of regulation Low High

Disclosure of information Entirely voluntary Large amount of disclosure required for listed,
for the campaign public companies

Information asymmetry Rather high Rather low

between emitters and investors

External auditor Unregulated, audit by self-proclaimed experts Strongly regulated, audit by certified auditors

Transaction cost Rather low, strongly self-determined by the emitter Very high, strongly determined by regulations
and mandatory processes

Issue price Self-determined Set by investment banks

Investors securities Coins or tokens are classified as securities and Companies must meet requirements by exchanges
represent a share of the emitting company and the Securities and Exchange Commission (SEC)

Investment decision Based on very high uncertainties (ICO whitepaper) Based on lower uncertainties (IPO prospectus)

Type of emitters Smaller and younger companies Often rather large and mature companies

Rights of co-determination Co-determination possible, depending on number of shares

Role of social media Important (emitter communicates exclusively Additonal (Use of social media can increase
through these channels with its investors) awareness before the launch of IPOs)

State of research Initial stage Very mature stage

Sources: Thies, F., Wallbach, S., Wessel, M., et al.

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Non-Fungible Tokens (NFTs) are a relatively It is important that holders understand how the
abstract use of blockchain. Digital art, photos, stable coins are collateralized and/or pegged to
music, famous tweets, or other digital files can be the underlying fiat currency. The coins have been
made the subject of a unique non-fungible token, popular as a crypto dollar deposit, especially in
which represents its ownership, and can be some emerging markets with capital controls
traded in a way which was until now impossible. (e.g., Nigeria, Argentina, Iran, Venezuela). As of
NFTs aim to attribute scarcity to any digital asset mid-2021, the largest stable coins were worth
that can be replicated infinitely but has only one approximately $100 billion.
true owner. In some ways they are analogous
DeFi applications, stable coins, security tokens,
to certificates of authenticity that typically
and NFTs represent the growing “Layer 2” of the
accompany scarce collectibles. In other ways
blockchain ecosystem. They largely operate on
they’re unprecedented.
top of an existing blockchain like Ethereum. Even
Stable Coins are digital tokens pegged to a though these applications and tokens make up
national currency, most often the US dollar. more than 90% of the number of digital assets
Tether, USD Coin, and Binance USD are the today, they continue to account for less than
top three stable coins and trade at $1/coin. 30% of ecosystem value as measured by market
Each protocol differs, but stable coins are capitalization. The bulk of the value remains in
typically backed 1:1 with USD and high-quality, Layer 1 coins, namely bitcoin and ether, which
short-term paper, and provide some form of together account for 60-80% of aggregate
Independent Reserve verification mechanism. crypto market cap.

Major Crypto Assets by Percentage of Total Market Capitalization (Bitcoin Dominance Chart)
Percentage of Total Market Cap

80%

60%

40%

20%

0%
Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Jan-18 Jul-18 Jan-19 Jul-19 Jan-20 Jul-20 Jan-21

2014 2015 2016 2017 2018 2019 2020 2021

 Bitcoin  Ethereum  Tether  Binance Coin  Cardano  Dogecoin  XRP  USD Coin  Polkadot  Uniswap  Others

Source: Coinmarketcap

For more information about how cryptocurrency may impact your portfolio,
contact your Key Private Bank advisor.

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About the Author

Justin Tantalo has 15 years of experience in investment management, both in Asset Allocation and
Fund Management. As a Senior Vice President with Key Private Bank, Justin applies his expertise in
Asset Allocation and helps oversee the equities and alternatives third-party manager research effort.
Justin received an MA in Economics from the University of Waterloo (Canada) and BA in Economics
from the University of Western Ontario (Canada). Justin is a CFA Charterholder.

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The Key Wealth Institute is comprised of a collection of financial professionals representing Key entities including Key Private Bank, KeyBank Institutional Advisors,
and Key Investment Services.
Any opinions, projections, or recommendations contained herein are subject to change without notice and are not intended as individual investment advice. This
material is presented for informational purposes only and should not be construed as individual tax or financial advice.
Bank and trust products are provided by KeyBank National Association (KeyBank), Member FDIC and Equal Housing Lender. Key Private Bank and KeyBank
Institutional Advisors are part of KeyBank. Investment products, brokerage, and investment advisory services are offered through Key Investment Services LLC
(KIS), member FINRA/SIPC and SEC-registered investment advisor. Insurance products are offered through KeyCorp Insurance Agency USA, Inc. (KIA). KIS and
KIA are affiliated with KeyBank.
Investment and insurance products are:
NOT FDIC INSURED • NOT BANK GUARANTEED • MAY LOSE VALUE • NOT A DEPOSIT • NOT INSURED BY ANY FEDERAL OR STATE GOVERNMENT AGENCY
KeyBank and its affiliates do not provide tax or legal advice. Individuals should consult their personal tax advisor before making any tax-related investment decisions.
©2021 KeyCorp. KeyBank is Member FDIC. 210720-1151191