Bitcoin’s Greater Fools

Bubble Dynamics

For the past month, I have toyed with the idea of writing about Bitcoin, the world’s premier “virtual currency”.  The primary reason I haven’t is that didn’t believe I had much to say that wasn’t already being said.  An asset cannot rise at the rate of Bitcoin (+1200% since the end of May) without catching everyone’s attention.  Nor can it rise at that rate without endless pronouncements that it’s a bubble.  The word bubble has been thrown around endlessly in recent years.  This is unfortunate, because when a word becomes overused, it’s meaning gets eroded.  To remain objective, I’ll remain agnostic on whether Bitcoin is a bubble or not.


For the sake of argument, I can imagine a scenario where Bitcoin’s present price of around $16,000 turns out to be cheap (I can IMAGINE it, I am not saying such a scenario is likely!). As an investor or speculator, the probabilities of the various scenarios, and the value created with each one,  is what should be considered.  Certainly, this is includes much uncertainty, and is impossible in practice.  But that’s what makes markets so much fun.


In bubbles, a large contingent of investors stop considering all but the most optimistic scenarios.  Conversations in online forums populated by Bitcoin bulls bears a strong resemblance to those among tech bulls in the late ’90s.  There are no pessimistic scenarios considered, and no valuation is beyond imagination.  Believers have the fervor of cultists, and nothing can shake their beliefs.  Now add to this price action that many say is already outpacing the most ridiculous bubble of all time, Dutch Tulip mania.  If it walks like a duck, and quacks like a duck…well, you get the picture.  However, my nature is not to approach things so simplistically.  Further analysis is in order.


Regardless of the final outcome, Bitcoin is a phenomenon which deserves several lines of inquiry.  To a great extent, it’s success (thus far) is an outgrowth of economic forces which have been building for decades.  I’ve touched upon monetary policy in several of my posts, and will go into much greater depth in the future ( Are We There Yet? )  Global central banks have “printed” (i.e. implemented quantitative easing) to the tune of about $20 Trillion since 2009.  The reality is much more complex than is generally understood, but I’ll skip that for now.  A major driving force in the development of virtual currencies is a belief in the ongoing devaluation of the world’s currencies, and a desire to hedge it.


Is Bitcoin Really a Currency


There are two aspects to Bitcoin, as there are to most of the virtual currencies that have been created (over 1300 in all):  a coin (currency); and blockchain technology.  Blockchain is a method of recording transactions digitally over time.  It allows for secure transactions to take place without the intermediation of a third party ( Wikipedia: Blockchain ).  It is a truly revolutionary technology that will have many applications beyond transactions in the future, and is a great part of the Bitcoin hype.  First though, I want to talk about the currency part of the equation.


A few years back, when gold was in a bull market (a rather pedestrian move of about 7.5X in eleven years), it was common to hear gold referred to as a “currency”.  Or by many a gold bug, the only “real currency”.  My initial feeling about about such proclamations it that they are an exercise in semantics.  Yet,  it is important to examine what are the characteristics that are desirable in a currency. Most importantly, what are the functions necessary for an asset to serve as a currency?  Essentially, there are three functions:


  1. Transactions
  2. Unit of Account
  3. Store of Value


Bitcoin enthusiasts love to point out that you can pay for many things with Bitcoin, but the list is not extensive ( I spent a day trying to pay for things with bitcoin and a bar of gold ). More importantly, it’s quite possible that the list is not going to grow, and may actually shrink.  The astounding volatility of Bitcoin is an impediment to vendors enabling purchases with the currency.  The largest online gaming vendor, Steam, announced recently they would no longer accept Bitcoin.  The company sited both the excessive volatility, and high fees ( Steam no longer accepting bitcoin  ).  My own analysis shows that the average move over the last month has been about plus or minus 5.7%,  with absurd daily ranges. Last week we saw a 30% range.  It’s not difficult to understand why a business wouldn’t want to conduct operations in a currency that volatile.  Once the trend becomes more two-way, or downward, I would expect vendors to be even more reluctant.


As for a unit of account (i.e. bookkeeping in the currency), it is unlikely either gold or any digital currency could ever be used unless governments allowed taxes to be paid with these alternative currencies.  In effect, governments would be giving up control over taxation, and fiscal policy.  Central banks would lose control of monetary policy. I can’t foresee a scenario where that would happen.


Ultimately, for both gold and Bitcoin, I think the only function that is relevant at the moment is the store of value.  For decades, gold bugs have hyped gold as insurance against profligate governments and central banks.  While the gold supply is not fixed, it moves at only about +1.5% a year.  Since that is well below fiat money growth, the logic is that gold should have a natural tendency to rise in price in perpetuity. That same logic has been applied to other assets in recent years (e.g. land and fine art), and we have seen speculative runs in all.


Bitcoin is driven by the same logic.  Supply is “mined” using a predetermined computer algorithm ( Bitcoin Mining ).  Anyone with access to the internet, and the proper computer hardware, can participate in the process.  Miners are awarded the privilege of receiving transaction fees for the “blocks” they have mined. Ultimately, the total number of Bitcoins will be capped at 21 million.  So, from a currency standpoint, when most fiat currencies tend to grow at rates of approximately 5% per year (depending on your measure of money supply), a currency that will have a fixed supply sometime in the future should grow in value substantially. That is reasonable, but misses some very important points.


Virtual Currency Supply is Theoretically Infinite


Many Bitcoin bulls like to hype the blockchain technology underlying the currency.  As I mentioned previously, blockchain is truly revolutionary.  It creates a ledger every time a new transaction takes place, and the process is encrypted, which keeps it secure.  The genius behind blockchain is that it negates the necessity of having an intermediary (bank or credit card company).  No wonder JP Morgan’s CEO, Jamie Dimon, called Bitcoin a scam!  Widespread usage of virtual currencies is a major threat to his business. Over time, it’s believed transaction fees for Bitcoin will fall, but for now, they are exorbitant ( High Bitcoin Fees ).


However, most importantly, Bitcoin does not have a monopoly on the technology.  Anyone with requisite knowledge of computer programming can create their own blockchain process, and introduce their own currency.  While Bitcoin has the “first mover advantage”, there are now over 1300 virtual currencies!  A key part of valuing any business  is analyzing how much competition it may face, beginning with barriers to entry into the market.  While virtual currencies are not technically businesses, together they can be analyzed like an industry.  Indications are that for the virtual currency space, the barriers to entry are extremely low ( Is This Bitcoin’s Fatal Flaw? ).  While many of the new ICO’s (Initial Currency Offerings) may be outright scams, Bitcoin has stiff competition from a number of legitimate alternatives.  Substantial innovation is taking place as well.  Some of the other virtual currencies may turn out to be superior for certain types of transactions.  For instance, Ethereum, the next largest virtual currency by total value, has the ability to embed “smart contracts” into its transactions.  That is, it can be programmed to only complete the transaction after certain contractual specifications have been met.  This is just one example.  Nevertheless, the point I am making is that Bitcoin is not unique in its ability to facilitate transactions. In addition, with a massive number of outstanding currencies, and new ones arising constantly, the scarcity argument for valuing the currency becomes irrelevant.


Past is Prologue


Price action in Bitcoin in the past month has been unprecedented if you consider it as an asset unto itself.  If you compare percentage returns to individual stocks, then it seems less extreme.  Individual technology stocks in the late 1990’s would routinely move in such a manner.  However, the largest and most stable of the bunch, were not typically quite so volatile as Bitcoin has been lately.  At the moment, Bitcoin commands a rather dominant place among virtual currencies, as its “first mover” status has not been eroded. At least, not yet.  In the meantime, many are attributing all of the positive attributes of virtual currencies to Bitcoin.  I believe that is the primary error bullish speculators are committing. 


There was a time when AOL was the premiere email provider, and the dominate portal on the internet.  It was such an icon, they made a movie with Tom Hanks and Meg Ryan , You’ve Got Mail, where the email service served as the centerpiece!  I know of nobody who still uses AOL for email, and can’t remember the last time I heard it mentioned.  Time Warner’s merger with AOL is often mentioned as one of the dumbest mergers of all time.  At the height of the tech bubble, from its options post on the American Stock Exchange, I personally watched Yahoo stock, now Altaba Inc. ( AABA ), trade up about 25% on the day it was placed in the S & P 500.  The stock now trades a little over half the valuation it had at its apex in 1999.  These are just two examples, but they illustrate the dynamic taking place right now, and how it might ultimately play out.


Gold provides another useful analogue.  The tech bubble speaks to the euphoria over the prospects of blockchain, but degradation of fiat money is the more enduring aspect of the virtual currency phenomenon.  It is completely legitimate for people to worry that ongoing quantitative easing will erode the world’s fiat currencies, and to look for long-term stores of value.  However, despite an enormous amount of global central bank liquidity injected (around $20 Trillion), gold is down over -30% from its highs.  Does that mean that there is something wrong with gold as a store of value?  Not necessarily. Instead, I believe there is something wrong with the narrative.  Despite a flood of liquidity in the last 8 years, inflation has been stubbornly low, and growth weak.  Monetary economics is a fascinating and mind-bending subject.  Simply put, I think many do not understand the fundamentals at work, and I look forward to addressing this issue in more depth in the future.


Bitcoin Futures


Futures on Bitcoin began trading this morning, and immediately traded up about +20%.  That isn’t particularly shocking considering the price action of late.  Allowing ecstatic bulls to trade with leverage is bound to create a ton of volatility to the upside, but now bears can take a part too, as previously there was no ability to sell short.  Some analysts, who have been calling for an end to the bull run for some time, believe this is the beginning of the end.  I am quite sympathetic to that view.  No longer will Bitcoin price action be completely dictated by pie-eyed optimists, many of whom may have a good understanding of the blockchain technology, but little of market history.  The same type of people who quit their job to day-trade in the late ’90’s, or were “flipping houses” in the mid-2000’s, are the type who are the biggest Bitcoin bulls.  As always, many of these people will just have to learn the hard way.


At approximately $250 billion worth of value, Bitcoin now commands a market valuation similar to many of the largest cap tech stocks.  It may be reasonable to assume that Bitcoin will survive, and will demand a large valuation in the future.  But as I have shown, beliefs in widespread adoption of Bitcoin for internet transactions faces major obstacles, and extraordinary competition.  It may also be reasonable to think virtual currencies will command a large collective valuation as a store of value in the future.  The key word here is collective.  And initially, many people may balk at the notion of putting their savings into an asset characterized by an algorythm they do not understand.  Regardless, Bitcoin will have to share that valuation with other virtual currencies.


In conclusion, I would caution that investors heed the signal provided by price action in gold.  Central banks have injected unprecedented liquidity into the global economy.  Prognostications of hyperinflation never materialized, which is why gold is well below its all-time highs.  Bitcoin’s price action, like many before it, is about momentum coupled with a compelling story.  As is common, the story has large holes in it.  For true believers, that realization is quite painful, but ultimately, unavoidable.  The Bitcoin bull may have a few more months to run, but at the risk of looking as foolish as many before me, I think the beginning of the end is here.







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