Bitcoin deconstructed

Barry McCall looks at the phenomenon that is bitcoin and asks is it more shadow than substance

Students of the financial market are all too aware of the “tulip mania” which gripped The Netherlands in the 17th century. In a single month, the humble bulbs which were imported from Turkey at the time rose in value by a near unimaginable 1,100 per cent. The mania was driven by greed and fear of missing out rather than any underlying asset value.

Regarded as the first genuine financial bubble, the price of a single bulb exceeded the annual pay of an average Dutch worker at one point. And it was to get worse.

In 1633, a single bulb of the Semper augustus tulip was already worth 5,500 guilders and within four years had almost doubled to 10,000 guilders. Mike Dash put some context on these numbers in his book “Tulipomania: The Story of the World’s Most Coveted Flower and the Extraordinary Passions It Aroused”.

Ten thousand guilders was enough to “feed, clothe and house a whole Dutch family for half a lifetime, or sufficient to purchase one of the grandest homes on the most fashionable canal in Amsterdam for cash, complete with a coach house and an 80-ft garden – and this at a time when homes in that city were as expensive as property anywhere in the world.”

When the price inevitably crashed many investors went bankrupt within the space of a single week. The damage to the Dutch economy was limited as the wild speculation was confined to a fairly small elite, many of whom were later relieved by the courts of their obligations to make good on futures contracts.

It is difficult not to draw parallels with this phenomenon and the recent quite staggering rise in the bitcoin cryptocurrency. Similar to tulips, bitcoin has no underlying asset value. Instead, it is simply worth what anyone is willing to pay for it at any given point in time.

And, like tulip bulbs, that price is susceptible to even the faintest market murmur. As noted American billionaire investor Mark Cuban put it recently: “You know it’s a bubble when a random twitter thread bounces the price.”

And that price certainly bounced over the turn of the year. At the beginning of 2015 one bitcoin was worth $283. One year later it had risen to €449 and by the beginning of 2017 was worth just shy of $900. By December 11, 2017 it had reached an all-time high of $19,458 before falling back to $8,269 on January 29, 2018. It subsequently recovered somewhat to trade at above $11,000.

The question is, however, where it’s likely to go to next. Will it hold that quite stellar valuation or will it settle back to 2015 levels? Or indeed, will it rise rapidly once again?

The answers to each of these questions belong to the realms of guesswork. There is scant historical evidence or trends to go on – the currency doesn’t celebrate its tenth birthday until next year after all – and there has been no underlying logic to its price movements in its short history.

You know it’s a bubble when a random twitter thread bounces the price

That history dates back to 2008 when an individual using the pseudonym Satoshi Nakamoto wrote a white paper describing the cryptocurrency. The first transaction occurred the following year when a resident of Temple City, California, computer scientist Hal Finney received bitcoin from an anonymous source.
Speculation has been rife since then that Mr Finney was in fact the inventor.

Bitcoin transactions do not involve intermediaries, possibly the currency’s most appealing feature to financial anarchists. Bitcoins can be used to buy goods or pay for services completely anonymously.

They can be bought on online marketplaces known as bitcoin exchanges such as Coinbase, Bitstamp or Bitfinex. There is no guarantee in relation to the security of these exchanges, however, and Bitfinex was hacked in 2016 leading to the theft of tens of millions of dollars worth of bitcoin.

Once they own them, people and organisations can send bitcoins to each other using mobile apps or PCs.
New bitcoins are created as a result of an activity known as mining – the solving of highly complex mathematical puzzles. Each time a puzzle is solved the successful miner gets 12.5 bitcoins. However, the underlying technology involved leads to the puzzles getting more complex every few weeks.

Bitcoin mining has now become a business activity in itself and in what appears to be a return to past form in relation to dubious financial activity it has been reported that more energy is consumed by Icelandic bitcoin miners than by all Icelandic households combined.

The bad news for the Icelandic miners is that there is a limit to the total number of bitcoins which can eventually be mined. This was set by the inventor at 21 million. Some say this was an effort to mimic gold in terms of making it a finite resource. However, the simile is somewhat strained given the fact that gold possesses an inherent beauty and intrinsic value which a virtual currency can never hope to match.

Furthermore, new sources of gold are constantly being identified and there is absolutely no guarantee that some talented coder will not at some stage in the future find a way of breaking the 21 million limit.

Public Log

Bitcoin transactions are recorded on a public log, but the names of the people involved are never disclosed. That enables people to buy and sell anything without fear of being traced and that’s the principal reason it has become the currency of choice for criminals around the world.
The other attraction for criminals is speculation. The ability to buy the currency anonymously makes it an ideal money laundering mechanism and the facility to buy goods or services anonymously with any gains makes it even more alluring.

This brings up another question. Does the currency itself have a future beyond being the favoured financial tool of the criminal classes?

If it is to survive it will have to beat off a growing legion of competitors. According to Crypto Trades, a specialist news service for the virtual currency world, by January of 2018 there were 1,387 cryptocurrencies in existence – more than five times the number of physical currencies in use in the world today. Bitcoin was the clear leader with a market capitalisation if $256 billion, Ethereum came in second with a market cap of $111 billion, with Ripple in third slot at $98 billion. The other 1,384 currencies are worth a total of €286 billion between them.

Of course, all of these figures are subject to rapid and quite startling change and by February 2018, those valuations had fallen by around 40 percent while the number of virtual currencies continued to climb.
This again brings us back to those fundamental questions, or probably just one question – is this just another tulip? Unfortunately for those who piled in at or near the top of the recent market surge the consensus among those who probably should know is that it most certainly is.

Ireland’s own Denis O’Brien, who has built a deserved reputation as a canny investor, told journalists at the recent Davos World Economic Forum that there is “absolutely no chance” that he would invest in bitcoin.
O’Brien is in good company in his view with Warren Buffet echoing it in a CNBC interview late last year. The Sage of Omaha, who as far back as 2014 called cryptocurrencies a mirage, said: “In terms of cryptocurrencies, generally, I can say almost with certainty that they will come to a bad ending. Now, when it happens or how, or anything else, I don’t know. We don’t own any, we’re not short any, we’ll never have a position in them.”

Interestingly, Buffet added that he would be glad to buy five-year put options on “every one of the cryptocurrencies.” Put options offer a way for investors to bet against an asset and they become more valuable as the asset’s price falls.

Another speaker at Davos this year was UBS bank chairman Alex Weber who said that cryptocurrencies were speculative, risky and attracting investors who “don’t fully understand these products.”

The infamous “Wolf of Wall Street”, Jordan Belfort, went a lot further when asked about Bitcoin recently. “It’s the biggest scam ever, such a huge gigantic scam that’s going to blow up in so many people’s faces. It’s far worse than anything I was ever doing.” Strong words indeed considering Mr Belfort’s colourful track record.
JP Morgan chairman and CEO James Dimon is firmly in the Buffet camp. “I could care less what Bitcoin trades for, how it trades, why it trades, who trades it. If you’re stupid enough to buy it, you’ll pay the price for it one day.”

Mark Cuban, who noted the asset’s vulnerability to tweets, is quite disparaging in his overall view and is on the record as saying: “There’s no intrinsic value, there’s no true ownership rights, you just have the ability to buy and sell. They’re like baseball cards and I think bitcoin is the same thing. Its value is a function of supply and demand. It doesn’t really do anything else.”

Even Nobel laureates are piling in with their negative views. Speaking at a conference in Lithuania reported on by Bloomberg last year, Robert Shiller, who was awarded the Nobel prize for his work on market bubbles, shared his belief that the currency’s appeal to at least some investors is its “anti-government, anti-regulation feel.” But, he added, “it’s such a wonderful story, if it were only true.”

Bill Gates, who it was once claimed was a fan of bitcoin, recently told a reddit AMA (ask me anything) that he believed the anonymity offered by the currency has directly led to deaths.

Richard Branson is on record for saying positive things about Bitcoin but you still can’t use it as a payment method with any of his businesses

Contending that government’s ability to illegal activities such as money laundering and terrorist funding was both necessary and a social good he said that the lack of traceability was dangerous. “Cryptocurrencies are used for buying fentanyl and other drugs, so it is a rare technology that has caused deaths in a fairly direct way”, he said.

He also warned against investing in it. “I think the speculative wave around ICOs (initial coin offerings) and cryptocurrencies is super risky.”

MarketWatch

In a recent MarketWatch article renowned asset manager Mitch Tuchman gave his explanation for why the advice of these experts is being ignored. “As with dot-coms and real estate, the fuel driving the bitcoin fire is the continual entry of new investors, more and more people motivated by FOMO, fear of missing out”, he wrote. “This can happen to even large stocks, of course. Nearly every asset class has its heady moments. Yet stocks bounce back, over and over, thanks to Buffett’s notion of intrinsic value.”

And he had a warning for would-be investors. “Given that bitcoin is supposed to replace cash, what is the ultimate source of cash flow from digital coins created on the internet? It’s dollars flowing from the pockets of buyers who want to own those coins. Cut off the supply of new investors and the bitcoin craze ends.”

It’s a pyramid or Ponzi in other words. “The fact is, bitcoin has no intrinsic value at all. While many digital coin ‘investors’ would argue that neither does a dollar, I counter that just about nobody thinks of American cash as an investment, except for perhaps currency speculators. Rather, dollars are a temporary store of value, a means of transmitting that value from one person to another. As Buffett says, valuing bitcoin is like trying to value a paper check drawn on a bank. Pointless.”

Perhaps the harshest assessment of all came from Nobel laureate Joseph Stiglitz, who told Bloomberg TV last November that bitcoin “ought to be outlawed. Bitcoin is successful only because of its potential for circumvention. It doesn’t serve any socially useful function.”

And there is bad news even for the criminals with governments and central banks starting to make moves towards regulating the sector, thereby bringing an end to the anonymity which is so alluring for users.

Bank of England governor Mark Carney spoke for many of his fellow regulators recently when he said in a speech in London at the end of February that the time had come to “regulate elements of the crypto-asset ecosystem to combat illicit activities. Authorities are rightly concerned that given their inefficiency and anonymity, one of the main reasons for their use is to shield illicit activities. This cannot be condoned. Anarchy may reign on the dark web, but in the UK it’s just a song that your parents used to listen to.”

While some investors of note have speculated on bitcoin and other cryptocurrencies it is hard to find any that actually back it as a long-term play. For example, Richard Branson is on record for saying positive things about Bitcoin but you still can’t use it as a payment method with any of his businesses and it would appear that his enthusiasm is really for the underlying blockchain technology.

The weight of opinion is certainly against bitcoin but only time will tell if this powerful consensus is correct in its thinking. They’ve been wrong before…