Friday, November 29, 2013

Bitcoin: The Future Of An Illusion

“John Law's pioneering note-issuing bank thrived until the French government was forced to admit that the number of paper notes being issued by the Banque Royale were not equal to the amount of metal coinage it held. The bubble burst at the end of 1720, when opponents of the financier attempted to convert their notes into specie en masse, forcing the bank to stop payment on its paper notes.”--Wiki

Now that the price of a Bitcoin has been bid above $1000, I cant ignore it any longer. It begs for comment from financial bloggers*.  Just this month, Bitcoin has gone from $200 to $1200, reportedly due to Chinese demand. Bitcoin has achieved price parity with gold and Google.** 

Bitcoin's literature has grown apace with its price. There is no end to how much you can read on the subject. I will not be devoting my life to reading the Bitcoin oeuvre. But I've read enough to have an opinion, which hasn't changed since I first heard of the phenomenon.

Bitcoin promotes itself as a superior currency to the fiat dollar. Its adherents believe it to be a “disruptive technology” that will ultimately supplant obsolete and discredited fiat currencies. It has been called “the internet of money”***. Bitcoin is the platonic ideal of a currency, free of the encumbrances of antique financial folkways. It comes with its own anti-statist ideology. It is, to use the latest cool word, “transgressive.” It appeals to rebels, those who think outside the box. The FT says that believers see Bitcoin as “purposefully designed to disrupt and destabilise the current economic status quo.” Like gold, Bitcoin has religious overtones.

Should you doubt me about the religious element, read the invective from the metallic and Bitcoin communities when someone dares to cast doubt on their belief system. The response is hostile and ad-hominem. There is no room for rational discussion.

I have seen enough of similar investment vehicles in my lifetime to be able to say with confidence that Bitcoin is another speculative bubble. There is a old story about canned sardines in China, which were being traded up to ever-higher prices. A skeptic opened one of the cans and found nothing but maggots. When confronted, the dealer explained “these sardines are for trading, not for eating”.

Dutch tulips, French bank notes “backed” by gold, Mississippi Company stock, South Sea Company stock, canned sardines, Ponzi, RCA, conglomerates, pyramid schemes, internet stocks, Beanie Babies, mortgage securities, precious metals--you name it, the instruments of speculation will always be handy for the greedy and the ignorant.

Bitcoin believers say that that because Bitcoin has gone up in price, that proves it’s not a bubble. Of course, it would not be a bubble unless it went up in price. The fact that a speculative instrument has risen in price is not indicative as to whether it is a bubble or not.

How can we distinguish between, say, a Google stock and a Ponzi scheme? After all, GOOG is an internet investment that has also gone up to $1000. The answer is fundamental analysis. GOOG may have speculative elements, but it is also a highly profitable and rapidly growing monopoly, which distinguishes it from many other internet stocks. GOOG may decline in value, but it isn’t likely to go to zero, like Beanie Babies or Global Crossing or Enron. (Gold is also unlikely to go to zero.)

The theory behind Bitcoin is that the ultimate supply is finite, at 21 million. As it grows in acceptance as a medium of exchange, it will rise in dollar value, much as gold has in the last 80 years. As one believer says:
“The true value will come when the technology and acceptance become pervasive, and Bitcoin evolves into a primary technology that a world of application, payment and otherwise, is built upon. People with knowledge and insight (the list of renowned technologists and economists is growing) are supporting it due to the real possibility it could become a dominant technology.”

If indeed a meaningful volume of retail trade were to be conducted in Bitcoin, demand for liquidity balances would likely drive up the dollar price to a level much higher than where it is today. Is in fact Bitcoin’s share of retail trade growing? Possibly, but I still say it’s a speculative bubble. Liquidity demand is not driving up the price; Chinese speculators are.

The important thing to remember is that, according to a recent UCSD study, most of the demand for Bitcoin is speculative, and not for use as a medium of exchange. Growth as a medium of exchange would create real persistent demand; speculative demand, by contrast, fluctuates.

Bitcoin is an unofficial currency; it is not regulated, nor are its “banks” regulated. When it blows up, there will be no one to blame or to sue. It is based entirely on anonymous trust. And therein lies its central fallacy: fiat currencies are bad because you can’t trust national central banks, but cyber currencies are good because you can certainly trust unnamed strangers with no fiduciary duty, no regulation, no balance sheet or street address.

Permit me to list some of the rather useful attributes of the dollar, and the less useful attributes of the Bitcoin:

The Dollar
1. Its supply is a known quantity disclosed at regular intervals by the Fed.
2. It is legal tender and it can be used to buy anything and to settle all financial transactions.
3. Dollar purchasing power stability is a Fed mandate.
4. Dollar bank deposits are federally guaranteed.
5. Bank robbery is a federal crime.
6. As a medium of exchange, it can take the form of cash, a debit card, or a credit card.
7. Consumer credit card fraud losses are limited by law.
8. The dollar’s value in dollars is stable.
9. Counterfeiting dollars is a federal crime.
10. Dollars can be readily obtained and exchanged for other currencies.
11. The dollar is highly liquid and fungible. Its price never changes, and virtually every good and service in the US can be bought with it.

The Bitcoin
1. Its supply is based on a promise; there is no official data.
2. It is not legal tender, and no one is obligated to accept it.
3. The minters of Bitcoin make no promises with respect to stable value.It fluctuates in nominal and real value.
4. Deposit balances are held by unregulated private entities with unknown addresses or financial strength.
5. Cyber-theft of Bitcoins is not a top priority at the FBI.
6. As a medium of exchange, it can only take the form of unregulated cyber credits and debits.
7. Fraud losses are to the account of the holder alone.
8. The Bitcoin’s value in dollars fluctuates.
9. Counterfeiting Bitcoins is not a federal crime, although it might someday come under wire fraud.
10. Bitcoins are quite hard to acquire and difficult to exchange for other currencies.
11. Bitcoins are illiquid; the price-discovery process is highly inefficient; there is no central clearinghouse; only a limited variety of goods and services can be bought with them.

To conclude: As a store of value, the Bitcoin is purely speculative. As a medium of exchange, it is inferior to the dollar and its modern derivatives. As a unit of account, it belongs with Beanie Babies and unlisted stocks. There is no saying how high Bitcoin's price will go; its future price is a random walk, ending at zero. All we know is that, at some point, it will crash.

Tidbits from the media:
>A British man says he threw out a hard drive that had 7,500 bitcoins on it, worth over $7.5 million as of Wednesday.
>The ECB has looked into the “threat” from Bitcoin and concluded: “It is mostly the holders of the currency that face risks, including the risk of a complete loss of the monetary value."
>The general consensus is that Bitcoin mining will have approached a point where only those with access to free or cheap electricity will continue operations, and even they will produce a relatively marginal return on investment, rather than the huge multiples possible even earlier this year.
>Every participant in the system must keep a copy of the block chain, which now exceeds 11 gigabytes in size and continues to grow steadily. This alone deters casual use.
>Even the largest Bitcoin Exchanges have been subject to operational interruption by hackers and/or malware, limiting the liquidity of Bitcoins on the Bitcoin Exchange Market and resulting in volatile prices and a reduction in confidence in the Bitcoin Network and the Bitcoin Exchange Market.
>The Winklevoss twins are screaming bulls on bitcoin. Cameron and Tyler Winklevoss—big investors in the digital currency—said Tuesday that Bitcoin should be worth at least 100 times more than it's valued today. "The small bull case scenario is a $400 billion market cap. So the market cap is around $4 billion right now," Tyler Winklevoss said in an interview.
>If a malicious actor or botnet obtains control in excess of 50% of the processing power active on the Bitcoin network, such actor or botnet could manipulate the source code of the Bitcoin network or the blockchain in a manner that adversely affects an investment in the shares or the ability of the trust to operate.
*If you want to read about Bitcoin, I recommend the Bitcoinmania Series written by Izabella Kaminska at FT Alphaville; she is on the case and has decidedly not drunk the Kool-Aid.
***  “Bitcoin is a fixed supply, a first-of-its-kind, global-in-scale, voluntary, decentralized open-source digital currency and payment network that enables direct, peer-to-peer, borderless, pseudo-anonymous, nearly-instantaneous, nearly-free and irreversible cash-like transfers of value. The first currency and money system in the world which has no counter-party risk to hold and to transfer. Instant transactions, no waiting for checks to clear, no chargebacks (merchants will like this), no account freezes (look out Paypal), no international wire transfer fee, no fees of any kind, no minimum balance, no maximum balance, worldwide access, always open, no waiting for business hours to make transactions, no waiting for an account to be approved before transacting, open an account in a few seconds, as easy as email, no bank account needed, extremely poor people can use it, extremely wealthy people can use it, no printing press, no hyper-inflation, no debt limit votes, no bank bailouts, completely voluntary. This sounds like the best payment system in the world!”
--Bitcoin believer at Reddit/bitcoin.


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