Archives for December 2017

Bitcoin – Snog, Marry, Avoid

Bitcoin, the digital currency has dominated most of the financial headlines in 2017. It rose in value by 20 times (not 20%) from early January to mid-December before falling by 45% in just a few days before Christmas. Many people are intrigued by it and want to know whether (i) they should buy some with a view to selling it for a profit (Snog), (ii) they should buy some and hold for the long term because it will be the money of the future (Marry) or (iii) refuse to get involved at all because the whole concept is bound to fail (Avoid).
AVOID: The paper explaining how Bitcoin would work was published in October 2008 (just as the global financial system was suffering a near fatal heart attack), written by “Satoshi Nakamoto”, whose identity remains unknown today. Entitled “Bitcoin: A Peer-to-Peer Electronic Cash System” It brilliantly set out the logistics of how a completely decentralised, online ledger system, based on blockchains could create a record of ownership that was trusted by any number of anonymous participants. The blockchain was the key differentiating technology and Bitcoin was the token that (s)he proposed to be used as the currency within this system.
This technology has now been proved to work and many others are seeking to find other uses for the blockchain concept. In this sense there is nothing inherently fraudulent or doomed to failure in Bitcoin. The early years of Bitcoin saw it generally used by those within the “geek” world who could interact with each other with tokens from which the outside world was excluded – there were very few ways in which Bitcoin could be spent in the real world, though in May 2010, a developer bought two pizzas for 10,000 Bitcoin (at the time of writing this is now worth c £100 million!). Satoshi Nakamoto still owns about 1 million Bitcoins (currently worth about £1 billion) but has never spent any of them – (s)he has not profited personally from the invention.
There is however one major drawback to a completely anonymous, digital currency and that is how and where to store it. There are “hot” wallets where the key information is held on a computer (or mobile device) connected to the internet. Here the security issue is hacking, and there are many examples of computers (including those of Bitcoin exchanges) being hacked and the wallets looted. The average person is not technically literate enough to secure their Bitcoin. “Cold” wallets are where the key information is held on devices that are not connected to the internet and thus not subject to hacking, but instead subject to the rather more prosaic risks of theft, loss, fire and being seen as garbage and thrown away.
The potential for Bitcoin has been that it could lead to a world where the half of the global population who are not part of the financial system or have any trust in the currency controlled by their government, could digitally transact with anyone else in the world in a common currency with complete confidence and security, creating massive opportunities for all.
Bitcoin could ease some of the key barriers to trade and there is no inherent reason to avoid Bitcoin provided that the investor has a solution with regard to storage.

MARRY: Outside the tech community the first class of investor to make use of Bitcoin were criminals. The one thing that cryptocurrencies can do better than real money is to carry out illicit transactions or launder ill-gotten gains. Morality and legality aside, this is a real advantage that offers private value (but social cost). Most of the trading done today comes from Asia and is widely believed to represent the profits from crime or the desire for rich Chinese to hold a part of their wealth offshore, and out of sight of the Chinese government. Governments around the world are now beginning to take firm action against potential money-laundering. They cannot act within the Bitcoin ecosystem, but they are able to take control of those points in the financial system where Bitcoin can be turned into mainstream currencies, and demand anti-money-laundering identity checks and source of funds disclosures. By making Bitcoin transactions the subject of suspicion, long term demand is likely to be dampened.
In addition, by taking transactions into an anonymous world, governments become concerned about the potential loss of tax revenues, and those retailers that might consider taking Bitcoin have to take note of possible reputational damage, if they do so. Most governments are unlikely to be willing to permit widespread use of Bitcoin, though many are actively looking at the possibility of launching a government-approved digital currency, though of course these will not provide anonymity for tax purposes!
The absence of any centralised control requires some otherwise inefficient resource use. Participants who sustain the system do so by competing to “mine” Bitcoin – it is estimated that today Bitcoin accounts for about 0.14% of global energy consumption and the way in Bitcoin works means that this is likely to continue to rise. In addition to being energy intensive the system can only process about 7 transactions per second compared with the c25,000 rate at which that the world’s major financial payment systems operate. For a high-tech innovation, this is surprisingly poor.
One of the key features of Bitcoin is that there is a hard limit on the total supply of 21 million Bitcoins. This creates a scarcity that can help to build value. Though there is this supply limit to Bitcoin, there is no limit on the number of alternative cryptocurrencies to Bitcoin. There now exist over 1300 such alternatives, and at least two of these, Ethereum and Ripple, appear to have clear advantages over Bitcoin. This enormous supply of competing cryptocurrencies is likely to restrict the growth in the Bitcoin price in the long term
Finally, the mooted development of quantum computing poses a huge threat to all the cryptographic security measures used online today. It is widely believed that the early stages of quantum computing would create a situation where any cryptographical security system in use today, could be cracked before new more secure systems can be created. In this world all Bitcoin accounts could be hacked.
There would thus seem to be a wide variety of reasons why Bitcoin is not likely to become the money of the future, which would be a good reason to buy and hold the cryptocurrency.

SNOG: The characteristics of the ideal asset to be the subject of a bubble or mania are all found in Bitcoin. It has zero intrinsic value – it is merely a collection of digital symbols or pulses that have little alternative use. Bitcoin produces no income and restricted new supply. In addition much of the supply is in relatively few hands – it is estimated that 4 million, or about one quarter, of Bitcoins in existence today have either been lost permanently or are not expected to ever be used (including Nakamoto’s 1 million Bitcoins). The very small free float (95% of Bitcoins are owned by just 4% of owners) means that small increases in demand have a sharp effect on price, which in turn encourages greater demand – this effect also works in reverse.
Given its zero intrinsic value, the Bitcoin price is thus dependent on human psychology and animal spirits – there is no economically measurable “right” price. The price will continue to be extremely volatile, in both directions – the more people wish to participate in the mania the higher the price will go, and the higher price goes, the more people will wish to participate!
Bitcoin is already the largest financial bubble or mania in history (the South Sea bubble saw a price gain of 10 times in a year, Bitcoin managed 20 times in 2017) – previous examples such as the tulip bubble, the South Sea bubble and the internet bubble have all been restricted to relatively small proportions of the world’s population. The combination of economic development across the whole world, the democratisation of information through the mobile internet, means that most of the world’s population can today fairly straightforwardly subscribe to an App such as Coinbase, transfer money to it and buy some Bitcoin. History shows how financial manias can become psychologically infectious – previously this was constrained by only a small minority being able to participate in the mania. The billions of the middle classes in Asia now have the means and opportunity to participate in a full-scale financial mania – this has not occurred previously, as bubbles were historically constrained by geography.
So, Bitcoin is not an AVOID – it is not a fraudulent enterprise, though it is much beloved by criminals. It is not a MARRY – there are too many disadvantages for it to become the money of the future. It could be a SNOG – something to buy but only in order to sell at a future date – it is another form of gambling (but where the gains are taxable), and those wishing to gamble should only invest with money they are prepared to lose.