The Other Side of the Bitcoin

With the rise of new technologies, each one more advanced than the last, a new form of electronic payment has emerged.
Bitcoin is a decentralized digital currency created for efficient electronic payments. It is run and controlled by what is known as a ‘blockchain’, a public ledger of all transactions in the bitcoin network. A ‘blockchain’ is essentially a company-wide spreadsheet that can be accessed by all. The purpose of the ‘blockchain’ is to determine legitimate transactions and deter attempts to re-spend coins that have already been spent.
Bitcoin works similarly to a check in that there are two different numbers per transaction: your personal private key (or account number) and a signature that confirms your transaction on the above mentioned ‘blockchain’. The digital currency can be spent in a number of different ways, but can only be held in two forms. A bitcoin user can hold an electronic wallet (e-wallet) via a web wallet or a software wallet by using a downloadable software. An e-wallet is essentially an online bank account that allows you to receive bitcoins, store them, and send them to others. A software wallet is a downloadable software that allows the consumer to be the custodian of their bitcoins. Often the latter leads to more liability for the consumer.
It all sounds pretty enticing, and maybe you are wondering if you should jump into this next innovative technological trend. But the rapid growth of bitcoin has many people concluding that it’s just another bubble waiting to burst.
Markets have seen many different financial bubbles over the years, and none of them have ended particularly well. A financial bubble occurs when market participants drive prices above market value. This investment behavior can be attributed to herd mentality, where people think that because everyone else is investing in a certain entity and seeing short-term success, that means it’s a good investment. Inevitably, these financial bubbles can’t be sustained long term and they burst.
The first documented economic bubble in history occurred in the 17th century, when Dutch tulips were all the rage. The contract prices of the newly introduced and popular bulbs grew to an outrageous high, eventually leading to a dramatic collapse or “burst” in February of 1637. Today this is known as “tulipmania.” More recent examples include the dot-com bubble of the late ‘90s and the housing bubble in the 2000s. I’m sure we all remember how those financial bubbles ended, and the repercussions that followed those bursts.
Looking back on all of these events, it’s easy to see now how these bubbles formed, so we can use these prior experiences to better predict financial bubbles. Today, the cause for concern is bitcoin, and it’s more the question of when the bubble will burst rather than if it will.
Bitcoin got its humble start six years ago at $2. Three years later it was at $300 and last week it topped off at $11,000. With a 1000% increase so far this year alone, it’s easy to see why many people are raising the alarm or joining the frenzy, depending on the person!
With its frequent surges and sharp price moves, bitcoin is as volatile as they come. In other words, if you think you want to give bitcoin a shot, it’s best to assume that you’ve already lost that money. Everything we’ve learned about financial bubbles over the past four centuries points to an imminent burst in this digital currency’s future, and you and your money don’t want to be caught in a tight spot when it does.
There is also speculation that regulators will step in at some point because of the potentially disastrous economic consequences associated with the runaway bitcoin prices. The first concern is as we’ve outlined above, the bubble will burst and cause devastating losses. Additionally, future contracts are opening bets for bitcoin, and some funds are set to take form in early 2018 to pitch bitcoin to more mainstream investors. The more bitcoin gets wrapped up in our financial system, the worse it will be for everyone when it bursts.
The other major consequence presents the other side of the “bitcoin”: what if the bubble doesn’t ever burst, and bitcoin becomes an alternative, or worse, a replacement for standard U.S. currency? We cannot see regulators allowing what to happen, so it’s safe to say that even if this bubble miraculously doesn’t burst, it will most likely lose traction one way or another.
As many of you know, at DWM we don’t try to time the markets, and when it comes to speculative investments that require you to do so, it’s best to avoid them altogether.

Bitcoin 101

bitcoinYogi Berra once famously said:  “The future ain’t what it used to be.”  So true. Amazon announced this month that purchases could be delivered to your doorstep by drones in a few years. And, it’s very possible that you won’t pay for them with U.S. dollars. You might be using Bitcoin, the new virtual currency.

Bitcoin (“BTC”) has soared into public attention this year as its price went from $15 in January to over $1,000 in early December. Actually, the basic concept of Bitcoin, a currency independent of governments and banks, dates back over 80 years to Thomas Edison. Mr. Edison not only was granted 1,093 patents, but he also was weighed in on economic issues. After World War I there were wide fluctuations in the value of the dollar and rampant inflation in much of the world. Mr. Edison distrusted banks and proposed a new monetary system using commodities as the underpinnings for a new currency. He and his friend Henry Ford called it “Ford-Edison Commodity Money.”  The idea was ahead of its time and didn’t catch on.

Fast forward to 2009. BTC software is developed by Satoshi Nakamoto (a pseudonym).  It allows users to send payments within a decentralized, independent peer-to-peer network. It does not require a financial institution or central clearing house.  Users simply need an internet connection and the BTC software to make and accept payments.

BTC fulfills some of Edison’s concepts:

  • It is backed by commodities- energy and time
  • The BTC network stores the transaction history inside a log called the “blockchain” which constantly grows as new records are added and never removed.  Though these are today cloud based, they are similar in concept to Edison’s proposed “commodity warehouses.”
  • It is (theoretically) inflation-proof

Early adopters have been computer geeks, libertarians, drug dealers and others world-wide. Now, BTC is attracting some surprising new fans. Fed Chairman Ben Bernanke said last month that it “may hold long-term promise.” A small but growing band of stores and companies are accepting payment in BTC, particularly internet companies in China. However, on December 5th, the Chinese government central bank effectively halted the use of BTC for Chinese business-to-business monetary exchange. BTC prices dropped 30% the following day.

Coincidentally, on December 5th, Bank of America Merrill Lynch became the first major financial institution to initiate analyst coverage of BTC. Their report started with the following: “We believe Bitcoin can become a major means of payment for e-commerce and may emerge as a serious competitor to traditional money transfer providers. As a medium of exchange, BTC has a clear potential for growth, in our view.” Further, they suggested that BTC will likely only have a limited role in black market/underworld transactions, since all transactions are public and every BTC has a unique transaction history that can’t be altered. BOA’s report also provided a valuation of BTC assuming it becomes a major player in e-commerce and a significant store of value (perhaps like silver). The report set the maximum value on one BTC at $1,300.

BOA also provided a nice recap of the advantages and disadvantages of BTC:

Advantages:

  • As a medium of exchange, it offers low transaction costs
  • As an alternative for cash, it has better security and more transparency of transactions
  • There is a finite supply of BTC
  • Its anonymity is advantageous to those in countries wanting to avoid controls or confiscation
  • It’s the first digital currency and while there will be others, it’s the current leader
  • For asset allocation purposes, it has a low or even negative correlation with the stock market

Disadvantages:

  • Its price volatility limits its role as a store of value
  • Regulators could impose controls over transaction costs
  • The quality of BTC exchange security is suspect. Hence, Bitcoin users/investors may be subject to both investment risk and credit risk.
  • Governments may halt or limit the use of BTC
  • It is not a legal tender- no one is required to accept them. Hence, its value is only as good as the perception of its worth. And, it is not a publicly traded security.

Bitcoin could become very important in the coming years. Or some other “cryptocurrency” may take its place. However, as Yogi also said, “it’s tough to make predictions, especially about the future.” Either way, we’ll be watching and reporting on the new phenomenon of digital currency as it plays out. Very exciting.