Tackling Bitcoin Mania – Caveat Emptor!

Everywhere I turn, the conversation is about Bitcoin. How much is it up? (18x as I write.) Is it a good idea to invest? Does a potential Bitcoin crash threaten the economy? Should we worry about it? In this post, I will take a closer look at Bitcoin, covering these questions as well as trying to understand what the perspectives are for this maverick financial instrument.

I concede that Bitcoin is a financial instrument, that much is clear. Beyond that what is it? The Daily Show produced a brilliant, if rather colourful, video about how to understand Bitcoin. That’s all Bitcoin really is, some anonymous guy’s personal currency, receiving increasing support from an ever wider pool of participants. The video makes fun of the fact that conventional currencies like the US dollar are also only faith-based mirages. But there’s a dynamic twist beyond the simple enduring acceptance of conventional currencies: Government’s have the power to tax and regulate. These tools equip them with the legitimate power to decide what constitutes money.

What I don’t concede is that Bitcoin is an investment. You might want to call it an asset, as it currently has value. But, I’m less comfortable with such a label. For me, an asset has utility, and Bitcoin doesn’t.

Why Isn’t It An Investment?

For me, as a student of finance, for something to be an investment, it should have a rigorously definable theoretical value. We might debate the parameters that define that valuation, since they will often involve forecasts, which are subjective measures. But, at least there should be a theoretical value before an instrument can be classified as an investment. Until then, it is a purely speculative game, akin not to investing but gambling or betting. Please, understand, I have nothing against either gambling or betting, but let’s call it things by their proper names.

Why Isn’t It An Asset?

I feel similarly about labelling it as an asset. Bitcoin defenders insist that it is a currency. A currency, they say is an asset backed by the faith of the public. Partly true, it is also a store of value and a means of exchange. Bitcoin is indeed a means of exchange, this was the original purported intention of its creation. And yes, the blockchain technology that it presented is reported to be superior to technologies that preceded it. But does that make bitcoin a currency? No. You can buy a few things with it, but not much. And those things are still priced in conventional currencies. They will, as I explain below, remain that way.

OK, but how can it not be a store of value, you ask? It’s worth over $18,000! True, this proves that it has value. Having value and being a store of value are not the same things. Bitcoin is way to volatile to be a store of value. And that is something that will never change. Bitcoin is a zero yield instrument, which is why it has no theoretical or intrinsic value. It is like gold, except that gold has some industrial uses, thousands of years of established reputation and is harder to fake than Bitcoin is for hackers to steal. And even then, I wouldn’t agree that gold is a store of value. It is an interesting speculative instrument (it has industrial uses, so we can call it that). But treating gold as an investable asset is a risky proposition, one pursued by only a minority of investors.

What’s All The Noise About?

So, if Bitcoin isn’t an investable asset, what’s all the noise about? Bitcoin defenders, who will already be chumping for ways to attack me as well as my arguments here, are an ever growing pool. They appear to have one thing in common: they own Bitcoin and have a vested interest in persuading others to own it too.

Now, there is nothing wrong with “talking your book,” which is finance speak for promoting an instrument that you own. But, reasoned people won’t be persuaded by their arguments about why we should buy Bitcoin. Again, there is nothing wrong with buying it, but do so understanding that you are entering a casino!

How Does It End?

Bitcoin are issued into the crypto-currency world at a controlled pace. The rise in value of Bitcoin, from about $1,000 to over $18,000 this year reflects that the pace of demand for Bitcoin has exceeded the controlled supply. That dynamic alone isn’t sustainable. It could run for a long time, but eventually supply and demand will balance, if it lives that long. Then its lack of yield will become a more significant factor.

Broadly speaking, I can envisage three possible outcomes for Bitcoin:

1) It Works. This for me is the lowest probable outcome, it would leave Bitcoin as a far less volatile instrument, putting it on par with gold as a “financial asset.” In times of political or economic strife, prices would go up, but otherwise it will remain less appealing due to its lack of yield (relative to most conventional currencies, which are valued through interest rates). Bitcoin lovers might see it supplanting conventional currencies, like the US dollar but that is unlikely because of outcome 3, below.

2) The Bubble Bursts, And It Dies Off. What worries me about Bitcoin is that, beyond everything else, it is a near perfectly designed speculative, instrument. There is a list of factors that an instrument must meet to have bubble potential, and Bitcoin has them all. It’s bubblicious characteristics are already more than apparent, just from looking at the chart of its price behaviour. All bubbles burst, whatever those TV adverts tell you. This one will be no exception, left to its own devices, the Bitcoin bubble will burst. When it does, either it will be the end of this speculative fad, or the start of a new rally, followed by outcome 3, below.

3) Governments Step In. The idea of governments relinquishing control over the cost and quantity of money strikes most qualified investors as being rather absurd. Recent years have shown perfectly how important it is for central banks and governments to be able to use economic levers to mitigate economic cycles and their impact on the general public. For now, governments are letting Bitcoin run, I suspect they will happily wait for the bubble to burst before they take any action, as long as the economic impact of waiting isn’t too great.

But we should not be mistaken, the greatest threat to Bitcoin is that governments can step in at any time to regulate or tax it back to a more reasonable price level or scale of usage. When this happens, of course users will cry murder. But deep down every buyer of Bitcoin knows this is the greatest risk.

Overall then, there is a place for Bitcoin. It would be best to consider it as akin to the casino, or other betting activities. There is nothing wrong with that. Millions of people go to the casino to have fun. But casinos are regulated. There is a limit to how they can approach you. The problem is that Bitcoin is entirely unregulated.

When I worked in a hedge fund, we were rightly banned from marketing to retail investors (the general public) we could only sell our services to qualified or professional investors who understood the risks. Bitcoin is an aberration because being unregulated, it is being touted directly to the general public. And this is precisely the interest of those who own and promote it. To lure in as many unsuspecting participants as possible. But the history of financial bubbles is clear. There is a reason why so few serious investors are involved in Bitcoin. Caveat Emptor!