Bitcoin or Bustcoin?
Digital Gold versus Physical Gold
The first crypto-currency, known as Bitcoin (BTC), was introduced in 2009 and initially sold for roughly 6 cents. That same coin today now fetches approximately $19,000 sporting a monstrous 300,000-fold increase in its short 8 years. In 2017 alone, Bitcoin has traded from a low of roughly $800 to a high of about $19,000. More than 1300 of these digital currencies have been created worth a combined $500 Billion.
This would make the crypto or digital currency sector probably the most spectacular bull market in history. By comparison, over the same time frame, the best performing larger stocks would include Nasdaq juggernauts Apple and Amazon which have achieved a roughly 8 times increase in price.
The increase in price, however, has been accompanied by breathtaking volatility, a fancy word for the degree of price risk. Moves of 20% or greater within 24 hours are not that uncommon. Bitcoin has also suffered a series of sharp crashes led by a 94% wipe out during 2011.
Projections for the future of BTC are extremely varied. A growing legion of fans point to the meteoric price rise and believe the market’s collective wisdom is speaking loudly. Bulls expect prices to continue their accelerated rise with targets as high as $1Million per coin. (http://www.zerohedge.com/news/2017-12-17/whitney-tilson-im-calling-top-cryptocurrency-madness-admits-bitcoin-could-hit-1-mill) Detractors call Bitcoin a fraud, a Ponzi scheme or just a giant speculative bubble reflecting the madness of crowds rather than the revolution in how business is done. They believe the intrinsic value is ZERO and ultimately the coin will be worthless.
The wide disparity in perception is the result of the quantum leap in price without any objective means to support the increase in “value”. The sources from which Bitcoin could derive value as well as its inherent risks are largely ignored by its holders. The investor community largely confuses price and value.
So, what exactly is Bitcoin? What are its sources of value? Can value be objectively measured?
Bitcoin is believed to be the future preferred medium of exchange because it’s decentralized, electronic and bypasses traditional banks. Entirely virtual, Bitcoin exists as a series of data entries stored in a “wallet” on a mobile device or computer. The wallet is an app analogous to a physical wallet in that it is required to store and transfer the coins electronically. The holder must control a type of password called a “private key”.
Transactions are processed by “miners” who aggregate many pending transactions into a bundle or a “block”. Once completed, each block is added to a cumulative ledger which is known as a “blockchain”. Miners earn both a transaction fee and additional new Bitcoins for assembling and processing each block of transactions. The total issued supply is believed to be currently 16.5 million coins while the ultimate total is limited to 21 million.
As the amount issued grows from the mining or processing of transactions, the amount of new Bitcoin rewarded to the miners per block decreases over time. Thus, the process of creating new bitcoin progressively becomes more expensive. This is analogous to mining physical gold which costs more to mine per ounce as the in-ground supply shrinks. Currently, it is estimated that the 21 million coin limit will be reached by roughly 2140.
Bitcoin’s Asset Characteristics (How It Derives Value)
BTC has traits it shares with currencies, Gold and other financial instruments, yet not enough for someone to be able to fully define or classify the asset.
For any asset to be considered a bona fide currency, like the dollar, it must meet the following three criteria: 1) a medium of exchange, 2) a store of wealth and 3) is widely accepted. The better an asset performs these three functions, the greater its value as a currency.
As to reaching the objective features that give an asset currency status, Bitcoin still fails although not completely. BTC does act as a medium of exchange for a growing volume of transactions, but the costs involved remain stubbornly high for it to be a serious competitor to the dollar or credit cards.
Transactions costs are a major roadblock to future growth and acceptance rate among merchants and/or retailers. The fees required to process a transaction are set by supply and demand. They are prone to skyrocket when volume or “traffic” exceeds capacity. In that case, the fees are determined by an auction among market participants. When activity exceeds capacity, completion time will also lengthen sharply. If someone needs speedy processing, they will be required to pay a premium fee in order to move ahead in the queue.
Another major factor producing the strong headwind to future growth is BTC’s nerve wracking price volatility. The profitability of a transaction to the merchant is exposed to adverse price risk until the coins are successfully converted to cash. The fees required to sell coins is higher the faster the need to execute a sale and can be as high as 8%. If the execution is not immediate, the fees become lower while a holder’s exposure to adverse price movements is higher.
Recent Historical Comparison of Price of Bitcoin versus Gold
Beginning December 2017 Bitcoin’s price decoupled from Gold.
Source: Zero Hedge
Bitcoin’s volatility (degree of price uncertainty) also makes it entirely unsuitable as a storage of wealth. To make matters worse, holders have suffered a very high historical loss rate from theft, scam and hacking. Studies reveal that up to 25% of the coins have been permanently lost. Banks provide physical security against theft or fraud while assets are in their custody. Deposits are insured by the Federal Depository Insurance Corp. (FDIC) for up to $250,000. The loss rate is of deposits is effectively zero. Some great charts showing a comparison of Gold versus Bitcoin as to price and volatility trends can be found here: (http://www.zerohedge.com/news/2017-12-18/hedge-funds-abandon-gold-chase-bitcoin )
Nonetheless, BTC possess certain key traits necessary to BECOME a safe and reliable store of wealth. In similar fashion to physical Gold, Bitcoin’s supply is limited to 21 million of issuance. Currencies, which are virtually cost free to transact, are exposed to the persistent watering down of value resulting from the potential for infinite supply creation. This nasty fatal flaw can be cured, but it requires the currency be backed by Gold or other hard assets.
Volatility is commonly measured as the standard deviation of daily returns over a 30 day or longer period. Bitcoin’s daily volatility, is currently measured at nearly 6% which when annualized is near 90%. In statistical talk, that means that roughly 1/3 of daily returns will exceed 6% or be lower than MINUS 6%. And, 1/3 of annual returns will be either exceed 90% or lower than MINUS 90%. The annual return in 2017 will be somewhere around 2000%. Not 200, 2000! By comparison, Gold’s daily volatility averages about 1% while currency volatility is closer to ½ of 1%. Some great information on BTC’s volatility and its historical levels can be found here: https://www.buybitcoinworldwide.com/volatility-index/
Market Volatility Trends of Gold Compared to Bitcoin
Source: Zero Hedge
Rather than falling, BTC’s volatility and price have both been steadily rising for years. That is very rare for a maturing market except during the final phase of asset bubbles. As price rises, the perception of market risk almost always lessens. This very unusual phenomenon of rising volatility and price also characterized the Nasdaq/Internet bubble which peaked in 2000. In this way, BTC shares traits with speculative equities. Any real relation to equities is near zero.
In December 2017, BTC began futures trading on the Chicago Mercantile Exchange and the Chicago Board of Options Exchange. Futures are contracts to buy or sell (deliver) an asset on a specific date at a specific price. This event is highly significant since it adds to overall market liquidity thus it should lessen the price swings over time.
Characteristics of Bitcoin Transactions
Initially, Bitcoin transaction fees were reasonably low, while the network capacity could easily handle the small level of activity generated. However, the network capacity has not kept pace with volume. Confirmation times are not instantaneous like cash or credit cards because the miners need to assemble an entire bundle before the processing protocol can begin. More detail on fee rates and transactions cost trends can be found here: (https://arstechnica.com/tech-policy/2017/12/bitcoin-fees-are-skyrocketing/)
Transaction times and security are inversely related. In other words, the rather long time required to complete a transfer is largely a function of the mining process which requires 6 separate verifications.
Processing or “mining” is also extraordinarily resource intensive, especially on electricity. The total annual electrical consumption required for mining transactions is reportedly greater than 159 countries will use in a year or equivalent to Denmark’s annual consumption. (http://www.businessinsider.com/bitcoin-mining-electricity-usage-2017-11) and (https://motherboard.vice.com/en_us/article/ywbbpm/bitcoin-mining-electricity-consumption-ethereum-energy-climate-change). While Bitcoin miners process about 450,000 transactions daily, they only total to less than one tenth of one percent of e-commerce market. How on Earth could BTC process enough transactions to really become a significant player without using every Kilowatt available? More information about mining costs and electrical use can be found here: https://www.ccn.com/isnt-ironic-global-bitcoin-mining-new-environmental-issue/
Bitcoin’s Risks and Vulnerabilities
Historically, the biggest losses have occurred when various exchanges have been successfully hacked. In order to dispose coins on an exchange, the holder must temporarily lose control of custody while Bitcoin is held for sale. The Mt. Gox exchange, which once handled 70% of all trading volume, was compromised in June 2013, during which 850,000 Bitcoin were illegally transferred. A very good list of top failures can be found here: https://cointelegraph.com/news/bitcoinfail-top-10-failures-in-bitcoin-history.
Bitcoins, like paper or Gold, can be lost or destroyed. If the wallet is destroyed along with the mobile phone or computer where its stored, the coins are lost permanently. Whoever has the private key controls the coins transfer. If the private key is lost or permanently forgotten, the coins disappear and reduce outstanding supply.
The amount of coins that have been lost permanently is estimated at a staggering 4 million. If that’s accurate, the issued amount of 16.5 million would fall to 12.5 million, or 25 percent since inception. Security, which is believed to be adequate, has many points of vulnerability with substantial losses in its short history. (http://fortune.com/2017/11/25/lost-bitcoins/)
Bitcoin’s high transaction fees and rather slow completion time also constitute a major barrier to growth since they make smaller transactions cost prohibitive. If a retailer were to do major Bitcoin commerce, it would either need to hedge price risk or bear the exposure to adverse movements. Large retailers Walmart, CVS and 7-11 all sell Bitcoin but NONE of them honor it.
The largest enterprise honoring Bitcoin is Overstock. However, the recent disproportionate leap in fees caused Bitcoin to lose a video game retailer. (http://www.businessinsider.com/5-big-companies-that-currently-accept-bitcoin-2017-7/#heres-why-more-businesses-arent-accepting-bitcoin-6) and (http://mashable.com/2017/12/07/bitcoin-steam-payment-end/#jkSS6vEMsPqP)
A further significant risk stems from the inflexibility of the architecture to incorporate quantum advances in technology. The risk of obsolescence or being surpassed by a new entrant is quite material. Bitcoin’s model may never be competitive. Ethereum, one of the larger rivals, can process 20 transactions per second compared to BTC’s limit of 4. Whether Bitcoin can achieve the type of advances that would be required to compete remains quite unclear.
Bitcoin Valuation Considerations
By far, the biggest risk is the general misperception of “value” and the belief that it’s virtually infinite. As discussed previously, the asset possessing the most traits in common with Bitcoin is Gold. However, Gold’s finite supply and 5000 year track record of stability place it among the best long run stores of value.
The total value of all existing mined Gold is about $2 Trillion. That means that Bitcoin’s market capitalization which is north of $300 Billion is approaching nearly 1/6th the value of all the Gold mined in history. If considered a currency, it would be the fifteenth largest in total market value.
While less applicable than Gold, the dollar is at least a useful comparison to BTC. The Federal Reserve defines “money” as M1, which is the sum of currency in circulation plus checking accounts. As of November 2017, The Federal Reserve reported M1 at $3.6 Trillion. Bitcoin is already nearly one tenth of the entire supply of dollar denominated money. Let that sink in for a minute. BTC’s market value is 1/6th of all the Gold ever mined and 1/10th of the entire US Money Supply.
Even credit card issuers, such as Visa or Mastercard, can shed some interesting light on the valuation. Visa, the largest player, currently processes about 150 MILLION transactions per day which is more than 300 times the volume of BTC. Visa is nearly universally accepted and provides instant confirmations, but it does NOT store wealth. Despite the obvious difference in usability in which VISA still dominates, the entire company is now trading for about $250 Billion which is substantially LESS than Bitcoin.
Since Bitcoin is highly unlikely to ever reach the utility of the Dollar or Gold, it might be more justifiable to place price targets at half of the total value of Gold and half of M1 money supply as proxies for maximum upside potential. Applying this methodology to Gold indicates a target value of $1Trillion (or half the value of total Gold ever mined) while using M1 suggests $1.8 Trillion (or half the M1 money supply), AT MOST.
Think of it this way: Bitcoin has already incorporated growth of 300,000 times its price while AT BEST no more than a 3 to 6 times increase is left to be realized. If Visa or Mastercard were also considered great proxies, the value indication would be substantially less.
While Bitcoin’s market value appears to be at extreme premium levels, price has completely decoupled from any type of objective measure of performance or utility. The risk is quite high that BTC could also decouple in the other direction, i.e. losing value while its usefulness and acceptance steadily improves.
Transaction volume for Bitcoin has increased over the last five years by a factor of 9 while the coin price has soared by a factor of 1500 times. Thus, the evidence is strong that Bitcoin HAS been more a medium of zealous speculation than any kind of valuable payment mechanism. Some great transactions and network stats can be found here: (https://blockchain.info/charts)
Bitcoin’s current market value appears to more than incorporate any near-term upside potential and leaves no room for error. In the short run, BTC can trade much higher and even exceed any conceivable notion of value. As the dotcom bubble burst, most of the internet companies failed, but left a few strong survivors. The probability that Bitcoin could fail is material but remains mostly unconsidered. Thus, we can conclude that at current prices, Bitcoin’s price risk vastly exceeds the potential for further significant gains.
Investors can never go wrong taking profits EARLY.
Marina del Rey, California December 21, 2017
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About the Author
Marko Budgyk is a former hedge fund manager and entrepreneur who now writes about politics, economic events, finance and other miscellaneous matters. He has an MBA in finance from the University of Chicago and has a BA in economics from Pomona College. He has been a guest expert on financial channels and quoted extensively in major business papers and magazines. He has returned to his first love which is writing.