Bitcoin, as explained to John Tuld: Pros, Cons and the Investment Case

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In the last six months, there’s no single thing I’ve been asked more about by people I know than Bitcoin.  That’s across the board: business people, roof tilers, consultants, family, friends, the lot.  I don’t move in tech circles, so I can safely say that not one of them understood anything about it other than everyone else is talking about it, and the price went up 1000% last year.

So, in two parts, I’m going to try to explain in in a way that John Tuld from Margin Call would have wanted it explained: like you would to a small child, or a golden retriever.

You can read about What the Hell It Is here.

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Alright, if you read part 1, you should have an idea what Bitcoin is.  If that didn’t put you to sleep, I’m going to run through some other aspects of Bitcoin worth knowing – loosely split into Pros and Cons – before talking about the Investment Case.  If I’m driving you nuts, just scroll to the bottom, and you’ll get your Investment Case.

PROS

The genius of Bitcoin is that it cuts away the middlemen and their costs, while maintaining an infrastructure that allows strangers to deal with each other.  If you read Part 1, you’ll have a bit of a handle on the two big advantages Bitcoin offers.

Access to the global economy for the unbanked

Something like 2.5 billion adults in the world don’t have access to banks, and as a result, are blocked out of the global economy. With Bitcoin, if somebody has access to the internet, or has a phone—it doesn’t even have to be a smartphone, it can be a feature phone that can receive text messages—it can be hooked into a computer system to deliver Bitcoin.  You still won’t reach all of those 2.5 billion, but you’ll get a decent proportion.

It’s not just countries Trump calls “shitholes”.  In Canada, the UK, and Australia, the proportion of people above the age of fifteen with a bank account ranges from 96-99%. But in the US, that number drops to 88%. In China, its 64%. In Argentina, 33%.  India: 35%. Pakistan: 10%.

Reducing transaction fees

Visa and MasterCard have formed a de facto payment system duopoly – and that system also allows banks to add on their own fees.  The top ten card issuers in the world are the big multinational banks like Barclays, HSBC, Wells Fargo, and Citibank, which issue them under licensing agreements with either Visa or MasterCard. Two companies and their banking partners dominate the global payment system.

But it’s not just about reducing the fees when you buy a Starbucks.

In those developing economies, there are two opportunities: the opportunity for non-cash electronic transfers locally, but also remittances of money from developed countries to developing countries – and the trade they help generate. The World Bank’s estimate is that the global remittance business is worth $500 billion annually. Fees for money sent from the US hit 10%; from the UK it can be double that. Add in exchange-rate costs, the total “friction” in the transaction can run as high as 30 percent.  If you’re living on $50 a week doing IT work for a US or UK company, saving $5-15 is a fortune.

But be warned: Bitcoin transactions now have transaction fees too, and they’re growing.

Taking currency control away from the more idiotic governments

This is a pro and a con – but since the libertarians who are into Bitcoin think this its a huge benefit, I’ll put it here.

All countries issue their own currencies.  They can also choose to print more of that currency whenever they feel like it, like the US and UK have done for the past decade in a relatively minor way, devaluing that currency.

If that doesn’t sound like too much of a problem to you, there’s some bits of history you should think about.  Zimbabwe went berserk printing money, and, because of the devaluation it caused, ended up with multibillion and one trillion denominated notes.  In the 1920s, the Weimar German government, unwilling to court military conflict with its European neighbours but also reluctant to upset the public by raising taxes, printed money to cover its debts and sent the German mark into an uncontrollable downward spiral. Children would arrange stacks of worthless 50-million-mark notes. That chaos helped lead to Adolf Hitler. Brazil’s 1980s dictatorships ended up with 30,000-plus percent inflation rates. Argentina’s many currency crises have led to it falling from the world’s 7th-richest country at start of the 20th century to 80th.

Of course, the downside to that is that an economy revolving around Bitcoin could exacerbate economic crises because it strips government policymakers of the capacity to adjust the money supply and to offset people’s instinct to hoard it at times of mass panic (like the US and UK did in 2008, successfully).

And the libertarian excitement about being free of government by taking their control of currency away from them ignores the value that government has provided, over time, to individuals, and to society.  Be careful what you wish for.

The Bitcoin technology is open source

While Bitcoin has plenty of negatives – and we’ll cover some below – the “protocol” is open-source, meaning its not proprietary, and anyone can access it and improve on it, or develop systems around it.

 

CONS

One of the things to remember as we work through some of the cons of Bitcoin is that we’re talking about technology – just like early computers, software programs and the internet were problematic, over time, solutions were developed.

Scalability

If bitcoin’s blockchain ends up as the default protocol for it and other cryptocurrencies, it has one big problem. The bitcoin network’s theoretical maximum capacity is (even with a recent forking from the main chain) 30 transactions per second.  Visa has a peak capacity of 50,000 transactions per second.  As a network, its going to need significant upgrading (which nerds are apparently working on solutions for).

Security

Unlike your banking and card systems, Bitcoin functions like cash in security terms. Once it is “sent”, it is sent; there’s no way to get it back – and no chargebacks like those that credit-card companies allow when your card is stolen or someone makes an unauthorised purchase.The key feature of a new payment system  in the internet age — think of PayPal in its early days — is the confidence that if the goods aren’t as described, you get your money back.  If you’ve ever disputed your lapdancing bill on your Visa the next day, you won’t be able to do that with Bitcoin. And like with cash, if your bitcoins are stolen, you can’t get them back.

If you keep your bitcoins in a “hot wallet” that’s sitting on an internet-connected computer, a hacker can, in theory, gain access to your private key and steal the coins. Or, if you lose your private key – literally the string of code needed to unlock bitcoins from a “cold wallet” that has been taken offline – or if you forget the password to your hot wallet and you are the only person with it, there’s no way of getting back your coins. They are as good as lost.

Every time a story comes out like people losing Bitcoin wallets, a Mt. Gox, or a hacker stealing coins, a bit more confidence is lost in the system.  While these security problems aren’t as big as those occurring within the bank-centric system of finance and credit-card payments, they add to the image problem.

Sure, there’s precautions around all this, but the whole “alphanumeric password combined with double-factor authentication” is a giant pain in the ass for most people, compared to reaching into your pocket.

The systems around Bitcoin

Ultimately, Bitcoin can only allow you to do a fraction of the things that you have gotten used to doing in everyday life with the banking system in the Western world – for the majority of things, you still have to convert it to a fiat currency.  Most merchants don’t accept it.  You also need digital wallets, internet access, passwords, security, all to own something that’s not easily transferrable.  Currently, it’s a pain in the ass.  Its not that easy for the everyday person to buy, sell or use.

Technology and consumerism is improving things: user-friendly, smartphone-based wallets to make payments easier; better and more trustworthy online exchanges for buying and selling bitcoins; bitcoin ATMs that make it easier for ordinary people to cash in and out of their local currency; gift cards that allow bitcoin holders to buy goods from merchants like Amazon that don’t accept the cryptocurrency; and things such as bitcoin-loaded debit cards that will work with regular point-of-sale card-swipe machines and banks’ ATMs.

But right now, its too difficult for most people to use: the friction level is too high.

Flameout potential

People were pretty excited about BetaMax, Segways and MiniDisc players for a while there, too.

In China, there are few financial incentives for using Bitcoin. The government-controlled UnionPay payment-card network is deliberately designed to incur low transaction fees, so card payments are more financially attractive for both consumers and merchants than bitcoin – and in a stable currency.  Tencent Holdings’ ubiquitous WeChat messaging app has around 400 million smartphone subscribers that can use it to instantly send money to friends, taxidrivers, or buy things from vending machines. Same with e-marketplace Alibaba’s (China’s Amazon) Alipay.

Like the MiniDisc player, it might get completely wiped out by someone coming up with the iPod.  Why, yes – I was one of the idiots who bought a £300 MiniDisc player, and spent £300 more on albums, only to toss it a year later.  Thanks, Steve Jobs.

Regulatory bodies

So far, despite some vague mentions, no government has attempted to step in and block or regulate Bitcoin.  Part of the reason is that it’s a tiny portion of the world’s wealth – much less than 1% of total fiat currencies.

But that might change if with increased value, or just negative publicity: big individual losses, hacking… or if it was used to fund a terrorist attack.  The same “money-laundering” regulations that were brought in post-9/11 are unlikely to allow Bitcoin to just function anonymously – not if you want to convert it back to the fiat currency system.

Already, “Know Your Customer” bank regulations are making it hard for people with Bitcoin gains to get those, once converted, into a standard bank account.

Bitcoin was intended from the outset to be resistant to government control. The early users were idealistic anarcho-capitalists who envisaged it being used by individuals to conduct commerce between themselves without the spectre of government theft (i.e. tax).

Again, this might be a “pro” as well as a “con”, but the chain of confirmed Bitcoin transactions is public. You can see the details of every bitcoin transaction ever conducted. Now, when looking at the “addresses” on the blockchain, there is nothing to identify the owners – they appear as strings of 26-34 letters and numbers.

But the traceability of the record of transactions has been exploited by law enforcement, like when the FBI seized bitcoins during its 2013 crackdown on the Silk Road online drug marketplace. Armed with subpoena powers, a law enforcement agency would, in theory, be able to force whatever institution provided a bitcoin wallet to divulge the owner’s identity.

Mining

The incentive to maintain the entire Bitcoin ledger is built around the issuing of some portion of Bitcoin to the computer owner who confirms the transactions.  The problem is that as heavyweight computing has become attracted to those incentives, it’s become an arms race.  Depending on the cost of your power, the electricity bill for mining one Bitcoin can be $2,000 to $8,000 – and that’s without the expensive computer costs needed to compete.

Companies are building “mining centres” in cooler, high altitude, cheap power US States.  In theory, any one organisation with the power to ‘win’ 51% of the time, could create whatever transactions they wanted (although the value of the Bitcoins they mined would crater from the loss of confidence in the system).

Bitcoin’s flaws as a currency

This is one key thing to understand about Bitcoin’s potential as a currency: for a currency to become money it must function as:

  1. a medium of exchange,
  2. a unit of account, and
  3. a store of value.

So we know Bitcoin is currently being used as a medium of exchange, albeit in a limited way.  Retailers have started signing up for payment-processing services offered by Silicon Valley–funded start-ups like BitPay, Coinbase, and GoCoin (at a cost, but less than the traditional bank/card system).

But almost no-one uses it as a a unit of account (like dollars or pounds). Merchants that do accept bitcoins still list their products’ prices in the national currency of the country in which they are based.

And part of the reason is the “store of value” issue.  Nobody wants to go to the grocery store week to week and see her bill change 10% or more just because the underlying bitcoin exchange rate is fluctuating. A currency has to have price stability if it is to function properly as a medium of exchange.  Bitcoin (and its alternatives) are nowhere near that stage.

 

THE INVESTMENT CASE

What you really want to know, after enduring all of that, is whether you should be buying some, right?  I don’t have a hot take for you that “It’s going to ZERO!!!”, or “It’ll be £250,000 in 2 years”.

My short answer: no.

Not as an “investment” anyway.  If you want to take the money you would spend gambling on an NFL season, go right ahead.  If you have a couple of per cent of your investment wealth that you normally keep for boom or bust stocks, that’d be a good spot too.  If you want to buy some because you’ll use it for transactions, fine.

But regardless of what its done in the past, Bitcoin is not an “investment” you should be making – and I’ll bore you with the longer answer of why.

Bitcoin isn’t a company where you can invest in profitable economic activity and grow your wealth with, like Apple, who sell 200 million new phones a year — all you can do is sell your Bitcoin again. It is a zero-sum investment — the actual money coming out can never be more than the actual money coming in. Bitcoin is like gold – it doesn’t produce anything.   What gives it any value at all at the moment is a) the miners, and b) speculators.

If you read through the list of “cons”, you’ll understand that there are plenty of reasons to believe that Bitcoin will never become ubiquitous.

If you read through that list of “pros”, you’ll understand that because its open source, there’s no guarantee that even if cryptocurrencies become what its proponents think they will be, there’s nothing to say that Bitcoin will be the winner.

Bitcoin miners need a huge amount of electricity and computing capital investment to run the system. As long as the costs of running the Bitcoin miners is lower than the value received, then Bitcoin will probably persist. But as soon as the formula-solving becomes too costly, meaning too few Bitcoin rewards are granted per solved block to justify the expense, miners will start shutting down. If/when that happens, blocks will take longer and longer to solve. This will extend and stretch out the time to process a transaction, and reduce the attractiveness of Bitcoin to merchants and holders alike.

The only thing that will keep Bitcoin’s system working is if Bitcoin keeps increasing in value and electricity and computing costs do not rise faster than the returns from Bitcoin mining.  A Bitcoin has itself has no value.  A Bitcoin and an intact and functioning mining operation has value.

As for speculators, cryptocurrencies as a whole currently exhibit a range of characteristics common to bubbles and/or known scams.

The seven-digit “price” you see the CNBC talking head give you for Bitcoin on his CRYPTO DESK!!!! is just marketing for Bitcoin. It’s gives the impression that Bitcoin is a solid tradeable object with an orderly market structure, that you can price down to the cent.  But a singular “price” for Bitcoin doesn’t exist — it’s a made-up number.  It’s not a number you can expect to exchange a Bitcoin for — it’s an average of the last sale price on a bunch of exchanges.  There is no market maker like there are for shares and commodities.

Worse, the spread on the exchanges are hundreds of dollars, and on volatile days it can be in the thousands.

“Market cap” figures are just as bad – it’s just whatever the last price was, multiplied by the number of tokens in existence.  Trading is so thin in any cryptocurrencies, even Bitcoin, that you could never realise a fraction of the number.

There are also no regulations around Bitcoin trading.  The thing to remember about investment (securities) regulations is that they came about because a lot of people got torched at some point. Currently recognised as standard on cryptocurrency exchanges:

  • wash trades — where you trade with yourself, to pump the price up or down, or just create the illusion of trading volume.  Or painting the tape — like wash trading, but with two or more participants.
  • spoofing — where you place a large order to create the illusion of market optimism or pessimism, and cancel as soon as the price gets anywhere near it.
  • front-running — where an exchange operator takes advantage of a buy or sell order before other customers can.
  • insiders with access to the database trading on their own exchange.

These things don’t mean that Bitcoin is worthless – but you have to recognise that it is now a speculator’s game.  It needs “greater fools” wanting to pay more than you paid for it for you to profit.  Old investors only profit with money from new investors — the key characteristic of a Ponzi scheme. Bitcoin just has no specific operator at the top.

Bitcoin in China isn’t advantageous as a payment process – it is purely a speculator’s game, a way to gamble on its price, either through exchanges or by mining it.  Chinese trading volumes outstrip those anywhere else in the world. Mining activity in China has been estimated to account for 30 percent of all hashing power.  Its worse, proportionally, in South Korea – according to a study, more than 3 in 10 salaried workers in South Korea have invested in one or more cryptocurrencies.

This current cryptocurrency frenzy draws strength from the same things which make pyramids and Ponzis so compelling: promising insane investment returns, accessible by the man on the street with next to no effort or understanding, and recruitment of new, individual participants as self-interested evangelists who have an initial win.  As with any exciting new technology, there’s a rush into the space by hordes of entrants, many of them unsophisticated and simply hoping for a win – or worse, to tell people they’ve invested in it.  That works for a few; most simply get burned.

That’s the way bubbles go – lots of people rush in, a bunch get trapped when it crashes.  As for when this will crash, you’ll be pleased to know I have no idea.  Bubbles inflate a long way: check out the Tulip Bubble*, South Sea Bubble or the Dotcom Bubble.

(*That’s not to say Bitcoin is like tulips – just that the bubble can inflate a long way before it pops)

If you are the sort of trader who can navigate the speculator’s game, it might have a long way to go; I can’t tell you.  I am almost certain it will end badly for a lot of people.  It’s certainly not what a roof tiler should be doing with his money.

 

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Disclaimer: this isn’t investment advice. This is a blog, and most of what I write on this site is pure garbage. Definitely do your own research and don’t rely on my half-assed analysis. There are much smarter people than me, and I am biased because I am not smart enough to trade Bitcoin as a speculator.

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