Cryptocurrency tulip mania
Let me explain my reasoning. It’s value is 100% derived from speculators and grandparents who have no business trading in highly risky asset classes. It faces more regulatory risk than any currency and has a huge exposure to technology risk. In short, it is a really unappealing asset.
When the zombie-apocalypse comes, the things that will be most valuable (assuming you’re not a zombie) will be food, shelter, and protection. Why? Because they address the bottom of Maslow’s Hierarchy of Needs. They have intrinsic value.
The value of other things is less clear. Take a computer for example – it’s value is derived from its utility but also demand and other market forces. It’s value is a combination of these things.
Then there is gold. Gold is special because it is the most common analogy for Bitcoins. That isn’t to say that it is a good analogy. Gold gets its value partly from an inherent value (its corrosion resistance is critical to some electronics manufacturing) and because of market demand. The market demand here, while it fluctuates, has thousands of years of history. We know that people have always valued gold and there is little risk that it will have $0 value tomorrow.
Sadly, none of what gives gold its value applies to Bitcoin. A Bitcoin is a cryptographic hash. It’s a string of numbers. When the zombies come for you – what good will it do? What inherent value does a string of numbers have? I’ll take the clean water and the gun, thank you very much.
But Brian, you shout, there IS market demand. True. The demand comes from speculators. And while Bitcoin has been around for a few years, the significant ramp in demand is less than a year old. Compounding this is the the insane volatility. Swings of >100% in value have happened in less than a day.
Caling Bitcoin the next form of gold is like saying that the Segway is the next car. Yea, they kind of do the same thing but there are some material differences.
At a meta-level, 100% of BTC value is driven by demand. It is driven by a perceived perpetual increase in value. In other words, people are betting that they can buy at price X and sell at price > X. They are betting that they will find someone who is willing to pay more for a Bitcoin than they were. Charles Ponzi would be proud. Of course, this begs the question. If someone thinks that the price of a Bitcoin is only going to go up at an above-market rate, why would they ever sell it?
Unusual Asset, Unusual Risks
Let’s take a slightly different approach to attack this pending cryptographic train wreck. Risks. Bitcoin inherently have more risks than just about any other asset class.
Currency Risk – Currencies fluctuate in value relative to each other. Go to XE.com to see this in action. Bitcoin have this too. Go to Mt Gox to view the same charts for BTC. A Bitcoin can be converted to USD, JPY or other currencies. If you convert USD -> BTC -> USD and do not get exactly 100% back every time, you have currency risk. What makes Bitcoin standout is the variance. I believe that σ^2 is not a complete measure of risk but it does highlight the fluctuations. Here is the big takeaway. I pulled data from the last week (below) and the largest change between USD-EUR was about 1%. For Bitcoin, it was about 15%. This was just a week picked at random – there are many examples of more drastic changes.
World Event Risks – Okay, any international company has this risk. If something happens in South Korea, Samsung’s stock price could change. What makes BTC unique is that a change in ANY country whose currency you can convert to/from BTC will have a ripple effect throughout the market. Germany wants to ban Bitcoin – there is a drop in demand and price follows. Paraguay starts hoarding BTC for some reason – demand skyrockets. Arguably, both of those risks are well beyond your control and the wide range of possibilities makes predicting material events impractical for most investors.
Tax Risk – Unless you’re operating a tax-exempt endowment, tax treatment should be a significant factor in your asset allocation exercise. Right now, gains on BTC aren’t taxed. Will they be tomorrow? Next year? It is safe to assume that if BTC survives a few more years that governments won’t leave cash sitting on the table. The question is – what rate will they use? Being unable to quantify or even estimate these variables should concern even the most intrepid investor.
Regulation – This is a big unknown. Alternative currencies pose a risk to governments. They are hard to monitor and governments do not have the monetary tools to control alternative currencies. The question is, if BTC takes off, how will they react? Will they severely tax them? Will there be burdensome reporting requirements? Will they simply be banned? It is not impossible to imagine a scenario where your Bitcoin portfolio goes to zero because of a regulation change.
Technology Risk – This risk is my favorite. Let’s talk about cryptography for a second. The goal of cryptography is not to be an impenetrable fortress forever. It is more like a physical firewall. A firewall will eventually break down and/or burn. The goal is to slow the progress of the fire down. Cryptography’s goal is to provide a barrier that is computationally expensive to breach given known techniques. We see this with every Windows Update. New algorithms are added to the SSL standard and minimum suggested key lengths are increased. What was secure 5 years ago is not secure today. Given this, there are multiple risks.
- First – you are betting that computing resources will not increase with time. That is simply a bet on the wrong side of history and technology.
- Second – you are betting that no known attacks exist (they do) and that none will ever exist. Software is made by humans. Humans are not perfect. Therefore software is not perfect. Again, these are bets where history has given us a clear directional indicator.
- Third – you are betting that the system already exists without flaws. If you don’t believe me, go Google “51% risk Bitcoin”.
Competitive Risk – Lastly, you have an odd dynamic for a currency – you have competitive risk. Just let that sink in for a second. Bitcoin are cool, but litecoin are the new hotness. Or is it Dogecoin? Or Coinye? I can’t tell. They are all based on the same principal and their differentiation strategy revolves around clever names.
So what can you do with a Bitcoin from an investing perspective?
Well, right now, most individual investors are limited to a simple long position. You buy it. You hope it goes up and you hope to sell it to someone who is more optimistic than you were. It is a 100% timing game. Hot potato is fun unless you’re the one at the very end of the game.
So how would I make money on BTC? I can think of three ways.
- First – I would take a short position. Bitcoin cannot keep going up in price any more than tulip bulbs. Yes, you need to factor in the cost of establishing and holding the position but fundamental logic and reason are on your side. The reason I don’t is simple. There really isn’t a liquid market where a small investor like me can express my position.
- Second – I would trade against volatility. If this were an easy-to-acquire stock, then trading based on views of volatility would be a cinch. Unfortunately, like above, the immature market makes expressing this view challenging.
- Lastly – the REAL way I would make money given unlimited resources – I would establish a Bitcoin fund. Consider this, you are largely isolated from fluctuations in BTC price because you make money off of management fees. Yet, you still get to benefit from the hype surrounding Bitcoin.
Aaron, one of my good friends happened to be writing an article on Bitcoins as I was writing this. He uses the term Volatility Shopping to describe how he made purchases at less-than-retail prices using the fluctuations in the BTC:USD conversion ratio.
Fundamentally, it is an issue of timing the market to generate returns. I can’t argue with his logic. You can make money timing. You can also lose money. Market timing is not a game that I want to play. Given this dynamic and my long-term negative outlook view on the currency, I still don’t think it belongs in a proper asset allocation exercise. Then again, my portfolio is weighted to return market beta.
Disagree with me?
Tell me why I’m wrong in the comments.