Bitcoin: A Though Experiment Run Amok

2017–12–26

WHAT’S A BLOCKCHAIN?

I first heard about it in 2010: Bitcoin, the currency of the future. Apparently some software nerds and cryptography hobbyists had come up with a virtual currency concept which used a shared (distributed) online registry to track and verify all transactions and ownership, the “blockchain”. The original thinking behind this concept was that this would allow for highly secure anonymous currency transactions without the involvement of pesky financial institutions or governments.

Users who assigned computational power to verifying the transaction registry and discovering new cryptographic “blocks” that further add to the security of the blockchain were awarded with new Bitcoins in order to incentivize involvement with this distributed currency network. This process is called bitcoin mining.

EARLY BITCOIN

I don’t know if Bitcoin was meant to be an actual global currency solution in some Utopian future, a thought exercise, or some sort of new security. However, it’s pretty likely it was nothing more than a thought exercise. For the first 2–3 years of its existence, the only users of Bitcoin were Silicon Valley nerds. The “currency” could not be used for much, it was mainly a novelty. Right through 2014, there were few vendors accepting Bitcoin and the perceived buying power and corresponding transaction volume was low.

The value of a Bitcoin is completely uncoupled from any other currency or commodity. This is fine, the Gold Standard by which paper currency could be traded for a fixed amount of gold bullion was abandoned by nearly every country after World War 2 (interestingly, the US did not abandon gold until 1971!). However, Bitcoin has no insurance agency like the FDIC backing up the registry, no pegged exchange rate, and no virtually no regulation.

Bitcoin was started in 2009. By 2012 there were as many as 7,000 Bitcoin transactions per day. By 2014, there were as many as 50,000 per day. I remember reading about how this could be the currency of choice for terrorists and drug dealers world wide (although I truly doubt these were the early adopters…). Correspondingly, the price increased from less than $10 per coin to around $200 per coin over the same 2012–2014 time period.

Bitcoin started out 2017 priced around $1,000 per coin with almost 300k daily transactions. By June it was above $2,000. I initially looked at the uptick in Bitcoin value as an anti-Trump hedge against a new recession; I sold a bunch of (non-Bitcoin) positions myself right after the election, and I doubt it was Trump’s base bidding up Bitcoin in the first half of the year. When investors get nervous, they flock to things that are uncoupled from the dollar/US economy. Gold started a record run from 2008–2010 right on the heels of the Great Recession. Maybe the initial run-up in Bitcoin was just another hedge against a destabilized US economy?

WHAT IT IS NOW

Since June things have gone crazy. The number of transactions carried out with Bitcoin per day hasn’t really increased at all, still around 300k per day, but the price has exploded to around $20,000 per coin at the peak and I bet it goes higher. There are (apparently) 100,000 vendors that accept Bitcoin, although I can’t say I have come across many of them and I bet there are only a handful that matter. Since the number of “mined” coins can only increase, and the apparent usefulness of Bitcoin (by daily transactions) has not changed, this price increase seems to be entirely driven by speculation, more and more investors ready and willing to trade real dollars for Bitcoin. There has been no underlying change in value, there is no interest rate, no central bank, and nothing preventing Bitcoin from going to zero. Unlike a share of stock, there are no underlying business fundamentals, dividends, or expectations for future earnings.

Since the beginning
Past 6 months…

IT GETS WORSE

Bitcoin, now worth more than 250 billion USD, has hit peak hype. Bitcoin “mining”, the use of computational power to verify and expand the registry, now consumes more power than the country of Ireland. This somehow seems wrong when most of the African continent sits in darkness. The increasing complexity of the blockchain has further contributed to the uselessness of this non-currency: it now takes hours-to-days to verify a single transaction. Can you imagine buying a gallon of milk or tank of gas with Bitcoin if it took 12 hours to process the purchase?

Unscrupulous “wantrepreneurs” have gotten in on the action, building their own cryptocurrency products on the same basic premise as blockchain. The most recent estimate has identified 1,324 cryptocurrencies built on the same blockchain principles. Most of these will be defunct by the time you finish this article.

In order to launch a new cryptocurrency, the new hotness in Silicon Valley is the “I.C.O”, or Initial Coin Offering. It’s just like an IPO, except there are no underwriters, banks, established markets, or regulators to worry about. A piece by tech writer Kevin Rose describes an ICO thus:

“If you’re having trouble picturing it: Imagine that a friend is building a casino and asks you to invest. In exchange, you get chips that can be used at the casino’s tables once it’s finished. Now imagine that the value of the chips isn’t fixed, and will instead fluctuate depending on the popularity of the casino, the number of other gamblers and the regulatory environment for the casinos. Oh, and instead of a friend, imagine it’s a stranger on the internet who might be using a fake name, who might not actually know how to build a casino, and whom you probably can’t sue for fraud if he steals your money and uses it to buy a Porche instead. That’s an I.C.O.”

THE FUTURE

This cannot and will not continue. Regulators and governments have been warning consumers to stay away, but nobody is listening. I especially like the warning from the People’s Bank of China: “One day you’ll see bitcoin’s dead body float away in front of you.” Poetic. Jamie Dimon, Chairman and CEO of JPMorgan has come under fire on internet forums for calling anyone who buys Bitcoin “stupid”. What does that guy know about investing, anyways?

More and more unsophisticated non-accredited investors are making bets on different new cryptocurrencies. I heard about undergrad lab techs from my last company trading on ICOs, people in my extended family investing in new blockchain-based currencies, new MIT startups raising millions through a coin offering and going out of business weeks later…

There are two possible scenarios: one is a major blockchain correction event in which investors lose their shirts, which will prompt swift regulation of these markets, the second is sudden international regulation of these markets leading to a major correction. Either way, investors will lose. I worry it will be those who can least afford total loss of invested capital who will be hurt the most.

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