Bitcoin – bubble or growing pains?
We believe bitcoin is not a bubble, but is growing into a role as an important financial instrument that will be used as a significant store of value for global wealth. Its whippy meteoric rise may be growing pains rather than an irrational mania.
There is a lot of emotion in the Bitcoin debate. A lot of influential bankers are dismissing it as a bubble and suggesting there may be something fraudulent and criminal at play in its meteoric rise in the last year. The implication being that its value may rise to extraordinary heights before crashing back towards nothing.
Some other less damning comparisons have been made to the Dotcom equity market bubble in the late 1990s. While there was a sense of mania at that time and a large number of companies failed, overall, the stock market is now higher and the best companies of that time have grown in concept and value to dominate the top list of companies. These commentators appear to see a sense of mania developing in the way bitcoin is trading, but are less committal on whether it has sustainable value.
I am coming down on the side that bitcoin has the potential to grow into a powerful highly valued financial instrument. While its volatility at this time is scary and has all the attributes of a financial bubble, it may well be growing pains as it breaks into the mainstream financial world.
Its meteoric rise may reflect a growing realization that it can become a meaningful financial instrument in which a significant proportion of global wealth will one day be invested. If this happens, given that it appears to have a limited supply, bitcoin may still only be at a fraction of its future equilibrium value, notwithstanding its more than 10-fold rise this year.
There is still wide debate over the concept of bitcoin. And it is not yet seen as a serious financial product, and its possible future equilibrium value is highly debatable. This is contributing to mania type thinking and trading. I prefer not to think of its whippy and wild rise as a result of a mania, but growing pains as bitcoin finds an equilibrium value that is more deserving a serious financial investable product.
I am not well studied in the groundings of bitcoin and the blockchain technology that underpins it. I am only just beginning to research the broader array of blockchain technology and cryptocurrency developments. As such, I am not speaking as an expert. I am open to all arguments, and as a reader, I advise you to broaden your own research and analysis. Please do tell me how I am wrong about bitcoin.
I have recently invested in bitcoin derivatives, but in an amount that I consider conservative and consistent with its highly volatile nature. These are my thoughts on why I think it could become a highly valuable financial asset.
Part of the reason that I have been moved to write about bitcoin is that it can be considered a form of currency and part of the realm of foreign exchange, which is my area of expertise. I feel compelled to understand it better. More and more, everyone in the traditional financial industry is likely to need to understand and form an opinion on how bitcoin other cryptocurrencies and blockchain technology may impact on their business.
Store of value
To be valuable, Bitcoin must be seen to become a store of value. A place where people feel secure parking a share of their savings. Investors, therefore, need to think that it is likely to hold its value and will not be confiscated by the government. They would like it to be portable and convertible into currency, other assets, or used directly in transactions.
Bitcoin has a number of unique attributes over other traditional financial assets that are used to store value.
One is that it does not appear to be beholden to any government. Governments can confiscate or tax most other financial assets, including bank deposits. As such, it has an additional intrinsic element of security that most financial assets do not.
Another is that bitcoin does not appear to need to be held in the custody of a bank or other depository institutions. It can be stored in the internet cloud or a personal computing device. It does not rely on the financial stability of the banking system. This may also be considered another unique, valuable feature.
It is highly portable, unlike bars of gold and suitcases of cash. As such, outside of a bank, it is also able to be kept safe by employing simple and cheap security measures, and moved easily, such as across borders.
It has a limited supply. To be valuable it needs to have at the very least a controlled supply. Bitcoin is ‘mined’ similar to gold, but it appears to have a finite supply of 21 million. The current supply appears to be around two thirds that amount. National currencies have a relatively rapid rate of supply growth. That supply is often manipulated by central banks and governments to target economic conditions.
The fact that central banks go to such extreme lengths to set mandates and targets for their activities, at their root, are designed to create a reputation of stability for the supply and value of their national currencies. However, even for major countries, the stability of their currencies is frequently called into question and subject to shocks and manipulation.
Brexit in the UK recently caused a massive depreciation in the GBP; one of the most trusted currencies. The ECB has pushed interest rates into negative territory; this significantly impacts the value and cost of EUR bank deposits. Bitcoin supply is not beholden to the whims of governments, and this is a very attractive attribute.
The fact that Bitcoin appears to have a limited supply implies that if it is eventually accepted as a viable and sustainable store of value, its price in terms national currencies should persistently trend higher. In this way, it will be seen as a hedge against inflation.
As a store of value, it has a number of unique attributes that suggest that it could become superior to cash, bank deposits, and gold. It is more portable than all these alternatives. It is less subject to vagaries of government in both their capacity to confiscate and tax, or manipulate their own currency. It is closer to gold in many ways, but it is more portable and useful as a transaction medium.
Below we address some of the common criticisms of bitcoin.
The network effect
Bitcoin was created essentially out of nothing, and competing products could be created that have all the same potential attributes as a store of value with transaction capabilities. In fact, several have been created already.
We would argue that while there may be infinite numbers of Bitcoin imitators, there can only be a few that develop the credibility to survive as a store of value. Competition is a factor in almost every industry, but the value of some products are created by the network they establish. The larger the network, the more useful and valuable its utility. As such, there end up being a few winners in these network industries.
Examples in other industries include Facebook for social media or Amazon in online retailing. There is room for some competitors, and they may become large and valuable too. They may keep each other honest in the sense that they must continue to provide a useful service at a reasonable price. But demand will tend to go to the company that has the largest network because there is greater utility in the largest most widely recognised network.
Bitcoin was the first and is the leading cryptocurrency. It is developing a strong network effect. It will not be easy for competitors to overtake and replace bitcoin. There may be scope for some to ride its coat-tails. But there does not appear to be any fundamental usefulness for more than one cryptocurrency that acts as a store of value. As such, Bitcoin may turn out to have a very strong network effect. The more it grows in stature, the more it will gain acceptance as the cryptocurrency that is the best store of value.
Out of the grip of government control
Another potential criticism is that bitcoin can be outlawed and rendered unusable as a transaction medium. Firstly, the fact that governments do not control it is a strength. As discussed above governments cannot be completely trusted. Governments have limited capacity to control what is stored on personal computers or cloud servers around the world. As such, governments can try, but they have limited ability to control the use of bitcoin as a store of value or a transaction medium.
Bitcoin may be a way to circumvent governments and conduct transactions related to criminal activity. But the real value potential for bitcoin is its capacity to provide a store of value for all people.
If governments choose to restrict transactions in Bitcoin within their borders, it will do nothing to stop the criminal underground use of bitcoin. As such, essentially, the only reason for governments to attempt to control bitcoin is that they feel threatened that it could overtake and replace their own national currencies.
As such, countries that attempt to outlaw use of bitcoin in their country risk damaging trust in their own currency. They would essentially signal to the public that bitcoin is a threat to their capacity to manipulate their national currency for their own agenda. China has flirted with restricting bitcoin activity, essentially because bitcoin was being used to circumvent the nation’s capital controls on moving savings abroad. In doing so, it may have only intensified public desire to shift capital abroad and increased domestic demand for bitcoin.
Because bitcoin is global, its success may only require one country to embrace its development to promote its growth as a store of value. That country would presumably receive international interest, generating economic activity and capital inflow; attributes that many countries might pursue.
Developed nations with largely free capital movement are more likely to embrace bitcoin as part of its financial market infrastructure. In fact, by helping it become mainstream, these governments are likely to have a better capacity to monitor and police underground criminal transactions.
Derivatives enhance bitcoin
Another criticism is that bitcoin’s blockchain ledger requires significant computing power to operate and this places a limit on its capacity to be used as a transaction medium. At some point, transactions would become too costly and too slow to be practical.
Firstly, it is useful that bitcoin can be readily used for transactions. It might currently be one of the cheaper and more effective ways to transfer sums across borders. However, its real potential value is as a store of value. When investors are moving savings around, speed and costs of bitcoin transactions are unlikely to be prohibitive. For everyday transactions, bitcoin may have some utility, but this is not an essential feature of its value.
Secondly, as bitcoin becomes mainstream, there is an increasing number of derivative products that are being developed that have the potential to increase its value as a store of value and transaction medium. To invest in bitcoin, most people will not buy actual bitcoin, but a derivative product (ETF, ETN, bond or futures contract) whose underlying value its directly linked to bitcoin. As such, transactions of bitcoin derivatives will not actually involve bitcoin, and thus they will not require the blockchain ledger to be updated and costly computing power. As in most financial products, the volume in derivatives trading far outweighs movement in the underlying commodity or instrument. The liquidity in derivative bitcoin is likely to form the bulk of effective transactions in bitcoin.
It’s not just about the blockchain
Many commentators have said that bitcoin is not valuable, it is the blockchain technology that underpins it that is valuable. As banks and governments utilize this blockchain and add it to their own products, they will do it better and bitcoin will die.
However, use of blockchain for other existing or future banking or government products does not undermine bitcoin’s attributes of limited supply, outside the direct control of governments or subject to the stability of a bank. If blockchain is indeed a groundbreaking invention, then it should only improve the confidence in bitcoin to act as a highly effective store of value with transaction capability.
Could the IMF, run by a collective of government’s with competing interests, including in particular maintaining the utility of their own national currencies, create an effective competitor to bitcoin? Investors are likely to prefer bitcoin still. An attempt by the IMF to replace or compete with bitcoin is likely to be treated with suspicion.
Is it too volatile?
People argue that its price volatility make it unsuitable as a store of value. Indeed it is not yet a proper store of value; it just has all the basic attributes of a store of value. Indeed, as we have argued, it has the potential to be a more effective store of value than traditional financial instruments or commodities. If you are buying bitcoin now, you are buying it in anticipation of what it could become. This is why I say that it is experiencing growing pains rather than a just a mania.
Bitcoin’s fundamental value
If bitcoin is to evolve into a store of value that rivals gold and bank deposits, then a significant portion of global wealth is likely to be invested in bitcoin. There is reported to be over $8tn currently invested in gold. Global wealth might be in the order of $800tn. This amount trends higher over time. There is a maximum amount of bitcoin of 21m. If $1tn were to be invested in bitcoin, each bitcoin would be worth $47,000. This might be seen as a conservative estimate of the potential value of bitcoin. Since bitcoin has basic attributes that are superior to other stores of value, I think it has potential to rise much further.