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The Road to Crypto Conversion
While this isn’t exactly the conversion of Saul on the road to Damascus, I came to a realization recently that subtly changes the way I look at the potential for large cryptocurrencies, such as Bitcoin.
Historically, my attitude has been dismissive about the value of bitcoin itself. While I recognize the amazing reach of blockchain technology and the genius of using asymmetric key cryptography to secure the public record of private transactions, I’ve always thought that bitcoin didn’t really achieve the promised goal, which was to be a better money than fiat dollars. After all, bitcoin is not backed by anything more than the dollar is – nothing. Its value is based on scarcity, and scarcity by itself is not a source of value (if it was, my toenail clippings would be immensely valuable). So in my 2016 book What’s Wrong with Money? I wrote in a chapter on bitcoin:
“But is bitcoin money? Calling it a virtual currency, or a digital currency, or a crypto-currency doesn’t make it money. At some level, it is of course money in the same sense as cigarettes are to prison inmates. It serves as a medium of exchange, a store of value, and a unit of account – but only within the special community that already accepts bitcoin as credible…It is not yet broadly a credible currency. It doesn’t have universal value because not everyone believes that everyone else will accept bitcoin.”
Even in that chapter I recognized that bitcoin may someday be money-like. And I underwent a partial conversion and even worked for a while on a paper with my co-authors Kari Walstad and Scott Wald to define a measure (“Crypto Trust Index”) that would objectively measure how much like money the cryptocurrency world was becoming. [That paper ended up being overtaken by real-world developments, as stablecoins fully backed by fiat balances are obviously crypto money by identity, rendering the question moot.]
But in my mind bitcoin, eth, etc aren’t money but speculative vehicles – they are distinctly separate from USDC, USDi, and other fully-backed coins. It may be that they belong in a portfolio with stables and/or securities, but since bitcoin has no intrinsic value I have always held the view that I don’t want to own it as it can go to zero in a nonce.[1]
Recently, as I said, I’ve had a mild conversion as a result of two realizations.
The first realization is that even in the traditional securities world, we sometimes invest in things which have no intrinsic value in many states of the world. For example, we buy out-of-the-money options, or equity in a firm that is highly leveraged so that if the business goes under, the equity-holders get nothing. I am not sure this is a good excuse to buy bitcoin, though, since even if a far out-of-the-money option is unlikely to ever have intrinsic value there are at least future states of the world in which it could have intrinsic value. Similarly, that penny stock might end up being worth something if business booms. So we could think about bitcoin as being an option that may go to zero or may go up a lot. The problem with this, and the reason this reasoning alone is not compelling to me, is twofold. First, those far out-of-the-money options and long shots tend to have low prices, not high prices, and bitcoin certainly does not seem to have a low price. Second, there is no state of the world in which bitcoin will ever have an intrinsic value. Therefore, it doesn’t make a lot of sense to think of it as a real option, but at best as a speculation with an option-like payout (low in many states of the world, but massive in a few states). Put another way, while the value of that penny stock or out-of-the-money option can go to zero for some clearly-defined reasons, bitcoin can go to zero for any reason or no reason and it wouldn’t be wrong.
The second realization, though, relates to scarcity. Yes, scarcity alone cannot be the basis for value (see: my toenails). For scarcity to matter, there needs to be exogenous demand. And that demand need not be rational. If someone wants to hold bitcoin, not caring that it has no intrinsic value (or erroneously believing that it has some), then scarcity matters. The realization is that scarcity goes from not mattering at all, to mattering a great deal, as soon as there is any demand. To be sure, if that demand goes away, then scarcity again ceases to matter.
(By the way, it is entirely possible and even likely that someone else has pointed this out.)
So the case for speculating in bitcoin (no, I won’t call it investing) is that since the total supply is independent of price, the supply curve is vertical and moving to the right at an ever-slower rate. As this happens, it takes less and less increase in demand to push price higher.
It also takes less and less decrease in demand to push price lower. Since there is no slope to the supply curve, it means that oscillations in demand are responsible for all of the oscillations in bitcoin’s price. And we can say more about the volatility dynamics. Early in bitcoin’s development – when demand was very low, supply was relatively high compared to demand, and the price was as a result very low – we were operating at the far left end of the demand curve where demand was relatively more elastic and therefore there was a lot of volatility. As bitcoin matures, and demand catches up to the existing supply, we should expect price volatility to decline. And this is, in fact, what has happened (chart below, source: Bloomberg, shows rolling 100-week historical volatility (about two years, but I like round numbers today), now at the low-low level of 43% (about 3x equity market volatility).
The fun part comes later, when the supply curve shifts get slower and slower as the bitcoin halving converges to zero and the bitcoin supply gets closer and closer to its absolute maximum. At that point (and here is where the uberbulls get really excited), if there is a steady secular increase in demand, price just goes up without bound.
Don’t get too excited, uberbulls, because we aren’t there yet. When we are starting to get close to that point I would expect that we will also see volatility start to go up again. If historical volatility continues to decline, it means (a) we aren’t close enough to that point that the vertical singularity is nigh, and/or (b) people are losing interest in or diversifying away from bitcoin so that the steady increase in demand is not manifesting and interest is fluctuating less and less. So, I am waiting for that volatility to begin to expand at higher prices.
In any case, I am much more likely to invest in tokenized real world assets than I am Bitcoin or Ethereum. I am not a speculator at heart. Heck, I’m a bond guy which means I worry more about return of my principal than return on my principal. But if you are already long bitcoin, I will no longer sneer at you, because I recognize at last that one way or the other I will may be driving your car someday – either because it was repossessed and I bought it at auction, or because I am your chauffer.
Did You Know? Want to buy USDi, the inflation-linked stable coin, but don’t own any crypto you can exchange for it? You can actually use the coin as an on-ramp. Accredited investors need merely complete onboarding with USDi Partners and then can invest fiat dollars and receive USDi coins.
[1] Pun intended.
Life is Like a Box of Bitcoin
Whether the evaporation of popular Bitcoin marketplace Mt. Gox (which may have nothing to do with the Gox in Dr. Seuss’s beloved One Fish, Two Fish, Red Fish, Blue Fish[1]) is due to fraud, hacking, incompetence, or some combination of all three – it appears it may have been hacked three years ago, and have been insolvent since then before vanishing from the Internet last night – doesn’t really matter. Either way, investors/speculators with money at Mt. Gox got MFGlobaled. The money wasn’t segregated (if it was money at all, and if it can be segregated at all), there was no audit (if there can be an audit trail for something that doesn’t have a known origin or destination), and the firm was not overseen in any fashion (if it is even possible to oversee something that exists mainly because it is difficult to oversee).
Like Schrödinger’s cat, it was kinda there, until someone actually looked and discovered it was dead.
I have carefully eschewed writing about Bitcoin in the past, though people have asked me to do so. I chose not to write about it because I had no wish to be filleted by one side or the other in the argument. But what I would have said would have been a series of simple observations that have nothing to do with how Bitcoin is mined, managed, or mishandled:
- This is hardly the first currency that has been outside of government control. Currencies existed outside of government control before they existed under government fiat.
- Historically speaking, there is a reason that government-sponsored currencies won, and it wasn’t because they were backed with gold. It was because people trusted the government when it said the currency was backed with gold.
- Trusted banks were issuers of currency for a long time. The coin of the realm has always been trust – and even if a currency is limited, or backed by limited metal, or whatever, you still need trusted institutions through which the coin flows, or it doesn’t work. Where is the trusted institution in Bitcoin’s case?
- So what’s the big deal?
This isn’t schadenfreude. I don’t care if Bitcoin succeeds or not; I don’t think its success or failure has anything to do with whether fiat currencies succeed or blow up. I don’t think Bitcoin is a “safe haven” any more than gold is a safe haven.
But at least I can touch gold. At least I know that gold will have some value in exchange, whereas I don’t know that Bitcoin will, tomorrow. And now, indeed it may not. Surely no institutional investor can now invest in Bitcoin deposits without answering the following question to the satisfaction of its board: “How can we be sure that our money won’t go the way of Mt. Gox?” And institutional acceptance is a huge hurdle for the future success of this substitute currency. Ditto firms using Bitcoin for transactions – a daylight overdraft that can go to zero overnight is a big risk for a bank.
And so, what I think was always the not-so-subtle problem for Bitcoin or any crypto-currency remains: for it to succeed, a trusted institution needs to be involved. Trust can’t be distributed across a network. And if an institution is involved, then the idea of a “people’s currency” loses weight. Bitcoin wasn’t the first of these attempts, and it won’t be the last, but in my mind that is the challenge. You can’t make money that only is used by the credulous and the gullible. It must be used by the incredulous and the suspicious. It is adoption by those people which defines the success or failure of a currency.
(Unfortunately, this puts certain elements at my alma mater in the former category. In our January 2014 alumni magazine was an article on Bitcoin. In the information bar “Bitcoin Dos and Don’ts”, the first point was “Do your research first! More information is available on Bitcoin.it, a wiki maintained by the bitcoin community. For Americans, the most popular and trustworthy place to buy and sell Bitcoins has historically been mtgox.com.” Whoops! Do your research first – popular does not imply trustworthy unless the thing is popular with people whose trust is hard to win!)
[1] “I like to box. How I like to box! So, every day, I box a Gox. In yellow socks I box my Gox. I box in yellow Gox box socks.”
