There has been a lot of talk about bitcoin, most of which seems distracted from what I consider to be the root of the issue. I think there’s an element of mania on the subject of Bitcoin and Blockchains. Bitcoins are a form of currency as well as a new technology, which lets the media talk about disruption, something they love to do. That seems to be contributing to the hype.

What is a currency ?

A currency is any commonly acceptable medium of exchange. It was gold in medieval times, it’s been cigarettes in jail and for some, reputation is the currency received in exchange for the time invested by the people who write for Wikipedia.

The value of any currency is determined what people will pay for it. So what determines how much a Bitcoin is worth ?

What’s a bitcoin worth ?

The most obvious thing to say about a Bitcoin is that it’s worth what people will pay for it. That comes down to the supply and demand for Bitcoins. There are a limited supply of Bitcoins in the world. Around 23 million I think. That’s the supply side, and it’s static. I can think of only 3 things demand side factors which would have a bearing.

  1. It’s being used as a medium of exchange.
    The fact that Bitcoin performs a simple service, acting as a medium of exchange, has utility value to it. In simple terms ‘money is useful stuff.’ Some say that Bitcoins are used by drug dealers and people traffickers to keep their transactions private and out of the eye of the government. That means that it services a niche market well and, for the nefarious, Bitcoin has a higher utility value than, say, USD. The more people that want to use Bitcoin as a medium of exchange, the more demand there will be for it and the higher the price of Bitcoins will be.
  2. It’s a store of value.
    When the military took power in Zimbabwe recently, people were prepared to pay a premium for a Bitcoin as a way of keeping their money where it could not be sequestered by the new – illegitimate – authorities. The more people who want to store their money in Bitcoins, the higher the demand will be and the higher the price of Bitcoins will go.
  3. As an investment :
    (This is the important one when we’re talking about bubbles.) Bitcoin is being used by many as an asset. Like any asset, Bitcoin has a risk profile and can be used as an investment. Generally, in the world of investments higher risks are associated with higher returns. The more people that want to use Bitcoin as an asset, as an investment, the higher the demand and the higher the price of Bitcoins.

(I’m assuming a clearing market here despite the fact that Bitcoin exchanges are more opaque than for most currencies.)

Things which are not causing the price of Bitcoins to explode

Bitcoin is brand which is used as a noun, a bit like Google, Hoover or Kleenex. A bitcoin is a cryptocurrency and there are actually many, many different bitcoins, about 3000, in total, around the world, at the moment. Another 150 a week or so are launched somewhere around the world. Mostly, these cryptocurrencies do much the same thing as the ‘official’ Bitcoin.

It’s worth noting that the use of Bitcoin as an investment actually reduces it’s utility as both a medium of exchange and as a store of value. Even drug dealers are business men. They don’t want to risk the value of the currency they use falling 20% between the point they swap it for drugs and the point they convert it to real dollars. The same is true for those who want to use it to secure their funds.

So, if you wanted to use Bitcoin as a medium of exchange, or a store of value, you can use one of the other cryptocurrencies and achieve your aim with substantially less risk. Therefore, it is not these things driving the demand for Bitcoins.

People are investing in Bitcoin

Sensible people invest in asserts which meet their risk / return criteria. If you think a stock is going to go on a long run of you may well accept the risk and invest. Another, more risk averse person wouldn’t make the investment.

As an investment, Bitcoin makes a lot of sense at the moment. As more people are drawn to the growth they see in the Bitcoin asset, they are prepared to invest because they want to make money through the speculation. It’s a high risk product but, for those prepared to accept the risk, Bitcoin’s growth is a self fulfilling prophecy. More success leads to more demand for the asset, prompting higher prices, encouraging more to enter the market and so on.

I’d say there is a lot of emotion and not a lot of information surrounding the purchase of these Bitcoins. Never-the-less, on the face of it’, in the very short term, as an asset, it appears to fit the risk / return profile of a lot of people and those who are buying it are doing well.

That means it’s not a bubble

A bubble is an asset category which is inaccurately valued. In the stock market, one good benchmark for whether stocks are overvalued is the Price / Earnings ratio. I haven’t looked this up but, from memory, when you get close to a PE ratio of 30, people tend to say it’s overvalued. They say that because you could never rely on the company making that much – over the next 30 years. Some doubt that you could be sure the company would still be around in 30 years.

Since the value of a Bitcoin is determined by supply and demand, influenced by the factors I’ve stated – and, since there is no ‘real world’ test (such as a PE ratio) of it’s ‘true’ value, in my view, it cannot be a bubble.

What then are the risks associated with Bitcoin as an investment ?

Structural risks that some people might not be aware of, when it comes to Bitcoins include the following :

  • The government will crack down:
    The government has two methods of influencing the economy. Monetary and fiscal policy. Monetary policy is controlling the money supply (including things like quantitative easing and the manipulation of interest rates.) Fiscal policy is government spending and taxation. Bitcoin allows government interference in neither. They need both. Any government in the world could simply legislate tomorrow that using Bitcoin is illegal. To be clear, existing regulations mean that you must pay tax on any gain you make investing in Bitcoin. You might think they have no way of knowing that you’ve used it – yet – but my view is that they will find out sooner or later. You have to turn it in to real money at some point and, as an online currency, there will be a log of that transaction.
  • Regulation is a good thing and Bitcoin is not regulated:
    There is a reason financial markets are regulated. People game the system to make money, whatever the system is. Traders in the UK gamed the ‘LIBOR’ system! Some of the smartest people in the world, working for the most trusted institutions in the world gamed the UK interest rate! Bitcoin is not regulated. If you think that market is not being gamed you have not thought it through. That involves at least some risk.
  • Not much history :
    We know what happens to the price of gold when a war or recession starts. We do not know what happens to Bitcoins in these (or almost any other) circumstance. This is at least some risk.
  • It’s not well understood technology:
    Other risks involve lack of understanding of the technology, the risk of theft (for example, one Bitcoin exchange was robbed the other day.)

To be clear, a whole bunch of risks I have not thought of because I don’t know the subject well enough.

You might agree with some of those risks. You might not agree with some of them. You could find Bitcoin to be an inherently risky thing to invest in just because it’s grown in value so fast. There are elements of this about which we might all disagree. What we agree about, I suspect, is that there is ‘’at least some risk’ associated with holding a bitcoin as an investment. That means it has to generate a return commensurate with that risk.

The steps to the crash

The price of Bitcoins will rise as long as the demand for the asset continues to rise. Demand continues to rise as long as the value keeps going up, providing an incentive sufficient to warrant the risk. It sounds circular and it is – but, unlike a circle, this process has an end.

Imagine this. Everyone in the world who loves high risk / high reward investments invests in Bitcoin over the next 2 years. Demand has to stop somewhere – the number of people who like this sort of investment has to end at some point. In this example, that happens after 2 years. When this happens, the price of Bitcoin has to stabilize – because there is no more new demand. We get to an equilibrium price which settles somewhere’’. It can happen quickly or slowly, as all of those people who want this sort of asset invest. As that happens, as the market nears saturation and demand drops off, the rate of appreciation of the currency starts to slow. At some stage, Bitcoins stop returning these incredibly high rates of growth and return to a static price point.

When this happens, there is no benefit in holding the asset any more. It now has át least some risk’ from the structural factors I’ve highlighted above. At the same time, it is not generating a return because there is no more demand. At that point, it makes sense for everyone to sell and there’s your crash.

Summing up

Whatever your point of view on these specific things, there is at least some risk associated with Bitcoin. That  means there has to be some return or it doesn’t make sense to be in the market.  And, as we’ve seen, returns must, at some point, fall to zero.

 

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