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Bitcoin: gamble or gold mine?

Commodity, currency or equity: does Bitcoin fit in your investment portfolio?
Bitcoin: gamble or gold mine?

The price has gone through the roof this year to exceed $6,000, but is Bitcoin really a good place to park some cash? Of course, Bitcoin has no shortage of detractors. Jamie Dimon, who for 10 years has headed JPMorgan, the largest US bank by assets, is one of the more vocal opponents, saying investors in cryptocurrencies are “stupid”. Brazil’s central bank chief, Ilan Goldfajn, is another, recently calling it a pyramid scheme. Jordan Belfort, the penny stocks trader immortalised as the Wolf of Wall Street, says it’s the “biggest scam ever”; and he should know a thing or two about those.

China outright banned Bitcoin trading and curbs have been imposed around the world to varying degrees. Even Bitcoin-friendly Japan may yet follow South Korea and ban initial coin offerings (ICOs) when a crypto-currency is launched. (In fact, banning competitors may only serve to drive up the price of established products such as Bitcoin even more).

There is a powerful argument that Bitcoin is nothing more than a very clever Ponzi (pyramid) scheme, while the rapid rise in its price this year exhibits classic signs of a speculative bubble of the worst kind (see charts 1 & 2). Bitcoin has no intrinsic value, so soaring prices can only be justified by the irrational belief that you will find someone else willing to pay more – the greater fool. Tulip bulbs spring to mind.

But it may be wrong to write off Bitcoin completely just yet.

 

Safe haven?

It may be called a crypto-currency, but in many ways Bitcoin is an awful lot more like a financial security such as a stock or commodity. Above all, it is most often compared to gold and it is certain shared characteristics with the yellow metal that lead some people to believe there is an intrinsic value in Bitcoin – that is to say, the price is not purely fuelled by speculative interest.

In the same way that investors are encouraged to hold a portion of their portfolio in gold as a safe haven, increasingly there are investors who are looking to allocate some cash to Bitcoin for the same reason.

I don’t think having a few Bitcoin in a digital ‘wallet’ is really like owning some gold bars in the bank, but it could be argued that the Bitcoin rally is comparable to the surge in gold prices that followed the launch of the first gold exchange traded funds (ETFs). 

The first gold ETF was launched on 23 March 2003. The explosion in gold prices that followed was remarkable. ETFs opened up the gold market like never before, and combined with the rise of the internet and electronic trading, meant ordinary investors had access to the gold market in ways not previously seen. 

The correlation between total ETF holdings and prices is revealing. Did gold ETFs fuel prices or did the rising gold price due to falling real US yields fuel demand for ETFs? It’s probably a little of both. Prices rise, which fuels investor interest, which spurs buying into ETFs and further gains. The creation of the asset class created a new demand source for the metal. ETF gold holdings are similar to that held by France and Italy, which possess the world’s fourth- and third-largest national reserves of the metal.

So is something similar happening today with investors turning to a newly accessible asset class that is considered some sort safe haven?

As ever with Bitcoin it’s a bit murky. Unlike gold, there is no industrial demand, nor can it be turned into jewellery. Gold has clear, tangible uses, unlike Bitcoin. And unlike gold, the blockchain technology can be easily copied – the sheer volume of ICOs shows this. A Bitcoin ETF could certainly push up prices of the underlying asset even more – at present the lightness of regulation and price volatility has professionals shying away from this sort of investment vehicle, but it’s a distinct possibility if and when Bitcoin enters a new phase of maturity. 

What’s interesting – and a point that can be used by either side of the argument – is that as the price rises demand is rising with it. In this sense we could describe Bitcoin as a so-called Veblen good where, as the usual rules of supply and demand break down, the more something costs, the higher the demand. 

The more interest in Bitcoin, the more the price rises to fresh records, which in turn fuels yet more investor interest. A feedback loop that is either vicious or virtuous depending on your point of view. The parallel with gold ETFs and gold prices is instructive and could to a certain extent explain what is happening – a new and convenient way to park some cash billed as a hedge against traditional stocks and bonds.

But why is Bitcoin – with exceedingly high price volatility to date – deemed a safe haven in the first place? The big appeal is that it’s a hedge against the system. Decentralised, free from the vagaries of regulation, inflation, devaluations or any other kind of interference from central banks, the blockchain technology cannot be tampered with. Almost everyone agrees the technology is here to stay, even if Bitcoin is ultimately worth zero. A bet on Bitcoin is seen as a wager of the future of blockchain technology and its ability to revolutionise financial transactions. 

There are similarities with gold. Paper, whether in the form of shares or bonds, can ultimately be worth zero. Governments can print more money, inflation can make it worthless. Gold, and now cryptocurrencies, are beyond the reach of central banks. 

Indeed, in other ways crypto-currencies are a better hedge. Gold can be confiscated – as it was in 1933 in the US when Franklin Roosevelt forced Americans to sell their bullion and gold coins to the government with the infamous Executive Order 6102. It is also hard to spend gold easily – it is heavy to carry around and these days you really need to convert it to local currency in order to use it. 

Blockchain disciples will stress that governments cannot confiscate or tamper with your digital coins, while as electronic payments become the norm and more companies come to accept Bitcoin, the crypto-currency becomes a viable medium of exchange.

Here we encounter a problem if we want to consider Bitcoin alongside gold. You don’t need an internet connection for gold (or paper money). In the Armageddon scenario, gold wins. And although free from banks it may be, Bitcoin is not entirely free to use. Goldman Sachs noted that transaction fees have jumped this year, reaching a peak in mid-July of nearly $9.

So we come back to gold ETFs. Owning a share in one is not really an Armageddon type hedge – you won’t be able to get your hands on the metal and swap it for food. It’s really a hedge against inflation and/or a financial crisis that leaves cash and stocks less valuable. And that is exactly how a large number of investors view Bitcoin.

 

Bullish

One particularly bullish analyst on Wall Street is Tom Lee of Fundstrat, who has taken a stab at valuing bitcoin as a substitute for gold.

He is of the opinion that cryptocurrencies are “cannibalising demand for gold” and estimates that Bitcoin’s value per unit “could be $20,000 to $55,000 by 2022”. Lee is no newcomer like so many of the Bitcoin believers; he was JPMorgan’s chief equity strategist from 2007 to 2014 and is noted for being very bearish on US equities.

The argument rests on the fact that Bitcoin supply is capped, while gold production is booming on the higher prices it has commanded over the past decade. This is certainly one factor behind the appeal of Bitcoin – only 21m will ever exist – but the thesis still hinges on the fundamental requirement for a user to be able to sell the Bitcoin to someone else at ‘face’ value. The problem with Bitcoin is that it is unproven as a reliable store of value.

 

What is money?

If Bitcoin wants to rival gold it has to deliver on certain fundamentals. And it is here that is at best unproven, at worst a disaster waiting to happen. 

Money – whether we mean dollars, pounds or gold – has always had to exhibit certain traits. 

First, it must be a store of value. Barring exceptional events you know that the pounds in the bank will in the future be worth roughly what they are today plus interest, minus inflation. Bitcoin’s price volatility clearly means it falls down on this point – one simply has no idea what it will be worth tomorrow, never mind a year from now. Compared with gold, Bitcoin has been seven times more volatile in 2017, according to a report from Goldman Sachs.

Second, it should be a unit of account – in other words provide a common base for prices. But as a result of the aforementioned price volatility there are at present few individuals or businesses in the world prepared to accept a Bitcoin before they know what the dollar value is. You may be nominally spending in Bitcoin but really this is just a token for a local currency value and the retailer will simply adjust its Bitcoin pricing to reflect the change. 

Third, it should act as a medium of exchange – something people can use to buy and sell. This is where there is the most optimism as the blockchain technology clearly holds huge potential at the transactional level. As we use less cash and rely on card and electronic payments, the payments ecosystem is generally supportive. But does that justify Bitcoin at $6,000?

 

Fiat punt

It may seem confusing to talk about commodities and currencies interchangeably, but this is for a reason. First, there is an important distinction to make that has yet to be fully resolved – no one can really agree if Bitcoin is either. Secondly, gold is money.

Originally the only money was gold (and silver) – it’s only relatively recently that it societies worked out it was easier to deposit the metal in the bank and use a paper note as a claim on it. This system lasted until 1971, when the Richard Nixon Administration decided to end the direct convertibility of the dollar into gold. When the link between the paper and metal was broken, we ended up with fiat currencies not backed by gold. For proponents of crypto-currencies, there is no difference between the two.

They may have a point. The International Monetary Fund neatly sums it up: “Fiat money is materially worthless, but has value simply because a nation collectively agrees to ascribe a value to it. In short, money works because people believe that it will.”

And herein lies the dichotomy at the heart of Bitcoin. Bulls point to the fact that like fiat currencies, as long there is consensus support – people collectively agreeing to ascribe a value to it – it has a value. Bears would point out that without central government and central banks acceptance it is not the same thing – regulators could crush it any time they like. 

To paraphrase the Obama administration’s undersecretary for terrorism and financial intelligence, David Cohen, a key way that the US protects its interests, projects power and exercises leadership on the world stage is through the use of financial measures. The dollar is the strongest weapon the US government has to exert power – it is not about to let that go. 

Commercial and central banks are examining the technology, but it’s unlikely they’re supportive of decentralising the money system. It is inconceivable the US government would back direct convertibility of Bitcoin into dollars, which leaves Bitcoin a rootless fiat currency wandering the desert. 

Which takes us back the currencies we use today. True, there is no intrinsic value in your £5 note, but there is a promise from the British government with all its resources and tax-raising powers to fulfil the obligation. It’s this that gives fiat currencies their value.

The third prospect for Bitcoin is that is neither commodity nor currency, but equity. Buying Bitcoin is a bit like purchasing a stock in a company that you know will only ever issue 21m shares and never pay you a penny in dividends. The only way to get a return is if more people are sucked in to purchasing it. There is no better definition of a Ponzi scheme than that. Diversification is wise, but it doesn’t mean you need to invest in everything.