Bitcoin and cryptocurrencies have been in the news a lot over the last few weeks with spectacular runs and crashes on a daily basis. Rob Rando takes time to educate us about the phenomena and voices his thoughts on the potential bubble.
What is cryptocurrency?
A Cryptocurrency is a decentralised electronic currency not controlled by a single organisation or government. It is an open source project that was designed to be a “peer-to-peer” version of electronic cash.
By definition, a “peer-to-peer” form of currency has no centralised system or third party approving the transactions. This means that if I was to electronically transfer you “cryptocurrency”, the transaction would go from my account straight to yours. No institution will be needed to approve the transaction and no money is passed through the institutions. In other words, banks would be cut out of the transaction.
The Cryptocurrency is underpinned by a public ledger called the blockchain, which records who owns what cryptocurrency units and records all transactions ever made in the currency. When a transaction is made it is added to the blockchain which is confirmed by other using the peer-to-peer network. One key benefit of the blockchain system is that once the transaction is confirmed, it cannot be reversed – only new transactions can be recorded to the chain.
A Cryptocurrency has no intrinsic value, meaning that it is not linked to any redeemable commodity or fiat currency (currency backed by the government that issued it, USD AUD etc.). The value of a cryptocurrency is derived from a community of people that are willing to accept a “token” (digital coin, bitcoin for example) as an acceptable form of payment for a good or service.
To create an inflation control there is a predefined limit on how many digital coins can be created over time. The amount of digital coins created every “era” (specific time period) halve each time, so as time goes on there is a finite amount of digital coin available. This is alternate to fiat currencies that can print more money if required.
What is Bitcoin?
Bitcoin was the first cryptocurrency created and is the largest by Market Capitalisation. It was created by someone under the pseudonym of Satoshi Nakamoto in 2009. Bitcoin has a limit of 21 million bitcoins that will be in full circulation. Currently only 16.5 million bitcoins are in circulation with the remaining to be slowly distributed until the year 2140.
(My) History of Bitcoin
I first stumbled upon Bitcoin back in 2011 when the price was sitting around $1.50 from a friend who told me of a 12-year old kid who bought $1,000 dollars of this mysterious new digital currency at 10 cents and turned it into $15’000 in less than 6 months. I thought I would speculated on it also and invest a small amount. Unfortunately, back in those days it was a lot easier said than done. Your computer processing power had be very high if you wanted to invest in Bitcoin. So I didn’t bother, and that possibly was the worst investment decision I will ever make. Over the next 2 months I watched the price of Bitcoin rise to nearly $30 and I had no idea why.
That 12 year old kid who invested $1,000 dollars into Bitcoin, had turned that into nearly $300,000 in less than a year. However, over the next few months the price of Bitcoin fell from its high of 29.60 in June 2011 back down to $2.05 by November that year.
The currency became quite mainstream during the beginning of 2012 when the Greek crisis was in full swing and media was spruiking the onset of the European Central Bank collapsing. Many Europeans began to move their money into Bitcoin. This caused the digital currency to rise to $13.
The real explosion upwards came in beginning of 2013 when the government of Cyprus announced a bail-in for banks meaning that financial institutions would have to impose losses on their shareholders, debt holders and even large depositors. People panicked out of their bank accounts into Bitcoin just like the Europeans had done the previous year. This caused the price to skyrocket from $13 to a peak of $230 within four months.
The strength of Bitcoin was unsustainable and a week later the price of Bitcoin had fallen back to $68. A total loss of 66% in 7 days from its high.
That was not the end of Bitcoin for the year though. In October, a new high demand player came into the marketplace demanding Bitcoins: the Chinese consumer. The Chinese bid the price of Bitcoin up to $1,147 by the Beginning of December.
That hype once again got beaten out of the market and the price fell from over $1,100 back down to the low $400 levels by April of 2014. This set the next phase for Bitcoin which was very benign.
The latest spike in Bitcoin was initially spurred on by Chinese government in late 2016 attempting to restrict domestic capital from leaving China. This lead speculators creating new Bitcoin hype.
The chart below (one of my favourites) shows the current insignificance of Chinese volume entering Bitcoin. In fact what this chart does show you is that there is a significant level of speculative trading coming from Japan and the US, trumping the trade volumes of Chinese investors.
This month the Chinese Government has announced a ban on ICOs (Initial Coin Offerings – the raising of funds for a new cryptocurrency venture – think an IPO but for cryptocurrency) to try and combat fraudulent and scam-like activity. The Bitcoin price plummeted but had recovered within a week once people realised existing cryptocurrencies were not affected. It was a sign of more to come though, even more recently the Chinese Government announced a crackdown on cryptocurrencies, saying they are planning to shut down the exchanges which these currencies are traded on. Bitcoin fell more than 20% as a result. Again, it quickly recovered. The main reason is because speculators are making the argument that China is an insignificant player in terms of trade volume in the cryptocurrency world. Japan (who have recently accepted bitcoin somewhat) and the US are the two major players.
Issues with Bitcoin and Cryptocurrencies
1. Cryptocurrency is not as finite as people think
There is a strong argument that bitcoins and other cryptocurrencies will retain value because there is a finite amount to trade. Wrong. Like our Australian dollar, Bitcoins can be traded in smaller values. In fact, the smallest value is called a Satoshi (named after the non-existent creator Satoshi Nakamoto) which is 0.00000001 of a bitcoin. In other words, 100 million Satoshi’s equals 1 bitcoin.
Lets stop for a minute and calculate that. We know that there can only ever be 21 million Bitcoins in circulation. That means that there are 2,100,000,000,000,000 Satoshi's or 2.1 quadrillion Satoshi’s that will be in circulation. Global money supply is estimated to be about USD 75 trillion (or 75,000,000,000,000). If I multiply 75 trillion by 100 I will get the total supply of cents available in the world, which equals about 7.5 quadrillion.
So this means that there are enough “Satoshis” to match over 30% of all the single cents in the world. That is not even taking into consideration the other 1000+ cryptocurrencies that are available to trade, which have much higher coin limits in comparison to Bitcoin. Saying there is a finite supply of bitcoins or any other cryptocurrency in the marketplace is preposterous. These digital coins can be broken down into smaller digital units to create a higher flow of tradeable volume.
2. Cryptocurrency will never be a store hold of wealth
One of the biggest issues facing the cryptocurrency world is the amount of volatility associated with the currency. This effectively will stop normal investors using these cryptocurrencies as a storehold of wealth. No sane investor will place their savings into a cryptocurrency because they consider it a safe holding. Just ask yourself this question. Would you rather have your life savings stored in Bitcoin or Australian dollars?
3. Would you use Cryptocurrency to purchase goods and services?
This leads us down the rabbit hole of common sense a little further. The next question you need to ask yourself is what is the purpose of holding bitcoin? Are you holding bitcoin because you want to use it like any other fiat currency to purchase goods or services? Or are you holding Bitcoin to speculate.
If you answered the question by saying that you would like to use cryptocurrencies to purchase goods or services, then you should be assuming that the price of these cryptocurrencies are going to stabilise at these current levels. Hypothetically, if you bought a TV this time last year paying 1 bitcoin (equivalent to $750 AUD), then you have lost a lot of wealth from that transaction, as the Bitcoin would be worth close to $5,000 AUD and the TV would have depreciated in value. It is for that reason, Bitcoin will never be used as a medium of exchange unless there is a price stability mechanism attached to it (which will never exist).
According to Gresham’s law “bad money drives out good” meaning that people would rather spend money that is stable like inflationary government-issued money or something that holds value, than spend something which may potentially be worth a lot more in the future.
4. Governments will not globally accept Bitcoin and other cryptocurrencies
Anyone who thinks that governments will accept Bitcoin or any other cryptocurrency is living in a dream. Let us once again use logic to find a reason why. Governments effectively use their fiat currencies as a controlling mechanism for their economic policies. In the most basic terms, our RBA uses Australian dollars to try and control the flow of money in the economy. Demanding governments accept Bitcoin or other cryptocurrencies is like asking them to accept monopoly money.
Is this a bubble?
There are over 1100 cryptocurrencies in the market today. Compare that to 180 paper currencies circulating and more than 6 times the amount of countries there are in the world. But that is not the true indicator of a bubble. A true indicator in my book is when stupid people make stupid money.
There is a cryptocurrency out there called FirstBlood (yes, as in the first Rambo movie) which was created in late September last year. It started with a market cap of less than $1. On the 21st of June 2017 FirstBlood hit a peak market cap over $239 Million USD. I assure you, there is nothing unique about FirstBlood other than the association with a great movie.
So, is this a bubble? I will strongly argue that this is a bubble. In saying that, Bitcoin will not be rendered worthless as I am confident there will be many people who will accept Bitcoin as a legitimate form of payment. As for the other Cryptocurrencies, my opinion is that the majority of them (besides Ethereum, Litecoin and some other larger cryptocurrencies) will be rendered worthless after this latest bubble bursts.
Remember, this is not the first cryptocurrency bubble. There have been many preceding this one. Like all the ones in the past, the cryptocurrencies came crashing down and late entry investors lost a lot of money.
If you think you can time the booms and busts of these cryptocurrencies or think you have spoken to someone who has found the secret to trading these worthless computer codes, I would suggest you take that money and go to your local casino or pub – you will have a better chance of making money there.
The real thing to be excited about?
What I do like about cryptocurrencies, is the Blockchain technology behind it. The blockchain is simply a digital ledger of information that is accessible around the world on a peer to peer network.
The easiest way to describe a blockchain is to think of a bunch of blocks. Each block is connected the next block creating a chain of blocks (hence the term blockchain). These blocks have a unique code which only allows it to be connected to the next block. This is monitored by thousands of computers around the world (peer-to-peer network), so it is practically impossible to hack. Now before blockchain enthusiasts ravish me for being too basic, I understand that there is a lot more complexities involved with the blockchain, so please forgive me.
More importantly this blockchain technology has the potential to disrupt a wide array of different services around the world.
In Australia, Jessi Baker has used the blockchain technology to allow consumers to track the origins of where fish are caught, delivered and sold. Blythe Master’s, a former JP Morgan Senior Executive, is now the CEO of Digital Asset, which is using Blockchain technology for several financial service applications, including end-to-end clearing and settlement activities for Exchanges (Yes, the ASX may be operated by blockchain technology soon).
If you know how to create a cryptocurrency, I highly suggest you give it a go and even name it after yourself, I am sure that alone would probably make you a millionaire before Christmas. Otherwise, I would just sit on the sideline and know that your money would be better served in sensible investments.
Having said that, the 12-year-old kid who invested $1000 dollars into Bitcoin at 10 cents is now worth close to 45 million dollars. Hmmmmm.
Note: These are my personal opinions and thoughts, I welcome a healthy discussion. Please feel free to get in touch.
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