Posts filed under Bitcoin

Bitcoin Series 9: Five reasons that bitcoin is currently volatile and why it does not matter

One of the major ‘criticisms’ of bitcoin is its volatility in relation to traditional currencies.   I do not worry about this because it is an inevitable outcome of a brand-new asset class.   In the event that bitcoin works and becomes adopted, volatility will diminish.  If bitcoin is not adopted, who cares if it is volatile?

The main drivers of bitcoin volatility are below.   In any positive outcome for bitcoin, they will diminish over time.

(1)    Regulatory Uncertainty.   The regulatory landscape has only started clarifying in the last couple of months.   Over the next two years, every major economy will have clear guidance (positive or negative) relating to bitcoin regulation and we will no longer have positive (US) or negative (China) surprises.

(2)    Money Supply:  The total value of the bitcoin money supply is less than $10B.    M1 for traditional currencies worldwide is in the range of $30T.   So trivial movements in traditional currency markets cause tsunami-like movements in bitcoin markets.

If bitcoin gains further adoption, money supply will almost by definition increase.    To believe otherwise would suggest that, as adoption increases and volatility decreases, the price will go down, aka fewer people will want to hold bitcoins than do today.

(3)    Liquidity:  Total bitcoin trading has exploded.  It still represents less than $100M of trading per day.   Traditional currency trading is measured in the trillions of dollars daily.   As with money supply (#2), bitcoin trading volume is still too small to absorb traditional currency market shifts smoothly.   Similarly, this will alleviate itself naturally as bitcoin becomes more adopted and trading volume increases.

(4)    Market access:  There are only three major exchanges (that trade traditional currency for bitcoin) in the world right now, each with some issues:

a. Mt. Gox in Japan that has not solved its issues in redeeming US dollars

b.      BTC China that has had most mechanisms for depositing yuan blocked by the Chinese government

c.       Bitstamp, a small company in Slovenia (that 2.5 years ago ran a computer shop) that handles most of the exchange volume for the United States and the EU

Anyone with experience with financial markets will recognize the absurdity of the current situation.   Japan and China have crippled exchanges.   In the US and EU if anyone wants to buy more than a few thousands of dollars worth of bitcoin in a day, they have to wire US dollars to a small unknown firm in Slovenia.    This is in no way a criticism of Bitstamp; they have done excellent work.   But pension fund manager, hedge fund or endowment is going to wire $20M of pension money to them given the perceived counterparty risk.

This is a really important point.   Once people feel more comfortable moving institutional money in and out of bitcoin for trading purposes, it will create liquidity, start to generate a market-making and stabilize the swings.

This will also allow the development of advanced financial / hedging instruments that allowing people to take different positions vis-a-vis the currency.

(5)    Limited transactions:   Adoption of bitcoin as a payment mechanism is still in its infancy.   We are still at the stage where it is world news when a firm accepts bitcoins.   As this changes and more payments are actually conducted in bitcoin, there will be a steady stream of non-speculative buying and selling of bitcoin that will provide day to day stability and liquidity.

Summary:  So long as adoption of bitcoin continues, the factors that create bitcoin volatility will diminish in their impact.   If for some unknown reason, bitcoin is a bust, then volatility will not go away.  But, in that case, who cares?

I will concede that it is possible that bitcoin, with the lack of a central bank, will always be a bit more volatile than traditional currencies, but it will stabilize at a far more stable range than it has today.

As a side note, it amuses me to see the financial services industry so concerned about bitcoin volatility.   This is an industry that has brought us options, derivatives, junk bonds, CDOs, CDOs squared and so on and has never met a way to enhance, hide or restructure volatility that it did not like.  Similarly, I can’t imagine how volatile the tech industry would look if we valued VC portfolios by trading every early stage company 24/7/365 on a variety of exchanges worldwide, keeping in mind the majority of them will go to zero.   Yet nobody is suggesting that we can’t societally handle this volatility and even invest the pensions of working class people in it.

For the full bitcoin series: ledracapital.com/bitcoin
Twitter: @polemitis and @ledracapital
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Posted on December 28, 2013 and filed under Bitcoin.

Bitcoin Series 8: Who is investing in bitcoin today?

First think about what value bitcoin provides as a store of value.  Given that, it makes sense who are the early investors in bitcoin.

While this is an over-simplification, there are three classes of investors today in bitcoin.

(a)    Early tech adopters for obvious reasons:  They see a platform for the future even if they don’t always understand all the financial implications.

(b)   Gold bugs and other anti-Fed / anti-inflation types:  They like the limited supply of bitcoin and view this as a new ‘gold’.  

(c)    Family offices and individuals within hedge funds:  These are the first semi-institutional investors in bitcoin.   Family offices do not have strict external guidelines for their investments and don’t have to worry as much about documentation and compliance issues.    Individuals in hedge funds that cannot yet invest institutionally have being doing so personally. 

What is the thought process here?   If you put 1-3% of assets in bitcoin, the volatility of bitcoin has limited impact on your overall portfolio (that is probably moving 1-2% daily anyway).    In terms of ultimate outcomes, the downside case is that it goes to close to $0.  The upside case is probably 10x to 20x from the current prices.   The probability of each case is an unknown.   A lot of people will take that bet with 1% of their assets.   If it does not work, a 1% loss does not change anyone’s life in any way.   If it does go up 10x, then you get to feel very smart, a visionary and so on.

The pure institutional investors are still, for the most part, on the sidelines.   This is understandable.   Bitcoin just entered the general business consciousness in October 2013, less than 3 months ago.   It will take time for both financial institutions,their support industries (legal, accounting) and regulators to understand bitcoin and figure out the liquidity, regulatory and compliance issues.  

-          How do you prove to your auditors that your fund does in fact control $10M worth of bitcoins?   It is a solveable question, but the infrastructure is not yet in place

-          Can you buy and sell $5M of bitcoins (a trivial amount of money) without moving the market.  Today the answer is ‘No.’

-          Are you willing to take the counterparty risk of the current exchanges?

I don't think the institutional investors will stay on the sidelines forever.   The financial services industry is relentless attracted to fee-generating opportunities and will find their way to bitcoin too.

For the full bitcoin series: ledracapital.com/bitcoin
Twitter: @polemitis and @ledracapital
Ledra Bitcoin Digest email newsletter: ledracapital.com/subscribe

Posted on December 28, 2013 and filed under Bitcoin.

Bitcoin Series 7: How is bitcoin a store of value?

Part I: Background

When considering if bitcoin is a store of value, please consider the following as background:

-          Bitcoin is infinitely, instantly transportable anywhere on the planet in a matter of seconds

-          By the end of 2014, there will be hundreds of thousands of merchants who will accept bitcoin for payment.    Bitpay already has 15,000 merchants and through Gyft one can access a few thousand other retailers.

-       There are exchanges that would convert bitcoins to a major currency of your choice.

In other words, there is a network.   Hint: this will be important later.

Part II: "Features"

With that background, now let's work backwards to how it can be a store of value. I think there four main elements that drive bitcoin’s utility to someone in the short-term as a store of value.

(a)    Non-confiscatable:

When properly handled, it is the least confiscatable asset known to man.    With some digits printed on a tiny slip of paper, one can control and transfer hundreds of millions of dollars anywhere in the world.    In an even more extreme example, one could actually memorize a passphrase and control one’s bitcoins with nothing more than one’s memory.

Bank accounts can be seized.   And so can real property, gold bars and fine art.    There is no realistic way to confiscate a fully secured bitcoin wallet short of torturing the owner to death for access to the private key.   And, with a few minutes of warning, bitcoins can be moved anywhere in the world avoiding even that risk. 

(b)  Portable / Liquid / Fungible / Divisible


Not a single other asset classes outside of currency is as portable / liquid / fungible / divisible as bitcoin.

Stocks, bonds, VC investments, private equity investments, real estate, timber, commodities, diamonds, gold, silver, fine art and the whole pantheon of the investment world all are less liquid than bitcoin.
 

(c)    Correlation


Bitcoin is an asset with limited correlation with other established asset classes.    As everyone learned in their Intro to Finance class, non-correlated asset classes add value to a portfolio.

(d) Disaster insurance


Bitcoin would be particularly useful in the event of a localized or personalized financial disaster.   If you are a rich Argentinean, it is likely that your local cash, real estate, stocks and business investments will tank at the same time.   If you think someday the US/Euro-zone are headed for disaster (I don’t but some do), then you might want to have some digital currency that will likely appreciate in that scenario.  

If somehow you have a personal financial disaster and have your financial assets frozen, it might not be bad to have a small pool of value that isn't blocked that can pay for your lunch the next day.

Part III: Users (as store of value)

Now, with those four characteristics, can we imagine some people who would want to keep some money in bitcoin?  

(a)    A corrupt oil minister taking bribes might consider having 30-50% of assets in bitcoin.   If he has to make a run for it to Switzerland, it is the safest way to take his money with him

(b)   A businessman in a volatile country where he faces political, personal or economic risk (of which there are dozens) might consider 10% of assets in bitcoin

(c)    A wealthy individual in a developed country might consider 2%-3% in bitcoin or related assets as long-term ‘disaster’ insurance.   If everything goes wrong (nationally or personally), it might not be bad to have some portable, hard-to-confiscate liquid assets

(d)   A family office, endowment, pension fund or so might consider a <1% to 3% allocation to bitcoin (or a basket of digital currencies) for speculative or diversification purposes (noting that this is highly speculative).

A middle class individual in Indiana will probably be the last person to have any money in bitcoin-as-a-store-of-value.   That is OK and appropriate.   They almost certainly have better risk-reward bets they can make with their money like paying down their credit cards.

The current state (for context) is that there are ~$63T of investable assets in the world and ~$30T of M1 global currency money supply.  Bitcoin represents 0.015% (1 / 6666th) of the former and 0.031% (1 / 3200th) of the the latter right now.   

Part IV: Conclusions

This is the part that people will ask: "But what prevents it from going to zero if people stop using it?"

Well, nothing.  If people stop using bitcoin, its intrinsic value is zero.   Its value is 100% derived by the fact that it is a network (aka other people and other businesses will accept bitcoin) and once you have that network, then it generates the exciting "Features" mentioned earlier which will support some level of demand for it. 

It is the same reason ebay, craigslist, twitter, and the fax machine have value.    In a world of one fax machine, it would be a worthless piece of metal.    In a world of 1 user, bitcoin would be worthless.

And as we previously discussed in the intrinsic value, the 'network' effect is also what supports the price of gold, stamps, mined diamonds and so on.    All of them trade permanently far above their 'intrinsic value' as a product if they were not accepted as a form of wealth.

For the full bitcoin series: ledracapital.com/bitcoin
Twitter: @polemitis and @ledracapital
Ledra Bitcoin Digest email newsletter: ledracapital.com/subscribe

Posted on December 28, 2013 and filed under Bitcoin.

Bitcoin Series 6: Intrinsic value - it is not that simple

One of the most frustrating discussions about bitcoin is the concept that it has no ‘intrinsic value’.  

First of all, that characterization is itself inaccurate when it comes to bitcoin.   A natively digital fungible transportable secure currency that millions of people accept has value has intrinsic value.

The naysayers would say “but this concept that it has value is itself a bubble, a delusion, it must return to its ‘instrinsic’ value that can't include the fact that people think it has value so it will go to $0.”

If that is the case, how does one explain the following?

-          A rare stamp has almost no intrinsic value (you can’t even mail a letter with it and they are hardly beautiful works of art), but if someone wants to give me a Penny Black, I am 100% certain that someone would pay me thousands of dollars for it

-          Lab diamonds are functionally equivalent to mined diamonds and a lot cheaper.    Yet, somehow that has had almost no impact on the price of mined diamonds

-          Gold has traded above its ‘intrinsic’ industrial value for thousands of years

If something gets established as a store of value it can trade above its ‘intrinsic’ value on a permanent basis based on the fact that other people will accept it.     So, while it is still undetermined that bitcoin will be accepted as store of value, there is no theoretical reason why an arbitrarily scarce asset (aka the Penny Black or gold or bitcoin) can’t accrue permanent market value.

In this regard, bitcoin has significant advantages over the examples above.   I can’t arbitrarily divide a diamond and send it instantly to India or buy, say, web hosting services with it.   I can do that with bitcoin.

For the full bitcoin series: ledracapital.com/bitcoin
Twitter: @polemitis and @ledracapital
Ledra Bitcoin Digest email newsletter: ledracapital.com/subscribe

Posted on December 28, 2013 and filed under Bitcoin.