There is certainly a lot of buzz lately about Bitcoin, and a lot of uncertainty about the how, what and why of it. This will be a somewhat lengthy, meaty post. So, if you want to know our current opinion/bottom line, skip to the last paragraph. A great deal of the commentary comes from Howard Marks, the founder of Oaktree Capital Management.
Two friends meet in the street and Jim tells Sue he has some great sardines for sale. The fish are pedigreed and pure-bred with full papers and high IQs. They were individually de-boned by hand and packed in the purest virgin olive oil. Also, the label was painted by a world-renowned artist.
Sue says, “That sounds great. I could use a tin. How much are they?” Jim tells her they are $10,000. Sue responds, “That’s crazy! Who would eat $10,000 sardines?” “Oh,” says Jim, “these aren’t eating sardines; these are trading sardines.”
I had been thinking about digital currencies like Bitcoin as investing sardines, and that may have been a mistake. Their fans tell me they’re spending sardines, and while that may be the case, I think now they’re being treated largely as trading sardines. The question remains open as to whether Bitcoin is (a) a currency, (b) a payment mechanism, (c) an asset class, or (d) a medium for speculation.
The main complaint is as follows:
Serious investing consists of buying things because the price is attractive relative to intrinsic value. Speculation, on the other hand, occurs when people buy something without any consideration of its underlying value or the appropriateness of its price, solely because they think others will pay more for it in the future.
If Bitcoin is an investment asset, it should have a value that can be appraised. Its fans say this isn’t the right way to view it. Possibly the weakest claim being made about Bitcoin is “it’s not real” – there is no intrinsic value behind it.
What Bitcoin partisans subsequently said is that Bitcoin should be thought of as a currency – a medium of exchange – not an investment asset. Given that the evolution of Bitcoin is so topical, I think further discussion is in order. To start, I’m going to present the case for it as a currency. What are the characteristics of a currency?
- Most importantly, it’s something that people agree can be used as legal tender (to buy things and pay debts), used as a store of value, and exchanged for other currencies.
- Currencies generally are created by governments. However, there have been exceptions. Banks issued their own currencies in our nation’s first century. It can also be argued that the “Green Stamps” from 1930-1980 and airline miles today have a lot in common with currencies.
- For a long time currencies were backed by (and exchangeable for) gold or silver, but that’s no longer the case. The truth is, there’s nothing behind currencies these days other than “full faith and credit” of their issuing government. But what do they promise? New currencies are sometimes created out of thin air (like the euro, which wasn’t legal tender sixteen years ago) and are sometimes devalued.
- Currencies change in value relative to each other. In theory, the changes are based on differential purchasing power. In practice, they are based on changes in supply and demand, which can stem from changes in purchasing power, among other things.
Bitcoin fans argue that it qualifies as a currency under a few different principals. Perhaps the most important argument is that it’s something that parties can agree to accept as legal tender and a store of value.
Whereas I said Bitcoin “isn’t real” because it has no intrinsic or underlying value, the same can be said for the dollar and other fiat currencies: there’s nothing behind them either. You can no longer exchange them for gold. (And what is gold, anyway? But that’s another subject.) In fact, government-issued fiat currencies are accorded value only because of a government edict. Why, the fans of Bitcoin ask, is such an edict superior to an agreement among people to accept a non-government-issued currency? Fiat currencies have value simply because of faith in the governments that issue them. If enough people believe in it, why can’t faith in Bitcoin suffice? If you consider the properties of fiat currencies, these are all darn good questions.
I see no reason why Bitcoin can’t be a currency since it shares the characteristics listed above, especially the fact that there are people (and businesses and even countries) that accept it as legal tender. But that’s not good enough for Bitcoin fans. It’s not the same as the dollar, they say; it’s better. In all the following ways, they’ve told me, Bitcoin is superior to government-issued currency. Being willing to agree that Bitcoin may become an accepted medium of exchange is not the same as saying you should buy it now to make money. Think about the fact that the price of Bitcoin has risen more than 1500% year-to-date. To the degree people argue that Bitcoin is a currency, then (a) why is it so volatile and (b) is that desirable? You might want to consider whether a real currency can do that or whether speculative buying is determining Bitcoin’s price. Another point to consider is whether what’s gone up can come down.
The immediate issue of Bitcoin as a currency still comes down to the question of whether today’s price is right. The price of a Bitcoin is around $16,600 today. Can one Bitcoin buy the same amount of goods as 16,600 dollar bills? Or the much higher amounts that Bitcoin bulls think it will soon be worth? I don’t think we have enough information to know, but the question isn’t irrelevant. If it were, this would be another case of “there’s no price too high.”
So what’s my real bottom line?
- Advocates say if Bitcoin is accepted as described above, you’ll make more than 50 times your money. Thus, success doesn’t have to be highly probable for buying Bitcoin to have a huge expected return. This is called “lottery-ticket thinking,” under which it seems smart to bet on an improbable outcome that offers a huge potential payoff. We saw it in full flower in the dot-com boom in 1999-2000, and I think we’re seeing it in action again today regarding Bitcoin. Nothing is as seductive as the possibility of vast wealth.
- Several of the “seeds for a boom” are at work in the Bitcoin surge: (a) there is a grain of underlying truth as set out above; (b) there’s the prospect of a virtuous circle: widespread demand will lead to wider acceptance as legal tender, which will lead to widespread demand; and (c) thus this tree may grow to the sky, as there is no obvious limit to this logic. None of these things necessarily make Bitcoin a mistake. They merely say elements that contributed to past bubbles can be detected today regarding Bitcoin.
- Finally, Bitcoin isn’t alone. There are hundreds of digital currencies already – including eleven with market capitalizations over a billion dollars – and no limits on the creation of new ones. So even if digital currencies are here to stay, who knows which one will turn out to be the winner? Hundreds of e-commerce start-ups appreciated rapidly in the tech bubble based on the premise that “the Internet will change the world”. It did, but most of the companies ended up worthless.
Martin Palomo serves as a Financial Advisor at Pinnacle Trust. You can reach him by email at email@example.com or by calling the office at 601-957-0323.