Taking bitcoin seriously

It’s time to stop laughing. When the value of bitcoin hit US$10,000 a few days ago it was no longer funny. It is now so popular, so well sought after by people that I think it is wrong to dance around my opinions about the cryptocurrency and write about bitcoin just the way I would about stocks, bonds or commodities.

I have received quite a bit of questions from readers asking about bitcoin and whether they should invest in it. My answer has usually been to not consider it as a significant investment option but that if you have some cash you can afford to lose there is nothing wrong with trying to ride the price to a little bit of profit.

This answer is clearly not satisfactory. For one thing, putting a little bit of loose cash into bitcoin will serve little purpose because of the high volatility which can quickly wipe out small capital. You need to make a significant commitment to it before you can enjoy the price gains. Also, my answer does not throw light on what I think bitcoin fundamentally is. I think it is time to do that.

What is bitcoin?

Bitcoin is a decentralized digital currency which allows people to transact with each other without the need for an intermediary. A public ledger of transactions, known as a blockchain is used to verify transactions, and this takes the place of the central body which would have been required to verify transactions if bitcoin was a centralized digital currency. The verification process is complex and requires tremendous computational power. People who undertake it are rewarded with bitcoins and this is how new coins are mined.

Currency or Commodity?

One of the hottest debates in the finance world at the moment is whether bitcoin is a currency or a commodity. A currency needs to have three basic characteristics – serve as a unit of account, a medium of exchange and a store of value. As a unit of account, bitcoin is practically useless. Imagine listing the prices of your items in bitcoin. One day someone would need $9,000 to buy it the next day they could need $11,000. For the same reason, the volatility of bitcoin makes it difficult to use as a medium of exchange. Also making it difficult to use as a medium of exchange is the fact that it still accepted by a relatively small number of merchants. (Though this is rapidly changing). As a store of value however, bitcoin has performed extremely well. From about $1,000 at the start of the year the price has soared and has more than rewarded anyone who put a significant amount of money into bitcoin. For these reasons, I consider bitcoin to be more of a commodity. Like gold, it is hard to price things in or exchange for goods and services but it will maintain the value of your investment over a period of time.

Is bitcoin a bubble?

Now this is THE question. The only way we can know for sure if any asset is a bubble is when it bursts. Yes, bitcoin does show a lot of the signs of a bubble. It has an enthusiastic ideological following, there are many people buying it for no other reason than because its price is rising, and there are a lot of buyers who do not know the first thing about bitcoin but are buying it anyway. But all of these do not necessarily mean it is a bubble. What most concerns me is the fundamental value of bitcoin and the way in which the gains of bitcoin’s price appreciation are distributed.

In the first place, bitcoin’s astronomic rise in price has not been driven by a larger adoption as a medium of exchange, as captured by Cullen Roche in a recent tweet.

 

That is a remarkable statistic. Bitcoin transactions have increased by only 20% but its price is over the moon. Another question about bitcoin’s fundamental value is the fact that governments may interfere some time in the future because they are unhappy that bitcoin facilitates illicit flows and illegal trade. So far China has already shown hostility to bitcoin. Another issue affecting its fundamental value is security. Bitcoin being lost or stolen is  nothing rare.

With regards to the distribution of gains from bitcoin’s price appreciation, the rise has overwhelmingly benefitted early holders (or hodlers as cryptocurrency fans love to say). Let’s do a little bit of microeconomic analysis. Assuming the demand for bitcoin rises, one would expect the price of bitcoin to rise. One would also expect the quantity supplied of bitcoin to rise as suppliers respond to the incentive of a higher marginal revenue. Now, mining new coins is extremely expensive. The energy used for mining bitcoin has surpassed the annual energy consumption of 159 countries. The electricity and hardware costs to mine bitcoin serves as a barrier of entry for new miners. People who want to benefit from the price rise are therefore far more likely to be buyers than miners. This is a perfect situation for people who already hodl bitcoin because in order for them to realize their gains, they need to sell and buy dollars or any other currency (Frances Coppola explains this brilliantly). They cannot all do so at once without crashing the price of bitcoin and so the difficulty in mining new coins and the steady flow of people buying hoping to benefit from even higher prices allows them to be able to convert their bitcoins to dollars. Now an investment which relies on new buyers to reward old hodlers sounds too close to a pyramid scheme for comfort.

I cannot say for sure if bitcoin is a bubble but based on the above I will say that it is currently overvalued based on its actual utility as a currency. But do I know if it will continue rising or fall to a price reflecting its fundamentals? No, I do not know and that is an answer most honest people will give.

Should you buy bitcoin?

One fact which many financial bloggers or advisers do not admit is that you can make money from an investment even if it is a bubble or a pyramid scheme. The difficulty, of course, is knowing when it’s time to pull out and realize your gains. In fact, it is close to impossible to know. This is why I usually give the non-committal answer of people using their loose cash to buy bitcoin. The fact is people are making money off bitcoin and us crypto-skeptics have to admit it. It is not enough to tell people that it will crash or it is a bubble while people are turning bitcoin millionaires. The fear of missing out is strong and people need more solid reasons as to why they should or should not make bitcoin a significant part of their portfolio.

So for now, my new answer would be “it depends on your financial goals.” If you are willing to take the risk for a short-time then sure, you can buy bitcoin in the hope of making a profit. But at this moment, I do not see bitcoin as a worthy part of any long-term portfolio.

PS: As this is a post which people would feel strongly about I think it is important that you read my disclaimer.

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Jerome Kuseh

Accountant | Economist-in-Training | Finance Blogger
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