Monday, January 27, 2014

Bitcoin: The First Crypto-Curreny, Not The Last & Only

I have been fairly vocal on Twitter about Bitcoin and last year wrote a couple of articles about the cryptocurrency. The first (Bitcoin Bubble or New Virtual Currency Paradigm?) covered the basics of the technology, discussed some of the risks and shared some comparisons with precious metals (which many were measuring it up against at the time). I ended on the note that we might be nearing the top of a bubble in price:
My gut tells me that at US$70 Bitcoins are probably closer to a short term bubble peak (given the short term nature of the rise) than at the base of an immediate move to $150 or other high price targets I have seen thrown around ($500+), but that doesn't mean they can't head higher (in the short or long term).
I got the short term call wrong, although I didn't discount the possibility of higher prices.

Click Chart To Enlarge
After an almost immediate move to $150, turning my gut (on this occasion) into a similar contrarian indicator to the Pascometer, the price retreated back under $100, before regaining it's composure over a few months and then soaring to over $1200. Recently the price has been fluctuating between around $900-1000.

The second post I wrote about Bitcoin covered some of the gaffes Glenn Stevens' (Governor, Reserve Bank of Australia) made about Bitcoin in an interview (Glenn Stevens Talks Bitcoin & Competing Currencies). I discussed the errors in his characterisation of Bitcoin, showed how we don't have competing currencies in Australia as he claimed and had a chuckle at this oxymoron:
Ironically Stevens ends his interview on a point, 'the ones [BB: currencies] that survive will be the ones that hold their value' and in the same breath says 'which is why we have an inflation target which we’re hitting'. How Stevens equates holding value with hitting an inflation target is beyond my comprehension, it seems more like an oxymoron.
Although I feel my posts have been relatively balanced, if you follow me on twitter or read my posts on Silver Stackers you could be forgiven for thinking that I'm anti-Bitcoin, in fact nothing could be further from the truth.

On one hand, I am a big fan of the Bitcoin protocol, the technology itself is innovative and has laid the ground work for some incredible advances in the way that we transfer value in the future (amongst other applications). The fact that a decentralised and secure payment system has been developed outside the traditional global banking system is fascinating.  On the other hand I am wary of those promoting Bitcoin, exaggerting it's benefits, talking as if it's 6 months away from mass adoption & expecting it to retain it's dominance over other cryptocurrencies forever.

To be fair I don't only cast a skeptical eye over the Bitcoin pumpers, I've also blogged extensively on precious metals commentary I don't agree with. For example, I questioned Andrew Maguire's central bank Gold buying figures, looked for non-conspiratorial explanations for the slow delivery of Germany's Gold from the United States and corrected inaccuracies in an article claiming we were nearing the end of the paper Gold market.

Exaggeration, conspiracy and irrational commentary abounds in the precious metals space, facts are distorted or ignored, comments are taken out of context and exploited by those trying to sell you their subscription trading service, market report or the physical metals themselves. I empathise with some of those in this space who are just trying get readers into an asset they think is essential to hold, but there is no way I can condone the tactics used (by some) to achieve their goals, the ends simply don't justify the means.

The cryptocurrency market (including Bitcoin and other cryptocurrencies, known by many as altcoins) shares some of the same exaggerated commentary as the precious metals sector, although arguably not to the same extent.

Most asset classes have highly emotive supporters prepared to pump them incessantly, but I suspect that the money / currency topics tend to attract the worst kind of this attention due to the 'nemesis' (i.e. fiat currencies and central banks) having such a large impact on our everyday lives.

One of the most common misrepresentations I see is this constant stream of businesses now 'accepting' Bitcoin in exchange for goods and services. Every time a large company accepts Bitcoin it's deemed the next nail in the coffin for fiat currencies and a watershed moment for Bitcoin. The reality is that most of these businesses organise Bitcoin conversion into fiat instantly using a payment processor such as BitPay.

Suggesting a business is 'accepting Bitcoin', when they are having it instantly converted to fiat, is a fallacy. As I pointed out on Twitter, a company would accept payment in just about anything provided there was a market and payment processor available to instantly convert it into the local fiat currency:

What businesses are really saying when use a payment processor, is that we want the purchasing power of Bitcoin owners, but are not really interested in holding the currency itself. This article from The Motley Fool explains how retailers benefit without any of the risks the consumers take with Bitcoin:
Overstock's partner on this is Coinbase, which allows the company to do an instant exchange from Bitcoin into dollars. Overstock CEO Patrick Byrne is a self-declared "true believer" in Bitcoin, but he and his team obviously understand that it is not yet a desirable asset for a publicly traded company (unless you are a Winklevoss and starting a publicly traded Bitcoin ETF). With zero regulatory infrastructure and wildly fluctuating value, it just doesn't make sense for Overstock to hold on to Bitcoin for more than a nanosecond.

Cash, at least in the foreseeable future, will remain king.

So what Overstock has done is benefit from all of the noise surrounding Bitcoin, and immediately mitigate the risk of actually dealing with it.
While Patrick Byrne claims to be a true believer in Bitcoin, an old saying comes to mind, about watching what they do, this exchange from a recent interview with Fortune:
Fortune: Do you own any bitcoins? Patrick Byrne: No. I own gold.
Fortune: Really, how much gold? Patrick Byrne: A lot.
Some have argued that in time businesses will accept Bitcoins, provide them to their suppliers, pay their employees in Bitcoin, essentially closing the loop:
They are forced to change out from bitcoin to fiat right now because their suppliers expect repayment in dollars, and employees expect wages in dollars. But that expectation is not set in stone.

The next big revolution will be when bitcoin takes the B2B market by storm when they realize they can settle accounts instantly, especially for international transactions and import/exporters.

When your suppliers are willing to take bitcoin, the next leap is when employees prefer being paid in bitcoin.

When that finally happens you have the closed loop and can do all your business in bitcoin without switching out--which will prove to be quite profitable over dealing in fiat. Reddit
However, for a closed loop to take place, it would mean that everyone is prepared to take the risk of price movements in the Bitcoin currency or utilise hedging. Imagine the inconvenience of being an employee paid in Bitcoins and not knowing what your pay packet would buy in two weeks when you received it. It would be like trying to perform daily transactions using a foreign currency, the difficulties of which (for Australian consumers) I pointed out in my last post on Bitcoin:
Can you just imagine the administrative nightmare that would result from performing regular transactions in a foreign currency and having to maintain a record of whether you made a gain or loss as a result of fluctuation in the currency markets? It is simply not practical.

Bitcoin is not immune from the same requirements, earlier this year the ATO commented specifically on the topic (although the comments have a business focus, it does not exempt individuals from the same requirements)...
Another regular way that Bitcoin supporters misrepresent the cryptocurrency is by comparing it's daily volume with that of PayPal, Western Union or other payment systems used by consumers to purchase goods or transfer currency. Coinometrics publishes these figures:

Click Image To Enlarge
But what is often ignored when making these comparisons is that it's not possible to separate the Bitcoin transactions which are speculative in nature vs those used for a genuine purpose such as purchasing goods and services. So comparing the two directly is disingenuous. A more valid comparison to make would be to compare the largest cryptocurrency payment processor, BitPay, who processed over $100 million worth of transactions in 2013 versus PayPal who processed $44 billion in the 3rd quarter alone.

It's impossible to know how many Bitcoin transactions are used for consumer purchases. A recent estimate in a Forbes article says buyers spent $500,000 worth of Bitcoins at Overstock since it started accepting them two weeks ago. That may sounds like a lot, but with Overstock revenues expected at $1.3 billion in 2013, we are talking about an annualised increase from Bitcoin of $13 million or 1% (assuming these buyers only went to Overstock due to their acceptance of Bitcoin).

Many of the so called advantages of Bitcoin only benefit one side of the transaction. For example, Bitcoin features non-reversible transactions, which can be a benefit for the business, but poses a risk to the consumer. This seems to be lost on some who claim that no trust is required in either direction when using Bitcoin:
It is a way to exchange money or assets between parties with no pre-existing trust: A string of numbers is sent over email or text message in the simplest case. The sender doesn’t need to know or trust the receiver or vice versa. Related, there are no chargebacks – this is the part that is literally like cash – if you have the money or the asset, you can pay with it; if you don’t, you can’t. Why Bitcoin Matters
Where an exchange occurs with Bitcoin going in one direction and goods or services going in the other, of course there has to be trust. Those arguing blindly for Bitcoin will normally introduce the potential for trusted third party transactions at this point, but I am yet to see this in practice for consumers and there are unknown side effects attached which could harm Bitcoins other advantages such as instant settlement and low cost.
 
From my observation, most of those who own Bitcoins are either technologists, those with a speculative interest in seeing the currency rise in value or those dissatisfied with the existing system which centralises money creation and control in the hands of the few (banks, governments), i.e. they have ideological reasons for owning it. I am yet to come across anyone who owns Bitcoin purely for the fact that it's a superior form of currency for online purchases or the transfer of value.

While Bitcoin is the largest cryptocurrency by far (market cap circa $11 billion), there are many other competitors that offer improvements or differences that appeal to various individuals tastes. They vary in size with market caps as small as $100k, to $50 million or more (the 20 largest are listed below via coinmarketcap.com):

Click Image To Enlarge
Some Bitcoin supporters argue that the first cryptocurrency is already too popular in the market and unlikely to be surpassed by a competitor due to it's ability to adapt and add new features. Another argument is that too much developement has already gone into Bitcoin for it to lose the top spot, but this is very short sighted given that many of the Bitcoin services, sites and apps in use or being developed could be modified to work with any cryptocurrency.

Primary issue I see with Bitcoin, is lack of stability in price. The biggest competition to Bitcoin may be evolution of a cryptocurrency which is stable in value, perhaps even one that is backed by another asset (such as Gold):
After extensive testing in the Pacific, KlickEx is pleased to announce the development of a new asset-backed and algorithmic crypto-currency for institutional and retail use. A stable, international risk-free asset is a key foundation for efficient financial markets, and KlickEx’s award winning interbank payment network has an exemplary track record in stability, and efficiency. Having eradicated the significant systematic deficiencies of Bitcoin, then bridged the portfolio limitations of the IMF’s SDR, the new base asset is a proactive response to recent negative public sentiment towards banking in general, and recent global events including The GFC, Euro-Crisis, BASEL II, III, and fiscal & political instability in Prime currencies. KlickEx At FinovateAsia
Or as speculated by Felix Salmon early last year, perhaps a cryptocurrency itself won't be the future, but rather a network that will facilitate transactions of any currency (Maybe Ripple has a chance or something similar):
A peer-to-peer payments system, allowing anybody on the internet to pay anybody else on the internet without having to sign up with some financial-services behemoth first, could revolutionize global commerce. It would have to be able to work with any currency, including bitcoin; it wouldn’t need its own unit of account. It would have to be flexible, too: some transactions would be cashlike and irreversible, while others would allow some kind of chargeback.

And, most importantly, it would work with, rather than against, today’s established monetary institutions...
...But whatever it looks like, in the end, we can be sure of one thing: it will owe a very large debt to Satoshi Nakamoto and his audacious attempt to invent a whole new currency. Bitcoin isn’t the future. But it has helped to light the way ahead.
Of course the Bitcoin purists won't like the sound of centralising an asset to back a cryptocurrency or the thought of involving existing financial institutions in the final solution, but the choice ultimately won't be theirs. The market will decide and I can't see the majority of people choosing a currency that puts them at a distinct disadvantage due it's wildly fluctuating price.

Betting on Bitcoin being the permanent global leader of cryptocurrencies is like putting your money on MySpace (in 2004) to be the leading social network (wouldn't have worked out too well). The cryptocurrency journey is just getting started. Take a punt if you like, but don't put all your eggs in the Bitcoin basket.


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6 comments:

  1. Great article, I agree with a good deal of it. My main points in response:


    1. It may be a case of "Is decentralisation of money worth increased volatility right now?". Reason for this being that any time there is a non-govt centralisation of money these days, it tends to get shut down e.g. e-gold, liberty dollar, liberty reserve etc. So while it might be nice to have a cryptocurrency backed by gold, the risk of a governmental takedown is too great for it to be long term stable in today's environment.


    2. I also differ in that I think price volatility will go down over time as more businesses accept bitcoin and more businesses start using it in a B2B sense - trading in bitcoin without entering the fiat economy.


    SL

    ReplyDelete
  2. Thanks. In regards to your points, you will see that the 'asset backed' crypto-currency referred to in the article is proposed by a company who is actually targeting central banks with their product and services. I agree with you that a non-government Gold backed currency might be difficult to establish, but if we were to see introduction of a Gold backed SDR or similar (see: http://www.bullionbaron.com/2013/12/road-map-to-new-international-monetary.html) then a cryptocurrency could play a part in settlement between central banks or even allowing institutions &/or individuals access to the same market. Even if not backed by assets, a cryptocurrency system provides an easy way for global governments to introduce a global currency (global ledger of payments where every transaction can be seen, what a dream come true for the NSA!). I think there is a very real possibility that government may embrace the technology, but probably not in the way that most had hoped...

    In regards to point 2, I do think the price of Bitcoin could settle down in time, but even if it settled down to a similar volatility as other currency crosses, it would still be an inconvenience for using in everyday transactions due to the laws in Australia (though some countries are a little more friendly).

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  4. http://themisescircle.org/blog/2013/08/22/the-problem-with-altcoins/

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  5. Thanks for the link Josh, I had a quick skim read. I think I spotted that one last year as well. Cliff notes as I recall are simply that Bitcoin is already too large & has too much invested for another cryptocurrency to overtake it (ever). That is a foolish assumption to make (one that I think I covered in the post above). Sure, one of these copycat coins that add nothing, but just change the name & number of coins mined are not going to replace Bitcoin, but that doesn't mean that nothing ever will. I am still learning about Ripple, but from what I can gather the protocol can facilitate the transfer of various currencies & even multiple cryptocurrencies, this is a massive leap forward from a single network and currency like BTC. What is your take on Ripple?

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  6. it's certainly got that "4 phases of a bull market" look about it.

    ReplyDelete