This week’s Insight will be a re-post of a piece that we wrote almost exactly a year ago called Bitcoin: Confidence Game or Currency Revolution. A lot has happened over the past twelve months, and the topic of Bitcoin is even more prevalent today than it was twelve months ago. In light of this, we decided that revisiting a primer on the digital currency would be of interest. But first, let’s briefly recap what has happened since we originally wrote this post.
The price/volume chart below is an update on what we included in our original post. As the chart shows, the price of Bitcoin dropped dramatically immediately after we wrote our Insight last year. Then, after trading sideways for several months the price skyrocketed nearly 500% to over $1,100 in late 2013! This price rise was attributed to a number of factors, including rising demand for Bitcoin in China and some open-minded comments about the digital currency from Federal Reserve officials.
However, since the speculative frenzy tapered off in November, the price has steadily declined by 60%. One of the reasons for this decline, and perhaps the most important Bitcoin-related event of the past twelve months, is the failure of the Japanese Bitcoin exchange Mt Gox. Wikipedia reports that Mt Gox was handling 70% of all Bitcoin transactions before a security breach caused it to suspend trading and shut down its website in February 2014. Mt Gox has since filed for bankruptcy, claiming that Bitcoin valued in the hundreds of millions of dollars was stolen by cyber criminals.
Despite its ups and downs, Bitcoin continues to advance the conversation on digital currencies and other alternatives to fiat money, and we expect the next twelve months could be just as interesting as the last.
The following was originally published on this blog on April 9, 2013:
"Confidence in money as a store of value is the ultimate driver of its value, both in the cyber and real worlds...” - Nick Colas, Chief Market Strategist at ConvergEx Group
The “free market” today is characterized by financial repression where interest rates are held artificially low by central banks that create/print new currency ad infinitum in hopes of reigniting animal spirits in the marketplace. We are in an age of unprecedented intervention and easy monetary policy, as most recently demonstrated by the Bank of Japan’s announcement that it intended to double the country’s monetary base by the end of next year. With all of this heavy handed intervention, some have begun to question the utility of fiat currencies whose supply and subsequent value is controlled by a banking cartel (central banks being the biggest player in said cartel). If money can be created or destroyed with the stroke of a pen, or more appropriately the strike of a couple keys on a keyboard, how much confidence can one have in its ability to retain value? Some Ivy League, Keynesian economists would argue that money is not meant to be a store of value and that it is simply in place to “facilitate transactions” indicating that savers must turn to other investments for stores of value. There is merit to this point, but it doesn’t change the fact that currency with unlimited supply runs the risk of a total loss of confidence and as the opening quote points out, confidence is the only thing that makes paper money worth anything in the first place.
Enter Bitcoins. Bitcoins are a type of digital currency that isn’t controlled by any government or bank. They were first introduced in 2009 following a white paper which was released a year earlier outlining the protocol for how the currency would work (the white paper was written under a pen name, and to this day its author remains unknown). The white paper suggested that the idea for Bitcoins was politically motivated as a response to the bank bailouts during the global financial crisis.
Bitcoins are added into circulation through a process called “mining”, in which a computer (or a group of computers) is required to solve a complex mathematical puzzle. In theory, anyone can sign up to use their computer or join a group of people using their computers to mine for Bitcoins. There is an absolute limit of 21 million Bitcoins of which a little over half are in circulation today. As resources dedicated to Bitcoin mining increase, the puzzle becomes more and more difficult to solve thus slowing down the mining process. By limiting the supply of Bitcoins in this fashion, the system has created scarcity in the market. In answer to the scarcity, exchanges have been created where people can buy and sell Bitcoins in exchange for other government backed, fiat currencies like the US Dollar.
So why would anyone want to acquire Bitcoins in the first place? The people that transact in this space would provide a variety of answers ranging from speculative trading to anti-establishment acts of free speech. But here’s the key…Bitcoins are also beginning to gain traction as a medium of exchange for goods and services. While not exactly your day-to-day shopping locations, the list of vendors accepting Bitcoins as payment is long and growing.
The price and popularity of Bitcoins has skyrocketed recently. The news media is gorging on Bitcoin stories over the past couple weeks due to their meteoric price rise and controversial nature. When Bitcoins first started trading on the Mt Gox Exchange back in 2010 they traded hands at $0.05 per coin. Around this time, it was reported that someone was able to trade 10,000 Bitcoins for $25 worth of pizza. As Bitcoins have grown in popularity they have attracted interest from investment banks and hedge funds. The price of Bitcoins have steadily marched upward as demand growth has outpaced the growth in supply. Along the way technological glitches and computer hackers have created temporary hiccups, but the price has quickly rebounded within weeks or months each time. By the end of 2012, Bitcoins were exchanging hands (or cyber wallets) at a rate of $13.50 per coin. As if this 270-fold increase wasn’t impressive enough, since the end of last year the value of Bitcoins has gone parabolic and is now north of $200 per coin, putting the cost of that 10,000 Bitcoin pizza at more than $2 million today.
Whenever the price of a thinly traded commodity (if digital currency can be considered a commodity) goes parabolic, it typically signals a price bubble that doesn’t end well for those buying late in the game. Bitcoins trading above $200 doesn’t necessarily legitimatize them as a currency either, as they still represent a miniscule market and have very limited use as a medium of exchange. More vocal critics would even characterize them as an elaborate confidence game or Ponzi scheme. As they become more valuable they will also attract more attention from cyber criminals, and there have already been several instances of hackers breaking into Bitcoin wallets or even compromising the Bitcoin protocol. In an article published by Reuters last year, banking and payment expert Simon Lelieveldt was quoted at the Digital Money Forum in London as saying:
“There is always a power base underlying a currency…Bitcoin is not going to fly because there is no central bank or power base. It's doomed to fail."
But the fact that they are no country’s liability and their price isn’t manipulated by over educated bankers with well-manicured beards is what makes Bitcoins so appealing to their devout supporters. Whether Bitcoins will have the staying power to become a legitimate currency remains to be seen, but with every Dollar, Yen, or Euro that is printed we move one step closer to alternative currencies like the Bitcoin becoming a valid medium of exchange and store of value.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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