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Bitcoins: a version of tulipomania

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ImageBitcoin value will crash, even if it goes through bubble phase of tulipomania scenario first. Bitcoin (or BTC) is worth something just because of market participants believe it is worth something. Why people keep buying BTC? Fun of participating in something novel plays a role for some. Greed should be present as the price increase looks like no-brainer to others. Certainly some of BTC value derives not from what it is, but rather what it is not.  What it is NOT: is not a fiat currency that may devalued by “printing press”, authorities can’t [yet] track down or block every single transaction, storage of the value is not dependent on solvency of any particular institution etc.

Video: You Really Should be Buying Bitcoin (a good explanatory video on BTC)

Without any central institution to destroy the value, no oppressive body to track and/or tax it and, generally, ease of transactions, for many BTC certainly is an attractive alternative to money. At this stage, BTC can perform the essential functions of money — medium of exchange, store of value, measurement of value, no question about it.

There is one trait what sets BTC apart from any other money equivalent: the amount of BTC in circulation capped at 21 million. Even reaching this limit will take some time, as the cost of mining BTC is already higher than their current market value.

We can certainly imagine that in near future an infrastructure is in place to make transactions easy. Easier than cash. Like to make payment with NFC phone and Mastercard Paypass installed, for example. In fact, the technology is in place already. It is just the matter of adaptation by users.

So with all the wonderful specs why BTC is just another bubble? Something free from malaises of fiat money, something quantitatively more limited than gold or diamonds, as anonymous [yet] as gold or diamonds, no storage cost, ease of transaction and at price what is less than production cost.

The reasons BTC as a currency are doomed:

  1. Non-debaseable money – true, but it is not unique and for BTC serves no purpose
    The number of BTC is limited by its algorithm at 21 million. However, so can be any other crypto currency (like litecoin), it is a question of mathematic algorithm. To a certain extend non-debasable are gold, silver, land etc. as well – all of which have gone through boom and bust. What is worse, 21 million BTC in circulation is a setback for development as money. If BTC was to replace all the fiat money in circulation, any single BTC would be worth millions (imagine global GDP of about US$71 trillion to be serviced by 21 million of BTC in circulation) and price of cup of coffee would be expressed as 0.000001 or less BTC – not very practical.
  2. Easy replicable by other crypto currency algorithms
    It is a crypto currency. BTC is based on one specific mathematical algorithm. Similar algorithms are easy to create. Litecoin is one example. Other crypto currencies may appear in endless variations. Such other crypto currencies are likely to be suitable for transaction using the same infrastructure as BTC. For all practical purposes, if somebody creates a crypto currency with global ambition to replace fiat money, for all practical purposes it is better to create something with 71 trillion rather and 21 million units in circulation.
  3. Anonymity will disappear
    Several governments have moved to bring BTC under regulation. US has recognized it as “virtual currency”, Germany as “financial instrument” – whatever the name, in any case BTC is an asset, which is subject government surveillance for anti-money laundering, licensing and tax purposes. All BTC transactions leave a trail on internet. BTC anonymity is not there to stay. In a sense, BTC is a victim of its own popularity as it attracts government scrutiny.
  4. Momentum will fade
    The momentum of novelty will fade. Probably most people on retail level get involved in BTC for fun. This factor will wear off eventually. Speculative interest will disappear after first crush. If all that backs BTC is confidence, then confidence may easily be highly volatile factor. Particularly when people recognize that behind BTC there is nothing else but the confidence.
  5. Technological risks
    The technology of mining, transacting and storing of BTC is new and critical flaws may appear.

All said, the key lesson from BTC is that interest (demand, need) for an alternative currency is strong and I expect that some properly backed, non-national currency will be invented.

Is it a sensible thing to invest money in BTC? I do not think so. The thing of BTC funds with 1000% annual returns may be the thing of the past. Have people made money of it. Absolutely. Early miners, for example. Today mining is not profitable. Will value of BTC increase? No idea, but tulipomania scenario is quite probable. I guess, there are people who know how to trade through bubbles. Is there any practical value of BTC? Apart from entertainment and promoting a novel idea, BTC actually can help to move funds cross-border below government radar scrutiny (something one cannot do with any major national currency). At least by now, but knowing government dislike for it as showed by Liberty Reserve case and having US$11b budget and 35k persons to go after it, it is unlikely the loophole will persist for long.

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Written by A.S.

August 30, 2013 at 7:47 pm

4 Responses

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  1. Reblogged this on Adithya Entertainment.

    adithyaentertainment

    September 2, 2013 at 1:19 pm

  2. A.S. you are both right and wrong about the assertion that BitCoin is a speculative bubble that will crash.

    Firstly, you are right in the past tense about BitCoin speculative bubbles that crash. There was a spectacular crash in April 2013 when it lost over half its value in a day. And there was a crash but a few days ago (albeit less spectacular) when Silk Road was shut down by the FBI. Yet here were are with the long term run of BTC value continuing. Your comparison then, to tulipomania is wrong because when the tulip bubble burst it didn’t come back – it stayed burst. But despite several BitCoin bubbles bursting so far, and no doubt more to come in the future, BitCoin keeps getting stronger.

    Wherever there is speculative investment, bubbles can form. That’s true of any asset, and it’s true that many people are mining or buying into BitCoin for speculative purposes. But it’s also true that as more more services and merchants accept BitCoin, its utility as a currency increases.

    The key point I think you’ve missed is that the value of a currency is relative to other currencies and to its purchasing power. At a time when the US, Japan, the EU, and in a way, China, have entered into a currency war to devalue their currencies, the game is changing for currencies globally. Massive sovereign debt in the US, Japan and EU mean that really there’s little alternative to increasing the money supply to peg down sovereign debt. This is debasing fiat money on a massive scale, and given that economic growth in these countries is stagnating, it’s likely that this process will accelerate. In other words, the relative value of fiat is going down.

    At the same time, we are witnessing greater merchant adoption of BitCoin, and a gradual acceptance by governments that BitCoin is here to stay and they will seek to regulate it (as Germany has done) going forward. The value of BitCoin is going up, and as this process increases, more people will look to it as a safe haven away from fiat – something that has already begun in Argentina where high inflation is making the peso worth less each month.

    Don’t assume that BitCoin will replace all fiat currencies. To begin with there are lots of obstacles to that. And furthermore, it won’t just be BitCoin that is in circulation. There will be LiteCoin, FeatherCoin, PP Coin, and other crypto-currencies also in circulation. They won’t be governed by nation states, but rather by the code that runs them and the foundations that oversee that code. This is much like the vision of Friedrich von Hayek had regarding several private currencies competing with one another. And it’s a matter of time before these currencies do supplant the debased fiat currencies.

    sol

    October 5, 2013 at 12:12 am

    • Sol, thanks for the feedback. Today I saw a good explanatory piece on bitcoint: http://www.avc.com/a_vc/2013/10/video-of-the-week-bitcoin-under-the-hood.html

      More than the video, I like the thesis about thinking of Bitcoin as technology [rather than currency].

      As a technology, BTC can be replicated. For that reason, BTC is unlikely to serve as a currency in the end. Qualified people can create such currencies [technologies] at will. True, BTC, while it serves as currency, is likely to be deflationary currency as the mining cost already exceeds the market rate and some of BTCs are and will be irreversible lost through lost keys (for example, hard disc failures storing keys without back-up …).
      I do not agree with the debasing argument. True, the number of BTCs is limited and as such cannot be debased. However, with BTC there is nothing to be debased in terms of hard assets backing it. Fiat currencies are typically backed by central bank reserves, no matter how meagre in relation to currency in circulation, and in wider sense by government tax revenues and state owned assets.
      BTC seems to derive its value from the fact that it is the most popular crypto currency and that crypto currencies are easy to use for anonymous transactions. The popularity explains why USD or EUR is used in the world trade rather much better backed NOK (Norwegian kronor), for example. In the same way, popularity explains why BTC rather than Litecoin is used. Anonymity is second big factor as each transaction in fiat currencies through banking system is traceable by authorities. Lack of anonymity renders fiat currencies unusable for transactions involving tax evasion, undeclared cross border money transfers and outright illegal transactions like buying and selling drugs. The anonymity factor is a good explanation why BTC value fluctuated from USD 140 to 110, settling at USD 123 on the day of Silkroad closure (Oct 2, 2013). Silkroad was a deep web online shop dealing in all kinds of illegal stuff with BTC as the payment currency and its closure rendered BTCs of many owners useless. If there is to point out one unique utility feature that sets BTC apart from fiat currencies, it is anonymity for online transactions.
      There are still many Silkroad type businesses out there, alongside with other uses of BTC and legitimate businesses accepting BTC. This may well explain why BTC has almost fully recovered its value three days later after Silkroad closure. Nevertheless, BTC’s popularity may turn out its weakest point, as it is likely to attract the most effort by governments to crack the anonymity. The day BTC stops to serve as means of payment for anonymous transactions, its value will crash and none will pay attention that it is limited to 21 million BTCs and cannot be debased like fiat currencies. Just because it is backed by popularity and anonymity only. Those may be highly perishable goods.
      With all said, there is a slight probability that BTC ease-of-use and popularity snowballs and become the key value drivers behind BTC. Then the ease-of-use must be at par with fiat currencies. As well, there is another probability that governments will not be able to crack BTC and BTC will continue to serve for what it serves now.
      On balance, I would say that BTC serves well as means of payment in certain situations, but I would not buy BTCs as investment. What will happen with BTC at the end is a rather complex formula involving various probabilities about cracking its anonymity, speed of adoption (i.e. popularity), technological improvements regarding ease-of-use, success of rival crypto currency projects etc.

      A.S.

      October 5, 2013 at 5:01 pm

  3. BTC was USD130 at the time of writing, then traded as high as USD1165 three months later and is at USD 250 now.

    Technological risks seem to be the risks which materialized. Not that there is a problem with BTC algorithm itself, but that BTC is not safe against theft — first Mt.Gox, now this:

    http://www.zdnet.com/article/mycoin-closes-its-doors-387-million-in-investor-funds-vanishes/

    A.S.

    February 27, 2015 at 10:00 pm


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