By Paul Courtney & Aaron Durlam
• Investors should take digital assets like bitcoin seriously for a few reasons: (1) the underlying blockchain technology has the potential to reshape entire sectors of the economy, (2) growth in cybercrime will result in a steady need for anonymous digital currencies, and (3) they have the potential to serve as a peer-to-peer store of value in a world with few trusted alternatives.
• While the overall digital assets space looks to be in a classic speculative mania, bitcoin and a few others have real utility today and immense potential in the future, but they face existential threats.
• Unbiased opinions are hard to find – conversations between bitcoin backers and skeptics are typically circular and not very productive, yet we believe there is some middle ground.
• Bitcoin’s value is somewhere between zero and whatever the last marginal investor or speculator will pay for it – we view it as a call option on a fascinating, but unknown future.
In 1952, Noah S. “Soggy” Sweat, Jr., a young member of the Mississippi House of Representatives, delivered his now famous “If-By-Whiskey” speech in response to a question on whether Mississippi should legalize or continue to prohibit the consumption of alcohol:
“If when you say whiskey you mean the devil’s brew, the poison scourge, the bloody monster, that defiles innocence, dethrones reason, destroys the home, creates misery and poverty, yea, literally takes the bread from the mouths of little children; if you mean the evil drink that topples the Christian man and woman from the pinnacle of righteous, gracious living into the bottomless pit of degradation, and shame and helplessness, and hopelessness, then certainly I am against it.
But, if by whiskey you mean the oil of conversation, the philosophic wine, the ale that is consumed when good fellows get together, that puts a song in their hearts and laughter on their lips, and the warm glow of contentment in their eyes; if you mean Christmas cheer; if you mean the stimulating drink that puts the spring in the old gentleman’s step on a frosty, crispy morning; if you mean the drink which enables a man to magnify his joy, and his happiness, and to forget, if only for a little while, life’s great tragedies, and heartaches, and sorrows; if you mean that drink, the sale of which pours into our treasuries untold millions of dollars, which are used to provide tender care for our little crippled children, our blind, our deaf, our dumb, our pitiful aged and infirm; to build highways and hospitals and schools, then certainly I am for it.
“The gulf between what the press and many regular people believe Bitcoin is, and what a growing critical mass of technologists believe Bitcoin is, remains enormous.”
– Marc Andreessen, Investor, Software Engineer
“Of our $49BN, we haven’t moved any of it to bitcoin.”
– Warren Buffett, Investor
Those familiar with the work of Oaktree’s Howard Marks will recognize the intro above from his 2010 memo on gold, All That Glitters. As Marks noted:
“Sweat’s response shows, depending on how you look at it, either how views can diverge on a given subject or how differently a tale can be spun.”
You cannot hold bitcoin in your hand and feel its weight, fashion it into a ring, or use it to crown a tooth, but the digital currency has a lot in common with gold. Like gold, conversations between bitcoin backers and skeptics are usually polarized, circular and not very productive. We believe there are at least three reasons for this.
First, the principles that underpin both bitcoin and gold are rooted in a deep distrust of the existing debt-fueled financial system and the reliance on “trusted” and centralized third-party intermediaries.
Second, both bitcoin and gold have no cash flow and therefore no objective method to calculate their value. Without a stream of cash flow to value an asset, we must make assumptions about the market’s desire for the asset in the future, which requires forecasts. Once we start down the road of forecasting, we bring our own subjective beliefs into the equation.
Finally, an informed opinion on bitcoin requires a substantial investment of time and energy in learning about the technology. Even if one is prepared to commit that time, the underlying protocols, competitive landscape and regulatory backdrop are all constantly changing making the learning curve extremely steep. Bitcoin supporters often view skeptics as luddites that “just don’t get it” while skeptics see bitcoin enthusiasts as the frenzied evangelists emblematic of the top of every great bubble throughout history. Reasonable voices get drowned out by headlines of impending crashes and calls for a $1 million bitcoin price.
As an aside, we will not be digging into how distributed ledgers (i.e. blockchains) work or the many other uses of this technology in this Insights. Bitcoin was the first digital currency and it remains the largest and most well-known; it’s an informative archetype.
A Circular Opinion
With Soggy Sweat’s opinion of Whiskey as a backdrop, we present our “view” on bitcoin:
We can be sure of very little in this life, but we are sure of this: Bitcoin is the perfect currency. Bitcoin makes it possible to send money anywhere in the world, at any time of day, in a fraction of the time and for a fraction of the cost of using a traditional bank intermediary. Its transactional value is evident in hundreds of thousands of dealings every day.
Bitcoin is relatively scarce – there will never be more than 21 million in circulation. While central banks can conjure up new fiat by the billions and trillions with the mere press of button, bitcoin’s scarcity makes it a superior store of value.
Bitcoin is electronic and therefore costs nothing to store, is nearly frictionless and is perfectly transportable – something that cannot be said for gold. It is also a better unit of account than other currencies as it is nearly perfectly divisible, at least to the eighth decimal.
Bitcoin also allows investors to store and transfer wealth outside an increasingly leveraged and fragile banking system – one that is governed by the arbitrary guidelines of a heavily regulated bureaucracy of toll-takers. It is the “internet of money”.
The potential market for bitcoin spans every person on earth with the ability to access the internet and the desire to transact for anything, anywhere.
As the first-mover in the race for a truly global digital medium of exchange and store of value, there should be absolutely no doubt that bitcoin is the currency of the future and a crucial part of any serious investment program.
Except of course that bitcoin is nothing but electrons floating about the ether with no legal recourse or claim outside of a byzantine world of anonymous people that pride themselves on skirting authority. Bitcoin has little, if any, intrinsic value, and even that is only because of its waning usefulness today.
While blockchain technology has wide applications, bitcoin is just one of many digital assets using it. Its role could easily be supplanted by a more elegant solution. Indeed, we are already seeing that happen as its dominance among other digital coins has declined from over 90% of total market share to under 45% today.
Bitcoin is also extremely inefficient. A system based on stacked, chronological proof-of-work for its security protocol requires an ever-increasing amount of processing power, data storage, cooling systems and electricity to run. At over 145 gigabytes, the bitcoin blockchain is bloated and impractical to use. This is beginning to show up in costs, which are increasing dramatically. As costs rise, its transactional use has declined. When the dust has settled, bitcoin will be seen as nothing more than proof-of-concept for a useful technology.
Bitcoin is also not secure enough for mass-adoption and the anonymity it provides is a two-edged sword. Lose your data wallet or the piece of paper you wrote your private key on and your entire stash is lost forever. There is no way to recover it.
Finally, bitcoin also fails as a store of value – its daily volatility makes penny stocks look dull. Its recent parabolic rise is looks like some of the great manias in history. Recent entrants to the space are motivated by the prospects of capital gains rather than its usefulness as originally intended.
And so, bitcoin is likely in the midst of a classic speculative mania fed by an increasingly uninformed mass of people who are buying it not to transact, but to profit and ultimately sell it to the next fool – the greater fool. We all know what happens when we run out of fools. For these reasons, we are quite certain that bitcoin is a modern-day Ponzi scheme and should be avoided at all costs.
Putting it in perspective
Viewed in isolation, bitcoin looks like a bubble…
But viewed relative to other markets or currencies, bitcoin is more of an afterthought.
The absurd, circular passage above is, of course, not our view, but it serves to demonstrate our point. Like gold, discussions about bitcoin and other digital assets typically end up as never-ending arguments.
These discussions do not only happen between separate people with opposing views. They take place inside our own heads, as our individual views swing back and forth with public sentiment and prices. As Michael Batnick captured so well in a recent blog post:
“The thing about bubbles, and for the record, I’m not brave or dumb enough to declare this one, is that they wear you down. They make you feel irresponsible for not getting involved. Today I found myself at this juncture. What if Bitcoin legitimately is the future of currency? What if this is how 30% of online transactions take place in ten years? Why wouldn’t I buy on this pullback? These are actual thoughts I had earlier today. And then I snapped out of it and started writing this blog post. We’re at the place where mocking and doubt has melted away and only fear of missing out is left. I no longer feel strongly that Bitcoin will cease to exist in three years, but I’m also not sure if it’s just a twenty-first century bubble either.”
The Future of Bitcoin
Despite our concerns, we think bitcoin may have a future under a few use-cases, most notably as a censor-resistant store of value (i.e. digital gold) and for large cross-border remittances. We do not think it works for smaller day-to-day payments because of its volatility and the inherent inefficiency of proof-of-work based security protocols, but that is a topic for another day. It could work for black market (or so called “dark web”) transactions, but the protocol may need to be changed to integrate more privacy.
And we are not downplaying the risks, which truly are existential. In fact, the scaling debate that is fast approaching its boiling point could result in two (or even more) different versions of bitcoin in the coming months. This potential “hard-fork” is the culmination of a multi-year debate over what bitcoin is and how it should evolve to deal with the unavoidable expansion of its main blockchain.
To try make a long story short, a hard-fork implies a fundamental change in the bitcoin protocol, which has the potential to undermine bitcoin’s role as an immutable store of value. This could bring the entire experiment crashing down. But there is hope: the market has seen forks before. Even if this one is contentious, the bitcoin network should adapt to support the version with the most potential. The bitcoin community has proved remarkably resilient over time. As Satoshi (the author/s of the original bitcoin white paper) wrote, “the network is robust in its unstructured simplicity.”
There are a few other factors which will impact the various use-cases.
First, bitcoin’s first-mover advantage gives it an enormous competitive edge and credibility as a digital store of value. Network effects – a phenomenon where each additional user in a network makes the entire network more valuable for all users – are the backbone of how cryptocurrencies gain acceptance and scale. They also create winner-take-all dynamics. If bitcoin can get through this year without compromising its perceived value, it may reassert itself as the dominant digital asset.
Second, bitcoin is losing its role as the currency of choice for cybercriminals. As the world gets increasingly wired and digitized, cybercrime will unfortunately grow with it. British insurer Lloyds estimates the costs of all cybercrime to businesses of nearly $500 billion a year globally. Juniper Research recently predicted that total costs of data breaches would increase to $2.1 trillion by 2019. In many of these cases, good actors will be forced to transact with bad ones in the currency of their choice. Corporations have been stockpiling bitcoin (and driving up the price) for years to be able to pay up quickly in the event of a ransomware attack, but cybercriminals are beginning to move on to other, more secretive digital coins.
The two with the most promise are Zcash and Monero. These “altcoins” (launched as alternatives to existing digital assets) have an extra layer of anonymity in their protocols, which allows the details of transactions to be hidden from anyone other than the two parties involved. Bitcoin transactions are technically still anonymous, but the keys used to authorize transactions are visible to everyone on the network. If a key is somehow traced back to an individual, every transaction that person has ever made is visible to the network.
Finally, to be fair to digital assets, similarly circular if-by discussions can be held across a wide range of assets today. With interest rates at or near the lowest levels in history – and some cases negative – investors have been incentivized to do some very peculiar things in the search for both returns and stores of value.
How Different Are Digital Assets Really?
According to a 2013 study by MasterCard, more than 80% of consumer spending in the U.S. was cashless. Paper money represents less than 5% of the broad money supply globally and that number is declining fast. Electronic currencies are already commonplace in our day-to-day lives. A crucial difference between something like bitcoin and a U.S. dollar is of course that the dollar is legal tender, but what if governments begin to accept bitcoin or something else as legal tender (like Japan has already done)?
Digital assets have no yield, but how different is that to the massive segments of the global bond markets that yield even less? Bloomberg reported in May that there was $9.5 trillion worth of sovereign bonds that had negative yields. Even in parts of the cash or bond markets where nominal yields are positive, they are often negative on a real (inflation-adjusted) basis.
Now consider that there are online platforms where you could loan out bitcoin as collateral for digital asset margin trading accounts and earn double-digit returns. Or you can simply lend your bitcoin to a business or individual on a peer-to-peer platform and earn similar yields.
Digital assets are risky, but are they riskier than some of the higher yielding parts of the corporate and sovereign bond markets? Would you rather speculate in bitcoin or 100-year bonds issued by Argentina, a country that has defaulted on its sovereign debt on eight separate occasions, most recently just three years ago. Those bonds were 3.5 times oversubscribed. Or what about bonds issues by Lebanon, a country that has not had a budget for 12 years, that trade with a yield slightly over 6%. Other bond categories like emerging market sovereign bonds and U.S. corporates have lower levels of return (spread) per unit of risk (duration) than at any point in history.
What about stocks? Is speculating in a digital asset any different than speculating in stocks like Tesla, Facebook, Amazon, Netflix, Nvidia and a host of other high-flyers with prices disconnected from current earnings. Like bitcoin, these stocks may or may not prove to be good long-term investments, but there is no guarantee of that today. Their value is based on faith in an unknown future. As a Forbes contributor wrote earlier this year:
“Tesla’s astounding market capitalization does require some explanation. At the most basic level, the stock price of a firm is no more than the net present value of all future earnings. [N]o one should believe that a company is going to suddenly make $1 billion in net profits if it barely broke even the year before.”
As of November 2016, Tesla’s market share in cars and light trucks was a tiny 0.3%. Over the same year, some 76,000 vehicles had rolled out from the factory. In contrast, Ford’s F-Series alone sold 780,000 units in 2015. How many cars does the financial market expect Tesla to sell in order to justify the stratospheric valuation?
Beside irrational exuberance, what else could explain such market behavior?
While we cannot confidently value bitcoin (no one can), we must humbly acknowledge that it has utility today. It may fail spectacularly tomorrow or it may rise tenfold over the next few years. When you look at it that way, bitcoin can be viewed as a call option on a really fascinating, but unknown future.
Source: C-SPAN (Yellen testimony to House Financial Services Committee)
The SpringTide Investment Team
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