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Q&A: What is your assessment of Bitcoin?

Question

What is your assessment of Bitcoin?

Are you familiar with Bitcoin? Would you categorize it as a "commodity"? Seems immune to inflation--agree or disagree? Good investment? Way to diversify?

Answer

Bitcoin is a "digital currency" that was launched in 2008. It is essentially an entirely digital system of transferable units based on cryptography algorithms that controls the expansion and tracking of the units. Bitcoin attempts to create an orderly system in which the "Bitcoins" can represent value and serve as a means for transacting business between two parties. Bitcoin has gained considerable traction worldwide. It has become an acceptable form of payment for a growing number of goods and services and is now convertible into many major currencies through a handful of merchants.

I would not categorize Bitcoin as a commodity, but rather as a virtual currency (a "legal construct" according to our collateral categorization schema). What is fascinating about Bitcoin is that the chief criticisms of its role and use as a potential currency are every bit as applicable to traditional fiat currencies such as the US Dollar, Yen, or Euro. At the end of the day, there is essentially only one major difference between Bitcoin and other world fiat currencies: control. But first, I will cover the major similarities...

Similarities:

Bitcoin is functionally similar to a currency in the sense that banks use the same type of cryptography algorithms to secure digital transactions conducted in major currencies, such as the US Dollar.

Bitcoin transactions are similar to PayPal in concept--just another way to digitally transfer currency from one person to another.


Bitcoins have no inherent value in the same way that a US Dollar (or any other fiat currency) is just a piece of paper with a number, or a digital unit represented in a bank account, to which we assign value. Bitcoins are simply digital units, to which value is assigned between two parties to conduct transactions.


Currently, Bitcoin's unit value is based on its growing societal acceptance as a store of value, which I believe is currently rooted in its ultimate convertibility into major traditional currencies. Should it ever lose this convertibility, I believe its value would plummet immediately. Ironically, this is no different than any other fiat currency. All fiat currencies have their value ultimately in their acceptance by society as a means of trade and transaction settlement. If they lose that status, then they are nothing more than fancy firestarter or colorful wallpaper.

The Principal Difference

Major world currencies are controlled ultimately by central banks. For example, the Federal Reserve controls the creation and dissemination of credit, which ultimately affects the supply of US Dollars. The same is the case for the European Central Bank and the Euro and the Central Bank of Japan and the Yen (and essentially every other country in the world). In coordination with each country's treasury, the control of the currency regulates (or causes, rather) inflation, affects the slowing or increasing of economic activity tied to borrowing, aids in taxing enforcement, promotes or stifles fiscal and budgetary expansion or contraction, etc. Ultimately, creation and control of the currency serves first those who create and control the currency.

Bitcoin, on the other hand, is not controlled by any central authority. Instead, it is controlled by a peer-to-peer (decentralized) series of cryptographic algorithms that track and record transactions and control Bitcoin supply.

Bitcoin mirrors a currency somewhat in the steady inflation of its supply over time to promote expanded trade using it as a means of transferring buying power. However, though Central Banks can indefinitely print more money, Bitcoin has a limit of approximately 21 Million BTCs that will be fully deployed by 2040. The pace of this deployment of new BTCs is also set by the algorithms that provide the basis for Bitcoin. Therefore, Bitcoin's inflation rate is rule-based, defined, and ultimately limited, whereas Central Banking authority and printing power is arbitrary, undefined, and ultimately unlimited.

The Emperor Has No Clothes

Before 1971, I could point out that Bitcoin falls short of a currency in that a true currency is ultimately a demand note backed by a government which is in turn tied to a certain level of gold or silver or some other scarce precious resource. However, Nixon removed the gold peg to the US Dollar in 1971 and most world currencies began to "float" free of any tie to value other than their relative value against other currencies.

So now a fiat currency remains a demand note against a government--but as is the case with most of the world right now, the governments that "back" the currencies are massively in debt and spending like there is no tomorrow. Moreover, these same governments have enabled this spending spree through outright printing of the currency (credit creation) through the Central Banks. This increases the supply and thus eventually decreases the value of the underlying currencies. Therefore, "true currencies" are no longer tied to any store of value or scare resource, and are subject to arbitrary Central Bank devaluation, which facilitates spending binges and fiscal instability of the same governments that supposedly "back" the currencies. It is only insofar as we, the people,trust or have faith in these pieces of paper or digital units in our bank accounts we call currencies that we are able to conduct business, buy goods and services, and settle accounts.

Wait! So how exactly is this different than Bitcoin? Oh, right... major governments stand behind "real" currencies...

Bottom Line:

I think the existence and proliferation of Bitcoin is an incredible development that exposes the reality behind all fiat currencies. The questions that Bitcoin naturally raises are equally valid questions for all fiat currencies--though the latter tend to receive much less scrutiny (How can you trust its value? What if someone is able to falsely increase the supply of Bitcoins? How stable is its pricing or buying power?).

All of that being said, would I consider Bitcoin to be a good investment? Probably not. That is not to say that I have any crystal ball and know that it will not go up in price. But there are several issues I have with Bitcoins that cause me to put it into the "means of transaction" rather than "good investment" bucket.

ISSUE # 1: Valuation. This next chart reveals the valuation of Bitcoin in US Dollars from inception to date.

I tend to like to buy low and sell high. Not so sure you can do that with Bitcoin at these lofty levels. Again, I could be overly conservative, and perhaps, given the pace credit creation for fiat currencies (read: "printing money") coming out of the Central Banks of the world, Bitcoin may continue to go even higher. However, this chart tells me that I may have missed the boat on getting a value-oriented acquisition in the near term and that I am more likely to have "bought high" given Bitcoin's historical prices.

ISSUE # 2: Inflation. You asked if Bitcoin is immune to inflation. While it might be immune to infinite inflation of a Central Bank (theoretically), it is not immune to outright inflation. Bitcoin's creators deliberately designed the supply to inflate steadily, from a small number of BTCs, to as many as 21 million by 2040. So you definitely have a level of inflation with Bitcoin, although it is designed to be steady in progress and finite in scope. Furthermore it might be that other currencies, including the US Dollar, will inflate faster over the same period.

As of today, there are approximately 11 Million Bitcoins in circulation. As of 2040, there will be approximately 21 Million Bitcoins in circulation. All other things being equal, that means a Bitcoin could be worth approximately half of its value today. Of course, this largely depends on Bitcoin's acceptance and use worldwide as well as the value of the other currencies that provide a proxy for Bitcoin's relative value.

This type of supply expansion is actually a positive development for Bitcoin's transactional use, providing enough Bitcoins to ensure ease of access for a larger population to put Bitcoin to use. But when it comes to investing, owning something for which you are certain will essentially double in supply adds a level of risk and speculation that depends on increasing demand to keep up with supply.

Scarcity, exclusivity, "having the corner on the market," being irreplaceable, etc. are virtues of investments one looks for to take some of the speculation for demand growth out of the equation. A fixed supply and an established demand can ensure price stability or growth if and as demand grows. Growing supply not only means that you must have growing demand to keep the price stable, but you also must have demand eventually outgrowing supply to provide appreciation.

This is why we at JRW tend to like to acquire real estate and other tangible assets as investments. It is much harder to move or duplicate a corner property on a busy intersection than it is to expand the supply of Bitcoin, or any other fiat currency for that matter.

Issue # 3:Hacking and Manipulation. Bitcoin has been hacked and manipulated multiple times in the past and could be hacked or manipulated again, disrupting the supply, pricing, usability, and ultimately the trust that underpins the value of Bitcoins.

This hacking and manipulation could affect you in two ways. First of all, if you are unlikely enough to be directly hacked, you could lose your Bitcoins and thus your principal outright. Bitcoins are non-refundable--there is no company that guarantees your Bitcoin supply from fraud or loss. You are dependent on third-party technology and the operators that stand behind them to be dependable and honest. Thus, you are taking on a level of counterparty risk that is not present with traditional currencies.

Second, if hacking and manipulation become a common enough occurrence, this could erode trust in Bitcoin, which is ultimately the only reason it has any value at all. If trust is eroded, demand could go down, which could decrease the value of Bitcoin substantially, thus causing you to lose value in another way.

Issue # 4: Government Competition. Governments are not big fans of direct competition when it comes to currency. Bitcoin provides not only potential competition, but it also provides a way for individuals to more conveniently dodge taxes since there is a potential of keeping transactions somewhat anonymous and since there is no central authority that tracks or controls the transfer of Bitcoins. This does not tend to sit very well with major world governments who have a track record for controlling the supply of currency for their own devices and who have a central system (Federal Reserve FedWire System) through which most domestic online transfers of money flow.

"Give me control of a nation's money and I care not who makes it's laws" -- Mayer Amschel Bauer Rothschild.

"He who controls the money supply of a nation controls the nation" -- James Garfield (20th U.S. President).

If Bitcoins indeed gain enough popularity to become a widely used system for transactions and settling payments, it could become illegal, taxed, or penalized in a way that would undermine its use and favor. Or if it is considered enough of a national threat as a separate currency, it could come under more subversive hacking techniques from various government defense agencies to undermine its use and the trust of its participants.

Sound far-fetched? Remember E-Gold? That was a much less popular system for transferring currency units that were supposed to be backed by gold as settlement for transactions and payment. The US Government shut it down since it did not limit its transactions to US Dollars or get licensed to do so.

E-gold was tried with violation of 18 USC 1960 in UNITED STATES OF AMERICA v. E-GOLD, LTD, District of Columbia court. The court found against E-gold, ruling that "a business can clearly engage in money transmitting without limiting its transactions to cash or currency and would commit a crime if it did so without being licensed."

How is Bitcoin different from E-Gold? In the primary sense, it is not different in that Bitcoin can be used for just about any transaction or transfer of value. Bitcoins foster an underground market since value transfers can be made somewhat anonymously and instantaneously from and to any point on the planet that provides an internet connection and without the ease of enforcing taxes. One big difference is that there are no central creators or controllers of the Bitcoin platform, reducing the government's ability to shut down Bitcoin from a single/centralized exchange or source.

Conclusion

Though gold is tangible rather than virtual, it is really no different than Bitcoins in that it only has value because the human race, almost universally, assigns value to the shiny metal. Its principal use is not productive--but we want it and are willing to pay a lot for it--thus giving the metal a value and price denominated in major currencies.

I love the concept of Bitcoin as a commentary on fiat currencies and as a revelation about how human beings assign and transfer value. Owning a Bitcoin is nothing more than owning a virtual unit in a digital system that did not even exist six years ago. That BTC is worth $140 right now. The entire system of BTCs is worth over $1 Billion now. That is truly fascinating and just goes to show how powerful human demand and assignment of value can be.

Nevertheless, I would not recommend Bitcoin as an investment. While it may become (and I hope it does) an effective and established system of settling transactions and payments, I would not speculate on its appreciation due to all of the potential risks I have listed above. At JRW, we target investments that provide the hedge against inflation that you are looking for, but that may not include many of the particular risks that apply to Bitcoins.


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Bitcoin, BTC, central bank, currencies, E-Gold, Federal Reserve, fiat currencies, gold, inflation

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