Monday 12 May 2014

Bitcoin, money, gold and my great unpublished novel

I have been asked by one of the readers of this blog to write about Bitcoin (So the first thing to note is that there is at least one other person reading this, it isn't just you). My first reaction was that I knew nothing about Bitcoin and anything I could say would just be meaningless biased drivel written to satisfy some agenda. Of course that would be no different from nearly any other Bitcoin based commentary. Or the rest of this blog.

Great lost novels of the past #1

My second reaction when I think of Bitcoin is to remember a novel I wrote about 15 years ago over two weeks. As you might expect from the fact it took two weeks to write it wasn't a very good novel. The loss of the only extant copy on a three and a half inch floppy was no great loss to the world. Certainly the disappearance of the floppy disk was a much greater loss to the world. At least to the world of double entendres since only people over 35 will laugh when I remind them that three and half inch floppies were actually stiff (unlike five and a quarter inch versions).

Storage media aside the most interesting part of the novel was the plot. Essentially in the future some bloke had created an alternative underground offshore currency. Another bloke was recruited by M15 to penetrate his organisation allegedly because it was helping to launder money. Actually the governments motive was to reduce tax evasion. Sound familiar?

So when thinking about Bitcoin I get a deep sense of regret that I didn't self publish the awful book at the time. Of course given the shocking writing it would have sold zero copies but subsequently I would have been recognised as a modern day prophet like William Gibson.

A question asked by an eight year old boy

I will now belatedly get to the point. To answer the question 'what is the difference between Bitcoin and money' we have first have to answer the question my son genuinely asked last week 'What is the difference between a cheque and money?'. To answer that question we need to know how what we call 'money' came about. The paper money and coins we use in modern societies are actually just cheques. A ten pound note is just a cheque for ten pounds, payable to bearer and drawn on the Bank of England. It also has a picture of the Queen and Charles Darwin on it which my cheques from failed socialist experiment the Co-op bank don't have. In a sense both are IOU's. One says the Bank of England owes the bearer a tenner. Originally that was ten pounds of gold, but that link has long since been broken. The Co-op cheque says that I owe the named payee ten quid.

The main difference between them is that I can use the ten pound note to buy just about anything. If I had a million ten pound notes I could easily buy a one bedroom flat in a wealthy part of London (unless house price inflation has rendered even that statement untrue by the time you read this). Though there might be some tiresome money laundering forms to fill in. On the other hand if I tried to buy that flat with a cheque for ten million quid there would be a short delay whilst someone ascertained whether that IOU was actually backed by a corresponding amount in my bank account (sadly it wouldn't be). One of the reasons for the picture of the Queen and all the security features is that the immediate acceptability of the humble tenner means that it is worth trying to forge.

Me and My Plumber

My bank account of course just contains electronic versions of the paper ten pound notes. So a cheque is an IOU which can be converted into a paper or electronic IOU. The important point here is we don't have to use money (a specific form of IOU), we could just use any IOU. Suppose my plumber and I agreed to do this. If we can come up with a cool name (carverCash?), agree on some prices (one poor science fiction novel – ten carverCashes. One toilet unblocked – five hundred carverCashes) then we have a currency. We could even set up an electronic exchange mechanism.

So we then have a fully fledged cryptocurrency. Which only two people will accept (and frankly I am not sure about my plumber going for it). This then is the Achilles heel of bitcoin. The other mechanics of bitcoin are not relevant. Its not quite unbreakable security, equivalent of the picture of the Queen and metal strip in the tenner, is not relevant. The cool sounding mining process is not relevant. If hardly anybody wants to use it then it is pointless.

If we think of the world of currencies as a product market then bitcoin is like the small record shop trying to compete against Amazon and Tesco. It might offer something unique and different like the ability to buy rare Pink Floyd white labels or to purchase drugs over the Internet with some anonymity. But most people don't need that so the most realistic best possible outcome is that the shop survives in a small niche; it is very unlikely to end up displacing the giants. The last time a currency 'broke into' the market and became a globally accepted means of exchange was when the US dollar became more important than the British pound about a hundred years ago, because the US displaced Britain as the leader in global trade. The Chinese currency may well overtake the dollar at some point if it becomes freely exchangeable, but that will be for the same reason - because nearly everything we buy is made in China. Bitcoin has no such advantage.

If not money, then what?

So having dismissed the chances of bitcoin becoming a globally accepted currency we are left with is it a possible investment. In my spare time I like to classify assets by their degree of being divorced from reality. If I go and buy a farm from someone that is pretty close to reality. When the farm is owned by a public company and I buy shares in that company we are getting slightly further away. Owning a call option on the companies shares is moving further away again, but underneath it all is the farm – a bad harvest will ultimately reduce the value of my option. Buying an interest rate future is entering a really whacky world since the underlying thing is not real but a price based on a survey of what people think the price should be (at least until the LIBOR market is properly reformed).

The price of anything is driven by supply and demand. Even with assets that are more real there is a good deal of 'animal spirits' in both elements so prices can be moved away from what might be called a fundamental value for quite some time. However in instruments linked more closely to real things there are limits to how crazy things can get. It may take time but speculative bubbles and anti bubbles in asset prices linked to real things always eventually pop at some price ceiling or floor.  This isn't true if you have an asset which doesn't have any connection to underlying reality.

So the value of bitcoins really has no floor or ceiling. If nobody wants them they will be worthless. If everyone wants them, given they will stop making them in the future, they will be priceless. That 'want' will be based purely on subjective perception rather than any underlying real factors. This does not mean they are a bad investment. Rather that one should not invest in them like you would invest in UK equities. Holding a constant long position in UK equities is a reasonable thing to do. For bitcoins it is probably not. We need to actively trade bitcoins.

Bitcoins equal not Money. Gold equal Money? -> Gold equal Bitcoins ?

A better asset to think about when trading bitcoins would be the asset that used to back all money – Gold. Why gold? Gold is not dissimilar to bitcoins in price behaviour. Underlying supply of gold is relatively short run inelastic, so speculative demand shocks will pull the price all over the place. It does have some industrial uses but its value is mostly determined by very subjective demand. If everyone stopped desiring gold tomorrow it would be pretty much worthless and similarly there is no potential ceiling on its future price. There is no income or rights to any underlying cashflow for either (although owning gold futures might earn a 'carry').

Gold does have however a much larger and stickier demand base, bitcoin jewellery being a pure substitute for the shiny yellow stuff. Also it has a long history of being a reasonable inflation hedge. So having a bit of static gold in your portfolio isn't a completely absurd idea.

Its worth noting that I mainly trade gold using trend following signals that are specifically designed to pick up changes in subjective sentiment, like those that drive other less real assets like bitcoins. Using a similar strategy for bitcoins might make sense. If we look at figure 1 we can see that there appear to be some decent trends. Note I have used a log scale so you can see the movements in the past more clearly.

 A simple moving average crossover indicates a short position in figure 2 might make currently sense.  This cursory look suggests going long bitcoins might not be the smartest move. In reality I would want to do much more analysis than this before even thinking about trading bitcoins.

Having done that I would be happy to trade bitcoin futures on a recognised exchange backed by a proper clearing house, if they were liquid enough. After all I trade gold futures. I even trade Eurodollar futures which are even more highly divorced from reality. That isn't possible now and a spot position in the actual asset makes me very nervous since the counterparty risk seems extremely high.

So the short answer is I wouldn't personally touch bitcoin with a bargepole. Not even if I needed to buy some to research my next novel.


  1. Interesting post,

    I am long Bitcoin and currently own about 6 or so. Let me give you my reasons, mostly because if I can convince a few more people then my speculation might pay off...:

    The most interesting part about Bitcoin is not the currency, it is the protocol. Much like TCP/IP revolutionised communication, Bitcoin the protocol could very well revolutionise financial transactions. The protocol is most importantly irrefutable proof of ownership without the need for a third trust party. Once I understood that bitcoin (with a small b) the currency was just the first app built on top of the protocol and that other apps that might latch onto the protocol could include smart contracts, securities, multi signer escrow transactions etc etc I couldn't stop thinking about it.

    So comparisons to the early web 1993/1994 are where most people think that the technology is now. Using this analogy, if you had a time machine and go back 20 years with a small pile of cash what would you buy for the greatest returns? Domain names would probably be the best investment you could make (unless you were very wealthy and had the cash to invest in a broad spectrum (ISP;s / backbone companies etc).

    Of course currently the Libertarian crazies love it at the moment but thats not going to last forever. The ETF's are on their way, the derivatives coming soon along with all the regulation for the exchanges.

    Not sure if you have read it but here is the original white paper that started it off:

    Marc Andreesen's thoughts on it (large investor in Coinbase)

    And here is a pretty interesting thought on where the price might head based on a few fundamental ideas, which is why I actually own some. An analysis based on smartphone adoption rates (or other disruptive technologies) which I think might have some merit:

  2. Thought that I would add this as I have just read it and the author says a few things much better than I could in my previous comment:

  3. First of all thanks for posting. And please keep doing so no matter how rude I am in return.

    I agree the protocol is very interesting and a neat idea. But I am not sure the analogy with early internet means you should be buying bitcoins. At the time comparisions were made with the gold rush - people who sold shovels made more money than gold miners did. But surely you should be buying companies with cool peer to peer security software rather than actual bitcoins?

    By the way as an ex professional statistician of sorts to be honest this kind of stuff makes me squirm

    As well as confusing a casual fit with causation he seems to be applying a model for market share and using it for price.

    What smartphones have, and what I am not yet convinced bitcoin has, is that they are a technology that isn't just disruptive but is actually better than what went before. Peer to peer PGP means we can do financial transactions over the internet and be completely secure. Given that they already exists the demand for another currency doesn't seem to be there to me. Interestingly in my novel I was talking about an offshore currency whose value was linked to a real one; kind of like the Hong Kong or Eurodollar markets.

    This is more interesting, but still doesn't justify owning these weird things.

  4. No problem I have thick skin and a desire to listen and debate with those who might have alternative views than my own.

    Selling shovels to gold miners seems like an apt comparison for the actual "mining" side of Bitcoin. I am fairly sure that there are lots of people going to lose their shirt on that one unless they live somewhere they get free power (Iceland maybe?). Buying bit coin itself I view a little differently: in the sense that I believe that the technologies that can be built on top of the block chain are coming down the road, I feel that I am buying into part of what is essentially a large decentralised corporation. I own a part of the internet backbone if you like; the slots that all of that technology uses. However, lets be honest, thats not the real reason I own it....

    Take the currency view for a moment (gold, fiat, whatever you want to think of it as), and its potential as a revolutionary payment method. I do believe its better than what went before. Here is why:

    The fee's for transferring bit coin are either none existent or so small as to not really matter. What does Western Union charge? 7-10%ish. The remittance companies could be in serious trouble. I always think of Indians in the Middle East but Hispanics in the US or whatever.

    Lets consider the use for online payments instead of credit cards. Typically an online retailer has small margins (lets say 5% in this case). Visa charges those companies 2-3% or so. Accepting bit coin has a huge affect if you consider that the online retailer holds onto its bit coin. Obviously right now that isn't going to happen and companies exist (coin base / bit pay) to take on the exchange risk. Now these guys currently charge a 1% fee but its still a whopping great increase on the bottom line and you can see a race to the bottom in the fees happening assuming bit coin takes off.

    Ah, you say. Visa / Mastercard fees are all basically eaten up to prevent fraud. From the merchant side they are happy as there can't be any chargebacks etc etc. From the customer side every time you give you CC details to someone online you are essentially giving them the key to your safe. They "pull" the payment from your account. With bit coin you "push" the payment from your account to theirs. They never see the private key to your safe and neither does anyone else.

    Micropayments is also an interesting one. They are realistically possible now with this technology due to those low fees. Imagine if you could charge every person 1p for viewing an article on you blog, or 5p for getting a recipe off a cooking site. It could all be built into the browser.

    So if bit coin were to even take a small portion (lets say 10%) of those 2 markets then surely you want to hold some bit coin?

    RE the model. I'm taking the price predictions with a pinch of salt. The part that does interest me is the technology adoption curve. When was the last truly revolutionary technology in consumer finance? CC's are nearly 50 years old. Paypal? Still the same old trust party system just moved online with a slightly more convenient use case. SWIFT? Arrrgh. I'm just sending 200 quid to a mate overseas who is organising the ski trip next year. 7 days later and I've missed the deadline for paying and it still hasn't arrived.....(I do understand the complexities behind that, its just frustrating that payment solutions is such a laggard industry). It might not be bit coin itself, but some version of the technology will win out. Bitcoin has first mover and a clear network advantage too.

    So thats why I own a few.

  5. I think our main point of disagreement is that all your points would be in favour of owning bitcoin plc (if such a thing existed) rather than bitcoins per se. By the way this kind of argument "So if bit coin were to even take a small portion (lets say 10%) of those 2 markets then surely you want to hold some bit coin?" reminds me awfully of language used in the internet boom. Its true that some internet companies do now have 10% or even 90% market share but investing in a basket of them back in 1999 would not have been profitable. Picking the winners isn't easy and as Warren Buffet says disruptive technologies like railways and airlines don't have a great record of making shareholders wealthy even if they are great for society overall.

    Its an interesting dichotomy that bitcoin's strength is probably as a virtual payments system but the volatility of the asset makes it very unsuitable for that purpose at least at the moment.

    To reiterate I think a payment currency linked to an existing currency or something like micropayment / paypal has the best chance of success in this market.

    1. Sorry for taking a while to respond but the day job gets in the way and for some reason I can waste hours on subjects like this so I have to moderate myself!

      Rob, I wonder if you are suffering from Douglas Adams rules on this sort of subject?

      Seriously though, there is an argument that I am a shareholder in Bitcoin PLC, in the sense that bit coin (my browser keeps autucorrecting that and I am giving up on it) is the worlds first "digital autonomous corporation". Its a stretch but lets see.

      At the end of the day I am sure that the bet I am making is a binary one. Bitcoin will either be worth a lot more or nothing in a few years time.

  6. I love the Douglas Adam's rule. Bitcoin just missed the 35 age cutoff!

    For a scary take on what DAC may be like, and an insight into my ex-professional life, read 'The Fear Factor' by Robert Harris.

    1. Hi Rob, I was reading your books and now going true your posts. Do you still have the same opinion about the BTC?

    2. Yes. I would never own spot BTC. I do now trade the futures however; long and short as appropriate.

  7. Wow, this article provides such a fascinating perspective on Bitcoin and its comparison to traditional forms of money and gold! I never thought about it in terms of trust and decentralization. Do you think Bitcoin has the potential to become a mainstream form of currency in the future?
    I'm looking forward to reading more of your blogs, especially ones about Best Financial Transitions.


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