Winklevoss Bitcoin Trust: Dumb Investment of the Week

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Winklevoss Bitcoin Trust: Dumb Investment of the Week

Winklevoss Bitcoin Trust: Dumb Investment of the Week by Ben Strubel of Strubel Investment Management

5/12/14

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While we have never been a fan of so-called digital crypto currencies, they have mostly remained outside the realm of traditional investments. That may change very soon. The Winklevoss twins, through the Winklevoss Bitcoin Trust, appear to be getting close to listing a bitcoin ETF on NASDAQ. This would make “investing” in bitcoins accessible to just about every investor.

I certainly don’t begrudge the Winklevoss twins for cashing in on the bitcoin craze. My problem is with bitcoins themselves. The bitcoin will be a failure as a currency due to several inherent flaws that make it unsuitable for use in commercial transactions over the long run. For that reason, the Winklevoss Bitcoin Trust and by extension bitcoins are our Dumb Investment of the Week.

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Understanding Modern Money

To understand the flaws in bitcoin, we first need to understand why something would be used as a currency and what gives currency its value. Let’s use the US dollar as an example.

The most important aspect of the US dollar that gives it value is that you are required to satisfy your tax obligations to the US government using dollars. This fact virtually guarantees dollars will always be in demand, as most citizens and businesses operating in the US will need dollars at some point.

A currency also needs to be easy to acquire to make it useful. Dollars are widely available, and the US government keeps adding dollars to the economy via deficit spending. Deficit spending usually carries with it a negative connotation, but that is not the case. The issuance of a currency also needs to keep up with a growing economy. As the population grows and productivity increases (hence more assets are created), ever more dollars need to be placed in circulation.

The value of a currency also needs to be stable. It is very difficult to conduct business when the value of the means of payment is fluctuating. For instance, suppose XYZ Company wants to upgrade its manufacturing equipment. The lead time to get the new equipment is one year. If the value of a currency is stable, then the equipment manufacturer can easily give XYZ Co. a quote and expect it to sign a contract.

Suppose the cost of the equipment will be $10M. In a low inflation environment like we have, the cost for the equipment a year from now might still be $10M. If inflation reaches the Fed target rate of, say, 2%, then perhaps the company would charge $10.2M. Even high inflation, provided it is steady, isn’t a problem as it can be planned around. Say inflation was a steady 10%. The company can just charge $11M. While high inflation makes people uncomfortable, it doesn’t hinder commerce so long as the rate of change is steady and predictable. If the price of goods and services rises by 10% as long as your salary rises by 10% as well, then there are no ill effects. Wild swings in the value of a currency or unpredictable inflation that causes problems. High inflation rates that are steady, while uncomfortable, can be planned around.

Seeing Bitcoin Deficiencies

Bitcoins have almost none of these properties. Bitcoins, like gold or silver, have no intrinsic value as a currency. There is no entity that requires a large group of people to pay bitcoins each year or face jail time.

In fact, the bitcoin is worse than precious metals as a store of value. While some precious metals, such as gold, can derive some value from industrial applications or for jewelry (particularly in India for cultural reasons) bitcoin has no alternative uses. If the “store of value” premium assigned to gold by gold bugs vanishes one day, then gold will still have some value due to its ancillary uses. Not so with bitcoin.

The chart below shows how volatile bitcoin values are.

(Chart from coindesk.com)

In fact, bitcoin is so volatile no one is even sure what one bitcoin is worth. The price of one bitcoin varies depending on which exchange you use.

Below is a one-hour price fluctuation chart from Friday May 9th. The value of a bitcoin ranges from $440 on BTC-e up to $152 on bitstamp. Also, the price of bitcoin fluctuated greatly in just the span of an hour.

Bitcoin

(Chart from coindesk.com)

It’s absolutely ludicrous to think that something with a value as unknown and as unstable as bitcoin has any value as a currency.

The other issue that makes bitcoin unsuitable as a currency is that only a finite amount of bitcoins will be available. Currently, approximately 11M bitcoins exist and around another 10M coins are able to be “mined,” bringing the maximum possible number of bitcoins in circulation to 21M. This finite supply means bitcoin has an enormous deflationary bias built in to the currency.

The limited amount of bitcoins available means that as global population and productivity increases, the supply of bitcoins will not be able to keep pace. For example, suppose the world consists of 100 bitcoins and 10 units of assets. In that scenario 10 bitcoins equal one asset. As productivity improves and population increases, the world will contain more assets but the bitcoin supply will stay constant.

Now imagine we have 20 assets and the same 100 bitcoins. Ten bitcoins now equals two assets. At first glance, this seems to be a positive. Bitcoins will stay scarce and become more valuable, right? Not necessarily. As deflation sets in and bitcoins become more valuable, there is more incentive to hoard bitcoins rather than use them in commerce. As commercial bitcoin transactions dry up, the value of bitcoin as currency will decline precipitously. If bitcoins don’t have value as a currency, then what are you left with? Just illusory data on a computer somewhere.

Bitcoins are a digital Ponzi scheme, not a digital crypto-currency. Investors would be wise to steer clear of bitcoins and any other digital currencies.

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Ben Strubel earned a Master’s in Business Administration in Investment Management from Drexel University’s LeBow College of Business in Philadelphia, PA. He was inducted into the Beta Gamma Sigma honor society, the highest academic honor society for master’s degree students. While at Drexel, Mr. Strubel founded the LeBow Graduate Investment Management Club and the DragonFund Large-Cap Fund, which was responsible for investing $250,000 of Drexel University’s endowment. He also holds a Graduate Certificate in Financial Planning from Florida State University. He earned a B.S. in Information Technology from Rochester Institute of Technology in Rochester, NY. He teaches classes on finance and investing at Harrisburg Area Community College and for Manheim Township. Mr. Strubel also writes for several investing websites including Valuewalk.com and SeekingAlpha.com. He resides in Lancaster, PA.
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23 COMMENTS

  1. “As deflation sets in and bitcoins become more valuable, there is more incentive to hoard bitcoins rather than use them in commerce.”

    Individuals do not need a depreciating currency as motivation to spend. Infinite want and desire will always provide for investing and spending. The need for basic necessities, such as food, clothing, and shelter, will also provide for currency circulation within an economic system. An appreciating currency does not offset these basic necessities and other contractual obligations.

    There is a difference between hoarding and investing. Hoarding is the process whereby an item is saved without productive use (currency sitting in one’s garage). Investing is the process of saving with productive use (currency being loaned to a business). Should Bitcoin win the currency war, bitcoin entrepreneurs have more to gain by investing, as the entrepreneur may collect interest on the investment, as opposed to hoarding.

  2. Bitcoin may well be the base of a Bitcoin standard based economy, i.e. Bitcoin may well be the reference all other assets are pegged to. In a way it would resemble the gold standard, before the IMF, the World Bank and fiat currencies kicked in.

    The IP protocol brought the concept of package routing and the TCP protocol brought the concept of reliability to communications. Similarly, Bitcoin brings the concept of scarcity to the internet, a necessary principle to provision the transfer and management of value. True and verifiable scarcity, not the one provided by the whims of central bankers and politicians.

  3. BTC definitely has some uses, I just have a hard time seeing it replace hard currency completely. It certainly is cheaper for certain types of transactions, but I view it more as an open source competitor for Visa, PayPal, or Western Union rather than a real alternative to government-backed bills.

  4. This has to be the dumbest article of the week!

    Take another look at the bitcoin price chart in this article and try to tell me that Bitstamp coins are $152 while BTC-e coins are $440.

    I won’t even go into anymore details as to why the article is Bogus. I would expect anyone who writes anything about finance to proofread before publishing.

  5. I don’t see expect our economy to contract in the long run, because our expanding knowledge and sharing of labour will keep our economy (and our wealth) growing. That’s why I don’t see bitcoin replacing fiat currencies, since its money supply is fixed. A economy that changes in size needs a money supply that changes with it. It’s one thing to have falling prices, we can deal with that. But falling wages? That’s much harder to maintain. I see a good use for Bitcoin as a payment transaction system, for (especially small) online payments, as a medium of currency exchange (e.g. accepting bitcoin in populair tourist areas), or even as a global reserve currency. But running large economies on bitcoin, I think that’s a bridge too far.

  6. True, I think in terms of Euros. But that’s also the case for US Dollars or Malaysian Ringgit. And that’s because I’m paid in Euros, and much of my expenses are priced in Euros. It doesn’t mean that bitcoin (or Dollars or Ringgit for that matter) are not real money. For me, it matters if something is cheaper in Euros. Not in Dollars, Ringgit or bitcoin. So yes, if I use Bitcoin, I buy the bitcoin I need when I need it (opposed to waiting 6 months). In that sense Bitcoin is a payment transaction system, and a darned good one, too. But apart from that I use Bitcoin as a store of value, too. You’re right that it lost 50% of its value the past half year. This initial period of expansion is a bumpy ride with many ups and downs. Future will tell if my store of value will perform like it did the past five years.

  7. My point is that, internally you are still thinking in terms of Euros, cementing the point that BTC has no real value, except in terms of how it is measured against other currencies that actually are a stable store of value. When you say that buying in BTC is cheaper, you mean that it is cheaper in EUROS. Nobody cares about BTC except in terms of what it is worth in terms of some other currency.

    It has no sense of value, except when compared with real money. It’s only a speculative proxy for real money that lowers transaction costs for some types of transactions at the cost of convenience and security vs traditional banking. You save 3%, but BTC has lost over 50% of it’s value in 6 months, so how much money do you actually save? The answer is to store everything in a stable currency and convert to BTC only as needed for individual transactions, but then BTC is really not much of a currency at all and more like a transfer service.

  8. No, it’s deflation. The longer you wait, the cheaper a smartphone becomes. (Or a computer, or a flat screen TV, or microwave, or a washing machine)

  9. Central banks can still exert some influence if they accumulate bitcoin and get involved in mining. They can’t create extra bitcoins, but they can inject some of their bitcoin holdings into the economy to provide a stimulus as needed, or buy bitcoin with other assets. Another way for governments to get bitcoins is of course taxation, and you can do a lot with that, so I think there would be enough options available to have a flexible monetary policy without the ability to inflate the money supply.

    Also, central banks can only control their own fiat currency, so all their power is worthless for international trade if other countries quit trusting their currency. But everyone would still trust bitcoin, which can be a distinct advantage in many plausible scenarios. No country is self-sufficient, so it seems to me a truly global currency would be a good thing. What if the dollar loses its purchasing power for some reason? Wouldn’t it be better to have a global currency that everyone would trust no matter what the central banks do? Countries do occasionally mess up their currencies by printing too much or whatever to the point that nobody wants it, and then they would have been better off using bitcoin. You are assuming more stability than I think is warranted, and this includes your dismissal of peak oil. The next financial crisis might well be too big for the Fed, and this is where Bitcoin can shine.

  10. Bitcoin has value as a currency. I can order in food cheaper with it (I get a half a euro discount when paying with bitcoin), or plane tickets (3% off), or send money abroad faster and cheaper (saves me about 3% sending money from the Netherlands to Malaysia). That’s value to me. But I am still one of the few to use it like that, probably. It’s only a matter of time until more people will discover it. If you can do all these things with tulips, you’re the man (or woman).

    With the price of bitcoin I meant the XBT-USD exchange rate. And for me, also USD has a price, btw. I guess I’m not so precise as you are in your diction.

  11. Bitcoins are tulip forwards. They have practically zero value as a true currency, and very few people truly use them as such.

    Even your post belays the lie about BTC. You talk about the “Price” of Bitcoin. Nobody talks about the “price” of $’s or Euros. You simply measure them in the value of goods and services they can buy. Nobody does this with BTC, they are just a speculative bet that has some novelty property as a way to buy things. Because they are so volatile, it’s not even really possible to do this, because the prices have to change on things daily.

  12. There are people, called economists, that do this type of analysis using numbers as opposed to beliefs.

    IF the economy goes into prolonged contraction, then yes, we will need to contract the money supply. But the Fed already can do this (and does) to control inflation. Large economic jumps are generally cause by unforeseen technological advances. Your prediction of contraction is generally driven by what you can foresee.

    However, I would suggest that peak oil is more likely to realign the relative values of things in the economy and push economic activity into other areas, but as long as the population grows, there will still be economic (GDP) growth in general (probably) over the long term.

    Deflation is basically never good except for people that have a lot more cash than they can effectively use in day-to-day life. Even in contracting economies, like Japan, they want to have a small amount of inflation.

    The bottom line is that bitcoin removes options. The central bank can introduce inflation, cause deflation, or keep things relatively steady depending on what would benefit the economy. They may not do a good job at it always, but they do a better job of it than Bitcoin would, because bitcoin cannot do this at all, by design.

  13. It seems like you have many facts wrong here and have barely proof-read your own material. You seem to have “mistakenly” (on purpose) got your price range wrong for a start. Where does it show $152 on that chart???

  14. “As deflation sets in and bitcoins become more valuable, there is more
    incentive to hoard bitcoins rather than use them in commerce.” — That’s the current situation. But…
    “As commercial bitcoin transactions dry up, the value of bitcoin as currency will decline precipitously.” — This isn’t happening. Many people owning bitcoin are eager to use them. That the value was declining after the last bubble is natural, just as it did after the previous bubbles the past couple of years.

    Note, the price is still more than the peak of the previous bubble ($266 in April 2013). As long as it stays that way, no bitcoin owner will worry. As long as bitcoin has existed (over 5 years now), never would you have lost when holding bitcoin for a year or more.

    “Bitcoins are a digital Ponzi scheme, not a digital crypto-currency.” — You obviously have no idea about Ponzi schemes or digital crypto currencies. Google it.

  15. I assume the author has never purchased a computer or a smartphone because he knows that if he waits he will be able to get more for his money… #deflation

  16. Deficit spending is all good when there is economic growth. It makes sense to inflate the money supply then. But what if the economy is contracting? Wouldn’t a deflationary currency such as Bitcoin make more sense then? I believe that due to the reality of peak oil and similar diminishing returns on the entire basis of economic growth, the economy can do only one of two things from here: contract or collapse. The dollar is locked into growth and won’t let us survive any other way, but with Bitcoin we could degrow the economy without collapsing. I think it would be a good idea to quit living on debt which can never be repaid because it assumes future growth that can never materialize, and it would be very hard to lend out too much Bitcoin. This is a good thing, because it promotes responsibility. I also think there would be much less volatility if Bitcoin gets widely used. It’s not like fiat money is completely predictable either. Financial crises tend to take everyone by surprise, including the Fed.

    Bitcoin is a better, more resilient and stable operating system for our economy, and we should do everything we can to embrace it, in my opinion. If we do, then we can survive shocks to the present centralized system that would otherwise do us in. I am talking about preserving the operational fabric of our civilization, because the current toolbox won’t work in a contracting economy.

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