Value Investing

Bitcoin Delusions, Blockchain Realities

We find no shortage of substantive financial discussions to be had as 2017 concludes: U.S. tax reform, the yield curve, Fed policy, corporate leverage, international valuations; they all come to mind and the list could go on. Nevertheless, the small talk of holiday parties, gym workouts, or grocery store checkout lines are dominated by—clearly—the hottest financial topic on earth: bitcoin. We had procrastinated on this topic (mostly hoping it would implode before we had to weigh in), but within the past week alone, we have been approached by a registered nurse, a fitness trainer, and the owner of a tree removal company all with one burning question on their minds: what do you think about bitcoin?

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money 2020 bitcoin bubble

Our short answer has been consistent, bitcoin is a cryptocurrency whose price has been inflated into a speculative bubble. Really though, who could blame their curiosity? Bitcoin’s gains are mesmerizing. Consider that a bitcoin in 2010 could be bought for $0.06, and today a bitcoin trades for $17,702.47, which means that if you bought $100 worth of bitcoins at the 2010 price of $0.06, you would be sitting on over $2.9 million. Now, you may be kicking yourself for not buying bitcoin back in 2010, but not as much as a man named Laszlo Hanyecz. As it turns out Mr. Hanyecz was a computer developer with an early interest in bitcoin, who, in 2010 bought two pizzas from Domino’s for a price of 10,000 bitcoins. Incidentally, at today’s bitcoin price he paid approximately $177 million for those two pizzas. Although the numbers are mind boggling, please resist the itch to join the fray, as recent anecdotal evidence suggests the bubble is ageing. Within the past week media reports have surfaced that bitcoin speculators are now using credit card borrowings and mortgage borrowings to fund purchases in the cryptocurrency. Once speculators are openly using leverage, it marks the beginning of the end, in our opinion. We have seen this movie before, and we hate to spoil it, but everyone in it gets killed in the end. Bubbles always end badly. However, with the opening of futures markets on bitcoin by the CBOE within the past week, bitcoin trading may find additional life as futures contracts by design use leverage through customary margin-based purchases. It is also possible that a Bitcoin ETF market could follow the introduction of futures in this cryptocurrency, as a futures market could potentially create enough liquidity in the asset to appease regulators. On the other hand, the futures market also enables speculators to bet against bitcoin through short-sale positions (if they dare) which may challenge bulls over time. Regardless of their side on the bitcoin trade (long or short) a speculator in bitcoin needs to be comfortable with the scenario of losing nearly the entire value of their holding. Still, these speculators—like all before—will struggle pulling themselves away from the intoxicating rush of dopamine releasing into their bodies with every upward move of 20% or more in bitcoin prices. By the time they realize they are bidding up a virtual can of sardines, it will be too late.

Now wait, bitcoin (and others) is a form of currency right, have we been too harsh? For the time being, no. The litmus test for a currency is that it provides two qualities, the first as a medium of exchange, and the second as a store of value. As a medium of exchange, bitcoin has a barely discernible presence in the global payment system. For example, bitcoin is only accepted by 3 (down from 5) of the top 500 online retailers as a form of payment. We believe part of the reason bitcoin is not more widely accepted is due to its remarkable price increase since inception: many retailers do not trust its value, and those who hold bitcoin prefer to continue holding it since they believe the price will continue rising. As a store of value, the problem again lies in the enormous price volatility. It is difficult to consider an asset as a store of value when its price fluctuates up to 20% per day. Looking beyond the price mania, which will eventually run its course, it is possible that bitcoin could gain traction as a substitute for gold. We believe that this is the main (perhaps only) intellectually grounded argument for bitcoin. Gold bugs appreciate that the supply of bitcoins increases methodically and slowly (at a fixed rate), which contrasts fiat currencies such as the dollar, euro and yen where central bankers can increase the money supply by a show of hands. If the financial markets took the viewpoint that bitcoin and other cryptocurrencies are gold substitutes, then their prices could move much higher still. Regardless of that view it pays to remember that gold too is a speculative asset, but is supported in the economy by practical industrial uses also. Gold has for its own part seen price manias come and go. For anyone holding the gold-substitute perspective on bitcoin it would make better sense to purchase after the current mania subsides.

With that public service announcement out of the way, we acknowledge there is an aspect to the bitcoin phenomenon that is genuinely interesting from a long-term view. We believe that even after the price mania surrounding cryptocurrencies eventually implodes, certain technological elements underpinning bitcoin (et al) seem likely to stay and even proliferate into investment opportunities. Namely, we are referring to the blockchain technology that makes these cryptocurrencies such as bitcoin possible.

From our perspective, the blockchain can be most simply described as a highly secure, open, distributed ledger system. Following this logic, bitcoin and the remaining cryptocurrencies are natural manifestations of this technology. In the example of bitcoin, blockchain technology is being utilized to create a virtual currency that many of its advocates purport as a substitute for gold (in an investment context).

To see this, we will run through a very brief illustration of how the blockchain functions in the daily context of bitcoin. Bitcoin transactions from all over the world are reported in packaged blocks to a networked database that is being tracked by so-called bitcoin “miners.” The role of miners is to validate bitcoin transactions. To do this, miners take the block of transaction data presented and use it to solve a complex mathematical formula that once solved encrypts the block of data with the correct “hash.” A hash is an encrypted code containing a string of letters and numbers that will represent and identify the block of transactions. Once the hash is successfully solved and created, the winning bitcoin miner adds the block with its identifying hash to the public blockchain. Other miners watching this verify and collectively approve the new hash. This begs the question, why do miners participate? In short, there are financial incentives. First, each winning block mined receives 12.5 bitcoins by the current schedule (it is periodically halved based on a predetermined schedule), and second, miners receive the transaction fees collected for doing business in bitcoin. One important stipulation is that a winning miner will not receive their reward until a subsequent 99 blocks have been successfully added. This creates an incentive for the miners to stay sufficiently engaged to ensure the integrity—through the profit motive—of the system. Putting it all together, the blockchain contains a public ledger of all transactions that have occurred in bitcoin to date; the blockchain is a ledger system.

Some of the most important qualities of the blockchain as a ledger system relate to its speed, accuracy, and transparency (i.e., public availability). Building off our remarks on the mining process, it is important to note that the mathematical computations that solve for the correct hash also incorporate the preceding block’s hash. Therefore, if any aspect of a given block’s transaction data is altered—in any way—its corresponding hash will instantly alter in real-time, in kind. This means that not only will tampering be instantly visible in the given block, but that every hash that follows in the blockchain will be affected also. This in turn means that any act of fraud or tampering with the integrity of the transaction data will become instantly broadcast and spotted by the mining community. Finally, because blocks are solved in real time, it also means that the recording of transaction data is completed in a matter of minutes. The basic translation is that the blockchain is a ledger offering a material improvement over previous systems through its speed and accuracy. The implications of these basic improvements are understated and potentially profound.

We chose the word profound because the economic reliance upon ledgers in nearly all global commercial (including government) activities is as timeless as it is essential. Ledgers represent the essential economic tool that records our property; including money (banks), securities (brokerage firms), and real estate (governments). While providing these ledger-based services, banks, brokerage firms (i.e., Fidelity, Schwab, Merrill Lynch, etc.), and governments charge us material amounts of fees to do so. Most of the fees are collected to support the wide array of bureaucrats and the overhead they create that is needed to conduct these services. Lastly, despite their efforts, the dated paperwork process is not only expensive, but slow, prone to errors, and in the worst cases susceptible to fraud. Returning to the blockchain, it has the potential to eliminate a wide array of bureaucratic record-keeping activity across the banking industry, the brokerage industry, and the public sector. Some observers also believe that “smart contracts” being developed by Bitcoin rival Etherium have the potential to disrupt, if not replace, the role of attorneys in the drafting of commercial contracts. Eliminating expensive intermediaries and bureaucratic activity should lead to lowering the costs for a number of essential consumer and business-related services across the economy, thereby increasing the standard of living. To bring some perspective on the potential cost savings the consulting firm Accenture conducted a study on the cost structure from eight of the largest global investment banks and found that implementing blockchain technology at these firms could lead to potential cost savings of 70% in financial reporting, 50% in compliance, and 50% in business operations. That amounts to annual savings of $8-$12 billion among those firms alone. Perhaps most important the blockchain is formally moving into the mainstream as the Australian Stock Exchange has recently decided to implement blockchain technology in the clearing and settlement of its trades. We expect more to come.

Finally, we believe the blockchain has the more distant potential to protect property rights among the citizens of countries where corrupt institutions hold sway. An unbiased, nearly impenetrable ledger system available for public view could deter the unscrupulous seizure of property in nations where property rights are not always honored by public officials and other powerful actors. If so, the blockchain could provide a role in expanding free-enterprise and the fight against poverty.

In conclusion, we believe it is likely that any wealth created through bitcoin could prove ethereal, and that the greatest potential for wealth creation lies in the savviest future applications of its underlying blockchain technology over the years to come.

Lauren C. Templeton

Principal

Scott Phillips

Principal

Article by Templeton and Phillips Capital Management