Jun 01, 2018

Bitcoin and Cryptocurrency: Sound Investment, Bubble, or… Something Else?

Jun 01, 2018
Mark R. Gordon — JD, MPP, CFP®, CFA
Chief Investment Officer & Chief Compliance Officer
Bitcoin and other “cryptocurrencies” had quite a year in 2017. Once the province of techies, libertarians, and gray-market traffickers, Bitcoin exploded into the mainstream. Countless articles and news reports focused on Bitcoin and its potentially disruptive technology. Such media attention, along with an eye-popping 1400% price increase, made Bitcoin a topic of daily conversation. We’ve received a number of questions regarding Bitcoin, typically asking whether it’s a sound investment in the future or a speculative bubble.

Today we’ll explain (briefly) how Bitcoin and similar cryptocurrencies work; discuss whether we consider them to be an investment, bubble, or something else; and suggest some guidelines for clients considering buying Bitcoin.

Blockchain: The Backbone of Cryptocurrency
Cryptocurrency (or “crypto”) refers to digital currencies using encryption features for security and verification. Bitcoin is the largest and most famous. Most cryptocurrencies are built on technology called blockchain. Blockchain is a decentralized global system that continuously updates transaction records. Computers solve complex mathematical problems to put transactions in blocks, and the blocks are then chained together in a public record. People can hold cryptocurrencies in a virtual wallet, or a digital “identity” encrypted for anonymity that is trackable but unalterable. In short, blockchain represents a digital ledger where the transactions are public but the parties are private.

Blockchain allows people to exchange directly without third-party intermediaries, potentially lowering costs. Because transactions are transparent and stored in multiple locations, it appears nearly impossible to edit a transaction, as one must alter all previous blocks in the chain at virtually the same time. Despite the potential benefits, blockchain is still experiencing scalability problems. The tradeoff between transaction speed and security currently prevents the technology from having broader usage. If you’re interested in learning more about blockchain technology, we recommend reading "Beyond the Bitcoin Bubble” in the New York Times Magazine.

The Case for Buying Bitcoin and Crypto Today
Bitcoin and other crypto (but not all as we discuss below) carry the promise of replacing US dollars and other traditional currency as a means of trade. Bitcoin proponents claim that, eventually, people will conduct many or most transactions in crypto. Buy it today, the theory goes, because the technology and limited supply will lead to higher prices later.

Investment vs Speculation
But is that investing? We’d say no. In our view, “investors” commit their capital in one or more ventures, hoping to add value over time. Stocks and bonds are prototypical investments. Equity investors give their money to a company so it can conduct its business and, if successful, will reward investors with a share of the profits via a dividend or increased share value. With bonds, investors lend their money to a company or government in return for a promise to pay back the loan with interest.

In each case, we can estimate the expected return through a company’s marginal cost of capital or a bond’s current yield. We believe this is the crux of investment: a pledge of capital with an expected return and an associated risk if expectations aren’t met.

Bitcoin and crypto are very different. To our mind, it’s much closer to those who buy gold (or water or oil) today believing that, in the future, either limited supply or increased demand will drive up the price. There’s no adding value, no expected return. Just the speculation that, tomorrow, someone will pay more than you did today. Thus, we believe it’s fair to characterize Bitcoin as a speculative commodity. We don’t necessarily believe “speculative” to be a pejorative – prices may indeed rise – but note it’s not the same as investing.

What Problem Does Bitcoin Solve?
Today, when we complete a non-cash transaction, it typically involves one or more third parties, including banks, credit-card companies, escrow agents, and others (like PayPal or Venmo). Those third parties represent additional cost. They also have access to your personal information. With Bitcoin, one could theoretically complete transactions at a lower cost and with greater privacy.

On the other hand, those third parties can provide security if something goes wrong. In the case of mistake or fraud, many consumers value the ability to seek redress from a third party. In other words, financial companies provide value for the cost. It’s possible that, in the future, people will value cost and privacy much more than security. But it’s not clear that this is the case. To our mind, for many people the concept of Bitcoin and crypto is a bearish bet against world governments and global financial institutions.

Is Bitcoin a Currency?
Technically yes, in practice no (or not yet). Yes, because people do exchange Bitcoin and other crypto for goods and services. No, because relatively few merchants accept Bitcoin. More important, Bitcoin’s rise and volatility mean that, for the moment, it can’t become a currency as we’ve come to expect.

As noted above, Bitcoin rose in price more than 10x during 2017. That means people had a very strong incentive to hold Bitcoin rather than spend them. If Bitcoin represented a material part of our economy, the price appreciation could have depressed consumer spending and led to an economic slowdown or recession. Conversely, Bitcoin dropped in value by 50% over a two-week period earlier this year. That’s the equivalent of hyperinflation and could also distort spending and consumption patterns. Bitcoin holders commonly face intraday double-digit percentage moves. We can’t have a stable currency if your morning coffee costs a lot more or less than your afternoon cup.

Are All Cryptocurrencies Like Bitcoin?
No. The largest cryptocurrencies (Bitcoin, Ethereum and Ripple) purport to provide a digital means of executing consumer transactions, but there are differences. Ethereum has many more applications than Bitcoin, and even lets people create their own cryptocurrencies using its technology. Ripple runs an international payment platform called RippleNet to allow for asset exchanges between banks, credit card companies, and other financial institutions.

Beyond that, there are numerous crypto “currencies” with little or no relationship to banking. Tron, for example, is currently one of the 15 largest cryptocurrencies. Tron seeks to establish a blockchain-based platform allowing musicians, artists, and other content providers to reach an audience without having to use a middle company like Apple, Amazon, or Facebook. To us, buying Tron “coins” is less like buying a currency or commodity and more like buying a stake in a (non-regulated) startup company. If the platform is successful, early Tron buyers stand to profit. If not, Tron coins will likely be worthless.

What if Crypto is the Future? Bitcoin vs Blockchain
We find blockchain technology intriguing and potentially disruptive. There is a difference, however, between the underlying technology and any individual cryptocurrency. As noted above, it’s not clear to us that the current global financial system is in such disarray that most people would prefer a decentralized, anonymous system with little or no recourse for disputes or fraud.

But what if we’re wrong? One can imagine a world where trust erodes in governments and financial institutions such that people prefer a blockchain ledger. In that event, we could have the widespread adoption of cryptocurrency. But how do we know what cryptocurrency people will use? Buying Bitcoin (or Ethereum or Ripple, etc.) today as investment or speculation assumes that, in the future, people will buy that particular crypto. In order for that to happen, there must be some unique aspect to the crypto that makes it irreplaceable. If not, or if any blockchain ledger will do, then most or all of the current cryptos will likely be out-of-date and worthless.

What’s the Final Price?
Assuming the best case scenario: cryptos take over a large swath of economic transactions and the price volatility goes down enough so that it can be a reliable store of value over time. At what price will Bitcoin settle? As we write this, the price of Bitcoin is just over $11,000. If the price at full adoption is, say, $100,000, then buying today will turn out to be a fantastic decision. But if the price at full adoption is $1000, buying today would be a disaster. That’s another question we believe those purchasing Bitcoin (or other crypto) should answer: assuming crypto proponents are right, what’s the endgame?

Are We in a Bubble? Should I own Crypto?
Bitcoin and other crypto aren’t investments in the traditional sense of taking risk for an expected return. Instead, we believe them to be a speculative commodity and a bet that this new technology will change the world.

Is it a bubble? It’s hard to say. As we’ve discussed above, it’s very difficult to tell whether today’s price accurately reflects Bitcoin’s likely adoption and final price. That’s the nature of speculation. We do note there are a few bubble-like indicators. First, Bitcoin has appreciated in price so much so rapidly that it’s consistent with – or more dramatic than – historical asset bubbles, as the chart below shows. Please note that most of the lines on the chart are gray and can be difficult to make out. We think that’s the point: most of the bubbles we’ve experienced in the past pale in comparison to Bitcoin’s rise in price: see graph.

Second, there’s some indication that investors are hungrily buying up any blockchain-rated technology or company without regard to fundamentals. One egregious example concerns the Long Island Iced Tea Corp., an unprofitable company selling non-alcoholic beverages. Late last year the company changed its name to Long Blockchain Corp. and rose almost 300% the next day.

Third, the amount of attention given to crypto is vastly out of step with its current place in the global economy. As we write this, the total value of all crypto in circulation, even after last year’s boom, is just about 1% of the aggregate value of the global stock market. A divergence between popularity and actual economic impact could help drive prices higher as people respond to what is essentially free advertising rather than economic fundamentals.

Finally, an anecdote. Late last year, we ate dinner at a Korean fried-chicken restaurant in Mountain View. While waiting for a table, we overheard one of the bartenders speaking with a patron. They were talking about how much money they’ve “made doing crypto” and discussed a number of new blockchain companies and whether they plan to invest. We couldn’t help but think of stories from the 1920s about stock tips from shoe-shine boys and cabbies.

Of course, two people talking at a restaurant doesn’t necessarily mean anything. But to us it’s highly reminiscent of the late-90s tech craze. For a couple of years, almost everyone who invested in tech or internet companies made a great deal of money. Moreover, many people eschewed common-sense investing principles because they thought they were in a new paradigm – the internet would change the world. They were right in that the technology was revolutionary. But most newly minted “internet investors” found themselves caught in a brutal three-year correction, some losing most of their capital.

Our Advice
Given its speculative nature, we’d caution against buying a material amount of Bitcoin or other crypto today. Most important: we strongly advise not committing an amount that might place your financial plan at risk. For us, it’s just too hard to discern whether one is buying in at a good price, what might be a good price at which to sell, or what the future returns might be (if any). That said, we understand why some would want to take part in an exciting, potentially disruptive technology.

For those that do, we’d suggest (1) buying an amount that you feel comfortable potentially losing most or all of, (2) make certain you understand exactly what crypto you’re buying and what it purports to do, and (3) set a target price at which you can commit to selling. We believe following these three steps will allow people to participate if blockchain really does change the world while helping to cushion the financial impact if it doesn’t.

Originally Published January 2018.