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Bitcoin: A Primer What Investors Need to Know

Bitcoin; everyone is talking about it.  That’s what happens when the perceived value of something rises 2,000% in a year.  (The value of Bitcoin, in terms of dollars, was under $1,000 at the start of 2107, and, as of this writing (December 18, 2017), has been as high as $20,000. Bitcoin boasts of its “Blockchain” technology, where every transaction is transparent and can be tracked, but also of its privacy, where no one can track the participants or owners of the Bitcoins.  But Bitcoin, itself, is not the Blockchain technology; it only uses it.  And Bitcoin doesn’t own it or have a patent on it.  In fact, every other Bitcoin copy-cat currency (and there are now over 120 of them) uses the Blockchain technology.

Bitcoin – the Crypto-Currency
Bitcoin is referred to as a “crypto-currency.”  In fact, when people say Bitcoin, they may really mean crypto-currency.  Like “Scotch” tape, or a “Xerox,” copy which are brand names whose brand has become synonymous with a generic product, Bitcoin has become the generic name for the crypto-currency concept.   The word “crypto” has been attached because the currency only exists in the world of the internet as electronic bits; it doesn’t have a physical presence.  But that isn’t really what makes it different because, in truth, most modern-day currencies (except gold) also mainly exist as electronic bits.  The vast-majority of U.S. dollars in the world only exist as electronic entries on the balance sheets of banks.  The difference between Bitcoin and other currencies is a) Bitcoin doesn’t exist on bank balance sheets, and b) dollars (and other major world currencies) on bank balance sheets can be turned into “cash” (paper currency or coins).

Bitcoin: A Currency
It isn’t its crypto-ness that distinguishes Bitcoin from other currencies.  It is its stability, its acceptability, its susceptibility to be stolen, its use for illicit purposes and its potential to be outlawed that distinguish it from generally accepted currencies.

Years ago, when I taught “Money & Banking 101,” a “currency” was defined as “a medium of exchange.”  It was “generally accepted and commonly used as a means of payment.”  Certainly, the U.S. dollar meets this definition in the U.S., as do most major world currencies in their participating countries (Euro, Yen, RMB, Pound, …).  Bitcoin, on the other hand, is accepted by some business establishments, but it isn’t generally accepted nor is it commonly used.  That doesn’t mean it can’t be, or won’t be (although, I have my doubts as you will learn as you read on).

Monetary history is full of currencies that blew up, usually because the sponsoring government resorted to the “printing press” and caused what is known as a hyper-inflation.  The most recent example of this was Zimbabwe, where, in 2008, the rate of inflation was so rapid that it couldn’t be reliably measured (80 billion percent according to Wikipedia).  Even today, in countries like Venezuela or even Cuba, the local government sponsored currency doesn’t really act as the medium of exchange.  In countries like these, there is a black-market currency (often the U.S. dollar) that acts as the de facto medium of exchange in the common economy.

Bitcoin Characteristics
This brings us to an important concept for a successful currency; its value must be stable.  If it isn’t, exchange is transacted in something that is stable.  In today’s foreign exchange market, there is stability in the value of currencies relative to one another, and, on a daily basis, the value of one currency in terms of another moves microscopically.  The fact is, people are only willing to hold their wealth in a currency if it is stable.  This means that a unit of that currency must be able to purchase the same market basket of goods and services tomorrow as it did today (or at a price that is so close to today’s price that the difference is “negligible,” where that “negligible difference is what we commonly refer to as the rate of inflation or deflation).

So, stability in value is a necessary characteristic for a successful currency.  As a result, it can reasonably be concluded that the wild fluctuations in the price of Bitcoin disqualify it from “currency” status.  Can you imagine having your wealth valued in a currency that could fluctuate in purchasing power by 10% or more per day?  (On the day I began writing this piece, December 13th, the value of Bitcoin fluctuated between $17,500 and $16,000 – that’s more than an 8% fluctuation in a single day!)

There are other very important issues that work against Bitcoin as a currency.
•    The fact that individual Bitcoin transactions can’t be tied to individuals, Its privacy characteristic, make transactions using it attractive to those engaged in illegal activities.  Assuming that Bitcoin became a widely-accepted currency, it is likely that governments would impose various regulatory regimes on it, not only to monitor potential illegal activities, but also to insure that people using the currency are protected from any potential abuse.  That regulatory scheme would make Bitcoin much less attractive to criminal elements.
•    Governments of all the major countries of the world reserve the right to print and issue money.  Would any be willing to have their currency operate side by side with a privately sponsored, unregulated one?  It is very unlikely that governments would relinquish their hegemony over money, as monetary policy is now considered an essential element of policy making.  Once made illegal, no legitimate businesses would be allowed to accept it, and even the criminal elements would eschew it as they would no longer be able to launder through it.  After all, the objective of the criminals is to get to legitimacy, and the means really matter little.
•    Fraud is a huge issue for Bitcoin.  There are many reports of Bitcoin wallets, the electronic spaces where Bitcoins must be stored, being hacked and the Bitcoins stolen.  In a regulated monetary system, like the one in the U.S. today, if money is taken from your bank account without your authorization, you are protected.  The bank is obligated to replace your money.  Bitcoin is unregulated, and since the individual owners of the Bitcoins are not identified, who is to say who owns the Bitcoins except the one who currently possesses them.  If your Bitcoins are stolen, to whom do you complain?  There is no government regulator, and there is no official Bitcoin company with a PR or complaint department.  You are just out of luck.  Furthermore, since this is all internet based, chances are that the thieves don’t even live in your country.  So, even if you could identify them, it still isn’t likely that you could do much.

For all the above reasons, it is highly unlikely that Bitcoin, or any of the other Bitcoin look-alikes, will become a serious currency.  If that is the case, then why so much interest?  Why is everyone talking about it?

Bitcoin: An Investment
Anytime the apparent value of an item rises 2,000% in a year, the populous becomes interested, and the gambling instincts in human behavior come to the fore.  (Nearly everyone knows that the odds in a casino are greatly in favor of the house, yet Las Vegas is one of the most successful economies on earth.)  The public’s interest appears to be in Bitcoin as an “investment,” not as a currency, and more specifically, as a “speculative” (get rich quick) investment.

No Valuation Metric
It is the obligation of an SEC Registered Investment Advisor (RIA), like Fieldstone Financial, to understand the risk tolerance of the client and to propose investments that fit the client’s risk/return profile.  For the vast-majority of clients, that means investments in high quality assets where those assets represent real businesses with products, technologies, cash flows, management teams, etc.  Bitcoin has none of these.  There is no company, management, cash flow, or product/service.  Bitcoin is just a bunch of unique electrons that are hard to duplicate, but really have no other useful purpose or utility (besides trying to be an alternative to currency).  As a result, there is no valuation metric, either quantitative or qualitative.  There is no one that can put a ‘buy’ or ‘sell’ rating on it, using today’s valuation techniques, like you can, say, on GE, Amazon, Microsoft, Apple etc.    When the profits, cash flows, dividends, etc. of a company rise or fall, or when a company gets a patent or develops a new technology that is useful, sought after, or has the potential to improve life, analysts model future value and, using a discounted cash flow process, place a present value on the company (i.e., the price of the company’s stock).  Bitcoin has none of the above except its attempt at currency status (which I dealt with above).

Is Bitcoin a Bubble?
So, what moves its value?  Only one thing.  The willingness of the next buyer to pay a higher or lower price.  And, what determines that?  Hype, market fervor – call it what you will.  But it isn’t anything except wild speculation and the hope that some greater fool will pay a higher price.  Large swings in the hype and fervor result in the significant price volatility observed.  One thing is for sure: when the fervor has run its course, the price will drop like a rock.

Bitcoin isn’t the first time we have seen speculative bubbles.  Oftentimes, these occur near the end of long business cycles (like we have today).  The accompanying chart shows the price movements of history’s major speculative price bubbles.  Note how Bitcoin appears to be following in the footsteps of the Tulip bubble, apparently, history’s biggest all-time bubble.  My colleague likes to compare Bitcoin to yesteryear’s “pet rock” mania where an entrepreneur became wealthy selling ordinary rocks with a smiley face on them.  In the future annals of financial history, I suspect that the “pet rock” will come out on top of Bitcoin; at least the “pet rock” still has value as a paperweight!

Money to Burn
I am not saying that money can’t be made in Bitcoin. What I am saying is that an investment in Bitcoin is quite speculative.  Since there is no way to measure intrinsic value, an RIA can’t recommend it as an investment.  Let’s be honest, without a valuation metric, how does anyone know when to “buy” or “sell?”  Is $2,000/Bitcoin cheap or dear?  No one knows, today.  We will only know with hindsight.

Furthermore, I am not saying that the Blockchain technology used by Bitcoin and the other cryptos isn’t useful and won’t be employed in the monetary system.  I am certain that it, or something like it, will be.  But, I am also certain that neither Bitcoin nor any of today’s other cryptos will survive as currencies, and this saga will be much discussed in the “Annals of the History of Bubbles.”

Robert Barone, Ph.D.

Postscript –  Bitcoin ATMs
Should the above analysis not have convinced you otherwise, and, provided that you have money you don’t need, Bitcoin is one way to speculate (casinos are another, and the upside there is that they provide you with free drinks!).  For your convenience, there are even Bitcoin ATMs.  Just go online to find the location nearest to you.

At today’s regular ATMs, most of which are associated with a bank, you can get cash, make a deposit, make loan payments, and even buy some other goods (like postage stamps).  At ATMs that are not affiliated with a bank, generally, only cash is dispensed.

But, because there is no Bitcoin “cash,” the only function of a Bitcoin ATM is the purchase or sale of Bitcoin.  As it turns out, that, itself, is a complex process, generally requiring, either on your phone or via a paper version, a two dimensional or matrix barcode to identify your electronic Bitcoin wallet (the only way you can hold Bitcoin, and subject to hacking as described above).  The Bitcoin ATM either receives from, or sends to, your Bitcoin wallet the Bitcoin that you have purchased or sold.  In addition, the Bitcoin ATM does accept cash, and it dispenses it, too.  But all the cash going into or coming out of a Bitcoin ATM is real currency (dollars, or the currency of the country in which the Bitcoin ATM is located).  When buying or selling Bitcoin at the Bitcoin ATM, there is a large “spread” between the “asked” (the price you must pay to purchase) and the “bid” (the price you get if you sell).  So, it appears that the only real function of the Bitcoin ATM is to make a profit (via the spread) for the Bitcoin ATM owner.

Disclosure: Robert Barone, Ph.D. is a Georgetown educated economist.  He is a financial advisor at Fieldstone Financial.  www.FieldstoneFinancial.com .

He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO and a Director and Chairman of the Federal Home Loan Bank of San Francisco.  Robert is currently a Director of CSAA Insurance Company (a AAA company) where he chairs the Finance and Investment Committee.  Robert leads the investment governance program at Fieldstone Financial, is the head of Fieldstone Research  www.FieldstoneResearch.com, and is co-portfolio manager of the Fieldstone Financial Fixed Income ETF (FFIU).

Statistics and other information have been compiled from various sources.  The facts and information are believed to be accurate and credible, but there is no guarantee as to the complete accuracy of this information.


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