Thoughts on Bitcoin Investing

The other day I was speaking to a friend about Bitcoins and referred to them as Beanie Babies for Techies. As an investment, Bitcoin is right up there with those infamous stuffed toys, Pokémon cards, and Danish tulip bulbs in 1600 – all examples of enormous speculative bubbles.

The opinions on Bitcoin are generally framed in terms of economists versus the tech savvy, but the arguments against Bitcoin as a currency are strong on both sides. A recent series of articles on Bitcoin and cryptocurrencies in the Scientific American, while not focused on Bitcoin as an investment, provides an excellent overview of the technology, economics, and social implications of cryptocurrencies.

First, it is important to acknowledge the technical achievement of Bitcoin. Bitcoin showed that it is possible to develop a distributed ledger to record transactions that is essentially impervious to fraud (under certain assumptions) and that does not rely on a central authority or middleman to guarantee accuracy. In Bitcoin, two parties exchange the “coins” using only their cryptographic “keys”, the transaction is then added to the distributed ledger by the distributed network according to certain rules built into the code base (which is public) and the updated ledger is secured by a hash that would clearly show any attempt at modification. In short, the ledger records all prior transactions back to the inception of Bitcoin.

Bitcoin was by all accounts a brilliant implementation of a distributed ledger system, and this technology is here to stay and already being used for a number of public and private distributed ledgers. One can see how distributed ledger technology can be used to record and validate transactions of many types: real estate title transfers, stock transfers, contracts, or pretty much anything that can be represented or hashed in digital form.

So why is Bitcoin itself doomed as an investment? There is no denying the fact that “first to market” (aka “network effect”) is a powerful fact of life, but there is so much wrong with Bitcoin as a medium of exchange or store of value that it seems highly improbable that it will be the final word. And if something better comes along and gains traction, where does that leave Bitcoin?

So what is wrong with Bitcoin?  Let us count the ways 🙂

From an economic perspective, one of Bitcoin’s major flaws is that the number of Bitcoins being “mined” bears little relationship to demand. Basic economic theory provides a direct relationship between supply and demand: as demand increases either supply increases enough to keep prices steady, or price will go up, and this applies to currencies. In the last year, the cost of a Bitcoin has gone up 2,300% against the dollar (a fairly stable medium of exchange in purchasing power). If Bitcoin were the currency of the world, demand would increase billions of times over and so would the value of the Bitcoin in purchasing power since supply is essentially fixed (and in fact by design there will be no more than 21 million Bitcoins issued). Now, would you spend a dollar today if tomorrow it would buy ten times as much stuff? Of course not, and all economic activity would come to a standstill. This scenario is called deflation which is considered a worse threat than inflation. Never has deflation anywhere, ever, come remotely close to what would be required to adopt Bitcoin as a widespread medium of exchange, and the result would be disaster.

Another economic argument against Bitcoin really amounts to much the same thing: it isn’t tied to anything with “intrinsic” value so it can fluctuate wildly. But the US dollar and the Euro are not legally tied to anything with intrinsic value either. However, central banks such as the Federal Reserve go to great lengths to maintain a steady “purchasing power” for currencies which essential does tie the value of the dollar or euro to not just a single source of value such as gold, but instead to a market basket of goods. This stability is what makes the dollar and the euro reserve currencies of choice.

In addition to these killer economic reasons why Bitcoin, as currently constituted, will never be a major medium of exchange are technical ones.

Famously, the process of mining Bitcoins, which is integral to the process of adding blocks of transactions to the ledger, consumes huge amounts of electricity. Estimates indicate the Bitcoin mining consumes more electricity than Amazon, Google, and eBay combined. The protocol coded for mining Bitcoins is competitive and explicitly designed to adjust to increased processing power to limit the number of Bitcoins produced. It is an ecological disaster and distinctly uncool in more than one sense.

A second technical issue is the inability of Bitcoin to handle a significant number of transactions. This limit is estimated to be around seven transactions a second, which is a tiny fraction of economic activity. (The limit is related to the protocol for mining and issuing new blocks which is explicitly designed to adapt to improved technology, so having faster processors doesn’t help).

Perhaps most concerning is that the Bitcoin validation and mining protocol are so demanding that a relatively small number of groups are effectively controlling the process.

These economic and technical issues make it highly unlikely that Bitcoin, as currently constituted, will ever become a widespread medium of exchange or, in the longer term, store of value. The Bitcoin protocol and code base is public and there is a dedicated group of well-meaning and technically brilliant software engineers working to improve it, but it seems unlikely that all the above issues can be addressed. And if they could, the value of the Bitcoin would have to crash in any case.

Google wasn’t the first or even fifth search engine, nor eBay the first auction site, so being first is not a guarantee of success. And a cryptocurrency must, by definition, be exchangeable – if a “better” cryptocurrency gains a footing, Bitcoins could be exchanged for that currency.

The current value of Bitcoins is based on it’s being first, and rampant speculation. It does have utility for anyone wishing to send money across borders (for example, repatriated earnings). Also, the ability to purchase Bitcoins anonymously is a boon for anyone living in a country with a poorly managed currency and/or widespread institutional corruption. However, those advantages are easier to appreciate when the currency itself is appreciating. And a cryptocurrency which fixes, even in part, the issues with Bitcoin would be more desirable, and quickly replace it in these roles, once it gains traction.

In summary, I wouldn’t bet on Bitcoin. I wouldn’t bet against it either because there is no telling when precisely the bubble will burst. But burst it almost certainly will.

It might retain some value as a collector’s item like an original Rembrandt. Of course there are millions of Bitcoins, and they have little esthetic value. Personally, I’d save up for the Rembrandt.


One thought on “Thoughts on Bitcoin Investing”

  1. Great post, agree 100% Rich. Stumbled upon this in my facebook feed and thought to myself “hey, I remember this guy” Just thought I’d say hey and how you’re doing

Comments are closed.