Annoying my friends with Bitcoin
Why can’t John just leave BTC alone?
I've been trying to understand the long-term implications of cryptocurrency ever since Dogecoin was a new joke around 2014. If you can make Cryptocurrencies as a joke, where’s the limited supply? I often felt like I was the only person who didn't "get it." My colleagues would buy or mine for coins and call it the future of money. I never understood why, so I'd ask them questions until I exhausted their patience.
Now that Bitcoin has reached incredible peaks, I hear more friends and colleagues discussing their crypto investment strategies again. Naturally, that means I've been talking to (i.e., arguing with) many folks about Bitcoin (BTC). I still don't fully understand why smart people buy them.
Before I discuss BTC, let's first address a hidden assumption here: that just because smart folks do something means that they endorse it or even gave it much thought. Especially when it comes to investing, buying something doesn't mean you think it will go up or offer better returns than alternatives. Seriously!
There are many mental models for investing, and betting on a lottery ticket is just one model. I mostly think of my investments through the lens of asset allocation; I don't particularly believe that corporate bonds will do better than US equities, but I still have them as part of my portfolio. Including an asset type in a portfolio doesn't imply that that asset's returns will be as high or higher than the other assets.
Other folks invest with the notion of preserving their wealth rather than growing it (i.e., they want to continue to pay their expenses without diminishing their net worth after inflation). These folks want to minimize volatility while maintaining their income. There are many other models for how to think about investing -- these are just some examples.
Another assumption when we model smart people is that intelligence possesses a transitive property. It often doesn't. I once worked with some brilliant engineers who believed they didn't have to pay income tax based on how the government uppercased their names. "JOE SMITH owes taxes? That's not me. My name is Joe Smith, and I owe no taxes."
Genius electrical engineering skills may not help in other fields! So a smart person who buys BTC might:
Not know much about BTC, economics, or currencies in general
Buy BTC on a lark or a recommendation
Enjoy slot machines
I just finished the latest edition of A Random Walk Down Wall Street (Burton Malkiel), and it has an excellent discussion about Bitcoin raising several interesting points. *Disclaimer: this isn't proof that BTC is worthless or dumb.*
The first point was that currencies need to work in debt transactions. The US Treasury even mentions debt in print on each dollar bill. I don't know about you, but I wouldn't participate on either side of a loan denominated in BTC. In a year, 1 Bitcoin might buy a MacBook Pro or a new BMW 330i.
If I lent out 1 BTC when it purchased a sports car, I'd feel quite disappointed if it only bought a laptop on repayment a year later. Likewise, if I borrowed a BTC to buy a MacBook Pro, and I'm paid in USD, I'll be in trouble if I need $36,000 to pay back the BTC. I'm not claiming that nobody would make these transactions -- just that only incredibly sophisticated investors are equipped to deal with them.
The US Dollar also varies in value according to inflation (or deflation); however, the inflation rate has recently stayed within predictable ranges -- about 2% annually for the past several years. US Inflation topped out around 18% immediately following the second world war, and bottomed out at around -10% during the depression. The negative 10%, by the way, represents deflation.
In the past year, BTC has gone up more than 410%. That behavior doesn't raise my confidence in BTC as a store of value. If Bitcoin were a dominant currency, this deflationary change would discourage commerce. Who'd buy a bag of Doritos today with money that might buy a nice meal tomorrow? This is one reason that economists fear deflation and why the dollar isn't pegged to gold. The amount of gold is limited, but the amount of goods and services in the world isn't.
The other concern A Random Walk raised is that BTC relatively few people control a large percentage of BTC outstanding. Unlike the public stock markets, nobody polices price manipulation of BTC.
A naive BTC investor might enjoy this lack of regulation. Surely holders of bitcoin will wish to raise the value of BTC, not lower it, right? Not so! There are several ways to make money on falling BTC prices, including selling futures contracts and selling short. If you control a significant pool of BTC, you may find it more attractive to trade on volatility than to sell your position.
There are many reasons a BTC whale might resist selling its holdings. The most obvious one is that BTC transactions (and wallet contents) are public. Won't folks notice if a whale transfers its holdings -- especially to an exchange?
Also, keep in mind that every transaction to USD requires a willing counterparty. There are wallets with billions of USD worth of BTC at current prices. Turning BTC to USD requires folks to buy BTC from you in USD! Coinbase Pro (one of the largest exchanges) seems to perform about $1.5B worth of USD / BTC transactions per day currently. That's a significant volume, but not enough to think another billion dollars won't make a difference.
I find these situations fascinating. Is BTC a currency? A commodity? A collectible? A gold rush? Depending on where you stand, it looks like all of these things. That also makes discussions quite challenging. Do we compare BTC volume to the Chicago Mercantile Exchange Group? Or do we compare BTC volume to Mastercard? Or maybe we should compare it to Apple stock (almost certainly not; Apple produces profits and dividends).
If we compare BTC to gold, do we compare it to Spanish doubloons or to holding SGOL? Doubloons are a coin, and SGOL works more like a database -- one backed by vaults full of gold.
Some of my friends have confessed that they own BTC because they don't understand the stock market. This worries and puzzles me. While BTC isn't a stock, the mechanisms that influence BTC prices are very similar. Short selling, buying on margin, and futures contracts impact BTC valuation as they do on shares of TSLA. Massive margin calls have the same potential to lower or raise prices as they might in any market. Without regulation, it's nearly impossible to comprehend what kinds of risks other BTC investors have added to the market.
On top of leverage on BTC, speculators regularly exchange BTC for other cryptocurrencies, which might have even less price stability and scrutiny. Suppose those other currencies are leveraged up (or believed fraudulent) and later collapse. In that case, the problem can propagate to BTC as investors in those currencies rush to preserve their capital or satisfy margin calls. This is why I worry about BTC investors who don't understand the stock market -- I don't think BTC trading is less complicated.
Wrapping up, keep in mind that I'm not a cryptocurrency expert; I'm primarily an index fund investor. I'm not telling you that Bitcoin is a bad investment; I'm skeptical, but I don't know. I even have a tiny amount of BTC and Etherium in Coinbase -- if I can ever unlock my account.
I would suggest that anyone with more than 10% of their net worth in a cryptocurrency should consider diversifying their portfolio. I personally believe in holding a diverse portfolio of mostly low-cost index funds representing the world's publicly traded equities and bonds.
Regardless, I find BTC fascinating and curious. I also believe that understanding how and why BTC is traded will probably more critical than understanding the software which defines Bitcoin. Blockchain technology is fascinating, but it doesn't determine the value of BTC; humans do that. If you don't understand how humans trade BTC, can you really predict its value?