Bitcoin Isn’t a Tulip and That’s Too Bad

December 1, 2017

One of the non-medical definitions of ‘mania’ is an excessive or unreasonable enthusiasm.  The term has been used in recent weeks to define Bitcoin and to draw parallels with other price-related mania in the past.  These would include the tech bubble of the late-1990s, and the Dutch tulip mania of the 17th century.  The comparisons are being drawn because  of the seemingly irrational speculative pursuit of the currency  and the potential for an equally painful retreat once investors see  a divide between price and intrinsic value.  Unfortunately, this situation is quite a bit different.

Bitcoin is one of more than 40 so-called virtual currencies (also known as cryptocurrencies) and it was the first, created out of a research paper published under the pseudo name Satoshi Nakimoto.   Unlike other currencies in the world’s history, that have been based on either a commodity (gold) or the pure faith in government (fiat money), a virtual currency is based on math.  Hence the term bit.

 

 

Since it is a digital currency it is both global and decentralized.  There is no monetary authority behind it, like the Bank or Canada or Federal Reserve.  It is essentially administrated across various nodes that together manage and maintain what is known as the blockchain.  This is a public ledger that tracks and stores all bitcoin transactions.  Essentially bitcoins become the reward for ‘mining’ the blockchain.  Payments are made based on an entry that defines where the bitcoins are being sent from, how many and where they are going to.  The key issue is that the identities are not known.

A bitcoin address is simply a private key that is created randomly and assigned and then used to create the actual public bitcoin address.  Figuring out the private key or identity of that key is next to impossible due to mathematical complexity and the sheer number of addresses.

Contrast this to a system of payments made up of bank and credit accounts.  Even in e-transfers, where identities are shown via email addresses, there is ultimately a bank account source and destination.  If necessary,  the identity of those accounts can be determined and the one thing the global financial industry has done fairly well in recent years is tighten up procedures to detract criminals from being able to use the financial system for things such as money laundering and terrorist funding.  Each year, billions are spent on upgrading systems to deal with attempts to use the system for nefarious purposes and, while the threat continues, it has become harder for criminals to transact through normal financial channels.

In the case of a digital currency it is easy to use funds from criminal activity or send funds towards groups involved in terrorism with little chance of being identified.  Now, I don’t want to leave the impression that the sole demand for cryptocurrencies like Bitcoin comes from crime; however, it would be naïve not to think that much of the demand for these currencies comes from illegitimate transactions. And these currencies are still in their infancy.

From that perspective, it may not be accurate at all to describe the current situation as a mania.  In the tulip case, a single bulb reached a price in excess of 3,000 guilders in 1637.  Similar to gold, tulips became a luxury item, especially for those strains that were quite rare.  A futures market developed and authorities instituted a ban on short-selling, opening the door for speculators to move in and bid up the prices of bulbs.  Like most commodity futures, tulip bulbs rarely traded hands at the height of the mania. And as the plague gripped the Netherlands, traders did not show up at auctions and the price of tulip bulbs capsized.

While both tulips and bitcoins share mania qualities, it is clear that the prices of tulips far exceeded their intrinsic value.  Nor was the tulip mania a global problem and economists have argued that it’s implosion didn’t have a significant impact on the European economy. If there is a strong criminal composition to bitcoins, then it is hard to say that prices exceed intrinsic value, though people are getting a glimpse at how much global crime is worth. What is not clear is how global monetary authorities and governments deal with this. As much as there is a push in Washington for less regulation in financial services, it is hard to fathom a situation where a completely unregulated mechanism is allowed to exist.

From an investor perspective there are some important considerations before jumping on the bitcoin bandwagon, beyond recognizing the types of activities that are beneath the surface. One of the basic and most important tenets in providing advice to retail investors is ‘know your product’. This involves not only the advisor understanding an investment product, but ensuring the client does as well. Years ago, few advisors could get their head around things like leveraged ETFs, so it is implausible that most would understand block chains, crypto currencies or the fundamentals behind them. My opinion is that this is an area to stay clear of, lest another plague-like development derail bitcoins.

 

 

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