How Should We Think About Bitcoin?

Is it a speculation or an investment?

Is it an Investment?

Bitcoin is most certainly not an investment. Investments can be valued based on a current or expected cash flow stream. Think CDs, bonds, stocks, or real estate. Bitcoin generates no cash flow. Yes, there are businesses that currently do not generate positive cash flow (think Tesla or Uber) but investors expect them to be cash flow positive in the future (even if the logic seems far-fetched and ultimately turns out to be wrong).

Since Bitcoin is not an investment we must then analyze it as a form of payment or currency.

Is it a Form of Payment or Currency?

Since Bitcoin generates no cash flows it’s best thought of as a form of currency or payment. In this scenario its ultimate value depends on its utility and potential for mainstream adoption.

For mainstream adoption, it’s unclear what problem Bitcoin currently (this is key, the operative word is CURRENTLY, as things can change) solves and why using it would be faster, safer, or easier than using traditional means of payment.

Bitcoin is not widely accepted by merchants (consumer spending makes up almost 70% of the US economy so wide acceptance is critical). It is currently not cheaper or easier than other forms of payment. For merchants that do accept Bitcoin they almost always contract with a third party to process payments or converted the Bitcoins received into a local currency. At present using Bitcoin does not offer consumers or merchants any advantages over other forms of payment.

There is also the issue of Bitcoins being lost forever, either intentionally or unintentionally. If a user forgets or misplaces the private key to their wallet their Bitcoins are lost forever. About a third of Bitcoins in existence haven’t been involved in transactions for the past five or six years and a substantial portion of those are believed to be permanently lost. Not something you have to worry about with a traditional bank account.

Bitcoin certainly isn’t safer in some respects. There have been regular hacks throughout the years that have resulted in perhaps a total of around 1M Bitcoins stolen. While wallets can be kept offline to prevent theft it does hamper the utility and ease of use of Bitcoin. Contrast this to traditional bank accounts and brokerage accounts that have Federal insurance that protects against theft.

There is also the problem of price stability. When I wake this morning I know the value of money in my bank account hasn’t changed drastically and neither has the price of a Starbucks coffee. The current wild fluctuations in price and frequent “flash crashes” mean that pricing things in Bitcoin and knowing what your true Bitcoin wealth is becomes problematic. If your Starbucks how do you decide how many Bitcoin’s your coffee is worth if the value can change by 20% in a few hours.

But, things are not all bad with Bitcoin. Bitcoin offers substantial utility and a huge advantage as an anonymous untraceable means of exchange for those involved in black or grey market activities. It’s also tremendously useful for moving large sums of money out of countries with capital controls.

Additionally, the blockchain and the idea of a secure, decentralized system for recording transactions can be immensely useful. There are plenty of centralized financial systems in place today such as credit card processing, the buying and selling of stocks, and even the purchase and sale of real estate that could be improved by blockchain technology. No one likes paying a portion of transaction costs to a middleman. If the transaction fees* for blockchain technology are less than those of competing centralized systems it possible that blockchain technology (and it could be Bitcoin) could supplant them.

*Right now new Bitcoins are created as a reward for processing and verifying transactions. Once the ultimate 21M limit of Bitcoins is reached it’s thought the reward for mining will be altered to be a percentage of each transaction. Hence the use of the term transaction fee. However, given the newness of blockchain technology, Bitcoin, and the various forks of Bitcoin nothing is set in stone.

Where is Bitcoin Headed?

In the short term I believe Bitcoin could be headed higher. Much higher.

Right now it looks like there will be some type of Bitcoin futures contract(s) approved. If this happens it’s highly likely that a Bitcoin ETF and possibly other types of Bitcoin funds will eventually be approved. That will open up Bitcoin “investment” to a wider variety of people, most critically it will enable people to devote a portion of their IRAs, 401(k)s, or other retirement accounts to Bitcoin “investments.”

If that is the case, Bitcoin is going up. Way up. It will likely go up for years and go up high enough and long enough to make anyone who ever called it a bubble look like an idiot.

The best corollary, in my opinion, for what will happen without mainstream adoption is the commodities bubble. The CFMA of 2000 gave rise to commodities being packaged in mainstream investments like ETFs and mutual funds. Poorly interpreted academic studies along with Wall Street smelling a way to make a quick buck led these investments to be heavily marketed to investors (mom and pop retirees along with pension funds and endowments). The result was an epic commodities bubble shown below.

It started in earnest around 2005 and imploded in 2009 along with the great recession. The fall in oil prices in 2014 marked another leg down as well.

If mainstream Bitcoin ETFs and mutual funds come into existance we will likely see the same pattern. Investor money will flow into the hot new exciting asset class with dubious investment prospects but a cool story. At some point the narrative will change and investors will get pummelled. There will be a lucky few millionaires and perhaps billionaires along the way but the vast majority will lose out.

If Bitcoin becomes a widely accepted medium of exchange and is convenient and easy to use for a large portion of society then it will cease to be a bubble and instead become what it was always touted to be. However, there are significant obstacles that Bitcoin needs to overcome before that is the case.

So How Should You Play Bitcoin?

So what should someone do about Bitcoin? Well Bitcoin should not take place the place of your savings or investments. Bitcoin is a speculation at this point. But, we are all allowed to spend our extra money on whatever hobbies and fun activities we like. Things that don’t generate any economic profit for us, just enjoyment. Well there is nothing wrong with spending some of that “fun money” or money you can afford to lose speculating on the future of the blockchain and Bitcoin. Just don’t bet your retirement or your rainy day fund on it.

 

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