Bitcoin: Future Money or Just a Bubble?
Bitcoin has spiked in value from US$7,000 per coin to US$60,000 per coin over the past year. The price may well be higher by the time you read this. It could just as well be lower. Bitcoin is nothing if not volatile. Still, the price spike is undeniable. An 860% rally in one year is world historic, and the rally is even more extreme if earlier lower valuations of bitcoin are used.
A multiyear chart of bitcoin prices (below) displays the greatest bubble behaviour in history — greater even than the Tulip Mania in the Netherlands in the early 17th century.
You don’t need a PhD in finance to see that bitcoin is a bubble. It’s apparent from the chart. The time series of prices over the past six months has been hyperbolic — almost vertical. Bitcoin is positioned for a major fall. But is it a mania or a rapid price adjustment to reflect supply and demand for what may soon be the universal medium of exchange?
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Bitcoin — future money or just a bubble?
The critique of bitcoin is well-known. It has no real use case except for money laundering and evading taxes or capital controls. It is not widely accepted as a medium of exchange. Its extreme price volatility makes it unsuitable as a store of value. That same volatility disqualifies bitcoin as a unit of account.
Bitcoin has no return, other than higher prices based on the greater fool theory. You can make money in bitcoin at any purchase price as long as there’s a greater fool willing to pay an even higher price. That system works until it doesn’t.
Bitcoin is a wealth transfer device, but not a wealth creation device. Bill Gates is worth US$100 billion because he created trillions of dollars in value through his Microsoft programs and operating systems. Bitcoin is a zero-sum game where one player takes money from another, but no new wealth is created.
Bitcoin is filling the atmosphere with CO2 because most of the ‘mining’ (really high-speed computer calculations requiring monumental amounts of electricity for processing and cooling) is done in China where most power plants are coal-fired.
Bitcoin will never be a reserve currency because its capped issuance at 21 million coins makes its price deflationary, which is unattractive to borrowers. Without a bitcoin bond market, there can be no securities in which central banks can invest reserves.
Bubble behaviour, or worse
Bitcoin could fall from US$60,000 to US$10,000 or lower before establishing a new base. Still, there is one important difference between other well-known bubbles — such as the Nikkei and NASDAQ bubbles — and the new bitcoin bubble.
The Nikkei and NASDAQ bubbles were based on a combination of investor mania, leverage, and hyped-up earnings releases from companies in the index. But there was relatively little outright fraud. In contrast, the bitcoin bubble is based almost entirely on fraud. There is substantial evidence that the price of bitcoin is based on a Ponzi scheme.
Over 50% of bitcoin purchases are made with another cryptocurrency called Tether, a so-called stablecoin. Tether has never accounted for the billions of dollars that buyers have used to acquire Tether. Hard currencies such as dollars go into Tether, while Tether is used to pump bitcoin, and the dollars are possibly skimmed away. That process does not work in reverse.
Here’s how the fraud works. A company called Bitfinex sponsors the cryptocurrency called Tether. This crypto is a so-called stablecoin. This means that the value of one Tether is fixed at US$1. When you buy a Tether for US$1, the money is supposedly held in safe liquid assets. When you cash in your Tether, you should receive US$1 in return (less small transaction costs). The problem is that no one has been able to locate the liquid assets that supposedly back Tether.
There has been no full audit and there is no transparency about the whereabouts or composition of the liquid assets backing the coin. Tether claims that its dollar reserves are held in a Bahamian bank named Deltec Bank & Trust. But independent research revealed that the assets claimed by Tether exceed the total US dollar assets of the entire Bahamian banking system.
Other research shows that those who buy Tether use them overwhelmingly to buy bitcoin from unregulated crypto exchanges domiciled in Africa and Asia. Of course, these exchanges exist in cyberspace only and are accessed through the internet. These exchanges offer leverage and award free Tether coins to those who bring in new customers. These Tethers have been used to bid up the price of bitcoin and create the bubble. Meanwhile, the dollars supposedly backing Tether are unaccounted for.
If this process were to go in reverse (which it inevitably will), the bitcoin values would collapse quickly (because of leverage) and Tether would be unable to redeem retreating bitcoin investors (because of the unaccounted-for liquid assets). Any Tether crooks could walk away with billions of dollars. The prices of bitcoin and Tether would collapse catastrophically. Bitcoin investors would walk away empty-handed.
Bubbles cause real damage when they burst
This is not just a spectator sport for prudent investors who don’t own bitcoin. The types of losses arising from a bitcoin collapse would easily spill over into brokerages and banks handling accounts of investors who were selling everything because they’re desperate to raise cash and avoid further losses.
Since the shady bitcoin and Tether exchanges are unregulated, there is perhaps little that can be done to avoid this coming fiasco. Investors should at least be alert to the potential collapse by increasing their cash allocations to help weather the storm.
That said, none of this may matter. Bitcoin has become a belief system. The true believers see what they want, hear what they want, and are immune to arguments of the non-believers.
All the best,
Strategist, The Daily Reckoning Australia
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