What follows is probably a good representation of my misunderstanding of Bitcoin and cryptocurrencies in general. The investment thesis for Bitcoin goes right by me. I don’t understand how it can be valued as an investment, other than it being in short supply relative to demand (at the moment). To me, it seems primarily based on a belief that someone else will ultimately pay a higher price for it.
This brings me to my next puzzle: Bitcoin as money. As long as it is quoted in dollars, how is it ever going to be real money, as in a medium of exchange? For it to be money it has to be quoted in the amounts of goods and services it can buy, independent of its dollar value. I guess that people who see it as some sort of store of value don’t actually believe in it as money. Their main concern is its value in dollars and how it — supposedly being a store of value — will protect the purchasing power of their fiat currencies.
Again this is not a position for or against Bitcoin. It is more like a long-winded question on the value of Bitcoin as an asset class and as a medium of exchange. See it as a plea for a better understanding other than the arguments based on halving cycles and other technical price correlations. So let’s start with Bitcoin as an investment.
Bitcoin as an investment vehicle
Many Bitcoin enthusiasts will argue that pension funds, mutual funds, and other large institutional investors should include Bitcoin as part of their portfolio. Some even claim they ran simulations that prove that allocating a part of assets under management to Bitcoin would have positively impacted the returns of large funds. But how can this be?
If large (pension) funds would collectively start buying Bitcoin, the price would immediately go through the roof. Especially when taking into account that 95% of all Bitcoin is held by 2% of Bitcoin holders, according to Bloomberg. So they either forgot to consider that when running the simulations, or they are being slightly deceptive. Maybe they themselves own Bitcoin and would really love to see the large funds getting involved on a large scale. Pump and dump anyone?
No seriously, I do think that their intentions are good, but that they forgot to take into consideration the impact on price were large funds to participate in Bitcoin on a large scale. While I have not seen the simulations, I seriously doubt that adding Bitcoin could have made a significant difference to the return of large funds. Funds that do not already own Bitcoin, that is.
The world’s 300 largest pension funds had some $19 trillion worth of assets under management in 2019. The market cap of Bitcoin is around $600 billion. If they would allocate up to 5% of their capital to Bitcoin that would potentially be around $1 trillion that would pour into a market where 2% of the holders own 95% of the assets with a total market capitalization of some $600 billion. And that is for pension funds alone. Calculating potential returns based on Bitcoin’s market price alone seems a tiny bit optimistic.
And is Bitcoin really an investment? An investment in what? It’s not like you are investing in blockchain technology when buying Bitcoin, and unlike more traditional assets it produces no earnings, dividends, or any other cash flows. In other words, if the blockchain technology finds widespread use in other applications or transactions, Bitcoin will not directly profit from that. Bitcoin is just another application of blockchain technology.
Is it a store of value then? It sure has increased exponentially in price if you were lucky enough to buy low and had the nerves to sit out some serious bumps along the way. If it is a store of value, it is a very volatile one. Which is not surprising given the ownership percentages quoted above. This makes the “float” very thin and any increase in demand will have a significant impact on the price. A single transaction can skyrocket the price of Bitcoin so to speak. In that, it more resembles an instrument of speculation where one is merely trying to outsmart the next guy.
Moreover, since its inception, there haven’t really been any occasions on which it could have proven its worth as a store of value. The store of value thesis, therefore, has yet to be proven. The only thing that can be said with certainty is that it has significantly increased in price, but so have other assets. A rising price doesn’t automatically make it a store of value, especially when we haven’t yet experienced any serious surges of (consumer price) inflation.
At the moment Bitcoin is more about scarcity, not unlike diamonds or paintings, or tulip bulbs. The early bird gets the worm. Money is made by buying before everybody else and selling before everybody else. At the moment — at least to me — it is characterized by a lot of FOMO. Everybody is talking about Bitcoin and everybody seems to own some. People don’t want to be left behind and want to get their hands on them, driven by (fake?) social proof. Once they’ve bought they hope that it will go higher still. But do they ever stop and ask the question of what it is that drives the price? Knowing that the large funds that do not already own Bitcoin can probably not participate — at least not in a significant way to make any difference to their bottom line — without causing the price to instantly soar, it is the retail investor that is left holding the bag. And whom are the 2% going to sell it to?
Bitcoin as money
What then about the ambition of Bitcoin to replace fiat currencies? I recently read about a guy who, in 2010, ordered two medium-sized pizzas and wanted to find out if he could pay with Bitcoin. He could. The pizzas cost him 10,000 Bitcoin at the time which at today’s valuations would be equivalent to $200 million. That must have been the most expensive pizzas in the history of humankind. Who said you couldn’t get rich opening a pizza parlor?
All joking aside, I don’t see how Bitcoin can replace fiat currencies when its value is not only determined based on it being a medium of exchange, like money. For it to substitute for money its value must be relatively stable, liquid, and generally accepted. Who is going to want to pay with Bitcoin if its value depends on other currencies and is therefore extremely volatile? Even if the price drops, people who have held on to their digital currencies will not as easily part with them in commercial transactions. Nobody wants to be that guy or girl who paid $200 million for a couple of pizzas. They will hold on, hoping it will regain its value — in fiat currencies that is. Conversely, merchants will be reluctant to accept payment in Bitcoin if they fear its value might drop by 50% or more in a matter of weeks, if not days. And as long as they have to pay their taxes in fiat currencies, commercial transactions in Bitcoin will remain the exception rather than the rule. So, unless Bitcoin is entirely decoupled from fiat currencies, how can it fulfill its role as a medium of exchange?
To become the or a medium of exchange might have been the objective of the creator(s) of Bitcoin but the way things are now I don’t see that happening anytime soon. In fact, the originator of Bitcoin, Satoshi, indeed did so to provide an alternative for fiat currencies. He or she feared, and rightly so, that central banks would continue “printing” money, creating ever-larger wealth inequality in the process. The early receivers of newly printed money will fare well while by the time it reaches the lower echelons of society prices will have increased already, making the last receivers actually worse off.
Satoshi is very right about the effects of money printing by central banks, and his or her intentions are very noble, but how exactly is the current configuration of Bitcoin aiding in reducing wealth inequality? Why would you cap something at 21 million that is supposed to substitute for trillions upon trillions of fiat currencies? Even if one Bitcoin is divisible in fractions of 100 millionths, surely (s)he must have known that, here too, there are early receivers. And as I have already pointed out, the ownership of Bitcoin is highly unequal.
And while it might have been the intention to prevent further wealth inequality by central bank policies and to replace fiat currencies, the fact remains that the derived value of Bitcoin would be built on economic quicksand. It is not so much the money supply per se that is the problem, at least not for the economy as a whole. It is the economic distortions that are brought about that are the real problem and that make an eventual bust even more severe than it otherwise would have been. Basing Bitcoin on the value of the dollar does not alter the misallocation of resources in the economy, at least not in the short run. It will set in motion a (painful) restructuring of the economy as the values of all other goods and services need to adjust to the new — and relatively fixed—money supply. This is not necessarily bad of course, but it will hurt.
Many argue that fiat currencies are nothing more than pieces of paper and rely entirely on trust, trust in government. And I wholeheartedly agree. But is that not also the case for Bitcoin? You are basically investing in ones and zeros and trust that the supply stays capped at 21 million. But who is enforcing that, who is to say that in the future someone will not decide to mine more Bitcoin if new, faster, and better technologies become available? Especially when it wants to fulfill its promise and purpose as an alternative for fiat currencies, i.e. as money. At 21 million Bitcoins how high does the price of one Bitcoin have to be to even be considered as a potential alternative to fiat currencies?
On top of that, following the success of Bitcoin, we will probably see a proliferation of alternative digital currencies — as is already the case now. With gold at least we know that the supply is relatively fixed and substitutes for gold are not easily produced. Unless you are an alchemist of course. By the way, adjusted for inflation, gold has never been a good investment either. It seriously underperforms the S&P500.
And what about the safety of the encryption? At the moment Bitcoin is very well encrypted and difficult, if not impossible to hack, but what when quantum computing finds its way into the mainstream? The belief in Bitcoin as a store of value is as much based on trust as are fiat currencies, at least that is my opinion. Furthermore, will governments allow it to become a real contender as an alternative to fiat currencies? In other words, Bitcoin addresses (in spirit) the symptoms but it doesn’t eradicate the disease, i.e. large government (interference) and central bank unaccountability.
To conclude I would like to reiterate that this is not a piece against Bitcoin or digital currency. I only think that it is still a long way from its objective as an alternative to fiat currencies. Furthermore, I also think that it currently fails in one of its other objectives and that is to alleviate wealth inequality. But also here I do not take sides and I do admire those who had the foresight to buy into it when the price was still relatively low and who had the fortitude to hold on.