The Bitcoin illusion — anonymous gambling


Tuesday, December 12, 2017

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It seems that almost everyone is either aware of or following the rapid, but somewhat erratic, increase in the price of Bitcoin. From obscure beginnings around 2008/2009 (which coincided with the sudden disappearance of a piece of free and powerful encryption software), the Bitcoin currency system grew by using cryptography to create a technology called blockchain that allowed an immutable ledger-based system to be distributed among anonymous people who create (or 'mine') the crypto-currency. Many have profited handsomely from buying Bitcoin, but it is only in the last year that super-normal gains began to be realised.

There is an ongoing discussion in public and private fora about the intrinsic value of Bitcoin, its categorisation as an asset, and usage as a stable form of currency. It appears that many experienced professionals tend to be sceptical about the value of the currency, whereas many technology enthusiasts, who are largely newcomers to the investment world, tend to argue that it is a viable asset and currency.

The stability of Bitcoin as an asset and the credibility of its market valuation are both questionable as Bitcoin has no real asset backing it. That is, a company stock is backed by the company's established business, property, equipment and goods/services, or a government bond is backed by that Government's ability to tax or print money. The risk profile, character and people managing these real assets determine the price of the stock or bonds on the market. However, in Bitcoin's case, what is the real asset that can be linked to the price of Bitcoin?

In my discussions, research and reading, some argue that, although the owners of Bitcoin are anonymous, pure and simple trust is what is the asset behind the growth of Bitcoin as an asset and currency. Of course, all business or trading is built on trust of some sort. For equities backed by real assets trust in the system of laws and governance and lower transaction costs sufficiently to enable buyers and sellers to participate in markets. For Bitcoin, that trust is built on the immutable distributed (blockchain) ledger. While the notion that trust can be built on a system outside of a Government's system of laws is very appealing, it still remains that Bitcoin has no real asset that can be used to evaluate its intrinsic value to bring it to a market capitalisation of US$232 billion (as at December 9, 2017).

Jamie Dimon of JPMorgan Chase called Bitcoin a fraud, while Nouriel Roubini, an economist, described Bitcoin as plumped for “gigantic speculative bubble” (see article in The Economist). The graph of the price changes included here shows a steep curve and rapid rise in Bitcoin's price in 2017. On December 7, 2017, Bitcoin's price rose somewhere between 25 per cent to 35 per cent (or more) in a matter of hours. Historical evidence shows that such rapid increases in assets are not sustainable. To give a few distinct examples at different levels: in the dot-com bust in 1999, the price of oil's crash in 2008 and 2014, and Enron's rise and crash, among many others, all show the same pattern of a rapid rise and sharp peak.

Alan Greenspan, former chair of the US Federal Reserve, called this pattern of behaviour “irrational exuberance” in relation to new markets that are not well understood. Could it be that Bitcoin's buyers are facing a sense of euphoria that is causing irrational buying patterns? Or the well-known 'herd effect' presents itself again in a new and emerging but little understood area?

In a sense, in an emerging market that is not well understood, participants may be doing the equivalent of gambling where the majority of players may lose significantly. The fact that these players are anonymous may be amplifying the effect due to poor assumptions by buyers about the other players in the market. Without any realistic or fundamental explanation for the value of Bitcoin, the growth of Bitcoin without any real asset backing it as a gauge of its intrinsic value appears to be fuelled by anonymous gambling.




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