MARKET WATCH: What’s Happening? Major U.S. exchange operators are rolling out Bitcoin trading platforms to satisfy heavy consumer demand. With the financial world now warming to cryptocurrencies and with Bitcoin’s price accelerating upward—recently breaching $10,000—optimists are convinced that this boom is only just beginning.
Our Take: Investors beware: This is more like Tulipmania than buying into the birth of Amazon. The only prospect that could possibly justify Bitcoin’s current price would be news that major economies are officially embracing it—and that is never going to happen. With governments shifting toward more transparent, accountable, and (yes) authoritarian means of running monetary policy, Bitcoin’s “crypto-currency” dream is not the future. In a world moving toward national sovereignty, Bitcoin remains a favorite of the endangered “citizen of nowhere.”
Bitcoin is headed for the trading desk: CME Group, the world’s largest derivatives and futures exchange operator, has announced plans to introduce Bitcoin futures by the end of the year. Optimists take this news as the latest sign that Bitcoin, after years of being dismissed as a fringe pursuit of devoted hobbyists, is finally going mainstream.
The numbers certainly reflect this optimism. Bitcoin’s YTD rise has been one of the biggest stories in a year full of bull markets. Since January, the price of a single Bitcoin has skyrocketed from less than $1,000 to over $11,000—a jump of roughly 1,000%. (Bitcoin is rising so quickly that it probably increased in value while you were reading that last sentence.) This windfall has given Bitcoin a market cap of $191 billion as of this writing, which would rank well within the top 10% of the S&P 500. On an average day, nearly 300,000 confirmed Bitcoin transactions take place on exchanges worldwide—up from virtually none a few short years ago.
THE DIGITAL CURRENCY BOOM
Bitcoin isn’t the world’s first digital currency—but it has certainly become the most popular. Its success can be chalked up to a combination of remarkable historical timing and groundbreaking technology.
Bitcoin’s origin traces back to late 2008, when a paper appeared entitled Bitcoin: A Peer-to-Peer Electronic Cash System. It was authored by a pseudonymous entity named Satoshi Nakamoto, who proposed “a system for electronic transactions without relying on trust.” With the United States in the depths of the Great Recession, this decentralized, libertarian proposal clearly hit home. A digital currency untied to any one government or nation was fodder for small-government skeptics who had learned not to trust central banks.
OK, sure, nobody ever lost cash in a bank or money market account during the GFC. But in the years that followed Bitcoin has nevertheless become popular on two levels. The first was as a lifestyle affectation of libertarians who want to go “off the grid.” The second (as we’ll discuss below) was as a perfect tool for outlaws who absolutely need to hide their activity. The first generates much media hoopla but few real-world transactions. The second generates little media but almost certainly the majority of Bitcoin’s real-world transactions volume.
The digital currency’s underlying technology ensures that users are freed from any intermediary or central control. Bitcoin runs on a blockchain, a “distributed ledger” that keeps a real-time record of everyone’s transaction on everyone’s computer. (Not everyone’s smartphone: The total blockchain file is too big for that—but there’s an SPV workaround for mobile users.)
Though this ledger is publicly visible, individual transactions are near-impossible to trace to any one source because real-world identities are missing. Instead, all that’s visible on the ledger are the anonymous “Bitcoin addresses” where the digital currency is stored. Only you know which address is yours. And you can open as many new addresses as you like. If you’re fearful of disclosure and want to be extra certain of secrecy, you can hire “tumblers” which split your transactions into many smaller ones and mix them together in random ways before spitting it all back to you in a new account.
In response to Bitcoin’s soaring popularity, many financial institutions are investing in platforms and services that will help their customers trade Bitcoin. CME Group isn’t the only exchange operator to try this strategy: Last month, upstart LedgerX officially became the first company to launch Bitcoin derivatives, overseeing more than $1 million in Bitcoin trades in its first week. Cboe, another large Chicago-based exchange operator, recently announced similar intentions. (Last week, the CFTC gave the green light to both CME and Cboe to begin trading.) Even Goldman Sachs is reportedly consulting digital currency experts in anticipation of adding Bitcoin services.
More evidence of how far Bitcoin has come: CoinDesk, a data firm that hosts a digital currency conference each year, recently unveiled its first-ever event explicitly geared toward mainstream investors. Among the 1,300 attendees were representatives from Wall Street heavyweights like Morgan Stanley.
Bitcoin’s success has even spawned a rash of “me too” currencies designed for every possible niche. After Bitcoin, the next-largest by market cap is Ethereum, a blockchain-enabled platform created by programmer and Bitcoin fan Vitalik Buterin. Unlike Bitcoin, which was formed for P2P transactions, Ethereum (and its currency, Ether) is designed to facilitate complex, multiparty B2B transactions. (So far, companies like Samsung and Toyota have experimented with Ethereum.) Then there is Ripple, a digital currency known primarily for its ultra-low latency and fast transaction speed. And fast-rising Iota, an infinitely scalable "third generation" currency that avoids "blocks" and transaction fees altogether.
While these are the most widely known digital currencies, there are more than 2,000 different coins in existence today, by the count of Big Data expert Bernard Marr. There are themed coins dedicated to specific pursuits (GunCoin), geographic locations (NewYorkCoin), and even foods (TacoCoin). In all, a record-high $1.32 billion of new coins were “minted” through initial coin offerings in Q3 2017—more than the amount raised in Q1 and Q2 combined, according to data from Token Report.
Some of these “altcoins” function differently and target a different market than Bitcoin (think of Ethereum and its B2B use). But others are mostly similar—or even used to be part of Bitcoin. A major driver of the proliferation of digital currencies is the “hard fork,” by which one digital currency splits into two currencies. When an idea to improve the underlying protocol of a currency fails to meet unanimous acceptance, developers sometimes create a separate version of the original currency, which is then traded as a new currency. In theory, owners of the original currency have the right to keep trading in both after the split. Bitcoin has so far spawned two such altcoins, Bitcoin Cash and Bitcoin Gold, each of which features a tweak in the functionality of legacy Bitcoin.
THE FUTURE OF BITCOIN
Clearly, Bitcoin is working its way into the mainstream, which raises the question: Where does it go from here? Many proponents are convinced that Bitcoin will become an official currency. U.K.- based Magister Advisors forecasts that by 2030, Bitcoin will be the world’s sixth-largest reserve currency. While speaking at a recent summit, Coinbase CEO Brian Armstrong said, “I do think some digital currency will end up being the reserve currency of the world.” Meanwhile, venture capitalist Fred Wilson predicts that, “By the end of this decade, we should start to see native blockchain applications receiving massive [mainstream] adoption.”
If these bulls are correct, then paying upwards of $11,000 for a single Bitcoin wouldn’t seem all that outlandish. An investment in something that eventually competes on a global scale with the dollar and the euro? Where do I sign?
But there is a fundamental problem with this prediction: By its very design, Bitcoin is not “money” in any commonly accepted sense of the word—and never will be.
Bitcoin doesn’t fit anywhere in the currency spectrum. Throughout history, across the full range of market economies at every stage of development, all currencies have been backed either by some tangible asset (as in a barter system evolving into the gold standard) or by regulatory decree (as in certificates of debt, usually public debts, evolving into a “fiat” currency).
Bitcoin checks neither box. Unlike “commodity money,” Bitcoin has no intrinsic value. And unlike “fiat money,” Bitcoin is not deemed legal tender in any nation nor can it be used to pay any nation’s taxes.
Linked to neither a thing nor a law, Bitcoin’s value is determined purely by speculation—which makes it prone to drastic price swings in the range of 30% of its value or more. (These price swings are so common that the Bitcoin crowd has a special word for them: “waves.”) Indeed, Bitcoin blows the whole concept of “value” out of the water. Who’s to say what a single coin is really worth? What’s stopping the price from rising from $11,000 to $11 million? (The latter isn’t a bad guess if you figure the world’s entire supply of money and near-money, around $200 trillion, will someday consist of Bitcoin.)
Untethered value means Bitcoin fails utterly to meet two of the three classic criteria of money: unit of account and store of value. And you thought Poles taking out mortgages in Swiss Francs had it bad. Imagine taking out a mortgage in Bitcoin and watching it double in 30 days! As University of Georgia economics professor Jeffrey Dorfman points out, “People don’t want investments or debts denominated in a currency whose value can change by 50 percent in a month.” (As for the last criteria of money, means of exchange, read on.)
“Trustless money” is an oxymoron. The basic problem? A successful currency requires tradition, trust, and transparency. But Bitcoin is predicated on novelty, distrust, and secrecy. These attributes are so embedded into Bitcoin’s design that they were explicitly highlighted in Nakamoto’s original manifesto.
Some say that Bitcoin is like gold because, while not a commodity, its ultimate supply is limited to 21 million coins by the algorithm with which it is “mined” (a Bitcoin technical term: yes, the analogy is deliberate). But we’ve had thousands of years to get pretty secure about the scarcity of gold: We now know that gold is an element created in either supernovae explosions or neutron star collisions. (To create a new gold atom, you’d basically have to vaporize the solar system.) But who has any security about the scarcity of Bitcoin—or even understands the math or programming or hidden backdoors within it? We don’t even know the identity of the faceless entity who created it.
“Scarcity,” as we’ve seen above, is hardly an accurate term to describe the digital currency market anymore. Bitcoin faces two distinct threats from within its own ranks. There’s the possibility that one of the countless altcoins on the market today—or even one not yet in existence—could stumble upon a better (faster, cheaper, more secure, less trackable) algorithm and become wildly popular, rendering Bitcoin useless. Alternatively, multiple hard forks by a consortium of powerful miner pools could flood the market with dozens of Bitcoin altcoins, diluting its value. After all, when a public firm does a stock split, the stock’s value falls by half. Even in the irrational market of digital currencies, the introduction of many different versions of Bitcoin could torpedo its value.
As for state approval, that’s a nonstarter so long as governments are in the business of ensuring that wealth is not stolen, fraud is discouraged, illicit transactions are detected, and taxes are paid. All of which Bitcoin by design makes exceedingly difficult—not impossible (as Silk Road gangsters learned to their sorrow), but hard enough to ensure, in Jamie Dimon’s words, that “no government will ever support a virtual currency… It’s not going to happen.”
There’s a reason why the bold predictions of Bitcoin’s dominance have mostly come from Bitcoin insiders and rarely from economists, policy experts, or political leaders. A platform built by a faceless entity for the express purpose of keeping transactions anonymous is anathema to those entrusted by the public to track of people’s spending. Bitcoin is most popular in authoritarian regimes where people have the most to hide, like Russia and China. Not coincidentally, these regimes have also been the first to crack down on its use.
Large transactions: at your own risk. Total privacy makes Bitcoin a terrible choice for storing lots of money since it can be so easily stolen. When you “buy Bitcoin,” all you are doing is sweeping numbers into a random address that is linked to you by means of a secret digital key (typically in a “digital wallet” on your mobile phone). The problem: If that key is stolen, your ownership disappears—and is virtually impossible to reclaim—because there is no public record that it was yours to begin with. There is no paper trail you can grab hold of, and no court you can turn to. According to Carnegie Mellon’s Nicolas Christin, “The only way to get [Bitcoin] back is by tracking you down and basically beating you up with a lead pipe.”
Alarmingly, the exchanges on which Bitcoin is stored and traded have been hacked at least three dozen times since 2011 alone, in which more than 980,000 Bitcoins have been stolen. In these cases, the only real legal recourse is to sue the exchanges in hopes of recouping what’s left behind. Good luck with that. Hackers who manage to gain access to a Bitcoin user’s digital wallet can wipe out a fortune in a matter of seconds. Just ask this Bitcoin user who woke up one morning to find his $500,000 Bitcoin stash empty. Very likely, he is no longer a Bitcoin enthusiast.
Small transactions don’t make much sense, either. Bitcoin is also a poor choice for making small transactions. The hurdle here is scaling. Each block in Bitcoin’s blockchain has a fixed capacity of just one megabyte every 10 minutes—which naturally leads to longer transaction confirmation times and higher fees with increased adoption. These problems are already cropping up: Since the beginning of 2017, the average Bitcoin merchant transaction fee has jumped from 35 cents to more than $7. Will you pay Uber in Bitcoin if either you or the driver have to pay a third party $7? Probably not.
While some of this is pure “rent” flowing to miners, the rest is accounted for by the brute physical cost of solving Bitcoin’s ever-more difficult cryptographic puzzles (“valid hashes”). Bitcoin’s global mining network currently consumes roughly 30 terawatts of electricity per year. That’s a lot—more than the entire consumption of Ireland. According to research by Dutch bank ING, a single Bitcoin transaction is enough to boil 36,000 kettles of water or power a (Dutch) home for four weeks. Which makes it roughly 20,000 times less energy-efficient than buying with Visa. Electric utilities and Nvidia (maker of dedicated “mining chips”) couldn’t be happier. Bitcoin may be many things, but enviro-friendly it is not.
There is a massive debate raging among Bitcoin developers over how to improve Bitcoin’s cost, speed, and efficiency. Near term, Bitcoin developers likely will be forced either to expand the blockchain’s capacity (a contentious, hard-fork-worthy issue) or to reroute some transactions onto less-secure secondary networks. Longer term, some suggest more radical options, such as “de-centralizing” Bitcoin by allowing transactions off the main grid or “re-centralizing” Bitcoin by returning to the (gulp!) top-down SQL-type database that true Bitcoin groupies loathe.
An emerging obstacle to reaching a solution is that Bitcoin miners get to “vote” on Bitcoin Improvement Proposals. To the ire of most users, most miners (surprise?) love pocketing high fees. Indeed, Bitcoin’s negative economies of scale could ultimately pave the way for another digital currency to win out. High fees are not an inherent problem with all digital currencies. To the contrary: Altcoins like Ethereum, Litecoin, Dash, and even Bitcoin Cash all carry an average merchant fee of less than 50 cents.
WHERE BITCON ABSOLUTELY EXCELS: ILLICIT ACTIVITY
Proponents and critics alike all agree that Bitcoin’s ultimate value lies in its ability to function, as a currency should, as practical means of exchange. That’s why backers are so eager to cite the growing number of mainstream retailers that are reportedly accepting Bitcoin.
But thus far, there’s little evidence that this is happening. Just three out of the top 500 e-commerce firms accept Bitcoin as a form of payment, according to a recent Morgan Stanley report. That’s down from five last year. And even among the companies routinely cited by these backers—like Microsoft and Overstock.com—the truth is that none of them are truly accepting Bitcoin. They don’t let Bitcoins rest for their even a nanosecond on their books. Rather, they’re partnering with firms like Coinbase or Bitpay, which then convert the payment into U.S. dollars. These industry middlemen are the very same firms with a vested interest in making the Bitcoin transaction universe appear large.
There is, however, one area in which Bitcoin has an unrivaled comparative advantage to any other type of money, and that’s the world of illicit activity. The dirty little secret about Bitcoin? Most of the people using it as an actual means of exchange have dirty little secrets to conceal.
Criminals have in fact been using Bitcoin almost since its inception. As early as 2011, Silk Road set up its darkweb bazaar where visitors could use Bitcoins to buy anything from fake IDs and stolen passwords to child porn and opioids. Bitcoin (along with a location-stripping browser like Tor) eliminates the biggest risks faced by the digital-age criminal. Worried about police tracing your IP address? Bitcoin makes this near-impossible. Worried about your buyer selling you out? No need—they will never even know your name.
To be sure, Silk Road 1.0 was busted by the FBI in 2013—and several of its direct successors, like Silk Road 2.0, Agora, and Evolution, have also since gone under. But like the mythical hydra, two heads seem to grow back for every one lopped off. By all estimates, the number of vendors, advertisers, consumer reviews, and (estimated) sales on the darkweb have doubled or tripled since 2013.
How much Bitcoin volume is accounted for by illicit transactions? Obviously, no one knows. Estimates based on sample darkweb “scrapings” suggest illegal drug sales of at least $250 million annually. But this is surely just the tip of the iceberg. Many sites are missed. Roughly a quarter of sales are wholesale (which may be resold at retail via Bitcoin). And many routine customers no doubt deal with their suppliers “offline.” There is moreover an entire infrastructure of darkweb enablers (Web designers, advertisers, fabricators, and so on) who are also largely paid in Bitcoin. Total gross turnover in this drug market could amount to several billion dollars.
Don’t think that’s plausible? According to the annual Global Drug Survey, the share of American drug-users who say they got high with the help of a website jumped from 8% in 2014 to 13% this year. This share is rising globally in markets like the U.K. and Ireland as well.
In many countries, the share of drug users facilitated by the darkweb is staggering. In the last 12 months, more than one-quarter of drug-users in countries like Finland (41.4%), Norway (27%), and the U.K. (25%) have gotten drugs online.
So let’s do some back-of-the-envelope math. According to U.N. estimates, the global illicit drug trade grosses around $400 billion per year. If we cautiously assume that just 2 or 3% of that is now transacted via Bitcoin, we’re already up to $8 or $12 billion in total transactions.
And why stop at drugs? What about the broader array of illicit activities, like human trafficking, weapons sales, extortion, espionage, and cybercrime—to say nothing of old-fashioned theft and embezzlement? The U.N. estimates the gross global revenue of organized crime at 1.5% of global GDP, or well over $1 trillion this year. If 2% of that has converted to Bitcoin, we’re looking at $20 billion yearly.
We could go further and add in Chinese investors who are trying to get around export controls. Or rogue states like North Korea and Iran, who are widely assumed to be making large Bitcoin transactions to evade global sanctions. And then consider tax evasion: According to The Economist, some $20 trillion have been sequestered in global tax havens. After the release of the Panama Papers, is it unreasonable to think that some evaders have started to transact with these shelters in Bitcoin?
No exact estimate of any of this is possible. And indeed, preventing any exact estimate is whole purpose of Bitcoin. But it’s no stretch to wager that at least $30 billion in gross global Bitcoin transactions involve other-than-legal transactions. Over the entire course of 2016 (before Bitcoin’s huge speculative ramp-up), the average annualized daily value of Bitcoin transactions was $58 billion. All this suggests that illicit activity may account for one half or more of Bitcoin’s total transactions volume. Excluding speculative trading, it’s likely that illicit activity accounts for the great majority of Bitcoin’s real goods-and-services transactions.
While the dollar amount of illicit Bitcoin activity is tough to measure, experts on organized crime do acknowledge that Bitcoin plays a huge part in global criminal activity. A recent report by the Australian Criminal Intelligence Commission states in no uncertain terms that Bitcoin is one of the key technological enablers of organized crime worldwide.
Going through all these scenarios, it’s fair to wonder why Bitcoin volume is as small as it is. Many law-breakers or law-evaders are apparently just starting to catch on: Absolute secrecy makes Bitcoin a no-brainer for most of them.
So let’s return to the bottom line. Inside the law, there’s little evidence that Bitcoin transactions are anything but speculative. According to Garrick Hileman, a Bitcoin expert at the Cambridge Center for Alternative Finance, “Based on the data we’ve collected, we think speculation is the primary driver [of higher transaction volume].” Drawing a similar conclusion is Credit Suisse CEO Tidjane Thiam, who says, “From what we can identify, the only reason today to buy or sell Bitcoin is to make money.”
Therein lies another essential truth about Bitcoin. Many of the same money managers who stand to make a killing on Bitcoin as a speculative investment readily admit that they see no real future for Bitcoin as a means of exchange.
Even as JPMorgan considers adding Bitcoin futures, its CEO, Jamie Dimon, is telling anyone who will listen that he believes Bitcoin is a “fraud.” For his part, in a recent interview with Hedgeye’s own Keith McCullough, currency expert and author Jim Rickards says that, “This is the only topic where I agree with Jamie Dimon… I call [Bitcoin] a Ponzi with no one in charge.” Hedge fund manager Mike Novogratz, who is starting a $500 million hedge fund to invest in digital currencies, admits that Bitcoin is a bubble—but has no qualms about profiting from it: “[Bitcoin] is going to be the largest bubble of our lifetimes… You can make a whole lot of money on the way up, and we plan on it.”
If you are long Bitcoin, never say that you were never told.
GENERATIONAL CHANGE: BOON OR BUST?
In spite of all these warning signs and storm flags, Bitcoin’s backers are confident that they have young consumers in their corner. After all, on the surface, Bitcoin seems like a good fit for forward-thinking Millennials lured by the futuristic promise of a democratized, algorithm-driven currency. It’s techie and geeky and most Boomers can’t understand it. The data seem to back this up: A CoinDesk report finds that 39% of Bitcoin users are between 25 and 34 years old, the largest share of any age group. Of all consumers who’ve heard of Bitcoin, Millennials are the most likely to say they’ve ever owned Bitcoin, that they plan to invest in Bitcoin, and that they’re open to using Bitcoin for purchases. A few Millennials are even incorporating Bitcoin into their retirement portfolios.
But these Bitcoin-loving Millennials remain in a small minority. To be sure, many Millennials (men especially) are using Bitcoin for small and relatively safe drug purchases: The Global Drug Survey finds that, compared to all drug buyers, buyers from the Web have a lower median age (24 vs. 40) and are more likely to be male (87% vs. 67%).
There is however no evidence that the best and brightest of this generation want to bank their future on speculative e-digits. To the contrary, Millennials are by and large a risk-averse generation that figures even getting a credit card is too risky (see: “Credit Cards Lose Their Charge”). They are also a generation that values social trust, which makes them unlikely to underwrite a system that epitomizes social distrust.
As we’ve mentioned before, it’s actually Generation X that best embodies the libertarian, trust-nobody ethos of digital currency. (See: “All Bark, No Bitcoin.”) Today, Xers (and some Boomers) no doubt constitute the vast majority of Bitcoin transactors and exchangers. But in the years ahead it will be Millennials, as voters and savers, who will mostly determine Bitcoin’s future.
THE FINAL WORD
Thanks in part to Millennials, the global mood is shifting toward transparency, accountability, and public authority in monetary and economic policymaking—a climate hostile to everything Bitcoin stands for.
Bitcoin was created in the depths of the Great Recession, when trust in centralized power was at its nadir. But today, with voters around the world casting their ballots in favor of populist and authoritarian leaders who promise order (see: “Are Millennials Giving Up on Democracy?”), the libertarian worldview that has catapulted Bitcoin into the mainstream is waning.
Abroad, the regulatory tide is clearly turning against Bitcoin. Look no further than China, where regulators have banned initial coin offerings and have been shutting down popular Bitcoin exchanges. This is ill news for Bitcoin bulls: A whopping 88% of all exchange-traded Bitcoins have done so on Chinese yuan-denominated exchanges.
Elsewhere, plenty of nations have either imposed an outright ban on the digital currency (Bolivia, Ecuador, Kyrgyzstan, and Bangladesh) or more stringent regulations (Poland, Israel, and Australia). In North America and Europe, efforts have just begun to extend the reach of AML and KYC (anti-money laundering and know your customer) regulations to Bitcoin exchanges. Most Millennials will be fully aligned behind government efforts to make currencies accountable and regulated and safe.
To be sure, not everything about Bitcoin is destined for failure. Bitcoin’s underlying blockchain technology holds great promise. Many industries stand to benefit from the adoption of a distributed ledger: Envision for instance, a health care system in which, instead of sending paperwork back and forth, providers and insurers could access claims instantaneously on a flawless, open-access file. Or imagine an Internet of Things in which appliances could "bargain" and "sell" each other resources (like data or electricity). Another potential use is in the writing of “smart contracts” that will only pay out under certain conditions (such as if a Kickstarter’s funding goal is met). This last area, by the way, is the purview of Ethereum.
But an open, public ledger is a very different idea than what we have now in Bitcoin. For a digital currency to truly go mainstream as a means of exchange, it must be built with transparency in mind. It’s like going from Myspace to Facebook: The Xer-inspired site may have been fun for a while, but “social media” didn’t really take off until the next generation bought in. And for Millennials to buy in, they needed to be able to put a name and a face to the identities they see there. They want trust and sociability—something that Bitcoin will never give them.
So what explains the Bitcoin boom? Don’t look for a rational justification. Nothing is more typical, in the midst of a surging bull market and high market valuations, than for investors to take “free” house money and bid up some promising yet not-quite-ready-for-prime-time idea to a ridiculous price. It happened in the late ‘90s over the dot-coms. It happened in the late ‘20s over a budding electronics industry. And happened in the late 1850s over railroads.
These industry-specific booms all ended in devastating crashes, not because the basic idea was without merit but because animal spirits temporarily short-circuited sound judgment. And in the aftermath, all generations at the time suffered—and the rising generation perhaps suffered most of all because they were least able to afford the loss and had never been hurt by the market before.
The same will likely happen once the next downturn hits and markets force investors to flush pure speculation out of their portfolios. Bitcoin’s true value—or lack thereof—will then be revealed.
