Bitcoin - Summary of arguments in favour of overvaluation

2017-10-04 13:58

I present 18 arguments for why Bitcoin is overvalued at 4300 USD/Bitcoin. I also discuss some implications for how to trade it, because of its volatility and potential upside.

My troubled relationship with Bitcoin

I have put together my thoughts about bitcoin here, of course as part of trading cryptocurrencies. Below I will present a number of arguments that leads to what many already has argued - that it is now a bubble, by pricing in a number of features that are shaky.

(note: this is written when BTCUSD stands at 4300)

General problems for Bitcoin

1) Many say that governments cannot stop bitcoin. It is nonsense that bitcoin cannot be stopped. Or more precisely; it may be impossible to eliminate it, but it can certainly be marginalized. Stock exchanges can be outlawed, ISPs can filter bitcoin traffic, exchanging coins can be regulated, miners can get their bitcoins confiscated, just to name a few options. Do not underestimate the violence monopoly of the state, and the power (and interventional propensity) of the dominating states. See how regulated the internet has become during the last two decades as compared to its first years. I do not think that any state will use extreme measures, but estimate the risk (10%?) and consider whether its consequences are priced in?

2) Bitcoin’s price is based on speculation. When I see discussions on the web between Bitcoin holders, it appears to me that they have very unclear ideas regarding its (underlying) value. Often it is based purely on price movement and a vague idea about bitcoin adoption. This is different from the larger traders of bitcoin, but it tells me that a lot of clueless actors are now drawn in - a feature of a mature bubble. The hype has now, as of the fall of 2017, reached the general speculator. The same type of clueless investors that buy penny stocks now buys bitcoin. If we believe that bitcoin has elements of a Ponzi game (where the miners form the start of the chain), the base is now becoming broader. The potential inflow might be limited, and the upside becomes limited as well. This is not a problem in itself, but it means that it is getting dangerous to play “the greater fool game”.

3) Bitcoin is based on blockchain. While blockchain seems to be a very potent technology, it does not follow that bitcoin will be adopted too. The problem is that many are still equating the two. A clearly possible scenario is that blockchain becomes adopted, while bitcoin is superseeded by some other cryptocurrency; either one of the already existing, or a coming one.  

4) Bitcoin has the first movers’ advantage. However, if we look at technological development, it is very often that the first mover has not survived. Facebook was not the first social medium, Google was not the first search engine, and so on and so forth. A special risk here is the launching of state-endorsed (and regulated) cryptocurrencies. They would not take all the value-storing and transactions. Bitcoin could still function as a medium of exchange for illicit operations, and would still have some value. However, many articles depict it as the coming world currency. Those who consider bitcoin a storage of value rather than a medium of exchange should take this notion more seriously. If bitcoin would be a common mode of payment, it would be much more resilient and ‘sticky’. When something becomes a everyday medium of exchange, it gets built into social and technical infrastructure (ranging from payment arrangement in shops to habituation by payers). A store of value which you access perhaps less than once a year is more easy to replace. If I was to take a long-term position in cryptocurrencies and believed that one of the coins currently existing would be the world standard, I would consider to invest in a basket of coins rather than bitcoin only. But there are many coins. Bitcoin is a bet on that it is the ultimate technology in an era that has just begun research and development in the area.

5) If we discount the bitcoin-holders that have acquired coins for speculation, bitcoin adoption (defined as actual, regular use) is very, very low - below 1% of the population even in the economies that use relatively little cash. There are many technologies, which initially enjoy exponential adoption, but which wears off after some time. Take Linux as an example; although it won certain niches (web servers) it never attained mass adoption. All technologies are not having first the innovators and early adopters, and in the end, the laggards. Some will be met with initial enthusiasm but then fade away or become a niche technology.

6) Let’s assume that the central banks would accept the idea of decentralized cryptocurrencies. They can combine cryptocurrencies and their current paradigm to some extent. Just like they keep gold reserves, they could keep cryptocurrencies as reserves. The sum of bitcoins are currently valued at 59 billion USD. If central banks would start buying them up, they would no doubt drive prices further upwards. Hence, that is a bad strategy for them. They would be much better off launching a new cryptocurrency, where they can first mine sufficient numbers of coins and then release them - for a much lower amount. This scenario would be disastrous for bitcoin.

7) Will the hard fork of Bitcoin and bitcoin cash, and future similar developments erode the trust in bitcoin? It is unsettling for the general user that there are suddenly two bitcoins. This is not a problem that is critical in itself, but it may damage the reputation of bitcoin and raise questions about its compatibility, stability and so forth. It increases its ‘wild west’ reputation.

8) Will the state, who depends on taxation for its very survival, accept a decentralized system where it cannot control storage of value? Tax on possession, or at least its returns, are common in many states. Why should the state accept this, when it can gently “nudge” citizens to use a system that enables tax on transactions? Perhaps it will be possible to strike a compromise here and build it into future versions of the blockchain, while keeping bitcoins so this is not a main issue.  

Now, in order not to muddle it; is bitcoin deriving its value as a storage of value or as a medium of exchange? The arguments against bitcoins are often conflating these two functions. I separate the problems of Bitcoin’s value below.  

Bitcoin as a medium of exchange

The discussion around Bitcoin’s role as medium of exchange is hopelessly vague (in itself a sign of hype). When people argue for it as a medium exchange, what is the scenario? That it is the dominating medium of exchange globally? That when we transact 1 USD between 2 people, the exchange will be mediated by bitcoin? Or that it becomes one of the top 10 mediums of exchange? If so, would it innclude not only USD but also e.g. paypal, visa, and other technologies that are not currencies, but layers of mediation?

First; I believe that blockchain, crypto-currencies and digital solutions will be massively adopted, and cash will become the exception rather than the norm. Digital money is already the dominating mode of exchange if we include the institutional forex markets. What speaks against that it will be precisely bitcoin that will be the dominant currency here? Well, see points 9-13 below.

9) Monetary policy is a central tool for the state today. The state cannot easily act as a lender of last resort if Bitcoin becomes dominant (unless they buy up large amounts of bitcoins - which is an entertaining conspiracy theory, but hardly realistic. If they wanted that, they would rather release their own cryptocurrency instead of buying bitcoins. The market would notice and it would be very expensive). I may be wrong here, but I find it hard to understand how raising and lowering interest hikes can be managed in the same way as now. Also, so-called helicopter money are not available. Devaluation is a popular tool amongst central banks when economies are weak. While one can argue that it would be better if the central banks improved the economy instead, the fact remains that they PREFER to have the tools of fiat currencies. I think that with cryptocurrencies comes many exciting possibilities to create a better governed society. However, I find it unlikely that the current central banks and all actors that benefit from the current arrangement would sit and let their current benefits and mode of thinking erode. There is no greater benefit they can derive from accepting bitcoin, and (see above) nor can the larger economies be forced to do so. I think that the central banks (and their allies) will co-opt the concept of cryptocurrencies in one way or another, in ways that enable them to keep the current tools. This is my key critique of bitcoin’s current pricing. 

This is primarily a problem for bitcoin as a medium of exchange and about denominators in particular. If non-fiat value storage would be so dangerous, why would central banks then not outlaw gold as well? The reason is that storage as value is not what concerns banks. What is important to them is to control the major denominator. When they control interest rate, they make certain that people that are holding (fiat-denominated) bonds get better interest and that investment banks change their rates. As long as the bonds and loans are issued in fiat, it does not matter for them if large amounts of value is stored in bitcoin. When people sign employment contracts where the wage is stated in bitcoin, central banks will be concerned. When banks are willing to issue loans in bitcoin, central banks will be concerned. It is not common practice today to take loans defined by ounces of gold outside the financial industry itself. The gold storage is tiny compared to the storage of fiat. The actual gold is currently valued at 6.3 trillion USD (give or take 15%), all fiat amounts to circa 86 Trillion USD (not counting derivatives). Bitcoin can double its value by 10 and still be smaller than gold.

10) The usability of bitcoin is hopeless if you compare it to other digital currencies, such as m-pesa, and probably there will be attempts to make crypto-currencies where usability is thought in from the beginning. Installation of software required can be cumbersome, the technology is not so easy to understand, and so on. When I say cumbersome, I put it in relation to its competitors - bank transfer. I think that many speculators have never tried to actually use bitcoins. While I understand that this is for security reasons, it speaks against its mainstream adoption as a major medium of exchange. On the other hand, how many people do actually understand how a bank transfer is made today? It has been encapsulated by providers and even if Bitcoin is cumbersome, it can probable be made user-friendly by such services. For instance, there are bitcoin-based visa cards.. That way, both criminal users (who are the early adopters) and mainstream users can use it, but then you conduct transaction at a 3-4% conversion cost because VISA do not trade in native bitcoins.

11) The transaction time can be long for consumers (yes, I know that you can pay more to get it processed faster), longer than its competitors (including Western bank solutions such as Swedish ’swish’, Denmark’s Mobilepay, etc).  

12) The moral panic risk. A bearish scenario: The US captures [put in random villain] headquarters and discovers hundreds of bitcoins in their treasures. What do you think the general opinion will demand?

13) Those who have actually tried to compute the fair value of bitcoin often arrives at a value far below the current one (4000 USD at the time of writing), e.g. by using the quantitative theory of money. Of course one could retort that it is the future adoption that is priced in. Bitcoin adoption is still increasing, but the adoption required e.g. by the quantitative theory of money to defend Bitcoin’s price at present is probably hundreds of times the current adoption.  

Bitcoin as a store of value

14) The well-known argument of volatility. No sane person would actually use it as a long-term store of value with its current volatility. Adoption presupposes lower volatility (or stable increase, deflation). This may of course stabilize, but before it does that, we will not see wider adoption for these purposes. A best case scenario for bitcoin would be that instead of skydiving down, it stabilizes and can thus start to attract people who want to use it as a store of value (making it to slowly climb again). To me, the typical pattern would be a major retrace before this happens if we look at hyped stocks.  

15) Trust. There are many more knowledgeable writers than this one on security, so I will leave the technical aside here. Due to Bitcoin’s technical complexity, people may doubt it. They may think that just maybe there is a vulnerability that suddenly renders their coins worthless. My point here is that even if this can be ruled out from a technical perspective, people may still doubt it. And then we have not mentioned the non-technical aspects of it; malintent by central people in the bitcoin community, phishing, etc.

16) We cannot rule out that a catastrophe such as Mt. Gox happens again. Bitcoin is more mature today, but the risk is still there. 

17) A common argument is that some citizens do not like the fiat currency of their state, because they do not trust whether the state will inflate the latter. There are, however, already ways to store savings in strong currencies such as the CHF (Swizz Franc) which fulfils that purpose - or gold. Many countries already operate with e.g. the U.S. dollar as a second currency. For instance, several African countries use dollars when they are pricing real estate and long-term investments of similar kind, since their own currencies are so prone to volatility and inflation.

18) Bitcoin’s big advantage is that it is finite, only 21.5 million coins. While it is good that it cannot easily be counterfeited, finite supply is a necessary but not sufficient quality for storage. There are plenty of antiquities that decrease in value, for instance. This is because more and more items become antique, even if they are limited in themselves. Bitcoin is limited too, but the number of crypto-currencies are not.  

So what?

Few of these arguments are novel. I have seen them elsewhere in different forms, so they are widespread, and known to the market. The question is when they will start to kick in. China moved towards cracking down on Bitcoin years ago. Bitcoin survived Mt. Gox. I have written here at length, but does it translate to a ‘sell’ of bitcoins at current price (4300)?

Almost all the arguments above are qualitative. They give no directions regarding any threshold value where the risk/reward becomes appetizing. Bitcoin is a type of investment where the ultimate reward scenario is extreme. If Bitcoin would attain the position of world currency and main store of value (overtake gold), its total market cap may be something like 31 trillion + 8 trillion = 40 trillion USD (1,9M USD/bitcoin). This calculation is simply based on that bitcoin would overtake the value of all physical fiat money plus all gold. This is of course highly abstract and naïve but gives an indication of the magnitude that we are talking. Even if there is only 0,1% chance for that this scenario becomes realized, bitcoin is still a buy at 1,900 USD at risk-adjusted value. I could easily have arrived at many other target values if I used other parameters such as economy growth, credit expansion etc., but it would still end at this magnitude of value given the 0.1% likelihood. To me, it illustrates the stakes in Bitcoin’s development and explains the hype somewhat. Even if I am a bitcoin price sceptic at the time of writing, I have to admit that I have seen surprising developments in the markets before, and it is almost presumptuous to reject current bitcoin success value with 99,9% confidence.

 A more realistic, but still very positive scenario if you accept my arguments against its adoption as medium of exchange, may be the following:

Bitcoin fails to establish itself as a major medium of exchange. However, Bitcoin becomes a significant store of value, peaking at “storing” 10% of gold’s valuation. That gives a valuation of 145,476 USD/bitcoin. (One could argue that there will still be 25% inflation in Bitcoin since all of it is not yet mined, so assume 100,000 USD/Bitcoin to round it off.)

Give it 1% chance only for this scenario to be realized; that gives a risk-adjusted price of 3000 USD/bitcoin.

In the end, the extremes of the reward situation make it almost impossible to act from a fundamental perspective. With stocks and bonds there is usually an upper limit which frames the potential.

I think that I can be quite confident that Bitcoin will not be a major medium of exchange, but the general arguments and the possibility of bitcoin as a store of value is more uncertain. While a bubble is likely, the valuation is not extreme enough to warrant shorting because of the extreme upside. However, it will not attain its success over night and jump 100%. Which strategy is more viable to trade such market conditions?

1) Generally a shorting position is more appealing from an FA-perspective.

2) Extreme risk (as usual) to short with no stop-loss.

3) Await favourable conditions from a technical perspective before shorting.

4) Look for falsifications of my arguments below, e.g. stabilization of price, long-term storage of value adoption, bitcoin as medium-of-exchange gets high usability, etc.

Comments are very welcome! I write to learn, and you can find me on Twitter (parasit).