As a follow-up to yesterday’s guest post, here are a few of my own thoughts about the challenges and opportunities. For full disclosure, I don’t currently own or have ever owned Bitcoin or any other cryptocurrency myself. I reached Financial Independence (FI) years ago the old fashioned way with equities and a little bit of real estate. Only a few weeks away from early retirement, I have no need to throw “Hail Mary passes” with my money! But just because I’m interested in finance and technology I should have an opinion, of course, so here are some of my random thoughts in random order on Bitcoin and Cryptocurrencies…
The great opportunity of cryptocurrencies: payment finality
Suppose you sell your used car for $2,000. Would you accept a personal check? Certainly not from a stranger! And I wouldn’t even accept one from a few people I do know, but that’s a different story! 🙂 How about a certified or cashier’s check? It provides more protection but even they have been stolen and forged, more on that below. In fact, even in the best possible case that the check is legit, your bank will put a hold on the deposit, especially for larger amounts. It happened to us after selling our apartment: that extremely big check, the largest amount I’ve ever deposited into my account, has a hold of nine days (!) before we have access to the funds. Seriously? It takes nine days to verify a check? Thanks for nothing, Wells Fargo!
So, after you have already parted with your possessions and signed over the title, you’re still waiting for your money to arrive! But even if the bank removes the hold on the check you’re still not in the clear. There have been documented cases where a check cleared but was later found to be fraudulent. The bank will want that money back! From the Office of the Comptroller of the Currency (part of the U.S. Treasury Department):
When you deposit a check into your account, your bank generally is required by law to make the funds available within a specific period of time (usually, one business day for a cashier’s check or other official instrument). This is true even if the check has not yet cleared through the banking system. Therefore, even if the funds have been made available in your account, you cannot be certain that the check has cleared or is “good.”
Your bank also may not be able to determine that the check is fraudulent when you deposit it. Rather, your bank may learn of the problem only when the check is returned unpaid by the other bank—which may take a couple weeks or more. Scammers try to make the item look genuine, which will delay discovery of the fraud. Once the item has been returned unpaid, your bank, generally, will be able to reverse the deposit to your account and collect the amount of the deposit from you.
[…] If you find yourself in this situation, you ordinarily would have a remedy against the person who wrote the check. However, you will have great difficulty pursuing any remedy against these scammers, especially if they reside in a foreign country or have disguised their identities.
So, Bitcoin and other cryptocurrencies fill an important void: If you receive an electronic payment via Bitcoin it is about as final as it gets. There are no chargebacks and you receive the money instantaneously. It’s like having cold hard cash in my hand but with the convenience of an electronic currency!
Give me your huddled and financially repressed masses…
In the excellent ChooseFI podcast on Monday they had a guest who had his Bitcoin epiphany observing guest workers getting fleeced with high fees when they send money back to loved ones in their home country. Bitcoin would have made those transactions hassle-free and much cheaper than a trip to the local money store. But it’s not just the unbanked and undocumented in the affluent countries that can benefit from cryptocurrencies. Hundreds of millions of people, maybe billions, live in countries with much less liberated financial markets than we are used to. Whether it’s the fear of taxation or confiscation (is there a difference?) or capital controls, or other forms of financial repression. There are a lot of potential users who don’t trust their own currency and/or government and a cryptocurrency might a good way or the only way to move money to safety.
The flipside of payment finality: fraud, hacks, loss of Bitcoins
Of course, finality also bites you sometimes. If your computer gets hacked or your password to your Bitcoin Wallet, or the entire site is compromised (Mt Gox), then the money is gone. Maybe you could have recourse against the exchange but it’s probably defunct and bankrupt after the hack. Good luck getting the money back!
People who don’t trust the exchanges due to concerns that they can be hacked might store their Bitcoins offline. Say on a thumb drive or even on a paper printout. But that’s not foolproof either. Here’s a story of someone who accidentally threw out a thumb drive with 7,500 Bitcoins, now worth over $75,000,000. That money sits in a landfill now! Especially if Bitcoin wants to go more mainstream there would be some security issues to be resolved. But they have to be resolved in a way so as to not throw out the baby with the bathwater, i.e., by preserving the payment finality, anonymity, and convenience of Bitcoin.
A third Bitcoin investment option: Futures
Aside from holding Bitcoin directly or gaining exposure through the “right” equities with Bitcoin/Blockchain exposure, another way of gaining exposure to Bitcoin would be to buy Bitcoin futures. One can trade Bitcoin Futures both on the CME and CBOE. The CME contract size is 10 Bitcoins, while on the CBOE one can trade one Bitcoin at a time. The Futures price tracks the spot (cash) price pretty closely, see chart below. And buying the Future avoids the risk of hackers sneaking into your account and sending Bitcoins on a one-way trip to Pyongyang.
A Bitcoin Best-Case Scenario
So, how big could Bitcoin become? Some pretty jaw-dropping numbers are floating around: $50,000, $500,000, a million dollars? How reasonable are those estimates? How big can a currency become? Well, let’s look around and compare. Let’s look at the M2 money supply of a few countries/regions: I compiled the M2 money supply numbers of the “Big-4” central banks: U.S. Federal Reserve, ECB, Bank of Japan and Bank of England. Note that the M2 supply comprises not just currency in circulation as banknotes and coins (only about a trillion USD, for example) but also the much larger category of “electronic money” such as demand deposits (checking accounts) etc. The total M2 supply is just under 40 trillion dollars for the big 4 central banks. Round that up to maybe 50 to 55 trillion dollars to include the remaining countries (I’m missing China) and we’re talking about a pretty serious number.
So, everybody, you pick what percentage of that $50-55 trillion pie can be shifted to Bitcoin divide by 21 million Bitcoins and we have an approximate exchange rate! Bitcoin at $1,000,000 apiece would imply a total market value of $21 trillion. Thus Bitcoin would have to replace about 40% of the world’s currencies, which seems a bit extreme to me. But a total market cap of one trillion dollars, replacing maybe about 2% of the world’s money, doesn’t seem so outrageous. That would put Bitcoin at $50,000 apiece.
Does a cryptocurrency have an intrinsic value?
Somebody brought this up in the comments section yesterday. Bitcoin and a lot of cryptocurrencies have no real intrinsic value. A computer solved some mathematical problem and spits out a Bitcoin. But that math problem is apparently something without any true value. At least I haven’t heard any cryptocurrency proving the Riemann Hypothesis. Now that would be a nice fat intrinsic value of $1,000,000 because that’s the prize money for anyone who can solve the 150+-year-old math problem.
But I digress. For someone like myself who’s very much focused on value – think earnings multiples, bond yields, etc. – the lack of an intrinsic value should be a problem, right? Well, maybe not. Paper money doesn’t have an intrinsic value either! The value of a cryptocurrency is the value of a medium of exchange that facilitates fast, easy, cheap, safe and anonymous electronic transfers. It’s not an intrinsic value, but a value nevertheless.
Also, remember that for as long as fiat money has been around, people have been willing to hold worthless piles of paper money and see them deflated away by rising price levels. But imagine you lived in the country of ERNtopia that has a fixed money supply of a certain number of ERNcoins. The total value of the money supply should expand roughly in line with the growth rate of nominal GDP. But since the number is fixed it means that the price per ERNcoin has to grow at the rate of nominal GDP! So, here would be a country where money balances in your crypto-wallet effectively pay interest!
Also, don’t get me wrong: ERNtopia hasn’t made money out of thin air. It merely took away the government’s ability to print free money and thus “tax away” nominal money balances through inflation. In other words:
A widespread adaptation of a cryptocurrency would mean the democratization of the government’s money printing profits!
So, instead of money balances being a hot potato I try to get rid of as quickly as possible, I might even hold some extra ERNcoins. I might even have an emergency fund, after all! That wouldn’t be a bad deal!
Could Bitcoin be the Palm Pilot of the Cryptocurrencies?
I’m not even talking about the worst case scenario of some major blowup due to fraud or hacking. Or a virus wiping out the entire ledger! No, much less dramatic, Bitcoin could just wither away and be replaced with another newer and better cryptocurrency. Sometimes being the first and the biggest player in the field is a huge advantage. But sometimes the first iteration of a major innovation is flawed and it takes another try by smarter folks. Just like the Palm Pilot failed and the iPhone succeeded. Amazon is now perfecting what a lot of companies tried 20 years ago but failed. My concern would be that certainly Bitcoin and maybe a lot of other cryptocurrencies were developed by extremely smart engineers and programmers. But they have no clue about the workings of the economy and the requirements of a payment system to run in the real world. In the U.S. alone, the ACH (Automated Clearing House) handled more than 25 billion transactions per year (or about 70 million a day), worth over 40 Trillion Dollars. Add to that all the credit card transactions, cash transactions, etc. and we’re at a number many times larger than the few 100k bitcoin transactions per day. Can Bitcoin handle a much larger volume?
Watch out for capital gains taxes!
Needless to say, if you became a Bitcoin millionaire over the last few years the IRS wants its share. Yup, that’s right, Bitcoin creates taxable events. Some could argue that this will be the undoing of cryptocurrencies. Get the IRS involved and you take the fun out of anything! Maybe… or maybe not. The easy fix would be that your cryto-wallet sends you a consolidated tax form at the end of the year: You made $543.21 in total long-term capital gains and $123.45 in total short-term capital gains. Enter on Schedule D of your 1040 tax form and you’re done. That wouldn’t be a big hassle, right?
Conclusion
So, am I optimistic or pessimistic about Bitcoin and cryptocurrencies? I don’t know! It’s probably both. The whole crypto-hype feels a bit like the DotCom bubble in the late 1990s. It’s not too far-fetched that one or some of the currencies around today will be the dominant player(s) in 20 years. Competing with all the government-run money supply! But which one? Which cryptocurrencies will go the path of Pets.com (bankrupt) and which one will be Amazon.com (worth hundreds of billions)? I can’t tell today. Bitcoin has the early mover advantage but that may also mean some design flaws. If any of the cryptocurrencies wants to take over the world, or even just x% of the global M2 money supply, it better be able to offer the computing power to handle x% of all the world’s monetary transactions, i.e., both cash and electronic. I will let the tech experts weigh in on that one! Before then I’ll stay stick with my current investments!
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