A Relentless Downturn

When Chinese investors discovered that Bitcoin might offer an avenue for circumventing China’s exchange controls, the digital currency soared to an incredible $1,250 per unit (on some, but not all Bitcoin exchanges – prices tend to vary a bit between the different exchanges). This was of course not only due to the perception that exchange controls could be evaded with Bitcoin; the Chinese are well known for their love of gambling after all. As real interest rates were in negative territory for long stretches of time in recent years, China’s citizens have sought out all sorts of investments to preserve the purchasing power of their savings – Bitcoin was just one more option, but China’s authorities ultimately cut this option off.

 

P1160701

Image credit: fmh

 

During the relentless, bubble-like advance of Bitcoin, various accompanying news items lent support to the rally as well. A quite prominent one was e.g. the “bail-in” of depositors at two large Cypriot banks, which caused traders and investors in several peripheral euro area countries to join the rush into the digital currency. The total number of Bitcoins that will be in issue once all of them have been “mined” is strictly limited to 21 million units. This limited supply conferred additional appeal to the currency, as did news that a number of well-known personalities such as the Vinkelvoss twins had invested large amounts in Bitcoin.

As the rally progressed, numerous traders and market forecasters made ever more exaggerated claims as to the possible future price Bitcoin would attain. They did so regardless of the fact that the so-called “barriers to entry” in the digital currency business are quite low, as evidenced by numerous competing crypto-currencies springing up in recent years. However, it should be noted that Bitcoin still enjoys the so-called “first mover advantage” – it is simply much better known and more widely accepted than its clones.

Alas, the notion that one would be able to make a fortune by buying Bitcoin anywhere near the peak of the bubble turned out to be misguided. As so often, the many wild forecasts of future riches actually turned out to be a warning sign. As the weekly chart below shows, the crypto-currency plunged to a low of $150 in mid January this year, before recovering somewhat to about $230.

The final plunge in early to mid January was accompanied by a huge expansion in trading volume. In the past, large spikes in volume have almost always been a sign that a short to medium term low was close, so from a trading perspective Bitcoin may actually be a reasonably good buy at levels below $200. Note here that we are certainly not issuing a recommendation, we are merely commenting on Bitcoin as a “trading sardine”.

 

1-bitcoin, weeklyBitcoin in USD terms, weekly: the bubble phase has been almost completely retraced as of mid January – click to enlarge.

 

Growing Acceptance as a (Secondary) Medium of Exchange

Bitcoin has suffered greatly from teething problems and a growing perception that it is increasingly subject to fraud. Some of the frauds that have occurred were reportedly based on technical weaknesses hackers were able to exploit. The most famous instance of Bitcoin fraud was the demise of the once largest Bitcoin exchange, Mt. Gox in Japan. Hackers were apparently able to insert themselves between transactions taking place there and effectively “doubled” them for a brief period of time, diverting Bitcoins to their own virtual “wallets” in the process.

This and similar scandals have undoubtedly contributed to the deflation of the bubble-like advance in 2013. Just recently, yet another large Bitcoin exchange-related fraud has been discovered to the chagrin of the customers of a Hong Kong based exchange ironically named “My Coin” (it should probably be renamed “Their Coin” now):

 

“Reports are emerging from Hong Kong that local bitcoin exchange MyCoin has shut its doors, taking with it possibly as much as HK$3bn ($386.9m) in investor funds. If true, the supposed losses are a staggering amount, although this estimate is based on the company’s own earlier claims that it served 3,000 clients who had invested HK$1m ($129,000) each.

For perspective, bitcoin’s entire market cap today stands at around USD$3bn. The issue came to light on Friday when about 30 people claiming to be victims of the company’s actions petitioned a local member of the Legislative Council, Leung Yiu-chung. The victims are reportedly due to make a statement to Hong Kong police on Wednesday.

Adding to the mystery are reports the company never operated as a genuine bitcoin business at all. Testimonies from customers describe an operation more like a Ponzi scheme that used the veneer of bitcoin trading as its lure. One local woman was quoted as saying:

“We were told by those at higher tiers [of the scheme] that we can get our money back if we find more new clients.”

Adding to the business’ pyramid-like feel were promises of cash prizes or Mercedes-Benz cars if customers could recruit new investors, said a report in Hong Kong’s South China Morning Post. Customers were never presented with receipts and were led to deposit their newly-acquired coins at a separate site to earn interest.

MyCoin had promised several months ago that it would soon be listed on the Hong Kong stock exchange, and according to photos posted online, also operated a bitcoin ATM.

Customers were promised returns of HK$1m in four months, and had been pressured into buying bitcoin-based contracts by real estate agents, insurance agents and law firm clerks. But after slowing down the release of payments and changing the rules to make it progressively more difficult to withdraw, the exchange’s office boarded up its doors for “renovations” last month, the report says.”

 

(emphasis added)

It seems Bitcoin was merely used as a vehicle for a classical Ponzi scheme in this case – nevertheless, such news no doubt tend to impinge negatively on the digital currency’s reputation.

Is Bitcoin actually money? Many people have stated that Bitcoin does not conform to the definition of money as laid out by Menger and Mises. However, it is obvious that Bitcoin originated in the free market, so one has to be careful with such assertions. In fact, if we apply the regression theorem to Bitcoin, it can be argued that at its inception, it did in fact possess a non-monetary use value.

Contrary to commodity money, this use value was not rooted in the physical realm (such as is the case with gold, which can be fashioned into jewelry and has other industrial uses), but was rather “idealistic” if you will. As Nikolai Gertschev argues, what makes Bitcoin an economic good can be summarized as follows:

 

“At their inception, bitcoins were created and first held within a “crypto-punk” community. It could then be safely assumed that they served the purpose of conveying a specific antiestablishment worldview. The first demand factor, initially for producing bitcoins, and then unavoidably but only indirectly for holding them, was rooted in their capacity to project a certain point of view. In a sense, bitcoins were comparable to an artistic medium of expression, such as music, literature, and painting.

Thanks to that initial source of value, bitcoins had a reference point that positioned them relative to other goods and services. From there onward, the technological features that characterize them led to an expansion of their demand. Bitcoins are imperishable. Storage and protection against theft or accidental loss come at a very low cost, as these are accessory services rendered by standard antivirus and back-up software. Marginal transaction costs are also practically zero, once the fixed cost of establishing and maintaining a network connection has been accounted for. All these aspects are common to real wealth assets. Thus, the second demand factor for bitcoins is explained by their capacity to store wealth at a low cost. From the status of a good which, as a “worldview-conveyor,” was largely used for personal enjoyment (and hence consumption), bitcoins evolved into an investment good that has become attractive well beyond its original crypto-punk community.”

 

(emphasis added)

We sympathize with this analysis, but at the same time we agree with those who argue (as e.g. Frank Shostak does here in a critical assessment) that Bitcoin crucially depends on the fact that it can be exchanged for other (fiat) currencies. Rather than being a money in its own right, Mr. Shostak says it simply represents a new method of employing existing fiat money in transactions.

Can these seemingly opposing viewpoints be squared? One possibility is to look at Bitcoin not as money as such, but rather as a secondary medium of exchange. As Mises noted with respect to secondary media of exchange:

 

“A first-class bond is more marketable than a house in 3 city’s main street, and an old fur coat is more marketable than an autograph of an eighteenth-century statesman. One no longer compares the marketability of the various vendible goods with the perfect marketability of money. One merely compares the degree of marketability of the various commodities. One may speak of the secondary marketability of the vendible goods.

He who owns a stock of goods of a high degree of secondary marketability is in a position to restrict his cash holding. He can expect that when one day it is necessary for him to increase his cash holding he will be in a position to sell these goods of a high degree of secondary marketability without delay at the highest price attainable at the market. Thus the size of a man’s or a firm’s cash holding is influenced by whether or not he owns a stock of goods with a high degree of secondary marketability.”

 

(emphasis added)

The secondary marketability of Bitcoin is indeed very high; it can undoubtedly be “sold without delay at the highest price attainable in the market” if a holder of Bitcoin wishes to increase his holdings of standard money. Note that Bitcoin exchange 247exchange has recently added fiat money withdrawals via debt and credit cards for holders of Bitcoin accounts to its services. For the moment we would therefore go with this definition: Bitcoin is a secondary medium of exchange.

In spite of the teething problems discussed above, the acceptance of Bitcoin as a means of payment in commercial transactions continues to increase. Again, there can be little doubt that this is only possible because retailers accepting Bitcoin in payment are able to quickly convert such payments into government-issued fiat money at Bitcoin exchanges. Bid/offer spreads at Bitcoin exchanges are quite tight, which is definitely telling us that market liquidity is reasonably good. It is evidently good enough for many retailers, as a recent survey on payment methods they are contemplating to accept in the near future shows.

 

2-payment methodsBitcoin continues to gain acceptance in payments, although it still lags behind other alternative payment methods – click to enlarge.

 

Along similar lines, 260 airlines will soon be able to accept Bitcoin via the UATP network, which is partnering them with Bitnet. Obviously, the original use value of Bitcoin plays no role in the decision of these retailers to accept it in payment. It is solely the crypto-currency’s exchange value that is of interest to them.

For a variety of reasons, we personally prefer gold as an alternative to standard money. Note that gold can also be employed in “digitized” payments via services such as Gold Money, so it can be used as a “modern” medium of exchange as well. Similar to Bitcoin payments, this of course requires vendors to actually accept this payment method.

Bitcoin has the advantage of lower cost (there are no storage and insurance costs involved), so even gold aficionados may find Bitcoin useful. However, it obviously has the disadvantage that it merely represents digits in a computer, whereas gold has a physical existence outside the digital realm – not to mention that it has thousands of years of history as money behind it. Still, it seems that demand for Bitcoin as a means of payment continues to increase, regardless of the collapse of the speculative bubble.

 

Bitcoin Trading

Bitcoin remains an interesting speculative/trading vehicle, especially as some exchanges have added margin trading, swaps and short selling to the range of services Bitcoin traders can employ. Those who believe that Bitcoin is just a fad that is ultimately destined for oblivion can e.g. express their opinion by entering into a swap and effectively shorting the currency by selling the Bitcoin they have borrowed (data on BTC swaps at Bitfinex can be seen here). In short, many traditional ways of trading are available these days – even BTC options have begun to trade in the meantime.

 

3-BTC swapsA screenshot of Bitfinex BTC swaps data – click to enlarge.

 Incidentally, BTC swaps data can also be used to gauge the sentiment of Bitcoin traders, by comparing the number of long versus short swaps currently open:

 

4-Long-short swapsLong and short BTC swaps at Bitfinex compared – this provides a gauge of Bitcoin trader sentiment – click to enlarge.

 

Conclusion

The Bitcoin bubble has certainly deflated, but it seems to us that something we have first asserted quite a while ago continues to apply: the digital currency is likely here to stay – at least as long as there are electricity, computers and the internet. As long as acceptance of Bitcoin as a means of payment continues to increase and the range of Bitcoin-related services keeps growing, we can be reasonably certain of this. Whether this makes it a good “store of value” is however a different question – our own view is that gold is vastly superior in this respect.

 

5-bitcoin, dailyBitcoin, daily: large volume spikes have often occurred near short term lows, even during the current bear market phase – click to enlarge.

 

Charts and tables by: Bitcoincharts, Bitfinex, Coin Desk

 

 

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4 Responses to “The Bitcoin Bubble Deflates – But the Currency Continues to Evolve”

  • mantrid:

    excellent article, Pater! I have a few comments though:

    GoldMoney isn’t ‘digitalized gold’ because essential property of physical gold is that it has no counterparty, while GoldMoney issues IOUs and is itself the counterparty. Meanwhile bitcoin has no counterparty either.
    The only counterparty of bitcoin you can think of is the distributed network (at least cryptopunk society) itself but then similarily the counterparty of physical gold is the society itself. With thousands years of history it is unlikely that societies would completely drop gold and it is unlikely that all network participants would leave distributed bitcoin infrastructure.

    For decades people keep arguing on what is money and what isn’t and have come to no consensus so far. I offer different theory on the topic:

    0. money is a form of ‘tickets for stuff’
    1. commodity-focused agricultural economy employs commodity-money (gold)
    2. service-focused industrialized economy employs service-money* (fiat money)
    3. information-based computerized economy employs digital-money (bitcoin)

    *) Fiat money is service-money because before central banking, bank-notes were issued by private banks which themselves offer (mostly financial) services (so bank-notes were backed by bank’s ability to make profits via savvy services). perhaps fiat money wouldn’t be so catastrophic if governments hadn’t monopolized monetary services and employed fractional reserve schemes that cause severe distortions.

    one can see as civilization progresses from agriculture to indutry to information society so is the form and concept of money it uses. also as economy implodes and revert backs to former stages due to crises so does the form of money used as well. that can be observed e.g. in recent Zimbabwe: as the hiperinflated economy plunged and accessing food became hard, service-money reverted to commodity-money (gold). when situation somewhat ‘stabilized’ people returned to service-money (mostly USD).

    so rather than arguing what is the ‘ultimate money’ I offer relating money definition to economic/civilizational context in which it is being used. with this theory if one expects severe collaps then gold would be the answer and if one expects rapid technological progress then bitcoin would be the anwer.

  • Calculus:

    One of the problems that Bitcoin has to get over is the negative propaganda.

    Ask a friend what they know about it (who doesn’t know much about it) and they’ll probably say it’s about ‘money laundering, drugs, sick porn etc’. Sure, it’s about all of those things but then the cash money in your pocket can also be about those things if you want.

    Time I think will heal the above but it may take 1-3 years.

    The other problem is it’s very polarising. You wither like it, or you hate it and nothing much will change your opinion. Sort of like Gold I suppose. This can be sorted out as well but only via very high prices again. No different to Gold, if that gets a major bid, say up to $3,000+ then many many of the anti-Gold crowd will funnily enough start to like it. Human nature folks.

    I also agree with No6, under 200 it looks like a buy but perhaps with a maximum of 1% of your assets. Think of it as a big out of the money call option that never expires.

  • numeflua:

    * Note that none of the thefts/hacks/heists have been due to a flaw in the protocol. The CEO of Mt. Gox blamed the demise of his exchange on a flaw in the protocol, but there is widespread skepticism in the community that is indeed what happened. Rather, the most likely scenario is that Mt. Gox was running on fractional reserve ever since a prior hack of the exchange (not the protocol) back in 2011 and it finally caught up to them.

    Hacks and heists occur when people are careless with their private keys (Bitcoin transactions require a public and private key pair to execute). If you are not in control of your private key, i.e., when you send your money to an exchange, you don’t have any bitcoins. You are trusting that third party with your coins, much like you would if you deposited your money in a bank, except without any deposit insurance. The whole point of Bitcoin is to avoid trusting third-parties. The whole point of Bitcoin is trustlessness.

    In fact, the actual Bitcoin protocol is by far the most secure computer system in the world, and nothing comes first. The lack of security is at the periphery where humans interact with the protocol. Better tools are being developed every day to improve security and make it more user-friendly.

    * The MyCoin loss is actually more like $8 million, not $400 million like originally reported.

    http://www.coindesk.com/mycoin-hong-kong-police-8-1-million/

    * I was ‘raised’ an Austrian. Mises and Rothbard were my introduction to economics. Yet, Bitcoin shows the flaw in the Austrian theory of money. Money’s function can be reduced to one thing: ledger. It have *arisen* as a commodity, but in terms of function, all it is is a ledger. Bitcoin is simply reducing money to its barest essentials: a giant, transparent ledger in the sky. There’s no need for Bitcoin to *arise* as a commodity or to be tangible. The origin story is irrelevant if the function is there.

    Consider one empirical piece of evidence against the Austrian viewpoint: Yap’s stone money

    http://www.npr.org/blogs/money/2011/02/15/131934618/the-island-of-stone-money

    These rocks are useless. They’re not commodities. People didn’t barter them; they were too big to move easily. They were simply announced publicly as being owned by someone, even the one at the bottom of the ocean. In other words, they were a ledger.

    I once raised this issue with you before: isn’t it interesting that gold having supposedly arisen as money because it’s the most saleable commodity was essentially useless prior to the last hundred years? The keen observer might conclude that its uselessness is one trait (among many others) that precisely makes it valuable as money. We don’t want useful things as money: they’d fluctuate too much. Bitcoin is even more useless for anything other than its role as a medium of exchange.

    Check out this fairly short video on this alternative view of money from Wences Casares:

    https://www.youtube.com/watch?v=gKkfhi8Eaiw

    And if you’re have a couple of hours to kill, this is one of the best things I’ve ever read on the topic of money:

    http://szabo.best.vwh.net/shell.html

    * I don’t think Bitcoin will be stable anytime soon because all of the bitcoins in the world today are valued at $3 billion. Even one person with a million dollars who wants to buy bitcoins on the open market would move the price by 10%. The valuation needs to be at least 100-1000x higher before larger institutions can even think about transacting with it without disturbing the market significantly.

    You can’t introduce something great into the world without a meteoric, yet volatile rise to its true value.

    * Thinking about Bitcoin as merely money is only scratching the surface. It’s programmable asset exchange–every little 100 millionth of a bitcoin can represent a house, a stock, a bond, a gold coin, etc. Smart contracts can automatically execute financial instructions based on variables. If I die and my death is published in an obituary, I can transfer my bitcoins to my three children automatically without a third party.

    Bitcoin is the ledger of civilization itself.

  • No6:

    Below $200- perhaps I will become a crypto-punk!!

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