Bitcoin - currency, commodity, asset class, or tulip?

As a former International Equity trader with such firms as Goldman Sachs, Credit Suisse and Morgan Stanley, I am often asked my opinion of Bitcoin. I hesitate because a complete answer is complex, nuanced, probabilistic, something that, with our instant media, people are loosing patience listening to. Perhaps this brief analysis will be helpful.

To answer the question of what Bitcoin should be worth, one must first answer the question what is Bitcoin. As it exists virtually, within a trusted and, hopefully, secure distributed database, we have nothing to compare it to. It is easy to jump to a conclusion that it is "like" the US dollar, or gold, or oil, or Yen. But this quick type of judgement misses some important points. Let's examine each possibility.

A currency, such as the US dollar is something that market participants, at least the buyer and the seller agree has a value and can be exchanged for something else such as a good or service. The receiver must be confident that they will be able to turn around and use that currency to exchange for another good or service. If you have a dollar today you are confident it will buy you a beer this weekend so you don't demand your wages at the end of every day so that you can rush out and buy something on the way home.

A fiat currency, such as the US dollar has the backing, in this case, of the United States government which has the responsibility of keeping the value of the dollar stable against prices and, therefore, against other currencies. Ultimately, the value of the dollar is upheld by the stability of the United States.

Day to day value changes would make it difficult to transact. If the dollar were to fluctuate throughout the day it would reduce its value for trade if, say for example, a gallon of gasoline cost four dollars in the morning but only cost three dollars in the afternoon. 

The US Treasury and another entity, the Federal Reserve, have many tools at their disposal to dampen short term market fluctuations. These tools include restricting and expanding the money supply, performing open market operations to buy or sell bills, notes or bonds. They include repurchase agreements, repos or reverse repos, to smooth out multi day volatility as well as provide funding to financial entities. They set parameters under which banks can lend and terms under which investors can margin securities. This is all very complex. I will gloss over the details here but, suffice it to say, these tools have been developed over many years, booms, busts, wars and crisis with many, sometimes painful, lessons learned along the way.

Longer term, the value of the dollar is influenced by the amount of government spending relative to taxes, the growth rates of the US economy and that of the rest of the world. The Fed can also affect interest rates which influences currency flows in and out of the country and corporate capital structures which affect capital investment. Again, complex stuff with many moving pieces. The point is, there is somebody minding the store.

Dollars earn an interest rate. If I put them into the financial system they earn a return. This return has, over the long term, hundreds of years, exceeded the loss of buying power caused by inflation. Put a dollar in the bank today and fifty years from now it will buy more than what it could purchase today. Bitcoin does not earn an interest rate.

So, can Bitcoin be considered a currency? It can be transferred, buyers and sellers can agree on a value versus a good or service. But, are day to day price swings a problem. You will have to decide for yourself but it has caused firms who once accepted Bitcoin to stop taking it. Transferring Bitcoin can also pose a problem. You can't write a Bitcoin check, pull a Bitcoin out of your wallet or use a Bitcoin credit or debit card. Transactions have to be settled on the blockchain which takes hours. Transaction costs are uncertain and fluctuate wildly. This is due to the computer processing necessary and the willingness of Bitcoin miners to subsidize transaction processing for the promise of mining new Bitcoins. The cost to process a transaction is market driven and changes throughout the day. There are plans to buffer the writing to the blockchain to lower transaction costs but there is no universally accepted method for handling smaller or frequent transactions. This issue even caused Bitcoin to spit in two last year creating Bitcoin Core and Bitcoin Cash. These two Bitcoins are now transactionally incompatible so their relative values are not fixed. You must sell one and buy the other at the market price to bridge the widening gap. On the supply side the number of Bitcoins are fixed at a limit that has not yet been reached. When the level is reached the cost of processing transactions may skyrocket without Bitcoin miners subsiding transaction costs. We will have to wait and see what happens but I don't see how this aspect ends well. At least Bitcoin doesn't have to worry about Congress spending into a deficit year after year. But, with a fixed number of Bitcoins there will be a built in deflation as the economy grows. Think about that one.

Can Bitcoin be considered a commodity? Commodities have a use other than holding it. For Bitcoin to be considered a commodity it would be unique in that it does not have a use. Oil is used for energy, wheat is used for food. Their value, like that of everything is governed by supply and demand. Most commodities have a cost of production and a value for use. Higher prices drive supplies to be increased, lower prices increases demand. If the price of oil goes up people by more efficient cars or put up solar panels. If the price of wheat goes up, people switch to corn or soybeans. Of course some commodities can rot and all must be stored and shipped. A somewhat special commodity is gold. Gold is used for jewelry and in the manufacture of electronics and other products. Gold can also be rented out to earn an interest rate. It can also be easily transported and used for barter. No blockchain is required but the buyer must be convinced of its purity and weight. The supply of gold is unlimited but the cost of mining or extracting it is high, relative to its value and there is no disruptive technology on the horizon that will greatly affect this balance.

Is Bitcoin an asset class? This concept is embodied in the idea of investing in Bitcoin. I hear all the time someone says they are invested in Bitcoin. Bitcoin is numbers in a distributed database with nobody responsible for backing it up. I don't know how to address this idea as, in my view, an asset must be something that can be expressed as a value such as a currency or a commodity. I have to leave this to the reader.

Is Bitcoin a tulip? I know, that's a flip comment. But, I would like to express my opinion to close and couldn't think of a better title for this section. In my view Bitcoin will have a lot of challenges if it is going to catch on as a viable currency. First, it is difficult to transfer. Writing to the blockchain takes time and computing power. Someone has to pay for that. The, almost, free ride provided by bitcoin miners will decline and come to an end. The total world energy use devoted to Bitcoin is staggering and unsustainable. If Bitcoin use is to increase computing power must increase. I don't see how such a huge expenditure can be covered by a currency that was billed as being the cheapest to transact. MasterCard, Visa and American Express provide very inexpensive transaction services. I have trouble seeing how Bitcoin can compete with that. Third, there is nobody behind Bitcoin. There no one actively providing stability, monitoring and enforcing against fraud and manipulation. On this last point I have noticed market action that to me is active price manipulation. I cannot prove it as I do not have the data as it's locked up in private and opaque changes but I recognize suspicious price action when I see it. If a government entity somehow gets the ability to look into it, I would bet you a dollar they will find price manipulation. Bitcoin exchanges are opaque which conceals trading abuses and it also protects criminals. The anonymity and the presence active players including North Korea and Chinese nationals looking to get their money out tells you something. Silk Road and ransomware payment demands for Bitcoin are signs.

In my view Bitcoin does not have the elements to become the new world currency. It is too difficult and increasingly expensive to transact, subject to price fluctuations and manipulation and is a safe haven for criminals. At some point enforcement agencies will crack it open, if only to collect taxes. I believe the value of Bitcoin is zero and to zero it will one day go. I just can't tell you when.