CRYPTO-CURRENCIES: WTF?

Dr. Fred Lazar

June 1, 2021

According to Wikipedia, Bitcoin was invented by an unknown person or group of people under the name Satoshi Nakamoto and released as open-source software in 2009. The system works without a central bank and supposedly without a single administrator. The transactions are verified by network nodes through the use of cryptography and recorded in a public-distributed ledger called a blockchain.

Is Bitcoin money, an asset or a combination of the two? What is the value of Bitcoin, the godfather of crypto-currencies?

As I write, Bitcoin is currently worth around $35,000. Is Bitcoin a bargain, or is it destined to become the 21st century’s version of Dutch tulip bulbs? Tulipmania, as it is commonly referred, is one of the world’s most famous market bubble and crashes. In Holland during the 1600s the tulip bulb rose to excessive amounts and could be traded for at least six times the average salary.

The answer depends on whom you ask.  

According to CoinDesk Editor Ollie Leech, “Bitcoin is going to $1 million a coin… I don’t know when bitcoin will cross $1 million but it will likely be after 2025.” The basis for his optimism is the supposed scarcity of Bitcoins.

Catherine Wood, 2020’s all-start stock picker, is also bullish on Bitcoin, although not quite as much as Leech. In a May 19 interview on Bloomberg TV, she said that she believes Bitcoin will reach a price of $500,000. Her optimism is based on some model her group has developed.

Influencers

In this age of Instagram, Tik Tok and YouTube, where countless influencers have created careers persuading their gullible followers, to buy anything; it is not surprising that there are “influencers” for crypto-currencies.

John Detrixhe (Quartz — www.Qz.com, February 24, 2021) commented on valuing Bitcoin: “A question that has long bedeviled bitcoin observers is how to value it. Lately the answer to its worth has been whatever influential people like Elon Musk and star stock picker Cathie Wood say it is.”

Investment banks have been influencers for decades, hyping all types of companies and assets because of the fees at the end of the rainbow. Now many of these banks are getting on the bandwagon, offering cryptocurrencies to their clients. Among them are the poster children for the 2008 mortgage debacle and financial crisis – Wells Fargo, Morgan Stanley, Goldman Sachs. What could possibly go wrong?

The hysteria and frenzy surrounding Bitcoin and other crypto-currencies is reminiscent of the Internet/Tech 1.0 bubble in the late 1990s. During that time, Henry Blodgett was a key influencer.

Bill Mann, writing in the Motley Fool on November 24, 2004, described Blodgett’s role:

Blodget's name is synonymous with what amounted to a near larceny of billions of dollars of shareholder assets…Blodget's master wasn't the individual investor, it wasn't the soft science of security analysis, and it sure as hell wasn't "truth" -- it was his company's desire to attract more incredibly profitable investment banking business from Internet IPOs and secondary offerings. And for a time, Blodget was great at it…Henry Blodget got in trouble with the law because he wrote messages internally at Merrill Lynch decrying the fact that he had to say nice things about washed-up overvalued piles of dreck… for fear that he would anger his true audience: the investment bankers and institutional investors who needed to win the relative performance game…Henry Blodget didn't create the corrupt quid pro quo analyst-as-investment-banking-marketer model, and he was in no way the only person to benefit from it. He was only its most recognizable face, the one for whom the fall from glory would be steepest, only because of the heights to which he had risen. The real mystery about Henry Blodget's career as an analyst, though, is not that he put out such misinformation and poorly reasoned analysis, but why people were so willing to be misinformed. He was paid millions of dollars not so much to provide crack stock analysis, but to serve as a cheerleader, and people lapped it up. They didn't want to be told what (a company) was worth, they wanted to be told that it was going to be substantially higher six months hence…Americans tend to laugh at people in less developed countries who believe in voodoo, curses, and other superstitions, and yet in 1999 there should be no doubt that many of the participants in the largest stock market bubble in history believed in something that was completely unsupported by reality. For a short period of time, investors believed in the magic that was emanating from Henry Blodget's keyboard.”

 

So how does one value Bitcoin or any other crypto-currency? To answer this question, we must first answer the question: what is Bitcoin?

It is not money and likely never will serve as money. I base this conclusion on at least three arguments.

One: Expenditures

The transaction costs for using Bitcoins, or any other crypto-currency, will become increasingly more prohibitive. As the popularity of Bitcoin has increased dramatically, and a massive herd is trying to invest in Bitcoins, with a commensurate exponential increase in trades in Bitcoin, the existing blockchain either cannot keep up with the volume of transactions — opening the door for fraud and other problems — or requires ever increasing server capacity and electricity consumption. Someone has to make the investment. Whoever this might be will require compensation. This will be reflected in increasing transactions costs for the use of Bitcoin.

Crypto-currency mining requires massive amounts of electricity to run the large computer server arrays needed to do the complex calculations required for cryptocurrency transactions, as well as for the air conditioning needed to cool these facilities. According to a recent report by Cambridge University, mining Bitcoins uses around 121 terawatt-hours a year, which is larger than the total energy used by Argentina.

UBS recently came out with a report that highlighted this environmental issue, one that will attract attention from ESG investors. The report noted: “Crypto mining and management can contribute to carbon emissions without improving living standards, given the computing power required…We are not convinced the growing cohort of sustainability-oriented investors can reconcile these problems.”

Exacerbating the problem are the increasing hedging costs for using Bitcoins to buy or sell anything. Hedging costs rise with the volatility of Bitcoin’s price — the exchange rate between a Bitcoin and some other currency, even another crypto-currency. And Bitcoin’s price has become increasingly volatile.

Two: Laundering Laws

The second argument is based on anti-money laundering regulations. Bitcoin serves to stroke the egos of anarchistic coders and serves the needs of money launderers and gamblers. For years, Bitcoin was the de facto currency of black markets on the so-called dark web. Near anonymous (when used properly), easy to store, and able to be transferred without an in-person interaction, Bitcoin was a natural fit for the “Amazon for drugs,” other illicit online black-market trading, and terrorism. For obvious reasons, anonymity is critical for the key players relying on crypto-currencies.

The US Government was able to start breaking down the secrecy walls around Swiss financial institutions. This created a demand for new secretive banks and safe havens, and technologies for moving money around anonymously and beyond the reach of the US. It is not surprising therefore, that crypto-currencies have become so popular.

For crypto-currencies to become mainstream and start serving the role of money, they will have to be subject to regulations similar to those covering financial institutions and financial transactions. This, however, will greatly diminish the attractiveness and role of such currencies.

Governments loom large as major headwinds to the otherwise unregulated crypto sector. Marion LaBoure, a Deutsche Bank analyst, pointed out in a recent research note:

“In the end, regulating cryptocurrencies is not that difficult. The Bank for International Settlements (BIS), the G7, and the G20 are all keeping a close eye on cryptocurrencies. And regulation is coming. The latter part of 2021 and early 2022 could be a turning point for cryptocurrencies around the world. Regulators have cryptocurrencies on their agenda as a key priority.”

Indeed, regulation already has commenced. In 2017, a federal judge in San Francisco ruled that Coinbase must supply the IRS with identifying information on users who had more than $20,000 in annual transactions on its platform between 2013 and 2015. Coinbase did succeed in limiting the government’s initial request for information on all Coinbase users who made transactions from 2013 to 2015 to a smaller subset of high-value users.

In May of this year, the Chinese Government set out its intent to crack down on digital assets and the U.S. Treasury Department said it planned to enforce anti-money-laundering rules and request that crypto transactions of $10,000 be reported to the government.

China banned financial institutions and payment companies from providing services related to cryptocurrency transactions. It also warned investors against speculative crypto trading. The Chinese Government also appears to be prepared to crack down on Bitcoin mining. China is the world’s largest cryptocurrency mining location, accounting for 65 per cent of the Bitcoin hash rate, a unit of measure for the processing power used by the Bitcoin network to verify transactions and mine new tokens of the cryptocurrency, according to estimates by the Cambridge Bitcoin Electricity Consumption Index. The Chinese Government, which has banned financial transactions of Bitcoin and other tokens since 2019, had turned a blind eye towards the cryptocurrency mining farms in Inner Mongolia, Sichuan, Xinjiang and other mainland locations, until now.

According to a new report from the US Treasury Department (May 20, 2021), the US Government wants to put new requirements in place that would make it easier to see how money is moving around, including digital currencies. The report notes that cryptocurrencies pose a “significant detection problem” and are used regularly by top earners who wish to evade taxes.

The proposed changes would create new reporting requirements built on the framework of existing 1099-INT forms that taxpayers currently use to report interest earned. Cryptocurrency exchanges and custodians would be required to report more information on the “gross inflows and outflows” of money moving through their accounts. Businesses would also be required to report cryptocurrency transactions above $10,000 under the new reporting requirements.

Jay Hatfield, chief executive officer of Infrastructure Capital Advisors in New York has warned that “Investors are underestimating the regulatory risk of crypto as governments defend their lucrative monopolies over currency.” According to Hatfield, the possible imposition of transaction reporting requirements in the US could be the “tip of the iceberg” of potential Treasury rules on virtual currencies.

Three: Who Can You Trust?

Finally, there is the trust factor. Trust is critical for financial markets to operate, and for currencies to be accepted as a medium of exchange. The Fed was able to resort to a blank check policy starting in the fourth quarter of 2008 because of the confidence people have in the Fed, the US dollar and the US Government. People might not like the US Government or its policies, but they continue to demand and hold US dollars. For a long time, US $20 bills were the favorite currency of the drug cartels.

Can the same level of trust develop for Bitcoin or any other crypto-currency? Who are behind these currencies? Who is Satoshi Nakamoto? What assurances are there that the respective supplies of Bitcoin and other crypto-currencies will be limited, or that very few new such currencies will be introduced? Can the miners be trusted to maintain the integrity of the blockchain? Where there is money to be made, fraudsters have a way of showing up.

US currencies used to have the saying: “In God we trust.” Perhaps not, but at least people trusted in the Fed and the US Government. Will people trust unknown entities who have a God-like complex?  

Bitcoin will not be used for transactions — the know your customer rule and anti-money laundering laws and exorbitant transactions costs will prevent this. Elon Musk did an about turn on accepting Bitcoins for the purchase of Teslas because he recognized the potential legal problems.

What is Bitcoin Then?

Bitcoin is not money!

Bitcoin is an asset.

Students are taught how to value an asset in Finance 101 courses. Usually, there is some cashflow or at least an expectation of some future cashflow involved. But the formula and the resulting values are based on guesses. We see this all the time in corporate acquisitions. If the original price is rejected, change the assumptions to justify a higher bid. We see how absurd assumptions can be used to justify billion-dollar values for so-called unicorns. But there are no cashflows from Bitcoins.

In the rarefied strata of the art world, the value of a piece of art is determined in part by its intrinsic value — the owner can display and see the art, impressing friends and others (ego plays an important part in valuing art) — and in part by guesses of what someone might offer in the future. The value of a piece of art also is driven by “influencers” — art dealers. Was the Mona Lisa the best work of da Vinci? Was it even the best piece of art created in the 16th century? These are subjective questions without definitive answers. But at least there is only one original Mona Lisa, unlike Bitcoins and all other crypto-currencies.

There is no intrinsic value in owning Bitcoins. They cannot be seen. They cannot be put on display. But are Bitcoins an asset that can hedge against rising levels of inflation?

There are people who do not trust governments and their central banks. They believe that governments will try to confiscate as much wealth as possible through taxation and regulation. Can anyone say President Biden and the Progressives?

They also believe that central banks will assist governments by allowing increasing rates of inflation to greatly debase the value of outstanding government debt. Modern Monetary Theory only reinforces these fears.

Throughout history there have been countless examples where governments have debased the value of money and left creditors impoverished. Die-hard monetarists believe that everywhere inflation is solely a monetary phenomenon. Even as most major central banks have demonstrated their independence from government during the past 35 years, monetarists are wary that this independence can quickly disappear.

The actions of the Federal Reserve since 2008 and the explosion of its balance sheet and the similar behavior of the European Central Bank since 2010, have created increasing uncertainty in the minds of monetarists about the independence of these two important central banks and the future course for inflation. There have been predictions of runaway inflation in the US and around the world since 2009.

Ben Holland, Enda Curran, Vivien Lou Chen and Kyoungwha Kim writing for Bloomberg (“The Great Inflation Debate is Heating up with Trillions at Stake,” August 25, 2020) pointed out:

“There’s hardly any question that carries greater weight in economics right now, or divides the financial world more sharply, than whether inflation is on the way back. One camp is convinced that the no-expense-spared fight against Covid-19 has put developed economies on course for rising prices on a scale they haven’t seen in decades. The other one says the virus is exacerbating the conditions of the past dozen years or so -- when deflation, rather than overheating, has been the big threat.”

The run-up in the price of gold from about US$300 an ounce to US$1,900 an ounce between 2003 and 2015 was driven by the fears of people who did not trust governments and their central banks. Gold was promoted as a safe haven against the inevitable collapse of major economies and accelerating rates of inflation. There is only so much gold available and the quantity cannot be manipulated by any government or central bank. Even today, there are many who are predicting that the price of gold will double in the near future as inflation rates begin to rise.

Bitcoin has been promoted for the same reasons as gold has been promoted. It is not surprising that it made its appearance in 2009, at the height of the financial crisis. Bitcoin is beyond the control of governments and central banks, at least for the time being. The supply is limited, theoretically.  

Instead of some yellow metallic object as a store of value, a hedge against the mismanagement by central banks and the corruption of governments, there is now a digital replacement. Unlike gold that could be confiscated by governments, the supposed security behind Bitcoin might prevent confiscation. Moreover, Bitcoin is much more mobile than gold.

Yet, various journalists, economists, and bankers have voiced concerns that Bitcoin is a Ponzi scheme. In 2013, Eric Posner, a law professor at the University of Chicago, stated that “a real Ponzi scheme takes fraud; bitcoin, by contrast, seems more like a collective delusion.” In July 2017, Howard Marks, a co-founder of Oaktree Capital, referred to Bitcoin as a pyramid scheme. On 12 September 2017, Jamie Dimon, CEO of JP Morgan Chase, called Bitcoin a "fraud" and said he would fire anyone in his firm caught trading it. Interestingly, Dimon is now considering creating products to enable his clients to trade in crypto-currencies. No reason to forego a fee generating opportunity even if you believe the asset is a fraud.

 

There are many strategies for hedging against rising levels of inflation. The increasing transaction costs for Bitcoins diminish the attractiveness of using Bitcoins as a hedge. Furthermore, despite the explosion in the Federal reserve’s balance sheet, there are few signs that the inflation rate will begin to rise, despite the upward blip in May.

 

But as long as there is money to be made in trying to avoid regulations and the long arms of the US Government and its agencies, creative people will continue to look for alternatives to work around the regulatory system. There will always be a demand, whether for Bitcoin or the next generation of digital currencies. And there will also be a demand for new ways to gamble. Wall Street is always prepared to facilitate and encourage gambling. To quote P. T. Barnum: “There’s a sucker born every minute.”

Does it have Value?

Thus, we arrive at an answer to the question: how to value Bitcoin.

The value of Bitcoin is determined by the greater fool theory. As long as there is someone willing to offer a higher price, the value of Bitcoin might continue to rise. Is a price of $500,000 or even $1 million out of the question? It all depends on how many greater fools are out there, and whether the next trendy fad comes along before Bitcoin reaches such levels and crashes.

Anything can be an asset. I am surprised that no one has thought of petrifying the poop of Queen Elizabeth’s Corgis. There would be some scarcity value, celebrity value and value as art. Or how much might the ashes of any of the Kardashians be worth?

I conclude with this observation by Marion LaBoure: “As fashion mogul Karl Lagerfeld pointed out, ‘Trendy is the last stage before tacky.’ What’s true for glamour and style might also be true for bitcoin. Just as a ‘fashion faux pas’ can happen suddenly, we just received proof that digital currencies can also quickly become passé.”

Can anyone say: non-fungible tokens?


1 What advocates for gold forget is that most of the gold extracted from the ground is still around. The existing stock of gold far exceeds the annual new supplies that enter the market.

*The views and opinions contained within subjects, content, information, data and imagery does not necessarily reflect those of iinta, iinta’s staff, or iinta’s affiliates. For full disclosure statement, please visit our Disclosure Page.