Between the Bubble and the Bitcoin Bitters

I recently read this item in the Wall Street Journal, “Nvidia misjudged how quickly prices for the graphics cards that those chips go into would normalize now that crypto currency mining isn’t as hot.” That seemed odd. For related posts you can now visit

In July 2007, I read about an obscure German bank in Düsseldorf, IKB Deutsche Industriebank. The bank was failing due to investments in bad US mortgage paper. That also seemed odd.

In the ten years since Satoshi Nakamoto wrote his famous white paper, Bitcoin (BTC) and blockchain have acquired the accouterments of legitimacy. There are experts, consultants, conferences and celebrations (Crypto-nite!). There are efforts to establish exchanges, banks and funds. Even the traditionalist CFA Institute includes crypto currencies in the CFA curriculum. The days of the founding idealists, libertarians, utopians, and anarchists seem a distant memory.

Early on, the FBI saw “Bitcoin Virtual Currency”, as a “venue for individuals to generate, transfer, launder, and steal illicit funds with some anonymity”. The famous Silk Road website for criminal transactions was a key component of early growth. The Feds believe that a significant number of the cryptos are just Ponzi-type scams. Cipher Trace, estimated that $2.5 billion has been effectively laundered via crypto currencies since 2009, with another $1.5 billion used to purchase criminal services.

Imagine, if Bitcoin had been available at the time, Eliot Spitzer might still be governor of New York!

Bitcoin is mathematically limited to 21 million coins. That controlled scarcity was likened to gold by the founders and was to contrast Bitcoin with the typical inflationary tendencies of governments issuing fiat currencies. That 21 million limit always had us wondering how you would pay the digital accountants that maintain the distributed ledger (dubbed miners by the cognoscenti) for their efforts when there were no Bitcoins left to find?

This problem is already apparent. When BTC prices fell below $4,000; the accountants began shutting down their expensive mining computers. According to the MIT Chain Letter some 600,000 mining/accounting machines have been shut down with the “hash rate” off by 20%.

CoinMarketCap lists 2,080 crypto currencies with an aggregate market cap of some $149 billion as of this writing. Cryptos, it seems, are as easy to create as the next Internet meme. The idea that scarcity would preserve value seems to have gone out the window with more than 1,300 of these digital markers showing no value or unknown value according to websites that track this data.

Valuation has always been a challenge since a digital accounting entry has no intrinsic value. The originating cyberpunks that started Bitcoin thought the value should be linked to the cost of electricity required in the mining process. The lack of an analytical framework for valuation is in stark contrast to fiat currencies where the value is sustained by the taxing power of a sovereign government combined with their monetary policy stance. The US and Switzerland stack up better than, say, Venezuela, accordingly.

We’ve read numerous treatises on Bitcoin value that have some amazingly twisted logic and math.

One of the more amusing ideas posits Bitcoin as network implying that it should be valued using Metcalf’s law. In Metcalf, value is equal to the square of the number of nodes or, in this case, traders. More BTC nodes will increase liquidity, which can add to utility, demand and a potential increase in value. If we follow this analogy to its conclusion, however, the US dollar should have seen a jump in value when it was adopted as the national currency in Ecuador and Zimbabwe.

A more logical link between the number of nodes and value is the increase in the number of speculators. Under the greater-fool theory of investing, the probability of finding a greater fool to buy your position at a higher price obviously increases with the number of fools (or nodes).

We weren’t able to find any reliable information on the legitimate Bitcoin economy or actual completed transactions for goods and services. The Bitcoin wiki has a link to a page that lists “Bitcoin accepting sites”. Unfortunately, as of this writing, that page is blank. It is not too surprising that non-speculative transactions never really took off. Most merchants that accept Bitcoin sell it immediately for US dollars to mitigate the volatility risk. Moreover, the accounting is incredibly complex and very very slow. The network can handle perhaps 10 transactions per second. This compares poorly with plain old Visa at 24,000.

The risk of holding a crypto position is not only limited to fraud or volatility. They are also easy to steal with the hacker-thieves possibly operating from the comfort of their parent’s basement. We note that $266 million of digital currencies were stolen from various exchanges in 2017. The famous Mt. Gox fraud resulted in losses of $450 million for investors. Cipher Trace estimates that the true losses to theft are 50% higher than the reported numbers. After all, if your funds are in the middle of a laundering process, you can hardly go to Interpol to complain about a theft.

To be fair, the traditional financial system gets hacked and suffers losses all the time. The key difference – the banking and brokerage system has protections for investors and depositors.

With all these problems becoming more prominent, Bitcoin advocates are now touting blockchain as the real noteworthy technology.

At its core, the distributed ledger is a complex, insanely expensive, incredibly slow accounting system that comes with a carbon footprint the size of a small African country. Despite this, The Economist pointed out that some major stock exchanges (Australia, Singapore and Switzerland) are experimenting with the blockchain idea. These are serious people not hair-on-fire crypto-crazies, so their efforts are worth a look.

Stock exchange transactions seem like a natural application, as they require the secure, accurate and efficient matching of buyer and seller. In the days when trades were done by phone and actual share certificates were moved around the streets of lower Manhattan, a mere 12 million shares a day brought the system to its knees. The NYSE restricted trading to four days a week to catch up the paperwork on the fifth day. The number of trades DK’d, rejected as “don’t know” or unmatched, was huge.

The solution in the 1970s was to computerize, digitize the ownership data and, most importantly, centralize the records so that there was one source of truth for all transactions. Sound familiar?

Centralization now allows the NYSE to trade more than 6 billion shares daily.

Blockchain technology, however, moves in the opposite direction with its expensive decentralized accounting structure. Based on the slow transaction speed and the thousands of “accountants” required, the clunky blockchain technology is more a return to the 1960s than a leap into the future.

Even the holy grail of “one source of truth” has fallen to the periodic incidents of Bitcoin “hard forks”. This is when two ledgers arise using different software tracking the same transactions. Not surprisingly they do not agree. A hard fork is not unusual and happens with any open source software. If someone has a better idea part of the market will adopt it while others stay with the old version. The distinction here is that two versions of Linux do not have such an immediate and dramatic financial impact on the users.

Bitcoin has suffered a number of these, “hard forks” with romantic names like Bitcoin XT, Bitcoin Classic, Bitcoin Unlimited, Bitcoin Cash, Bitcoin Gold and Segregated Witness. There is also the puzzling, SegWit2X, hard fork. Over the years, in each case, the system trembled but eventually recovered and investors were made whole. But the risk remains.

Last, it is easy to think of ideas where blockchain might add substantial value. When I lived in Kenya, the government was unable to maintain a secure, fraud-free and accurate record of who owned what. Consequently, property transactions were very risky. Property transactions are notoriously slow and the volume is small, so the limitations of blockchain technology would not be a hindrance in that application. The cost, however, is an issue. And who is going to pay the miners to keep the system going?

Now that they exist, the world will always need crypto currencies. There will always be criminals who need an anonymous and efficient payment system. There will always be Ponzi-scams to promote and ransomware payments to arrange. There will always be governments that have abused their currency driving down the road to hyperinflation. And there will always be speculators betting that there is a greater fool out there waiting to buy their position at a higher price.

– Jim Anderson