Bitcoin, blockchain and bubbles: cutting through the hype

Online since 22.03.2018 • Filed under Investment • From Issue 7 - March to August 2018 page(s) 91-93
Bitcoin, blockchain and bubbles: cutting through the hype

Recent Bitcoin mania has raised a heated debate as to what the world’s largest cryptocurrency (by market capitalisation) is worth. Until recently, Bitcoin garnered attention mostly from computer science boffins and the criminal underworld, but the 1000% price rise since the beginning of 2017 is turning heads around the globe.

As the famous Wall Street saying goes: ‘When even shoeshine boys are giving you stock tips, it’s time to sell.’ Is this adage warranted in the case of Bitcoin?

Bitcoin’s appeal centres on the fact that it operates independently of any central bank. It is seen as the new age of global currency and payment methods. Of the roughly US$470 billion total cryptocurrency universe,

Bitcoin comprises just over 40%. And although it is prominent now, it has in fact been active since 2009.

Bitcoin’s rapid price acceleration since the beginning of 2017 has largely been due to the explosion of cryptocurrency into the mainstream, the ease of accessibility to the man on the street, and a large bout of

FOMO (fear of missing out) that drove the price to dizzy heights into the latter part of December last year.

The technology or algorithm behind Bitcoin, namely blockchain, has far more powerful reach as a platform than Bitcoin itself, in our view. A fintech specialist describing the technology on question-and-answer site Quora said: ‘Blockchain technology creates a decentralised digital public record of transactions that are secure, anonymous, tamper-proof, and unchangeable Instead of a bank or other intermediary maintaining a

private database of records, blockchain technology makes all records public.’ Disintermediation is blockchain’s biggest advantage: removing the middle-man ensures that users of the blockchain are in control of their information and transactions, data integrity is affirmed and, in theory at least, transaction times and transaction costs are minimised.

Uses of blockchain technology in the real world include making payments (the most commonly known); supplychain management (for example, tracking your food at every step from farm or sea to table); smart contracts (including land registries); cloud storage; online voting; trade settlement; and payments of grants. Being a relatively new technology there is still much potential to be unlocked in blockchain, and many large corporations are exploring potential uses.

How should Bitcoin be valued?

A key factor is to determine whether it is an asset class and, if so, what the appropriate valuation criteria to assess it might be. There are significant stumbling blocks here as there are no underlying fundamentals that allow us to price or value Bitcoin.

If we assume that Bitcoin is a currency, we would try to ascertain a long-run fair value by using various models: relative purchasing power parity, inflation differentials, or interest rate differentials. But these values are impossible to ascertain for Bitcoin given the lack of central bank involvement, the absence of a domiciled area or, indeed, any linking economic fundamentals. If we treat Bitcoin as a basic security, then there are no fundamentals that we can use to assess it, leaving us unable to reach an appropriate valuation assessment.

Despite this stumbling block, there is no doubt that Bitcoin has done exceptionally well. A fact that is evident if you merely consider the performance of the cryptocurrency in recent months.

If we cannot estimate value using traditional criteria, we can still assess a tradeable asset based on its supply and demand. For Bitcoin, we can break down participants into two broad spheres: those using Bitcoin for trading and those who are speculators. We know from anecdotal evidence that Bitcoin still isn’t widely used as legal tender, based on the lack of vendors accepting it and the relative charges from third-party providers that link consumers with vendors. Additionally, as a store of value, it is extremely volatile and an unlikely source for long-term wealth preservation.

There is also a vast portion of trade that could be based on unreported illicit activity, but without further information it is difficult to understand the supply/demand dynamics from those users. We do believe that cryptocurrencies will be used much more in the future but, at present, this represents a small portion of global trade.

If the only way we can value Bitcoin is based on supply and demand, and if those using Bitcoin practically as legal tender comprise just a small part of its demand, then we are left with a large portion of the current demand for Bitcoin being speculative.

With no viable way to determine what price Bitcoin, or any cryptocurrency, should be trading at based on usual valuation criteria, should demand slump it could result in spectacular losses along the lines of those seen during previous bubbles (something which is true even in Bitcoin’s relatively short history).

To fully understand how important underlying fundamentals are, consider the fact that Figure 1 does not represent Bitcoin but rather BlackBerry from the period 2006 to mid-2008, a time when the brand (within the company RIM), was absolutely soaring: it rose 525% in under three years. Since that peak the stock has lost 92% to its current price. Just consider whether you would have bought or sold the stock during the period in 2008 when it traded at a lofty price. You would consider any number of factors, including the company’s underlying fundamentals, its strategic positioning and the overall competitive landscape.

Feeding on optimism

We believe that the hype and price appreciation of select cryptocurrencies belies any of the underlying traits that we would look for in a sound investment, and rather feeds on optimism regarding the future of cryptocurrencies. We cannot tell you if these currencies are expensive or not, but we believe that without this knowledge it is impossible for us to invest in an asset class that seems to trade purely on momentum and sentiment.

In addition, there are some headwinds which – at least at this stage – could prevent Bitcoin being rapidly and widely accepted. These include:

• Bitcoin’s transaction processing is relatively slow, handling up to seven transactions per second, whereas service providers such as Visa and Mastercard can handle thousands per second.

• The size relative to the global monetary base is tiny.

• Without acceptance from regulating authorities, involvement in cryptocurrencies by large institutional players and governments will remain limited.

• It is unlikely that Bitcoin will replace money in the near to medium term because governments have far too much to lose from this move.

• Although Bitcoin can be used to pay for goods and services, its heightened volatility negates the definition of a currency as a store of value.

A mathematical algorithm

Ultimately, Bitcoin is just a mathematical algorithm. There is no doubt that the technology behind bitcoin

(blockchain) is revolutionary, but bitcoin itself requires much wider acceptance and continual improvement for price movers like we’ve seen to be sustainable. Other than its pure (but declining) dominance, Bitcoin has no distinguishable competitive advantage over other cryptocurrencies.

Bitcoin is to cryptocurrencies what the Motorola DynaTAC 8000X was to mobile phones. The first of its kind is not necessarily always the best, and technological innovation changes rapidly. As there is no clear way of accurately valuing any cryptocurrency, it does not instil confidence in making any kind of rational investment decision.

Momentum is a powerful force, and while the price can continue to run, the biggest risk is not missing out but rather in waking up to the realisation that Bitcoin isn’t the chosen one. Just ask BlackBerry.

[Ed: Kindly note that this article does not constitute financial advice. All information and opinions provided are of a general nature and are not intended to address the circumstances of any individual.]

A member of the Peregrine Group, Citadel Investment Services Proprietary Limited is licensed as a financial services provider in terms of the Financial Advisory and Intermediary Services Act, 2002. Citadel is a specialist wealth manager with over 20 years’ experience in providing bespoke solutions for high net worth individuals. Through character-rich engagement and building strong relationships based on mutual respect and trust, Citadel enables its clients to explore the true potential of their hard-earned money. The best fiduciary, risk and asset management expertise is used to strategise, implement and manage a financial roadmap for its clients and their family. For more information, visit www.citadel.co.za

Issue 7 - March to August 2018

Issue 7 - March to August 2018

This article was featured on page 91-93 of SABI Magazine Issue 7 - March to August 2018 .

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