Bitcoin and Fundamentals

“I didn’t even know what it was. Why would I invest in a piece of coin?”
Rita Scott, 70-year-old grandmother cited in The Wall Street Journal, November 29, 2017

“It’s not a real thing, eventually it will be closed. It’s worse than tulip bulbs.”
Jamie Dimon, JPMorgan CEO, September 2017 (cited in Vanity Fair, October 13, 2017).

Bitcoin is all the rage, again. Last week, the price rose above $10,000 for the first time. Following a Friday announcement by the Commodity Futures Trading Commission, the Chicago Mercantile Exchange, the CBOE Futures Exchange, and the Cantor Exchange appear poised to launch Bitcoin futures or other derivatives contracts, with Nasdaq likely to follow. Portfolio advisers are encouraging cryptocurrency diversification. In London’s Metro, advertisements assure potential investors that “Crypto needn’t be cryptic.” And, as skyrocketing prices gain headlines, less sophisticated investors are diving in (Ms. Scott bought a few hundred dollars’ worth).

The danger is that investors will interpret the surging price itself (and the associated hullabaloo) as a sufficient signal to buy, fueling an asset price bubble (and, eventually, a painful crash).

No one can ever say with certainty when an asset price boom is a bubble. In theory, a bubble occurs if the price of an asset becomes completely detached from any fundamental value. In the case of an equity, for example, imagine that the price surges because of momentum. That is, investors buy solely because they see the price rising, without any change in the discount rate, in risk tolerance, or in the projected dividend stream―the three fundamental drivers of equity value from the classic dividend discount model.

In practice, people can disagree greatly about projected dividends (or about the appropriate risk premium). So, even in the ill-fated tech stock boom of the late 1990s, when stock prices surged for many companies that never earned a profit, advocates usually found (invented?) other metrics to substantiate their belief that “This one will be the next Microsoft.” And, tech bears could go broke shorting those stocks long before their warnings that “this time is not different” came true. Indeed, even long after an asset price boom goes bust, the ex ante relationship to fundamentals can remain in dispute (see, for example, Peter Garber’s study of the 17th century Tulipmania).

Nevertheless, as Jamie Dimon suggests, it makes sense to ask what fundamental services Bitcoin provides. More specifically, have the prospects for those services improved sufficiently over the past year to warrant the 10-fold increase in price that has vaulted Bitcoin’s market capitalization into the range of the top 50 U.S. firms?

We strongly doubt it. The remainder of this post explains why.

Start with the fact that, unlike a stock, there is no prospect of Bitcoin ever paying a dividend since there are no earnings. Instead, Bitcoin’s chief benefits appear to arise from the transactions privacy that cryptocurrency advocates tout. As the chart below indicates, the volume of Bitcoin trading on exchanges surged in 2015 and 2016. That was a period of relatively high capital outflows from China, even in the face of extensive capital controls. Indeed, as we wrote early this year, fully 97 percent of 2016 Bitcoin exchange transactions took place in China! Had Bitcoin become primarily a device to evade restrictions on capital outflows?

Bitcoin Exchange Weekly Volume (Millions), 2011-November 20, 2017

Note: The China exchanges include BTCC, Huobi, and OKCoin. Source: Bitcoinity.org.

Note: The China exchanges include BTCC, Huobi, and OKCoin. Source: Bitcoinity.org.

Regardless of whether they perceived Bitcoin as fueling capital flight, since the start of this year Chinese authorities have intervened aggressively to slash Bitcoin trading. In January 2017, the People’s Bank of China (PBoC) warned the country’s three large cryptocurrency exchanges to enhance legal compliance, and began a series of inspections to monitor their behavior, prompting the introduction of trading fees and the disabling of Bitcoin withdrawals. Since then, activity on these exchanges has dried up, leading recently to a halt of Yuan/Bitcoin trading.

Perhaps it is a coincidence, but January also marks the recent trough of China’s foreign reserves. Since then, the PBoC reports increases in each of the past nine months.

So, what can we conclude from this pattern of Bitcoin use and the policy response? It shows that one of the chief long-run benefits of Bitcoin—the privacy (or concealment) feature—has limited value. When the use of Bitcoin to evade laws and regulations reaches a sufficient scale, it invites a regulatory crackdown that reduces the usage, long-run appeal, and (one would think) value of Bitcoin. If anything, it is surprising that the Chinese authorities, who are exceptionally willing to intervene, waited until the country’s exchanges had come to dominate global transactions, and until capital flight gained public attention and political salience, before taking action to stop Bitcoin trading.

These developments suggest that governments more broadly are unlikely to acquiesce for long to large-scale use of Bitcoin for illegal activity—whether it be money laundering, drug and human trafficking, weapons sales, or just old-fashioned tax evasion. Recall the 2013 U.S. crackdown on the Silk Road marketplace, part of the “dark web,” that jailed its leader for life. And, consider the recent statement by ECB Vice-President Vítor Constâncio: “[C]rypto-currencies can never prevail as general money substitutes. Their designation is a misnomer as they are not a currency but just a commodity used as a speculative asset and as a restricted medium of exchange in very special circumstances, comprising criminal activities or failed States with collapsed institutions.”

Then there is last week’s assessment from Randal Quarles, in his first speech as the Federal Reserve Board’s Vice Chairman for Supervision: “While these digital currencies may not pose major concerns at their current levels of use, more serious financial stability issues may result if they achieve wide-scale usage.” Vice Chairman Quarles went on to address the sources of Bitcoin’s value directly: “[T]he currency or asset at the center of some of these systems is not backed by other secure assets, has no intrinsic value, is not the liability of a regulated banking institution, and in leading cases, is not the liability of any institution at all.” As he also noted, the varying treatment of digital currencies by the CFTC, SEC, IRS, and the Financial Crimes Enforcement Network exemplifies their complexity.

All this makes us think that, over the past year, Bitcoin’s fundamentals—that is, the factors affecting the present value of the services that Bitcoin is likely to provide in the future—have deteriorated precisely as the price has surged. We usually expect successful currencies to exhibit a network effect: the more widely and intensively people use them, the more valuable they are. Yet, as we have seen, since January on-exchange transactions in Bitcoin this year are down by 95 percent!

Not only that, but Bitcoin faces competition for the crypto crown: one source lists over 1,300 alternatives. Granted, Bitcoin accounts for more than half of the total market value of digital currencies, but the competition highlights that the long-run limit on Bitcoin supply—built into its algorithmic design—could lead to digital coin substitution rather than to ever-higher prices. And, relative production costs could encourage alternatives: according to Digiconomist, the energy required for a transaction in Bitcoin’s closest competitor, Ethereum (55KWh), is 80 percent lower than for a transaction in Bitcoin (267 KWh) itself. Indeed, the estimate of current Bitcoin electricity consumption is sufficient to power nearly three million U.S. households!

We are equally skeptical of other supposed benefits of Bitcoin—such as lower transactions costs. For a variety of reasons, the private and public sectors are both hard at work improving efficiency of the domestic and international payments systems (see our earlier post). Financial intermediaries and central banks have powerful incentives to make sure that Bitcoin remains a sideshow (consider, for example, the seignorage associated with fiat currencies). And, importantly, the cost-reducing blockchain (distributed ledger) technology, which exists independent of Bitcoin, is fueling numerous new ventures (including those of leading international banks) that are attracting high levels of funding (there are even several ETFs on the way for investing in firms that adopt blockchain technology).

So, the price of Bitcoin has all the hallmarks of a bubble. What could puncture it?

One possibility is the advent of derivatives. Some may argue that derivatives present an opportunity for institutional investors to go long in the Bitcoin market, creating demand and supporting prices. But that view is hardly universal (see, for example, here). Indeed, experience suggests otherwise: recall how derivatives contracts on new mortgage-backed securities indexes allowed skeptics to short subprime debt instruments, encouraging a greater focus on their fundamentals as housing prices peaked in 2006-2007. As Gary Gorton explains in The Panic of 2007: “The introduction of the ABX indices, synthetics related to portfolios of subprime bonds, in 2006 created common knowledge about the effects of these risks by providing centralized prices and a mechanism for shorting.” It seems possible that the introduction of Bitcoin futures, which facilitate short positions, will eventually turn the boom into a bust.

Another threat to Bitcoin is a broader international crackdown on the concealment of cross-border transactions, perhaps for national security reasons (think North Korea), or to retrieve funds from tax havens, in addition to all the familiar concerns about illegal activity.

Our bottom line: when unsophisticated investors start buying an asset whose key virtue is that they can sell it to others with similarly limited knowledge, then it is time to worry. We seriously doubt that advice to buy cryptocurrencies, even a diversified portfolio, is sound. Instead, we hope that regulators will remind financial service providers to focus on the suitability for their clients of speculative crypto-investments and to require robust collateralization of any loans to fund these investments.

Why buy a piece of a coin? Unless you need to hide your (illegal) transactions, you will just be transferring more wealth to the select few who started the scheme.

Acknowledgements: The authors are grateful to their friends and Stern colleagues—Hanna Halaburda, Walker Hanlon, and Venky Venkateswaran—for very helpful discussions.