Reason why bitcoin could be a terrible investment

Bitcoin’s value has fallen sharply and no one knows what will happen next, highlighting previously overlooked risks.

Have you ever attended a football game when your team is losing, you wonder about something that happened and the fans of the winning teams start chanting happily “SCOREBOARD!” ? They point to the numbers that show their victory is assured and laugh at your pitiful complaints.

This has been felt over the past few years when talking about possible problems with bitcoin. If you tried to ask a question about bitcoin, it was drowned out by the exultations of fans and the revving up of their Lamborghinis.

They were on the foredeck of their private yachts, sipping cocktails as the crew cleaned up the platinum helipad. Anyone sitting in a rental property, sipping tap water and trying to ask skeptical questions looked like an idiot for missing something.

Bitcoin is very difficult to compare to other assets that we have long known and agreed to be valuable. Thus, the best argument in favor of bitcoin has generally been its price.

“Yeah, sure, it seems odd that this completely man-made thing that has no clear function has value, but look: people are buying it for A$80,000! That means something to you! ” – bitcoin fans.

This argument works! Or at least it worked when bitcoin was worth over AU$80,000, as it was a few months ago. But now bitcoin is worth less than AU$30,000, and the questions someone might ask about it suddenly seem a little less silly.

No one knows where bitcoin goes from here. Maybe up or down. So let’s take this opportunity to ask some of these questions.

Bitcoin is considered a large “store of value”. Some call it “digital gold”. But is it a great store of value? We could ask this question to people who invested their money six months ago, and they will tell you that half of its value is gone.

Look at the red line in the chart below: it spiked as bitcoin doubled; then plunged as bitcoin fell more than half. The blue line in the following chart shows the changes in the price of gold over the same period. Metallic gold has been much less volatile than “digital gold”!

To be clear, I’m not a hater, just a skeptic. I have owned Bitcoin, Ethereum and other cryptocurrencies. I’m excited about the idea and made a surprising amount of money (not all of them were good buys! I bought shitty altcoins that went to zero). But even as I speculated and cashed in, I couldn’t dislodge my worries about whether it made sense, whether it was more than a bubble.

make something out of nothing

Can you just invent an asset out of nowhere, like the pseudonym Satoshi Nakamoto did with bitcoin? Most of the time, what people value is rare or very difficult to produce, such as gold, diamonds and earth. Bitcoin’s source code is public. You can replicate bitcoin this afternoon if you want (and people have, making copies and slight variations).

What makes the core version of bitcoin unique so far is the ecosystem built around it – the bitcoin miners, the people who own the bitcoin, the systems in place to transfer the bitcoin. They are highly motivated to improve support systems and encourage people to buy bitcoin, increase adoption, maintain belief, and keep the price high.

If you point out that bitcoin depends on belief, bitcoin fans will say aha! national currencies are the perfect example of an asset invented out of nowhere that depends on belief!

And that’s a good point. So, what makes the value of a national currency? The answer is: you can use it, and people believe the government will keep the value of that currency from eroding too quickly, and they believe the government itself is stable.

Where this does not apply, you find black markets in other currencies. Venezuela, Argentina, Montenegro, Nauru: People all over the world use foreign currency because they don’t trust their own currency.

Bitcoin may indeed be more trustworthy than some governments! This is not necessarily a sufficient criterion (for me) to fully trust him. So the point remains the same: the value of bitcoin depends on trust and belief. What affects this belief?

Do you use bitcoin?

Lol.

The original intention of bitcoin was to create a useful currency. The original white paper of bitcoin begins with the words “Commerce on the Internet…”. But bitcoin is not widely used for internet commerce. Cash is much more widely accepted.

Bitcoin transaction fees are still high, speed is still slow, despite significant improvements. And the price of bitcoin keeps changing wildly, discouraging people from accepting it as payment. Bitcoin’s primary function is – for now – as an asset.

Whether you think it’s a good asset depends on when you bought it.

Let’s be very clear, since 2008 bitcoin’s value has gone much, much higher. If you bought a long time ago and didn’t sell too soon, I applaud your foresight and resolve. The recent drop from over AU$80,000 to under AU$30,000 is small in comparison – a fall of over 60%. The increase since 2015 is more than 9,000%. This means bitcoin is still more than 90 times higher than it was seven years ago.

But bitcoin is changing hands. Anyone who bought in the last 18 months lost money. For them – and for people likely to buy in the future – past earnings are irrelevant. Past performance is not indicative of future performance, as they say.

What does experience tell us?

Bitcoin was invented in 2008 and introduced to the world in 2009. Since then, bitcoin has had its ups and downs, but on average its performance is impressive. Is this experiment enough to conclude that bitcoin is immune to dramatic reversals?

I would say we should reserve judgment. This is the kind of situation described by Nassim Nicholas Taleb in his famous book The black swan: People tend to conclude that a system is secure based on a relatively small amount of data.

Taleb argues that this type of conclusion is valid as long as the risks are foreseeable. For example, people can measure the range of the biggest wave at the highest tide and build their house out of range.

But that does not save them if there is a tsunami. Bitcoin is mounting evidence that it is sustainable, but it has nothing to do with the track record of gold, land, diamonds or stocks. A tsunami – metaphorically – could however harm it.

I don’t want anyone to end up reading this believing bitcoin is dead. It’s not, I’m not saying it is. What I ask everyone to do is to consider whether bitcoin is more likely to be immortal or mortal, divine or fallible.

Possible tsunamis

The point of Black Swans is that they are not predictable. But one issue for bitcoin that is getting a lot of discussion is supply.

The maximum number of bitcoins that will ever be created is 21 million. So far just over 19 million have been made. This, some bitcoin fans believe, is one of the reasons bitcoin is good. Unlike national currencies, which are constantly printing, the supply of bitcoins is capped. It’s really rare.

The remaining 2 million will be made over the next 120 years.

But production is not evenly distributed. One million will be made over the next four years or so, and then another million over the next 116 years. Every four years or so, production halves.

This is important because new bitcoins are used as rewards for people who maintain the bitcoin ecosystem we talked about earlier.

Bitcoin ‘miners’ are given bitcoins to confirm transactions are legitimate (that’s what mining is, they do complicated calculations using a lot of electricity to confirm transactions and get paid for it by bitcoin).

It’s a smart system that has proven itself so far: bitcoin may not be fast or energy-efficient, but it’s reliable.

But the rewards for confirming transactions are legitimate are dwindling in number. Will there be enough incentives to “mine” bitcoin in the future?

Bitcoin has proven itself as long as the mining reward is high in terms of BTC and the price of bitcoin increases. It has yet to prove itself when the mining reward is low in terms of BTC, if the price of bitcoin enters an extended decline, or especially if both are true. A cryptocurrency that only works when its price increases is not safe.

Perhaps this problem will be decisively solved by the use of transaction fees to compensate miners, without making bitcoin expensive to trade. There are other problems:

cryptographic – could quantum computers get smart enough to crack the bitcoin system and make it dangerous?

Maybe bitcoin becomes legitimately useful for something and it becomes useful to have many ecosystems with many cheap bitcoins instead of one ecosystem with few expensive bitcoins.

There are no barriers to creating better cryptocurrencies. Maybe bitcoin is the MySpace of crypto and one fine day the Facebook of cryptocurrency comes along and eats its lunch.

But sure, maybe bitcoin is well-designed and everyone selling right now will regret it for the rest of their lives.

It’s hard to get anyone to think about the risks when the price is going up. The purpose of this article is to use this lull in whooping cough to remind people that bitcoin is still new, has only thrived in one market cycle, and faces known risks and unknown.

I urge you, even if you buy, not to buy more than you can afford to lose and to view all claims with skepticism.

Jason Murphy is an economist | @jasemurphy. He is the author of the book Incentivology