The Emperor’s New Coins – Don’t Let BaitCoins Lure You Down A Rabbit Hole

As the public discourse around Bitcoin reaches a crescendo, a number of learned commentators are comparing the current Bitcoin mania to the Tulip mania of the 17th century or even to the South Sea Bubble, where a great number of British people lost huge amounts of wealth in the 18th century as a result of purchasing the stock of companies that didn’t actually generate any value.

However, I beg to disagree. In the case of those who physically bought tulips (rather than the futures contracts attached to tulips), when the crash came, they at least owned a bunch of beautiful flowers. In the case of Bitcoins, people will be left with a string of 0s and 1s which will never be seen, admired, enjoyed or felt.

The Bitcoin high priests (because there is a certain level of almost theological fundamentalism one senses when one speaks with Bitcoin proponents) will argue and explain that Bitcoin is a fairer way of redistributing wealth and how it will be the currency of the world because it is free of central bank influence.

Except when you ask them to explain how:

  • There will only ever be 21 million Bitcoins – because that is the theoretical maximum limit
  • It can ever be a transparent when 1 million of those coins are owned by possibly one person or a small group of people (Satoshi Nakamoto) – who is unknown and whose origins are shrouded in mystery
  • It can be considered equitable when 40% of all Bitcoins are owned by 1,000 peoplein the world who are all linked to each other and can collude to move the Bitcoin markets at once.

There are some real fundamental problems with Bitcoins which I’m highlighting below and which I hope gives food for thought.

The real issues with Bitcoin and the arguments made by Bitcoin proponents

What is the intrinsic value of Bitcoin?

 The single biggest issue about Bitcoin is around what the intrinsic value of Bitcoin is. There will be any number of convoluted answers about what people think the inherent value of Bitcoin is, but it gained the greatest usage by merchants and purveyors of illegal merchandise on the dark web through sites like the Silk Road where you could buy anything from crack cocaine to knuckle dusters.

I was reflecting on the factors driving the valuation of Bitcoin valuation, 4 years ago in 2013 (when Silk Road was at its peak) and now and reflecting on the drivers leading to Bitcoins valuation. The figure below is my view of some of the factors driving Bitcoin valuation.

Figure 1 – Factors driving Bitcoin valuation

In the very early days, when you required a few Bitcoins to pay for pizza, the usage of Bitcoin was limited to a very small group of individuals who wanted an anonymous mode of exchange. The bearer nature of Bitcoin meant that it provided the level of anonymity that one requires in order to transact bravely in all forms of drugs (except it didn’t and a whole bunch of people were caught when Silk Road was shut down – and also because the founder of Silk Road, Ross Ulbricht aka ‘Dread Pirate Roberts’, chose to use his actual name to set up his anonymous site….and boasted about it in his LinkedIn profile!). Crime generates US$2.1 trillion worth of economic activity, or 3.6% of the world’s GDP. This suggests a sizeable market for anyone who wants to move on from transferring large amounts of US dollars physically or electronically towards a virtual, anonymous currency which can be transferred across borders through anonymous digital wallets.

There were also small groups of Libertarian vendors who were accepting Bitcoin as a means of exchange but Bitcoin’s perception, be it as a commodity or currency, was fairly limited. However, through the hype generated through the valid use cases of the underlying technology driving Bitcoin, Blockchain, Bitcoin hit the public domain in a much bigger way and a small group of individuals started creating the hype around it, which increased people’s perception of what the value of each Bitcoin should be.

That is what figure 1 above suggests – the value of Bitcoin has been driven by the irrational and exuberant perception of some of the market around what the value of Bitcoin ought to be, rather than on any sound fundamentals or basis.

This then leads to my original question: What is then the inherent value of Bitcoin?

Why should anyone consider it as a store of value and the most fundamental question of them all is, when all is said and done, what is a Bitcoin backed by?

Paul Krugman said it best when he explained that, “To be successful, money must be both a medium of exchange and a reasonably stable store of value. And it remains completely unclear why Bitcoin should be a stable store of value.”Krugman’s interview with BusinessInsider is also hugely instructive for those interested in learning more about his thoughts on Bitcoin.

‘Ah,’ the Bitcoin high priests will exclaim, ‘what then is any currency in the world backed by?’ and use that as an argument to argue the value of Bitcoin.

Let’s be clear, a Bitcoin has no underlying value. It generates no value, except in its own exchange, and there is nothing to back the price of a Bitcoin, except only the trust of the purveyors of Bitcoins, which in turn is backed by nothing but hope and the promise that there will be another sucker who will come along to buy the coin at a price higher than they were duped into buying.

Other fiat currencies, say the US dollar, the Chinese renminbi, or any other national currency are essentially backed by the underlying economic output of the country. Governments are able to defend and protect a currency on the back of the strength of its reserves or economy. These currencies are accepted as a means of exchange and faith in the economic system is implicit.

If Bitcoin goes into a free fall, what authority or government is going to step in to prop it up and ensure the confidence within the underlying asset? What economic output does Bitcoin generate that underpins its value?

No underlying value – not like a fiat currency backed by the underlying economic output and governments are able to defend and protect a currency on the back of the strength of its reserves and the currency is accepted as a means of exchange and faith in the economic system is implicit.

The naiveté of Bitcoin high priests

Bitcoin enthusiasts proclaim how Bitcoin will become the de facto currency of the world.

Let’s be clear. The moment anyone or anything comes close to threatening the national sovereignty of a country, they will be shut down and shut out.

Over time, I foresee national economies and regulators killing Bitcoin outright (the way China banned it outright) or killing it through a thousand cuts (or regulatory burdens such as considering Bitcoins to be commodities rather than currencies and taxing holders of Bitcoins for capital gains – as the IRS are seeking to do in the US). The IRS in the US is also hunting down Bitcoin users and breaking their shield of anonymity so as to find them and tax them.

The British government, through the UK Treasury, is also looking at greater regulation of Bitcoin in an effort to bolster anti money laundering or the countering of the financing of terrorism (AML/CFT). Australia is following suit in a similar vein, and it’s a matter of time this becomes a wider campaign, driven by concerted regulatory authorities.

The moment governments introduce sufficiently high capital gains taxes – and they will because they will be able to justify it as a tax on something that has been made purely through speculative channels and with no underlying economic activity – and over time, this will destroy Bitcoin’s value?

The reason why governments will, over time, not allow for Bitcoin’s operations is because it threatens the sovereignty and integrity of their national borders. Governments will never cede their ability to use monetary policy to control and influence economic activity. This is precisely what Bitcoins do as they fall beyond the reaches of central banks and regulators and how can a country aim to control inflation, employment, underlying economic activity, if a currency that they cannot control is influencing their economy? This is the challenge economies like Vietnam or Indonesia face because of the pervasive influence of the US dollar on their economy and they are unable to exercise monetary policy tools.

The race to regulate Bitcoin has begun, and ultimately, this is what will lead to the moderation or possibly the demise of a currency that is not backed by underlying value, economic activity or output.

It’s all about finding the next sucker

The way the Bitcoin market is moving now, nobody is actually using Bitcoin as a medium of exchange or as a currency. It is a commodity or an asset that people are holding on to, and hopefully selling it off to somebody else before the whole thing implodes.

Since the start of the year, Bitcoin’s price has jumped more than 1,000 percent since the start of the year, and Bitcoin futures just began trading at the Chicago Board Options Exchange (what happens when you bring together a fake currency and a financial weapon of mass destruction??)

The shadowy nature of Bitcoin’s true controllers

The other real issue with Bitcoin is the completely opaque structure of Bitcoin’s ownership structure. Satoshi Nakamoto, the founder of Bitcoin, allegedly owns up to 1 million Bitcoins, or roughly 5% of the theoretical maximum number of Bitcoins (21 million). If and when Nakamoto chooses to cash out, it will lead to a collapse of the currency as we have it.

Another estimated 1,000 people own up to 40% of the total Bitcoins in circulation – most of them who are connected to each other. There is a persistent, and reasonable concern, that if these Bitcoin owners choose to ‘pump and dump’ the Bitcoins (given the lack of any real governance or regulation around Bitcoin trading at present), then those shouldering the fallout will be the investors who came in without understanding what it is and without an ability to influence the market or hope for some form of regulatory/governance mechanism to support them.

Collusion, which is generally illegal for almost any other asset class, can take place with impunity amongst the Bitcoin community (the majority of coins which are controlled by a very small group of individuals). The Bitcoin whales (or those who control significant portions of the Bitcoin world) are under (currently) no regulation, there is little anonymity, and there is no oversight – so how will this lead to the type of transparency that one requires in order to be the de facto currency of the world?

Bitcoin’s widespread acceptability isn’t all that it is cracked out to be

Bitcoin enthusiasts will claim that Bitcoin is going to be the new digital gold that will overhaul the existing global monetary system – overhaul to what exactly is not something they are able to answer. They will cite it’s widening acceptability as a medium of exchange – but it ain’t.

Bitcoin’s acceptance as a mode of exchange is still hugely limited. Last year, 1% (or 5) of the top 500 online businesses accepted Bitcoin as a medium of exchange. Given the fanfare Bitcoin has had, you would expect there to be an increase in its acceptability. But actually, only 3 of the top 500 (or less than a percent) online retailers are now accepting Bitcoin – so the number has fallen.

The single biggest traded commodity each given day, is oil. It is oil that drives the strength and value of the US dollar. There is almost never going to be a time where anyone will sell oil in Bitcoin. Nobody (sane) will seek to sell their home or property in Bitcoins. Everyday life will rarely include Bitcoin in its path – and it is not going to become the ‘de facto currency of the world’ which is part of the excuse individuals use to explain the current price levels.

Furthermore, it is also important to note that, even in the world of cryptocurrencies, Bitcoin isn’t the only non-value generating currency or show in town. There are numerous other cryptocurrencies (including DarkCoin – which has increased in value exponentially over the last few months, Litecoin, Ethereum, etc), all with the same level of vulnerabilities and issues. Why should any of the currencies be THE cryptocurrency of choice?

This is remarkably similar to the conditions that led to the South Sea Bubble, a period of history where even Sir Isaac Newton lost a fortune which led to his famous quote, “I can calculate the movement of the stars, but not the madness of men.”

Incidentally, Venezuela just launched Petro, their own national cryptocurrency – and to be fair, at least Petro is backed (allegedly) by the national oil reserves of Venezuela, which is more than can be said for Bitcoin.

It’s a secure trading currency

 The Bitcoin enthusiasts argue about the security Bitcoin offers. It doesn’t.

South Korean Bitcoin exchange was hacked and has gone bust in recent days – with North Korean hackers being blamed. There is a continuous stream of reports of digital wallets and coins being stolen and with little recourse for individuals who have lost their earnings. This is what happens in a world without regulation.

These are not isolated incidents either. In a report delivered in 2016, Reuters argued that a third of all cryptocurrency exchanges have been hacked.

The fact that authorities are routinely seizing Bitcoins (see examples of SwedenBulgariaUS) suggests that a concerted drive by determined individuals can also take control of the Bitcoins you think you own.

Beware and be careful

From the time I started on this article 3 days ago, to the current time, I note that the Bitcoin valuation has gone from close to US$20,000 to just over US$13,000, with no real change in underlying world economic conditions in those 3 days.

It just goes to prove my point that a currency based on nothing, will move due to anything.

Ultimately, one should never buy what one doesn’t understand. Of course, the likes of the Winklevoss brothers will argue that Bitcoin will grow by twenty times – but that’s of course only because they own a huge chunk of Bitcoins and will only benefit from a price increase.

I worry greatly when I see young people take out credit card debt to buy these coins or in some insane cases, take out second mortgages!As I’ve said earlier, nobody’s going to sell their homes for Bitcoins, so why bet your savings on it?

People are going to be at the mercy of forces they can never hope to control or understand, and should not be investing in what essentially a fad based on no real underlying value or economics. Aswath Damodaran’s (Professor at NYU Stern School of Business) warning about it being a potentially lucrative but dangerous pricing game with no good ending is one that people should do well to heed.

People also often make a mistake in assuming a paper profit translates to actual cash surplus. We already are reading about the lack of liquidity in the market place alongside cases of individuals who are unable to liquidate their Bitcoins for cash, especially during a downturn.

Nobel Prize winner Joe Stiglitz argues that Bitcoin should be outlawed because it doesn’t serve any real useful function but ultimately it may not require any legislative forms of control because it will disappear into the margins of society where it began once people realise the lack of substance or value that one can attach to it and after people realise in the end, it comes down to a bunch of digital bits they can never see or touch and which is not backed by anything real.

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10 Things To Learn From Warren Buffett’s 2017 Letter to Berkshire Hathaway Shareholders

The Oracle of Omaha’s latest letter to his Berkshire Hathaway (BH) shareholders is filled with Buffett’s typical humour, humility and cutting insight.

Below are some early reflections from his 2017 letter which was issued on the 25th of February.

1.   Always Look For The Opportunities

Buffett (and Charlie Munger, BH’s Vice Chairman) will always be “prepared mentally and financially to act fact when opportunities present themselves.”

He then goes on to add, in classic Buffett-style,

“Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons.”

2.   It’s Okay To Make Mistakes (Just Make Sure You Learn From Them)

Buffett shares his anecdotes about how he’s “made some dumb purchases, paying far too much..” and gives some examples of when he overpaid for companies such as Dexter Shoes which lost all value and for which he paid for in Berkshire shares (shares now worth $6 billion – arguably the most expensive shoe company in the world!). He then made a similar mistake buying General Reinsurance, again with shares. From that point, he explained how he has ensured that most of BH’s deals came from internally-generated cash rather than through BH shares.

“Today, I would rather prep for a colonoscopy than issue Berkshire shares,” declares Buffett. The lesson here is how it is okay for mistakes to be made, but what won’t be okay is not learning from them!

3.   The American Dream – Built By Immigrants

Buffett remains the eternal optimist. He remarks on the ‘miraculous’ achievement of the United States of America over the last 240 years through the efforts of a ‘tide of talented and ambitious immigrants’, the rule of law and human ingenuity. He explains how, since 1776, Americans have managed to amass wealth totalling $90 trillion.

He does acknowledge that the majority of the homes, cars and other assets are often borrowed but goes on to add how even if the owner defaults on the asset, it remains within American hands.

The one point he does touch on very cursorily is about how the wealth is divided but argues that it is okay as long as it belongs exclusively to Americans. The real challenge here is how less than 1% of Americans actually own the bulk of the wealth – and this inequality is arguably the biggest challenge America faces in the coming years and decades.

4.   Remaining Bullish

“Babies born in America today are the luckiest crop in history,” claims Buffett very boldly. He goes on to explain how American businesses are going to be without doubt ‘winning’ as President Trump may claim.

He then reminds investors that ‘widespread fear is your friend as an investor, because it serves up bargain purchases,’ and that ‘personal fear is your enemy.’

5.   Succession Planning and Managing Talent

Buffett speaks of Ajit Jain who manages Berkshire Hathaway Reinsurance Group and extols his virtues including how Ajit’s operation ‘combines capacity, speed, decisiveness, and most important, brains in a manner unique in the insurance business.’

Buffett talks about how when Ajit Jain first came to BH, he had no experience in insurance and went on to build one of the most successful insurance businesses. Buffett goes on to say, “I there was ever to be another Ajit and you could swap me for him, don’t hesitate. Make the trade!” providing further hints that Ajit Jain could become the next chief of BH.

Ajit Jain is also another immigrant from India who has established his roots in the US and it will be interesting to have the views of Steve Bannon who was dismayed by the fact that there were too many CEOs from South Asia.

6.   The Power of Marketing

Buffett demonstrates how you should always be unashamedly promoting the brand you represent and goes on to tell all readers of the letter to go on to GEICO (an automobile insurance firm) by providing their contact details to save money on their auto insurance! He extols the virtues of GEICO’s superior advantages driven by low costs and how they’ve grown (from making US$8 million annually in 1951 to making that same amount now every 3 hours!).

7.   The Importance Of Having Trusted Advisors Beside You

Buffett explains how he has made errors and ‘stumbled’ either in assessing the fidelity or ability of managers and also talks about how one could count on him certainly making more errors. He then touches on how he is fortunate that Charlie Munger is always around to say ‘no’ to his worst ideas! Anyone who thinks they have no need for guides or advisors is going to be sadly mistaken.

8.   Targets Drive Behaviour And Culture – The Challenge of CEOs Who “Always Make The Numbers.”

Buffett fires a shot across the bow for CEOs who tend to omit certain items or expenses in order to ‘make the numbers’ and meet analysts’ expectations. Buffett warns how CEOs who ‘overtly look for ways to report high numbers tend to foster a culture in which subordinates strive to be “helpful” as well.”

As Buffett explains, business is too unpredictable for numbers to be always met and when a CEO’s focus is driven solely by Wall Street’s expectations, he or she will be ‘tempted to make up the numbers.’

9.   What Value (Or Fees) Do Those Hedge Fund Managers Add?

Buffett has hedge fund managers plainly in his sight. He bemoans the prevailing hedge fund standard of “2 and 20” which means a 2% annual fixed fees and 20% of profits – which means hedge fund managers end up making money (simply by piling on the assets) even if the underlying fund performs badly.

Buffett argues how merely investing in an unmanaged low-cost index would do far better than through some very expensive fund managers and highlights how only one individual, a Ted Seides, from thousands of professional investment managers offered to take him up on a $500,000 bet that a low-cost S&P fund would beat (over a 10-year period) five expensive hedge funds. He goes on to explain that 1,000 monkeys are as likely to make similar market predictions as 1,000 fund managers…

Buffett’s guidance is that all large and small investors should stick with low-cost funds as it is always going to be the hedge fund managers rather than clients who reap the benefits.

He adds how he has always recommended a low-cost S&P 500 index to his friends but how wealthier investors have always only politely thanked him for the guidance and went away to listen to the ‘siren song of a high-fee manager.’ Buffett estimates that more than US$100 billion has been wasted in the past ten decades as a result of “elite superior investment guidance,” and how most of the financial damage impacted pension funds for public employees.

10. Mind the GAAP – the Woes of Warren

One final point to note about Warren’s on-going challenges with accounting standards, or Generally Accepted Accounting Principles (GAAP). He explains that amortisation is not truly an economic cost and therefore should not be reflected in the way US GAAP requires them to. He also feels that GAAP-prescribes depreciation methods also understate true economic costs which mean earnings are overstated.

Buffett highlights how the changes in BH acquisition strategy – from merely owning a portfolio of stocks to outright ownership of businesses. This meant that rather than having a balance sheet that was ‘marked to market’ (or having a balance sheet that reflected prevailing share prices for the stocks they own) they had now companies they owned or controlled and therefore had to be reflected as per current GAAP or accounting standards. This meant that they have had to write down for companies that lost value (referred to Buffett as the “losers”) but could not revalue the goodwill for the companies that performed well (or the “winners”). This is why their market-value gain was 23.4% in 2016 vs a book value gain of 10.7%.