Bit By Bitcoin — The Luddite Investor
I get asked about crypto currency a lot. Bitcoin (BTC) in particular. Most of these questions are from quite intelligent, well-off suburbanites. As the title suggests, they have an unwavering faith in fractional reserve banking, the Federal Reserve, money supply, Lehman Brothers, and the monetary and financial system. Some never gave these things a thought and remain oblivious, while others, despite fragmented knowledge on crypto, will quickly dismiss it as tulips, monopoly money, magic internet cash, and a fraud. Of course none of you wise folks reading this post fit that description. On that friendly welcoming note, let’s jump to the questions (mostly verbatim) and fairly rudimentary answers.
What craziness is going on with BTC?
This is a reasonable question considering bitcoin (BTC), at the time of writing, is well over $10,000 per unit. No, bitcoin didn’t come out with a smashing Q3 financial report or anything like that to see this soaring valuation. Of course speculators affect the price but the rise is mainly due to increased adoption. People worldwide are buying and holding bitcoin. This includes a recent surge of individuals and institutional buyers from South Korea, Japan and India.
The most recent climb was due to the impending first ever bitcoin futures market being launched by CBOE and CME. By Dec 8 the prices are likely to climb even further probably into the $14K range.
Is bitcoin a Ponzi scheme?
In a classic Ponzi scheme someone promises consistent and attractive returns for your investment. Behind the scenes, the operation involves acquiring more investors and redistributing the newer capital in the form of dividends to the old investors. Capital isn’t employed for anything useful so no value is added in the process. Evidently Ponzi and pyramid schemes are great for those who get in early.
With bitcoin there is neither an unscrupulous fund inviting you to invest nor an entity that is promising returns. It is not a company or a government. Bitcoin is more of a global digital commodity and has value similar to gold and silver. It’s utility and impact on society extends far beyond any commodity ever seen. More on this below.
Is this a bubble and when does it burst?
Absolutely there is a bubble. An easy measure of hype is to take a look at market cap of some of the top valued cryptocurrencies. Majority of them have valuations that outrageously exceed their utility, potential, or circulation. Granted the market cap numbers in this case don’t paint any realistic picture of the financials due to the lack of market depth.
However, among these, bitcoin is the most mature and relatively least bubbly. Despite everything the crypto movement is in a very early stage by any measure. A burst is not imminent but it’s good to stay in tune and read on.
The concept of market cap is muddled in crypto because most coins have no market depth. For e.g. say 100K XRP are are in general trade circulation. This is just an artificial supply crunch while a handful of people hold 90% of the *pre-mined* supply. Now if the pumped price is $5, we simply do 5 x 39billion (total supply), call it market cap and rejoice! The math is meaningless.
Is bitcoin really worth that much?
Once again you could draw a parallel with gold. Is gold really worth $40,000 per kg? Extraction does not cost nearly as much. It is an arbitrary value we have settled on based upon, among other things, its relative scarcity. Major fluctuation of that price is caused by speculators. Bitcoin improves over the properties of gold as in the following answer.
What is driving this demand for BTC?
We realize that demand drives up the price. But what is driving demand? There are three things that are working for BTC. It’s growth history, availability, and the fact that most owners have learnt to hold (HODL) it for the long term.
Granted that at the outset BTC was used heavily for transacting on the darkweb. But now BTC is the #1 asset listed on every legitimate exchange. Fearless and impressed with this phenomenal rise to power, people are rushing to their nearest exchange with their deposits to grab a piece of the pie.
Countries with political/economic instability (e.g Zimbabwe) see particular rise in BTC demand as citizens try to defend against hyperinflation of their money with something that’s stable, liquid, as well as easy to obtain. What better than a global deflationary currency to park your money while the military coup blows over?
How does it compare to gold?
Gold is a good analogy as it’s value comes from it’s relative scarcity, ornamental value and people’s long standing perception towards the metal. Otherwise gold generally has very little practical use and has no “intrinsic” value other than that what humans artificially attach to it.
Bitcoin shares some of these characteristics. Gold has to be extracted from a mine as an ore and then put through an extensive process of smelting and purification. Bitcoin is created in a mathematical mine powered by open source software that requires enormous computing power.
Despite the value attached to gold, it cannot be used in commerce (try it out on your next visit to the saloon)
Even if you did choose to use gold as a medium of exchange, it would be very difficult to ascertain if a piece of gold is authentic. You would need a trusted third-party to appraise it’s value and verify that it’s not fake. Precision is also impossible since divisibility is lacking (for e.g. if you had to pay exactly $5 worth). Add to all this the unwieldy nature of coins or chunks of gold.
The alternative, paper money, appears convenient because we simply have faith in the government seals and markings that appear on the currency notes and coins. Despite deterrents, currency notes are easily counterfeited. Since the supply of fiat is open ended you also have inflation to deal with (discussed in a later post: The Politics)
Bitcoin shines when it comes to addressing these shortcomings:
- It can be reliably sent to anyone (or anything) in the world
- It cannot be counterfeited
- You can verify, authenticate and transfer ownership peer-to-peer without the need for an intermediary
- You can carry any amount, anywhere in the world, anytime, just on your smartphone and use it as a method of payment
- There is a known limited supply and so fairly inflation proof
- It is (almost) infinitely divisible. The smallest available denomination of USD is one penny. The smallest denomination of BTC is a Satoshi — 100,000,000 of which make up 1 bitcoin. This is important because even though the fee makes it impractical, it is possible to send or receive a hundred millionth of a bitcoin
- Maintains high liquidity as you can instantly sell on an exchange, a friend, or to a complete stranger on the street
Finally, gold once mined retains its physical properties indefinitely despite the fluctuating value relative to fiat. A cryptocurrency is only meaningful as long as there are miners supporting the ledger on which the transactions exist. It’s akin to a government deciding to demonetize one or more of the reserve bank issued notes. Governments can take abrupt unilateral decisions, however miners would only abandon a currency when it is no longer economically viable and not profitable to support. Consequently, crypto currencies cannot be banned by countries.
How do I buy bitcoin?
Short answer — head over to Gemini.com, Kraken.com and you should be able to get by with a fee of about 0.25% per trade. For a multitude of reasons I dislike Coinbase.
A FOMO (fear of missing out) investor is impatient and wants to hear of nothing but the formula to gains. But I encourage them to take a moment and understand ownership and sovereignty when it comes to bitcoin and other cryptos.
When you buy digital currency at an exchange it is just like buying stock or a commodity contract in the stock market or an options exchange. Traditional investors almost never really take ownership of the assets underlying the financial products they buy. For e.g none of the people I know, who deal with oil futures, have ended up with barrels of crude rolled up to their doorstep. The “assets” are in custody of some trusted entity handling your money. Effectively you don’t have full control over it and often probably for good practical reasons.
Imagine this scenario with cash. Let’s say you bought euros with dollars. You probably want to have that money readily in accessible either in your wallet or at a bank. Similar to cash, you can “physically” own and store crypto with little effort and without the need for a trusted custodian. All intermediaries, that add can management fees and regulatory controls are eliminated. This is true ownership and control.
Having said that, if you are in it just to quickly park money, then letting the exchanges manage your funds is ok. But to go down the rabbit hole, find out more about wallets
It is so volatile. What’s a good price to buy?
Let’s face it. We are all in this because of FOMO — Fear Of Missing Out! The ultimate attraction is the prospect of quadrupling money over a weekend. Most readers would have retirement and mutual funds that are tightly controlled for risk would have never traded a single stock or ever thought of opening an eTrade account. But the same folks are cartwheeling to crypto trading exchanges despite digital tokens being orders of magnitude more risky than regular stocks.
I could throw in the obligatory legal disclaimer — “this is not financial advice..talk to your financial advisor” but I’m fairly certain that your financial advisor knows nothing (about crypto). So essentially you are on your own and will have to start small and start somewhere.
There are several cryptocurrencies to choose from. I often hear “I missed the boat” when people see a rapid run-up after a particular token gets some media attention and speculators rush to it to make overnight profits. This usually happens after a prolonged period of price stagnancy (eg. litecoin or ripple). Often this is a good point to get in behind early adopters instead of considering it a missed opportunity.
Bitcoin has presented such opportunities probably hundreds of times. But every time friends of mine thought the price was too high and they were “waiting for the price to drop to get in”. I’m talking about ever since the price was $600 to this day when it is 20x that. Everything is a missed boat in retrospect. So better to look at future potential than count candlesticks of history.
I am involved with crypto businesses so I have the luxury of little more exposure to the subject matter than others. This may make me slightly more comfortable with crypto investments. But in general I believe putting money into new volatile markets requires a very different mindset (I don’t claim to be one of them).
To summarize, here are few things to takeaway
- There is no good price
- As an investor with no particular interest in the greater cause of crypto, you should only be concerned about percentage growth of your investment. So it doesn’t matter if the price is $500 or $20,000
- You can invest as little as you want $100 to start. Unlike a stock like Google where you must buy at least 1 stock, most crypto is divisible. For e.g. you don’t have to buy 1BTC you can buy 0.0001BTC
- Traditional stock trades have a brokerage fees per trade ranging from $6 to $20 or more. Crypto exchanges charge 0.25% or less of the USD order amount which is conducive to small orders.
Any speculator with at least $500K can manipulate the price for the short term at any exchange. This is seen as the inherent volatility but in the long term these manipulations are far more diffused.
I heard you can buy coffee with bitcoin?
As this excerpt from the original white paper describes, eliminating the overhead of having intermediaries and the associated fees was one of the main goals of bitcoin.
Sounds great but those golden days are gone. The fees for a small transaction like coffee no longer make bitcoin viable for small payments. The high fees are due to competing transactions and is a well-known scaling problem for which there are many solutions in development. There are also several alternative cryptocurrencies that try to address this issue (altcoins).
We got it — BTC terrible for small payments. are plenty of ways to get around the fees and use BTC anywhere you like as explained next.
What fees? Why do I care about fees as a buyer?
Crypto payments radically differ from traditional payments. With a Visa for e.g. you pay $9.99 to a merchant who receives about $9.30 after processing fees. The transaction usually takes around 10 seconds and it takes 2 or more days before the merchant can access the funds.
If you want to send someone 0.05 BTC, you would have to actually send 0.05001 or more. So the fee is included in the sender’s amount to incentivize the operators to process your transaction. The receiver will get exactly 0.05 BTC. This can take anywhere from a minute to hours based on the amount of fee. After this the recipient has full access to the funds received and doesn’t have to wait for a settlement.
Where is it used? I only heard where it can’t be used.
The acceptance of bitcoin as a payment method is still rare. You can buy various gift cards, shop at Overstock, or buy real-estate in some cases but direct use as currency is statistically negligible as of now (2017).
Peel off this rosy facade and there’s a massive underground market for everything from sex toys to drugs to hit men that runs exclusively on bitcoin. Just putting bad news first.
However noting to worry. There are services like BitPay that make spending your bitcoin perfectly easy. A BitPay debit card simply holds a USD balance. Whenever you send them bitcoin they will exchange to USD based on the spot rate. This usually takes just a few minutes. The card works like any credit card so you can effectively pay with your bitcoin for anything and anywhere in the world.
Besides this you can buy every imaginable giftcard in exchange for BTC at sites like egifter.com etc. So basically you don’t have to use too much imagination to find ways spend your BTC.
How does it work?
I cover the idea behind the distributed ledger (blockchain) in a separate post. Usually the ledger at your bank contains your credit and debit transactions. This information is securely stored somewhere on the bank’s database which nobody other than the bank and you can access. The blockchain turns this idea inside out. All transactions are duplicated across thousands of independent servers all over the world and are visible to the public. However unlike a bank, users remains anonymous* and it is difficult to determine the participants of the transaction — which basically shows two account numbers (addresses) and the amount moved. For e.g. here’s a transaction involving about $2 million.
Why is the price going up relative to the dollar? If BTC is a currency then arbitrage should take care of normalizing it. Does not make sense!
Arbitrage is a healthy process that helps stabilize prices across markets. It is present in every stock exchanges and forex market. In crypto exchanges, due to the limited market depth, arbitrage across exchanges takes time and requires significant setup. For e.g. let’s say the price of bitcoin on Kraken and Gemini differs by $200. Common sense would dicate that you buy BTC on Kraken, send it to Gemini and liquidate. Rinse and repeat!
Practically, however, it may take at least 30mins for the BTC to be transferred across the exchanges. In the meantime the volatility can adversely affect the price and defeat the purpose of the transfer. To minimize this we could up the fees for a quicker transfer which again cuts into the profit we are after. Now extend this example to arbitrage among exchanges across different countries and you get the idea of the complexity.
What is so weird about BTC?
Due to a lifetime of conditioning we are used to thinking of currency, savings, trading etc. in a certain way. To appreciate crypto economics a deep unlearning (relearning) of the basics is needed as it shakes up the fundamentals of money itself. Imagine holding an asset that’s a medium of exchange, store of value, and an investment all rolled into one. Can’t think anything similar? That’s why it’s so weird.
Does it replace the need for banks?
Yes cryptocurrency has the potential to eliminate the need for a bank. In an ideal crypto economy transactions would take place between parties privately without any surveillance and third-party intervention. A bank or the government would only comes into the picture when you cross the threshold from crypto to fiat or vice-versa. Currently businesses that do accept bitcoin almost never hold it. It is just used as a settlement layer.
Why is it time for bitcoin? Why now and not 10yrs ago?
Well bitcoin is already close to 10. Until the bitcoin paper came out there were some suggestions on how to address the double spend problem in a digital world, but it was not fully solved. Bitcoin’s implementation was the first fully working peer-to-peer electronic cash system. Fast global internet provided the perfect infrastructure for the network to grow.
Is it legal?
Yes it is. Governments despise anything people do that’s not traceable or trackable. Most have enacted extremely intrusive and far-reaching policies under the pretense of preventing money laundering (AML) and customer tracking (KYC). Crypto causes all kinds of regulatory headaches for governments but even the most oppressive ones cannot do much about it. Hence it is legal.
Who’s the CEO of Bitcoin?
Bitcoin is not a company. It’s not a bank. For all practical purposes it’s a digital commodity.
How can I trust it when it is backed by nothing?
The primordial reason for bitcoin’s creation was trust. Or rather to eliminate the need for trust. It removes the “trusted middlman” between two (or more) parties who want to enter into a transaction. This is very similar to cash. With paper money you could trade with another person without the need for a third-party. This is because both participants recognize and accept the fiat currency as valid a medium of exchange. However in the digital world no such thing existed. All transactions must be processed by a bank or a payment processor (like MasterCard).
You could send money by Paypal and call it a digital transaction but both parties must trust Paypal to do the settlement. Additionally Paypal must report those transactions to their banks, regulators and so on. So the transaction will occur only if all the middlemen approve.
Bitcoin is digital cash which can be exchanged electronically without any “trusted” third-party. The payment processor in this case is the crowdsourced automated network of computers running the open sourced bitcoin software.
So bitcoin is unregulated only in the context of government backing. For e.g. FDIC exists to boost your confidence in your bank so you are assured of recovering your money if it tanks. In the crypto world the collective ecosystem of users and miners ensure complete integrity of your ownership. In effect it is self-regulating and the institutionalized concept of backing doesn’t exist.
Subsequent posts talk about wallets, trading, the politics of cryptocurrency, and commerce. Did I miss a good question? Leave a comment.
