Authors: Dietmar Peetz, PhD and Gregory Mall
Bitcoin’s price has seen a meteoric rise over the last years. Bitcoin is a real asset but what is not real is the value assigned to it. We argue that Bitcoin has reached bubble territory and will ultimately correct. However, we believe that in the intermediate term, the bubble can become even bigger in the process of financialization. It is to bear in mind that Bitcoin is not for the faint hearted but for speculative investors with very high risk tolerance.
In 2017, digital currencies have been a hot topic. Bitcoin, the now dominant representative of the crypto currency industry, has seen further dramatic price increases. From 2009, the year of introduction, until end of August 2017, Bitcoin’s rise has been super-exponential, just recently surpassing a market cap of more than 70bn USD. Despite all the media hype, we contend in this article that Bitcoin, like all other crypto currencies, should not be seen as a currency in terms of a medium of exchange, but rather as a distinct asset class. Nevertheless, given crypto currencies’ meteoric price increases, we believe the crypto currency sphere to be in bubble territory, making eventual consolidation inevitable; in this sense, investors may be well served to recall that asset valuations go from boom to bust – from overvaluation to undervaluation (and eventually back to overvaluation). As a result, we believe that Bitcoin, as it is currently valued (September 18, 2017) juxtaposed against monetization reality and ill-defined monetization (profit) prospects, is a speculation, not an investment. Accordingly, speculators with very high risk (volatility) tolerance may find “cryptos” of interest.
What is Bitcoin?
Bitcoin is based on a public ledger system – a so-called blockchain, where all transactions made in Bitcoins are recorded in a cryptographic and hence anonymous manner. Every time a bitcoin is transacted from one digital wallet to another, it will be documented on the blockchain. A person owning Bitcoins holds a unique digital key to access his/her Bitcoins. Whoever owns the key, controls the Bitcoins. If the key is lost, the Bitcoins are lost. Transactions are irreversible and settlement occurs as soon as the ledger is updated. Updating the blockchain occurs by solving a computationally intensive mathematical puzzle. The computer (node) that solves this puzzle first and contributes to the blockchain receives a certain number of Bitcoins (so-called “mining,” a purposeful analogy to labor and energy intensive precious metals mining). The number of awarded Bitcoins will subsequently be halved every four years after that. The total amount of Bitcoins is fixed at 21m. The blockchain is distributed between all the nodes and can only be manipulated if any one-party controls over 50% of the computing power.
Why Bitcoin Is not a transaction currency
The original idea of Bitcoin was to create a purely anonymous peer-to-peer payment system based on cryptographic proof rather than a trusted third-party intermediary. Because of its de-centralized nature, the idea quickly gained traction in the libertarian as well as countercultural movement. Many saw it as the manifestation of ideas nurtured in the Austrian school of economics. Specifically, a currency liberated from any sort of governmental interference, which would facilitate true price discovery, the backbone of robust free market capitalism. This was also the reason why Bitcoin became popular on the dark net, enabling safe and anonymous transactions with no interference of traditional financial intermediaries. But is Bitcoin truly a currency? Let’s analyze:
A currency is an instrument which is used to facilitate transactions between parties. It is a medium of exchange meant to help buyers and sellers to find the right price at which transaction can take place. It is at this price that economics says the market has “cleared.” Clearing is important because it helps to bring transparency and predictability to the marketplace, which in turn strengthens social reciprocity and encourages more transactions. However, when a currency cannot be accurately valued, this clearing mechanism does not work anymore (Weimar hyperinflation being the classic example). That is the point when things become irrational, such as aggressive bidding for fear of more currency in circulation (inflation) or refusing to use the currency in anticipation of less currency in circulation (deflation). In terms of Bitcoin being labeled a currency, suffice it to say that we see several issues speaking against such viability. First, there currently exists no commonly accepted valuation model for Bitcoin. Second, unlike precious metals, highly volatile Bitcoin has no history of being accepted as money and it lacks any time-tested store of value credentials (accepted intrinsic worth), both of which are key currency attributes. Third, all else being equal, Bitcoin would have potentially material deflationary consequences. Digital production is programmed to stop when the total number of Bitcoins reaches 21m (16.5m have been “mined” already). If Bitcoin had to be used to facilitate all transactions in the world, that would lead to a contracting world economy very similar to the austerity policies imposed on Greece, but on a much larger (global) scale. In contrast, consider that central banks have the mandate not only to ensure the stability of the financial system, but to manage their respective nations’ fiat money supplies with a view to achieving inter alia price stability, i.e., to prevent either excessive inflation or deflation. Fourth, we are of the opinion that the same fears of deflation, which were used as a rationale for the US to abandon the Gold standard in 1971, would embolden authorities to prevent Bitcoin from becoming a currency. Based on historical precedents, it is not unthinkable that in times of economic or financial crisis, political and regulatory pressure on an unwanted currency would increase, possibly in a similar manner as in the US in 1934, when the Gold Reserve Act of 1934 was ratified, nationalizing all gold and subsequently revaluing it by 69% in US dollar terms.
The finite limit of Bitcoins has additional drawbacks. The majority of coins are expected to be “mined” in the next 20 years which, in the absence of a large-scale hardware revolution, will lower the individual incentive for “miners” to perform the computationally intensive settlement process. Although – due to the generous “mining” system – Bitcoin transactions and the energy to “mine” them are currently cheap for the individual buyer and seller, the process itself is incredibly energy intensive. Currently, Bitcoin’s aggregate energy consumption is estimated to be around 16.3 Terra Watt/h (180 Kw/h per transaction), although there are only roughly 5 million people using Bitcoin. “Mining” becomes more profitable the higher Bitcoin prices rise. That said, “miners” have to invest heavily into technology to keep pace with other “miners.” When most Bitcoins are in circulation, the “miners” will need to be explicitly compensated by transaction fees which are unlikely to be lower than current transaction fees. Based on generous estimates, Bitcoin can currently handle around 7 transactions a second. Its rival Visa can currently handle around 65,000 transactions a second. Transaction capacity will depend on future hardware possibilities, but without radical scaling (huge, unearthed economies of scale), it is unlikely for Bitcoin to come anywhere near established payment systems. We believe that although more and more vendors will accept Bitcoins, this is happening mostly from a marketing perspective and this trend is most likely to reverse once the Bitcoin price would enter bear market territory. In a related and most germane manner, the enormously high Bitcoin price volatility makes it unsuitable for a reliable day-to-day exchange medium.
There are other reasons to be skeptical about the long-term prospects of Bitcoin as a currency. Apart from the obvious risks such as fraud, hacking, and theft, Bitcoin and other crypto currencies face a variety of legal hurdles. Due to its anonymity as well as its lack of governmental control, regulators around the world are not pleased with the relatively wide-spread acceptance Bitcoin has gained over the years. Since Bitcoins are often used to circumvent capital controls as well as potentially violate existing capital market statutes, it is possible that regulatory agencies may prohibit the possession of Bitcoins. The People’s Bank of China has recently taken the strictest approach to date, declaring ICOs (initial coin offerings) as illegal. The SEC has also started to scrutinize ICO-markets more closely, although the agency has not been as determined in its attempt to restrict the process altogether. Other agencies around the world are likely to follow suit. The bottom line: cryptos and ICOs will eventually be widely subject to the same compliance requirements as other capital and currency markets, which would likely dent both the appeal and the valuations of cryptos, possibly substantially.
Even if governments do not explicitly regulate the exchange of Bitcoin, it is unlikely that they will accept it as a payment solution for levied taxes. Any individual person using only Bitcoin would still need to redeem it into local currency in order to pay local taxes. The other issue is that as Bitcoin is a purely virtual (cyberspace) asset/claim, select judicial branches of national governments have determined that Bitcoin should be viewed as property – not for legal protection, but for taxation reasons. Unlike other financial claims, with Bitcoin there is no counterparty involved. Therefore, there is no counterparty risk and no need for a credit risk premium. However, there have been reports of cases wherein owners which converted Bitcoins into cash had to wait several days, exposing the holders to liquidity risk and potentially price risk. We suspect that in the case of a Bitcoin bear market, more leveraged retail investors will try locking in gains, further contributing to the liquidity backlog problem. At such a stage, we would expect the market to start fully pricing in liquidity and price risks, which would likely further drag down prices, a classical feedback loop.
Why Bitcoin created a new asset class
On the surface, it is difficult to imagine how capital flows from Bitcoin can be routed into productive real economy investments such as building new factories or machinery – which return a profit including a risk premium to the capital owner. Cash flows and risk premia are the main determinants to price traditional asset classes such as equities or bonds. Unfortunately, there exist currently no generally accepted financial pricing model for Bitcoin. Another technical problem would be that interest rates on loans made in Bitcoin would have to come from the limited money supply of Bitcoin itself, which further exacerbates the deflationary effects of Bitcoin.
Humans have always been very creative in overcoming seemingly impossible problems, such as the current one. One possible solution is financialization, in which tangible or intangible capital or activities are transformed into financial instruments. We believe that financialization will transform Bitcoin into a distinct asset class, i.e., if it can provide the means for broader investor participation – be it with vehicles such as exchange traded funds (ETF), funds, certificates or derivatives.
It is important to note that so far, it was predominantly retail investors and capital flows from China and other countries that drove the price of Bitcoin. Now that large financial institutions have initiated research coverage, other institutions are likely to follow. Acknowledging Bitcoins’ current excessive price volatility, we agree with most analysts that its volatility will decrease once (if) it becomes fully embedded into the financial system. Indeed, Bitcoin’s volatility has been trending down since it reached peak levels in 2014, while its daily trading liquidity has shown an upward trend. The aforesaid could further increase institutional interest, desperate for Beta diversifying alternative investments in today’s ultra-low or even negative yield environment. With increasing demand, financial innovation will ensure that new investment vehicles will emerge which, at a later stage, will be designed for leveraged speculators. A further milestone for the general acceptance of Bitcoin as a financial asset class would be if financialization will also have found a way to use Bitcoin as collateral for debt financing in a traditional fiat currency. Today, Bitcoin shows almost zero correlation to other major asset classes. As institutional investors add the financialized version of Bitcoin as a diversifier in a balanced portfolio, we expect its covariance properties to be similar to those of gold in the past.
Now, could Bitcoin become a new store of value function, similarly to physical gold? One of the main reasons for gold’s success was its limited supply as well as its essentially perpetual shelf life. Bitcoin has no intrinsic value, but a utility value in addition to the described beneficial diversification properties, which could add value from a portfolio management perspective. Furthermore, Bitcoin is more mobile but less fungible than physical gold. Bitcoin requires a technical network and energy input to exist – if it loses a critical mass of computation, it becomes utterly unfeasible and therefore could be seen as a store of value within but not outside of this network. Interestingly, Bitcoin usage has seen its steepest increase in countries which are having currency trouble such as India and Venezuela. Surbitcoin, Venezuela’s largest bitcoin exchange saw accounts to skyrocket from 450 in 2014 to almost 100,000 in 2016.
Why we believe Bitcoin is a bubble and why it could continue for years
Bitcoin is software and needs energy to exist. Therefore, it is a real asset. But countless other enterprises, as capitalized during past manias, consumed prodigious amounts of energy and invested massively yet never ended up reaching profitability or attaining anywhere near the earnings necessary to justify their erstwhile bubble valuations or market caps. Those enterprises also comprised real assets. Commensurately, what is not real – or perhaps rational would be a better adjective – is Bitcoin’s “value” when measured in a fiat currency such as USD. Some skeptics even go so far as to say that since the financial basis of Bitcoin is a fiat Ponzi scheme, Bitcoin’s technology is only the masking shell of this Ponzi scheme.
Historical performance in not indicative for future performance. Source: own calculations
Since September 2015, the crypto currency has been in a long-term uptrend with momentum massively accelerating since July 2017. Although it is obvious that this price increase seems unsustainable in the long-term, there are arguments for a continuation of this trend for some time.
A clear bubble indicator for Bitcoin as well as other crypto currencies seems to be the booming ICO (initial coin offering) market. The ICO market can be seen as a mix between seed investing and crowdfunding, in essence circumventing existing capital market regulations. There are thousands of startup companies, raising funds within seconds by issuing equity shares based on crypto currencies. Many of them see ICO as cheap lottery tickets very similar to the IPO frenzy during the New Economy Hype beginning of the 2000s.
These shares often trade at penny-stock prices, experiencing dramatic price increases within hours and are often trading at very low liquidity. Most of these companies merely offer a so-called “white-paper,” basically a business plan that explains which product a company wants to develop in the future and how it wants to market it. Most of these promised projects are praised as having huge potential but are extremely uncertain to be actually developed. Since these ICOs are usually raised in one or another form of crypto currency, there is an inherent conflict of interest as regards actually converting crypto currencies into fiat currency, also ironically known as “hard cash.” As long as the price is rising, most companies will probably only redeem the absolute minimum of their crypto-reserves in order to pay for overhead costs. Once the price falls, however, it is very likely that most of the companies will want to convert their reserves, which may spark a chain reaction. Although the total market cap of ICO-companies is currently around 7.5bn USD, it is likely to grow further. In what may be viewed as a contrarian (bullish) sign, funds raised through ICOs increased since the US securities and exchange commission began to caution investors. We believe that if the ICO-market becomes big enough, the non-correlation between crypto currencies and equity markets might actually break down, i.e., the two asset classes become positively correlated. Although since its 2009 creation Bitcoin has shown a very low correlation to equity markets, it is worth remembering that this has been an exceptionally robust bull-market era. If equity markets would crash, other risk-off sentiment may potentially spillover to the ICO market and, as a consequence, to the crypto market.
It is also important to bear in mind that although ICO and the dotcom era are founded on irrational exuberance, at least the companies promised some sort of future cash flows. Cisco for example was a real company selling goods and recording cash flows. Crypto currencies on the other hand – similarly to the tulip mania – do not generate value. In other words, as an investor it only makes sense to invest in crypto currencies due to the positive price trend. Since there is no intrinsic value, skeptics argue that in the long term the asset class has to fall back to the value of zero. Most investors acknowledge the bubble situation. However, they argue that central bank’s easy money will help the bubble mania to grow bigger and bigger, thus attracting even more investors (speculators) looking for easy profits. They remain bullish because of the Greater Fool Theory.
Bitcoin has become the flagship for an increasingly opaque crypto currency market. For the above-mentioned reasons, we believe the most realistic scenario for Bitcoin, based on the premise of the currency not being banned by major regulatory agencies, is that it will continue to rise in price in the short to medium term with increased institutional demand prior to the initial hype fading. At that juncture, Bitcoin’s monetization or return prospect realities will begin to set in and, if history is any guide, eventually dominate valuation. Although we believe Bitcoin to be in a bubble, this does not mean that the underlying blockchain-technology will not have a bright future in a financial as well as in a commercial context. Blockchain could be a disruptive force in the long run and completely transform our financial system, similarly to the way stock ownership did in the 17th century. But as noted by Bloomberg columnist Matt Levine, there might be a long road ahead: “The first like 300 years of the history of stocks were filled with hucksters and hype and bubbles and disaster. Crypto currencies and blockchain really could be revolutionary technologies that will ultimately pervade every aspect of the economy, even while almost every individual project could be nonsense.” Just because the dotcom hype was a clear bubble, this does not mean that the internet itself was not a groundbreaking technology. As is often the case in bubbles, fantasies are starting to go wild. No differentiation between sensible and irrational projects are made. While the immediate expectations are overblown, the long-term effects can still be disruptive.
A continuation of the Bitcoin frenzy analogous to other speculative bubbles is possible with exactly the same long-term consequences. The trend of financialization will continue and ultimately overshadow the original idea of a digital payment system. Financialization of Bitcoin is neither bad nor good per se, but merely the symptom of a larger disease of a bubble in investable monies and too few productive real economy investments, particularly in developed markets. Borrowing money for free and having easy access to capital and leverage (for big entities) is the fuel asset bubbles crave. By aggressively mitigating the effects of the 2008 financial crisis via unparalleled global monetary debasement extending for nearly a decade, central banks have brought us today’s “bubbles everywhere” investment landscape. Once capital is not productive, it becomes destructive. From a historical perspective, valuations in traditional asset classes such as bonds as well as equities have become stretched. Plus, alternative investments often do not live up to their promises in terms of being a true beta diversifier. As a consequence, investors are looking for alternatives which they may have found in crypto currencies. But as in the Dutch tulip mania, investors (speculators) have to ask themselves where does any particular asset such as Bitcoin derive its value from. Bitcoin is not a financial asset in itself, it is a real asset, such as software or the internet itself, and thus the law of entropy applies; sustained blockchain usage growth isn’t viable unless affordable and abundant 24/7 energy remain available – our strategic trajectory here isn’t cheery. In addition, Bitcoin cannot exist outside the social and financial system. Due to this inherent, inevitable integration, we expect the correlation to other asset classes, whether positive or negative, to increase in times of crises. A diversifier, after all, or just a big bubble looking for a needle?
The content of this article reflects the author’s personal view on this topic.
Dr. Dietmar Peetz studied finance in Germany and the UK and proceeded to work in the asset management industry, assuring client satisfaction on achieving their investment goals. Passionate about complexity science, he became an expert for investment algorithms and systematic return strategies at Credit Suisse.
Gregory Mall is working as a multi asset portfolio manager at Credit Suisse with a focus on global macro themes. He graduated from the University of St. Gallen, Switzerland with a M.A. in Economics in 2015. He gained extensive theoretical and practical experience with crypto coins over the last years.
 The basic relationship between money supply in circulation and value of aggregate transactions is shown in the famous quantity theory of money. For a good discussion Genreith 2014), “Field Theory of macroeconomics”, arXiv:1407.6334v1
 Scaling by increasing the current block size is a very controversial topic since the larger bitcoin community argues that this would defy Bitcoin’s decentralized structure, the original raison d’être for the currency. It is interesting to note that 97% of all miners decided not to support Bitcoin cash but rather the current solution, a solution that some argue favors Bitcoin as an investment vehicle vs. a transactional currency.
 In addition, Bitcoin would need to become a construction of double entry accounting very similar to the rest of our monetary and financial system.
 Fiat money has value by convention but isn’t backed by any physical wealth.
 See Soddy (1926), “Wealth, Virtual Wealth and Debt”, for a good definition of real assets.
 See Genreith (2017), “Is the financial system a slow-motion Ponzi scheme?”, Journal of Social Business, Vol. 7, No. 1.