Cryptocurrencies: a Bitcoinfusing

                  In the last few months I’ve been asked on more than one occasion what my thoughts are regarding an investment in cryptocurrencies.  I typically respond with, “It's probably an unwise gamble”.  I use the word gamble intentionally as to not confuse the purchase of a cryptocurrency with the process of investing.  Due to the frequency I’ve been asked this question, and the real possibility of losing money on the endeavor, I thought it was worthwhile to write down why I personally would not purchase a cryptocurrency.

                  Before purchasing any asset it is important to understand the value proposition presented.  When buying a house, the value proposition is a place to live that protects you from the elements, for a car it is transportation from point A to point B. For internet service, it is a connection to the content created by billions of people daily.  The value proposition for a cryptocurrency is similar to the US dollar - it offers a way to store value and is the basis for trade.

Currencies offer tremendous value to societies that utilize them by facilitating transactions that would not be possible without them.  I would argue that a good currency must possess three characteristics at a minimum:

  1. It must be divisible.  A good currency needs to divisible into various units of value so that transactions can occur across a broad range of value.  Divisibility can be accomplished physically – such as with gold which is valued based on weight, or by varying denominations, like the $1, $5, or $10 bill.
  2. It must be easily and safely transferrable.  A good currency has to be available to transact business at different places and times.  For this reason it needs to travel and transfer well.
  3. It must be certain of its value.  This is by far the most important element.  Every transaction that occurs globally using currencies are based on one key element – TRUSTPeople have faith that the paper they are receiving will be accepted at a later point in time by others in the economy.  They also are trusting that the paper money they are exchanging won’t fluctuate wildly between transactions.  Trust is the most important element of a successful currency.  The United States dollar is the most trusted currency in the world.  I believe this trust is rooted in the long history of acceptance, a direct tie to the strongest economy in the world, and the backing of the strongest military on the planet.  There are currently 177 currencies used worldwide that are widely accepted (such as the USD, British pound, and Euro) and each has varying degrees of trust placed in the currency.  When a currency isn’t trusted it loses value rapidly and experiences bouts of hyper-inflation.

Then there are other characteristics that are beneficial, but not required for a currency:

  • It should have a limited quantity available.  A limited quantity available makes it difficult, or impossible, to inflate the currency.  Inflation is a means to arbitrarily create more money.  In the United States the Federal Reserve controls the money supply and is able to create additional US dollars out of thin air.  This has the net effect of creating inflation and transferring wealth from net investors to net borrows over long periods of time.  This is one of several strong arguments as to why a cryptocurrency may be a superior store of value.
  • It should possess intrinsic value.  Currencies that have held their value throughout history typically have a perceived intrinsic value, such as gold or silver.  As a piece of paper the United States dollar has no intrinsic value.

 

Cryptocurrencies score relatively well in many of these categories. 

They are easily divisible, transferable, are durable, and they have a limited quantity available (Bitcoin will max out at ~21 million coins by 2140).  They even excel in some areas.  A blockchain with a single ledger has significant advantages over our current monetary system.  However, they currently fail on the most important characteristic – being certain of value. 

The price of cryptocurrencies fluctuates wildly on a daily basis.  I would even argue that as it currently stands Bitcoin is not actually used as a currency – it is used as a speculative gamble in an asset class that some people believe will eventually become a currency. The reason I believe it is not a currency is that it is very rarely used in transactions.  The first ever Bitcoin transaction occurred just 7 years ago when 10,000 bitcoins were exchanged for two pizzas.  Today those 10,000 bitcoins are valued at more than $170 million dollars.  You can see why people are currently hesitant to actually use their bitcoins to buy anything.

Up until recently I had no way to apply sound logic in order to estimate the value of any cryptocurrency.  The entire asset class seemed to be an indulgence in speculation akin to the Great Tulip Bubble that occurred in Holland in the early 1600s.  During that bubble a single tulip (yes, the flower) could purchase an entire house.  I did, however, find an investor letter recently by FRMO Corp that detailed the logic behind their large investment in bitcoin.  An excerpt from the letter can be found below and the entire letter can be read here:

At the moment, most people do not accept the legitimacy of private non-fiat money; however, cryptocurrency was recently made legal tender in Japan. Thus, the possibility exists that a cryptocurrency like bitcoin could become a parallel currency to the fiat currency. Merely as an exercise, to understand the appreciation potential, let us assume that bitcoin becomes a parallel currency to the dollar in the U.S. The U.S. supply of money, known as M2, is currently about $13.17 trillion. The market capitalization of bitcoin is about $67.72 billion. Under the no arbitrage rule, if bitcoin were the functional equivalent of fiat money, one might be tempted to say that it should have the same value as fiat money. In this case, it implies appreciation of 194x, without any allowance for the fact that U.S. M2 is constantly increasing. Of course, bitcoin is a worldwide currency, so consideration would need to be given to the M2 of all the other nations of the world. For instance, Japanese M2 is about $9.2 trillion. The European Union, or Eurozone, M2 is about $10.84 trillion. Using Japan alone, the possible coefficient of expansion is 135.9x. It must be noted that the entire cryptocurrency project might be a total failure; however, if it is not a failure, one can now see its return potential.
— FRMO Corp. 2017 Letter to Shareholders Page 2 of 8.

The logic is that if Bitcoin were to replace the entire M2 supply, then the 16.8 million coins that currently exist would need to be valued at an equivalent dollar amount of the monetary supply which they replaced.  Assuming that this logic is valid, then there are two variables we need to know in order to determine if Bitcoin is currently undervalued or overvalued:

A. The dollar value of the global monetary supply that would be replaced by Bitcoin in the future.  To help with this estimate we can sum the major currency markets – the US, Japan, and the Eurozone – which total $33 trillion.  We then need to assume what percent of this money supply would be replaced by bitcoin. 

Question for YOU: What % of the money supply do you think bitcoin will replace?                              

B. The probability that event #1 actually happens. 

Question for YOU:  What is the probability that event #1 actually happens?                                

Using the formula presented below we can calculate what the fair value of Bitcoin should be today.  If the actual value of bitcoin is more than your estimate it is an unwise gamble, if it is less than your estimate than it is a wise gamble.  Use your estimates above to calculate your fair value of bitcoin using the formula below:

Your Fair Value of Bitcoin = A x $33 trillion x B

Probability of Occurrence
% of Money Supply Replaced
Fair Value
100%
1%
$330 Billion
5%
10%
$165 Billion
1.5%
100%
$495 Billion

                  You can use the same formula to reverse engineer the problem and calculate the values investors believe are fair for the probability A, and % of money supply replaced, B. There are 16.8 million coins outstanding and each coin is valued near $18,000 bringing the total to $302,400,000,000.  We can use this information and the above formula to calculate the implied probability that the owners of Bitcoin are placing on certain events.  For example, we can calculate that bitcoin fanatics assume that there is a 100% chance that 0.9% of all transactions will occur with Bitcoin in the future or;

Market Fair Value of Bitcoin = A x $33 trillion x B

$302 Billion = 0.9% x $33 trillion x 100%

                  I personally believe that Bitcoin replacing 1% of all transactions globally is a long shot.

                  We can also calculate the maximum possible return of a Bitcoin investment by inputting the maximum values for variables A & B (100% for each):

Max Value of Bitcoin = 100% x $33 trillion x 100%

Max Return = $33 trillion / $302 billion ≈ 109x 

The maximum return for investors in Bitcoin today is about 109x their money (not a bad return at all).  However, this assumes that Bitcoin becomes the only currency on planet earth.  For individuals that say, "I just want to invest a little and see what happens", the gains are capped at 109x. If you put up $100 of your own money, it won't allow you to retire in any universe. I personally believe it is far more likely that the value of Bitcoin becomes zero. Additionally, Charlie Munger stated that it would be terrible even if individuals make money off Bitcoin, because they will have positive feedback participating in a very foolish activity and that reinforcement will hurt them in the long run.

 

Would you rather?

         When considering the purchase of Bitcoin it is important to think about what you are buying.  Investors are effectively purchasing a very tiny piece of a currency blockchain that is valued at $302 billion dollars.  Let’s imagine for a moment that instead of buying a tiny piece of this large blockchain you have enough money to buy the entire chain.  After writing a check for $302 billion you would become the sole owner of all 16.8 million Bitcoins.  What would you do with your Bitcoins?  Try to sell them or trade them for something else?  They have no value apart from the ability to exchange them…and almost no one globally accepts them as currency.

Image what you could have bought with $302 billion instead.  Would you rather own $302 billion dollars of Bitcoin or…would you rather purchase all of the following…


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Investors in Bitcoin are purchasing a very small % of option #1…instead of the same exact percentage of option #2.  You can see why we’re not big fans of ‘investing’ in Bitcoin.  There are much better options for the same price.

 

Disclaimer

This communication shall not constitute an offer or an invitation to trade or invest. No party should treat any of the contents herein as advice. This document expresses the views of the author at the time of publication and such views are subject to change without notice. Selective Wealth Management (“Selective”) has no duty or obligation to update the information contained herein. Investing contains risk. Selective does not solicit in any state in which such solicitation or sale would be unlawful prior to registration or qualification under the laws of any such state. Past performance is not necessarily indicative of future results.