Wednesday, November 29, 2017

How Much Damage Will the Bitcoin Bubble Do?

Bitcoin is a bubble.  There's no doubt about that.  Its value has risen 1,000% this year, and indeed by $1,000  (or about 10%) on each of the past two trading days.  This morning, it popped over $11,000 before dropping about 18% (i.e., over $2,000), all in one trading day.  That's volatile.  That's a bubble if ever there was one.  We once again have graphic evidence that there are a lot of stupid idiots in the financial markets.  History teaches that market stupidity can have major, and indeed systemic, consequences.  Those of us careful enough to avoid Bitcoin may nevertheless be adversely affected by the idiots.  The question at this point is how much damage will this bubble do.

The investors who trade Bitcoin can be found all over the world.  Their personal losses, although potentially large in the aggregate, may be spread out and therefore appear to have a  relatively diffuse impact.  A person who risked and lost most of their net worth on Bitcoin can now look forward to uncomfortable (to say the least) discussions with their spouse and children.  But that personal loss won't affect the rest of us.

The potentially widespread and even systemic impact of Bitcoin losses could come from where and how Bitcoin was traded.  Bitcoin is traded on exchanges and through brokerage firms.  If investors were trading on margin (i.e., with borrowed money) and can't repay the loans, the brokerage firms will take the loss.  If the customers were able to transact directly with a Bitcoin exchange, the exchange takes the loss.  Or, if transactions went through a brokerage firm that sent them to an exchange and the firm can't pay the exchange what it owes for trades, the exchange takes the loss.  There is no organized settlement and clearance process for Bitcoin.  Unlike stocks and bonds, there is no clearing firm, with substantial amounts of capital, to protect against large scale defaults in payments.  If a Bitcoin exchange collapses, the firms and individuals to whom it owes money may be S.O.L.

If a brokerage or proprietary trading firm takes Bitcoin losses, it still needs to pay its obligations.  In order to do so, it may begin liquidating other assets it holds--stocks, bonds, commodities and currencies.  If the firm's losses are big enough, its selling may affect the price of those other assets.  If those other assets begin to sag, other investors (who may not be involved with Bitcoin at all) may begin to sell in order to limit their losses.  This increases the downward pressure on those assets, which may lead in turn to yet more selling.  The potential for a more widespread market crash may develop.

In order to reduce the potential for market contagion, financial regulators need to identify the firms and exchanges where the impact of Bitcoin losses may be concentrated and take steps to limit the damage.  That would be pretty hard, since Bitcoin trading is, by and large, unregulated and there is no organized way to find out where the losses and risks may lurk.  In other words, we may not find out how bad things are until the losses have landed in our laps.

When Bitcoin was trading for a few hundred dollars (in those ancient times as far back as a year ago), the potential for major or systemic loss was almost nonexistent.  But when Bitcoin rises by 10% a day and drops 18% in a day, while trading around $10,000 or more, the losses may be much, much larger and the potential for major or systemic losses increases commensurately with the increases in transaction amounts.  Even though they could have shrugged a year ago, regulators and creditors of Bitcoin exchanges and traders need to start paying serious attention.  The volatility in Bitcoin could easily get worse before it gets better.  Bitcoin may soon trade for $25,000, $50,000 or even more.  The losses, when they inevitably come, could involve mucho dinero--and we mean mucho.  Failure to give Bitcoin their full attention could be very costly and painful, not only for players in the Bitcoin markets but also for we innocent bystanders.  The time for vigilance has arrived.

Tuesday, November 14, 2017

Is Inflation Hitting Bitcoin?

Bitcoin is supposed to be insulated from inflation.  Because there is a predetermined limit to the number of Bitcoins that can be created (21 million), Bitcoin supposedly should not be subject to anything like the monetary actions of governments, which can inflate fiat currencies by printing more money.  There was an operational problem in August 2010, when someone created 184 million Bitcoins in a single transaction.  But this transaction was voided and the operational problem dealt with.  Thus, the 21 million coin limit was preserved.

Nevertheless, Bitcoin is subject to inflation risk.  Inflation results from increasing the amount of a currency.  Although the number of Bitcoins is limited, the number of digital alternatives to Bitcoin is not.  Other cryptocurrencies, such as Ethereum, can be created with relative ease.  There are few barriers to entry.  Some 1100 cryptocurrencies now exist.  Among them is Bitcoin cash, created by the Bitcoin community with features that make it easier than Bitcoin to use for transactions.  The Bitcoin community also created Bitcoin gold, a cryptocurrency created to facilitate decentralized mining (Bitcoin itself is now dominated by a small number of large miners).  As these alternatives proliferate, the value of Bitcoin can fluctuate wildly.

So far, Bitcoin has recovered from its sharp drops, and continued an overall upward trend in value.  But volatility attracts fast money, and cash seems to be flowing into the Bitcoin market for speculative purposes.  This may not end well.  Hot money never stays in one place for long.  With all the alternatives to Bitcoin, and the low barriers to entry for more, numerous other venues for volatility and speculation are or will become available.  Speculators will stampede to whatever market appears to offer larger and quicker profits.  The effect on Bitcoin could be similar to inflation.  As cash flows away from Bitcoin, its value will diminish.  Pause and think before you buy Bitcoins.