I write this after seeing in the news that “the bitcoin loses more than 30% of value in its worst week since 2013.” We are more than used to hearing that bitcoin collapses and shoots up seemingly randomly. Normally, an investment with this degree of volatility is only assumed by very expert speculators and yet in my environment, I know many people who are investing in Bitcoin.
Why do many people invest in bitcoin? Leaving short speculators aside, investors believe that bitcoin in the (near) future will be the medium of universal exchange and the deposit of value that will replace dollar, euro, etc…
Bitcoin can not be a means of universal exchange
Bitcoin and its technology brought the promise of having an anonymous exchange medium without intermediaries. Actually, this already exists: pay in cash. The advantage of paying with a cryptocurrency would be that it made it easier to pay remotely. However, in the real world, buying something with bitcoin or transferring funds – for example to a family member in another country – is not easy at all. There is no app that makes it easy even though many startups are trying it. And even if it becomes usable, the fees are so high that it would not be worth it. Using it to send money to another country and exchange it for traditional currency using a bitcoin ATM can cost 15% commission between issuance and withdrawal.
In turn, if we do not use it to buy or send money but to invest, intermediaries charge several types of commissions for trading with bitcoins:
- transaction commission: each intermediary sets it between 0.2% and 3%.
- fund deposit commission: if you do it with a card, for example, it is not a minor expense and varies a lot depending on the method of payment.
- fund withdrawal commission: when converting bitcoin into fiat currency some intermediaries apply commission on their part to which they can add commissions from your bank. It also applies if you change the bitcoins to other cryptocurrencies.
- Currency exchange commission: if you deposit euros in an intermediary that only accepts dollars you will support a change commission. To avoid it, use an intermediary that accepts your currency directly.
The biggest problem is not so much the commissions but the history of bad practices accumulated by the exchange or intermediaries. Here are some of the tricks they blatantly use:
- wash trades – trading with yourself to create volume and influence the price, as reported in Bitfinex.
- spoofing – huge buy or sell orders to simulate a moment of optimism or pessimism that is canceled as it affects the price. This practice has been denounced in Coinbase and others.
- painting the tape – like wash trades but with multiple participants. Mark KarpelÃ¨s acknowledged before a judge that he used this technique in the Mt. Gox exchange.
- front-running – where a trader is able to filter his order before that of the clients at propitious moments.
It is not possible to emphasize the little rigor of the security measures of these intermediaries when they are not directly engaged in manipulating the market. Without the supervision of any authority, the main exchange of the moment called Mt Gox sank in 2014 losing all the bitcoins (850,000 bitcoins).
The most accepted theory is that they suffered massive robberies of their cryptocurrencies for not having adequate security measures. In 2016, the same happened with the Australian exchange Igot and we could make an endless list of incidents of these companies.
It is difficult to think that these bad practices will disappear without regulation.
Bitcoin can not be a store of value
The currencies that we use daily, the euro or the dollar, are a deposit of value. This means that I am confident that if I keep 3,000 euros at home a year later those euros will have a value very similar to the initial one. If my salary is in euros I know – with little variation – what things I can buy with them in the near future.
A cryptocurrency that aspires to replace the dollar can not have a 30% drop in a week, as just happened! It had drops of 93% in 2011, 70% in 2013 or 86% in 2014 (apart from the first years where the roller coaster was continuous). And it can not multiply its value in a year without damaging the economy. Even the most dysfunctional traditional currencies do not reach these extremes. Let’s imagine what the gentleman of Florida should think about who bought 2 pizzas for 10,000 bitcoins in 2010.
Nobody will use a currency for daily transactions if its value is erratic. Without stability, no one will ask for a loan in that currency or use it to make purchases.
A world with Bitcoin
Until well into the twentieth century, traditional currencies were conditional on the gold standard: all the money in circulation was backed up in some government vault by bullion.
Current currencies are not directly supported by anything other than trust in the currency itself and this allows governments to make major interventions on the economy, such as the one we recently experienced in the real estate crisis of 2007. The current system is very imperfect but allows central banks to control credit or price stability by expanding or contracting the amount of money in the market.
A global economy based on bitcoin would be to return to the gold standard, that is to say to the rigid supply of currency, given that this cryptocurrency will stop producing when it reaches the figure of 21 million bitcoins. 80% of the total bitcoins have already been extracted by the miners and the difficulty of their extraction grows exponentially (every time the growth in the number of bitcoins is slower, the system has been designed like this).
The universal use of bitcoin would mean to deprive governments of monetary policy and to be able to contract and expand the money supply when they need it, forgetting the lesson we learned in the Great Depression. The creator of Bitcoin explained in 2008 in a paper that bitcoin would eliminate inflation. That is why bitcoin attracts gold bugs and all those opposed to government intervention in the currency.
We are living in a contradiction in which more and more voices are asking for the elimination of physical money (using currency like the current one but only cards and transfers) to combat tax fraud and criminal activities while giving credibility to bitcoin which makes it even more difficult to monitor the transactions.
Sweden is making progress to reduce the portion of its economy that is made in cash. Spain limits every few years the money that you can pay in cash per transaction, forcing you to identify yourself electronically. How is this compatible with a currency that leaves no trace of who issues and receives a transaction? How does this help in the fight against fraud and crime? How many investors in bitcoin comply with the treasury?
There is also talk of ecological disaster. We are emitting between 8,000 and 13,000 kilograms of CO2 into the atmosphere for every bitcoin extracted in mainly Chinese farms whose electricity comes from coal. Inefficient even if people looking for creative applications.
But blockchain is fashionable: smart contracts
The most original of bitcoin is blockchain, which, in my opinion, is the innovation that will remain after the bitcoin fashion is over. Wanting to highlight the originality of the proposal (distributed accounting, fault tolerant, very difficult or impossible to counterfeit, etc) I also want to emphasize that it is trying to apply to everything as a fashion rather than as a solution. I will give an example of smart contracts.
Smart contracts are contracts written in software instead of using a legal text that are included in blockchain so that it is known by all parties and unforgeable. They can include rules to transfer money without the “manual” consent of the parties following some pre-established rules. Their theoretical advantage is that they are self-executing and do not require lawyers to review the operation nor are there possible disputes.
A real-world example of how this can be problematic for many use cases is The DAO (Distributed Autonomous Organization), an investment vehicle where investors using their cryptographic keys vote what investments to do without the managers and therefore the commissions for management. We have saved the intermediary.
This system invested 50 million dollars in an investment fund controlled by a programmer who knew the system and took advantage for himself. After this questionable investment, some investors claimed to have been robbed and others that the entire value of the DAO system is the autonomy of their operation and that monitoring it would be to end the sense of the fund. The author of the “hack” published a statement with the following statement:
“I am disappointed to find that some people call the use of a system feature” theft “I am making explicit use of something that is included in the smart contract and my lawyer has told me that what I have done is legal. If you wish, you can review the terms of the DAO contract.”
The author was laughing at the concept “the code is the law.” In the end, it was decided to intervene the system and retroactively cancel the trade. Normally, transactions that involve a lot of money have human supervision for a valid reason.
After this point, I think blockchain can bring us interesting innovations after this experimental phase and has long value despite some of its applications as bitcoin.
So if I know what I’m doing, can I invest?
Bitcoin rises strongly because it has two types of investors: those who invest speculatively and, on the other hand, those who invest in the long term because they believe that bitcoin is the means of payment for the future.
For those who speculate – many have become rich – Bitcoin is a bet with a high risk but with great reward. With the entry of bitcoin in the derivatives market you can also bet downwards. If you know what you’re doing, I have nothing to say.
If you are a long-term investor and you believe in Bitcoin after all that I have put above, I only advise you to store the cryptocurrencies in your possession with a hardware wallet, and to not invest what you don’t mind losing because many people think that bitcoin has no value in the long term…and is unpredictable in the short.