If you have been under a “financial news” rock for the past few months, I thought I would welcome you with a story you are likely to have missed…Bitcoin, or more broadly Cryptocurrencies. I generally read about things that I find interesting or at least relevant to the modern finance world. I think cryptocurrencies qualifies, at least marginally. To receive the full explanation of why, you are going to have to read to the end.
A few weeks back, I read the book Digital Gold, which is a good historical overview of the development of Bitcoin and the people involved. The book is informative, well written and a quick read, if you are looking for a something to do this next weekend in the absence of the NFL.
I would like to focus on a few things.
First, bitcoin’s origins grew out of the interconnectedness of our digital world. If I need to hire a plumber (with three young girls, a plumber is needed too often in my house), you can pay the plumber in cash, check, credit card, or potentially Venmo. There are some transaction fees associated with a credit card, and some hassle of having cash or a check, but the process is relatively straightforward. However, if you want to pay a software developer in Croatia, you are going to need to set up an international wire transfer, potentially use Western Union (if this developer doesn’t have a bank account) or some other means. These are costly, time-consuming and generally hassle-filled. The kernel of Bitcoin’s development started with this problem.
“The money imagined by the Cypherpunks looked to take the standardizing character of money to its logical extreme, allowing for a universal money that could be spent anywhere, unlike the constrained national currencies we currently carry around and exchange at each border.”
Concurrently, some involved in the project had a severe distrust of government fiat currencies. Inflationary concerns in places like Venezuela are almost unthinkable in the U.S., but if your cash money becomes worthless in the matter of months due to inflation, you begin to be more open to other “stores of value.” Additionally, in 2008-2009, the banking crisis was front and center. Obviously, the banks were public enemy number one. Bitcoin could also potentially provide an end run around the banks involvement in the financial lives of the public. Distrust of governments and large financials institutions were additional drivers.
“What we want is fully anonymous, ultra low transaction cost, transferable units of exchange. If we get that going (and obviously there are some people trying DigiCash, and a couple of others), the banks will become the obsolete dinosaurs they deserve to become.” [DigiCash was a predecessor idea to Bitcoin]
Fast forward past the history of Bitcoin’s development and perhaps its most intriguing back story, Silk Road, you have the present day situation. Currently, Bitcoin’s ability to achieve any of its original goals is severely limited. First, the goal of an “fast and ultra-low transaction cost” currency have been doomed. The average transaction fee today is around $25. That’s right, $25. So, if you want to buy a $10 pizza with Bitcoin, your total charge would be $35, which is absolutely nuts. Even an international wire with Wells Fargo, my current bank, only costs me $10.
“The bitcoin scalability problem is a consequence of the fact that blocks in the blockchain are limited to one MB in size. Bitcoin miner fees for processing bitcoin transactions rose to above $25 per transaction in December 2017, making small payments uneconomical. In contrast to Visa’s peak of 24,000 transactions per second, the bitcoin network’s theoretical maximum capacity sits between 3.3 to 7 transactions per second.”
If you need a real-life example that Bitcoin is not a good, fast, ultra-low cost transaction currency, look no further than The North American Bitcoin Conference being held in Miami this year. The conference stopped accepted Bitcoin as a currency for its registration fees because “Due to network congestion and manual processing, we have closed ticket payments using Cryptocurrencies.” Too slow and transaction fees are too high. Real life is funnier than fiction.
Second, the idea to eliminate a central processing agency from financial transactions has also been lost. Instead of eliminating the banks, Bitcoin has merely shifted these “back-end” responsibilities to “organizations” not under the oversight of any goverments, yet. Currently, Coinbase is the largest of these administrators in the U.S., however, previously, this role was held by Mt. Gox, until it was hacked and all of the bitcoins Mt. Gox held for its customers were stolen. However, since Mt. Gox or Coinbase, for that matter, were not or are not considered financial depository institutions (yet), the controls and safeguards typically associated were not required. Theoretically, customers can hold their bitcoin privately, in the same way that you could theoretically keep $100k stashed in your mattress, but so far, many people have chosen an unregulated and potentially unsecure organization to provide them with a false sense of security. Incidentally, one of the people profiled in the book, an older man in Argentina took to the idea of bitcoin because of the hyper-inflation he had experienced in Argentina experienced the following:
“The older man in Argentina who had purchased large numbers of coins from Wences Casares, back in 2012, had also kept them with Mt. Gox. The man had been using Bitcoin to keep his retirement savings out of the unreliable peso—but now it was Bitcoin that failed him.”
Bitcoin’s promise has been underwhelming in these two goals, borderless currency and disintermediation of governments and financials institutions. However, it is interesting to see how a third argument has sprung up, most likely, because the first two failed so miserably.
Third, the idea of a store of value and its corresponding comparison to gold as an “asset class.” However, it is tough to see how Bitcoin’s price instability can be seen as an adequate store of value. If you had invested your retirement savings in Bitcoin a few week back after I finished this book at the then current price of $17,000 per one Bitcoin, you current “investment” would be down 35%. I am not sure how a 35% decline in a matter of a month can be considered a store of value. Proponents will argue that if you just hold on, Bitcoin’s price will invariably go up. I don’t see any reason for this to be true, other than the fact that it has been true for Bitcoin’s immensely short existence of approximately 8 years.
“After touching on the history of money and Bitcoin’s advantages over gold, Wences explained his back-of-the-envelope calculations of what Bitcoin might be worth if people began to realize its value as a substitute for gold. All the gold in the world was worth around $7 trillion. If Bitcoin became even half as popular, that would put the value of each Bitcoin at around $500,000—or about fourteen thousand times more than its $34 value that day in March.”
I think this “pivot,” as some like to call it, is telling when it comes to the financial world. If your first two predictions don’t work, go ahead and make a third, it can’t hurt. To be honest, there is really no reason for gold to be a store of value and, if it is possible, even less of a reason to think that Bitcoin should act as an appropriate store of value.
The humorous part of this comparison is the idea that there is a “fixed supply” of Bitcoin, however, if you have spent 10 minutes on the subject, you realize quickly that there is basically a new cryptocurrency being created each day. Even Bitcoin itself has split (or forked) and who knows how many additional forks will happen in the future. In other words, the supply of Bitcoin is not fixed. Munger’s comments on this point below are even more direct.
Market Psychology and Munger:
The iron rule of financial bubbles and speculation is the more people who are demonstrably stupider than you get rich, the more regret you will likely feel. This feeling of regret will increase the likelihood of you caving and chasing the speculative bubble . (I should add, as a parenthetical, if any of these people are in-laws, the regret will be magnified 10-fold).
Recognizing this rule, it is best to think of financial bubbles in this manner. If your neighbor, Stupid Risk Taker (his family naming practices are a little odd), spent years buying lotto tickets, only to one day win the lotto, it would be asinine for Stupid Risk Taker to then go on a speaking tour proclaiming how his hard work, determination and perseverance in the face of long odds led him to his success. You wouldn’t start buying lotto tickets, you would laugh and move on because you can do math and know the lotto is a tax on stupidity. The same applies to financial speculation, there are going to be people around you who will get lucky. This doesn’t change the odds of the lotto, and it doesn’t change the value or lack of value of bitcoin.
I have re-written this market psychology section a few times this past week, but it still fails to reach the humor and directness of Charlie Munger on the same topic (including a stealth life lesson) . So, I will hand over the microphone to the man behind the man…..
SCOTT DERUE: Wow. So Charlie, I’m going to turn to a few questions from the audience as we start to wrap up. Probably half my questions here are about Bitcoin and cryptocurrency.
MUNGER: I could answer those very quickly. I think it’s perfectly asinine to even pause to think about them.
You know it’s one thing to think that gold has some marvelous store of value because man has no way of inventing more gold or getting it very easily. So it has the advantage of rarity. Believe me, man is capable of somehow creating more Bitcoin. They tell you they’re not going to do it, but they mean they’re not going to do it unless they want to. That’s what they mean when they say they’re not going to do it. If they tell you they have rules and they can’t do it, don’t believe them. When there’s enough incentive, bad things will happen.
It’s bad people, crazy bubble, bad idea, luring people into the concept of easy wealth without much insight or work. That’s the last thing on earth you should think about. If it worked, it would be bad for you because you would try and do it again. It’s totally insane.
And by the way, I’ve just laid out a wonderful life lesson for you. Give a whole lot of things a wide berth. They don’t exist, you know: crooks, crazies, egomaniacs, people full of resentment, people full of self-pity, people who feel like victims. There’s a whole lot of things that aren’t going to work for you. Figure out what they are and avoid them like the plague. And one of them is Bitcoin.
And the worst thing that would happen is if you won, because then you’d do it again. It’s total insanity, and it’s so easy to simplify life if all of these things are beneath you. People are promoting Bitcoin—I don’t want them to know my address. They’re not my kind of people.
You can find the rest of the transcript of Charlie’s interview at University of Michigan here: Munger Speech At Michigan.
As a side note, Charlie Munger is the Chairman of the Board of a publicly traded company, Daily Journal Corporation, which will hold its annual meeting in LA on February 14 this year. It’s a great event and Charlie is invariably more direct (or less politically correct) than Buffett in his speaking, so it’s a great time. John and I will both be attending. If you need the details, please feel free to email me or John.
Matt Brice is the portfolio manager at The Sova Group and can be reached at firstname.lastname@example.org.