Bitcoin and the Ship of Fools

Bitcoin

Peter Mallouk
JD, MBA, CFP®
Chief Investment Officer
cpi@creativeplanning.com

And the Ship of Fools

Bitcoin is all over the internet and media of late. What is the deal? Let’s break it down. First, we will cover some background information.

When you hear about Bitcoin, you likely also hear about blockchain technology at the same time. The reason is they were both invented together, and Bitcoin cannot exist without blockchain technology.

Blockchain essentially allows someone to handle a transaction over the internet with confidence in the other party, even though the other party is a stranger. Prior to blockchain, an intermediary would be necessary to confidently conduct a transaction with a stranger. The most commonly used example involves a real estate transaction. Let’s say you decide to sell your house. Most likely, a stranger is going to buy it. How does that person know you own your home? Do they just take your word for it? Of course not. Now, you and I know you are a super trustworthy person, but the stranger does not have any idea what kind of person you are. Instead, he relies on the local government, which provides a centralized ledger or database for deeds and titles. This enables the buyer and his lender (if there is one) to purchase the home with confidence. The buyer wants to see the most recent deed on file in the local government’s database because he cannot trust the deed that you provide. You could have just made it up, and the house could really be owned by someone else! Essentially, everyone is relying on the centralized database.

Blockchain can eliminate the need for a centralized database. With blockchain technology, a group of people can each have their own ledger to keep track of deeds. When you sell your home to Mary Sue, all parties agree the sale happened and update their ledgers. When Mary Sue is ready to sell, the next buyer can instantly confirm she has clear title as it is listed as such across the blockchain. This accomplishes two things. First, the middle man, in this case the local government, is removed. Second, the transaction can happen instantly. There is no need to involve a lawyer, request records or to validate their authenticity.

Think of how you presently handle a document. When I am done writing this letter,1 I will email it to someone in my office who will mark it up, telling me where I sound silly or where I may come across as too right or left leaning.2 She will make notes, save it on her computer, and send it back to me. I will get defensive, but realize she is right, and make the appropriate changes, saving it to my computer. I will then send it to another person in my office. He will edit it, and insert all sorts of notes, saving it on his computer along the way.3 He will then send his version back to me. This is also how lawyers negotiate contracts. One starts a contract, then emails it to another who marks it up and sends it back. With blockchain, my document can sit on all of our computers at once and any changes happen to all the documents at the same time. Likewise, lawyers can update a contract across a blockchain, without having to send it back and forth.

Blockchain is basically a decentralized database that stores a group of transactions in real time. All transactions are verified by consensus of other parties on the blockchain. Everyone participating in the blockchain has a completely synchronized record of all transactions that have ever occurred, and yes, it is real and will likely change the way we do a lot of things.

Before we get to Bitcoin, we need to learn a new thing: cryptocurrency. Cryptocurrency is electronic money that uses cryptography4 to make transactions secure, to prevent the unauthorized creation of additional units and to verify the transfer of the currency.

That brings us to the inventor of blockchain and Bitcoin, Satoshi Nakamoto.5 Get this: no one knows who Satoshi Nakamoto is or if it is a person or group of people.6 Satoshi does not like or trust the government. Any government.7 When releasing Bitcoin, Satoshi included some commentary essentially saying his mission is to cut out governments and create a decentralized system the government cannot easily attack, furthering his libertarian cause. He invented Bitcoin, the first decentralized digital currency. The reason it is effectively decentralized is Satoshi also invented the blockchain to ensure Bitcoin could easily be verified as legitimate and that no additional Bitcoin could be created and thrown into the system.

Remember the example regarding real estate deeds? We used to validate deeds by going to the local government’s centralized database. With blockchain, we may soon live in a world where deeds are on a blockchain network with a historical ledger, and new transactions are instantly validated across a network. Similarly, today we count on the Federal government to back the dollar, and control the currency through central banks. All countries have similar government backed currencies. We then use local banks as middle men for these transactions. With the invention of blockchain, Satoshi created the platform for Bitcoin, eliminating the government and banks from being relevant to Bitcoin transactions.

Bitcoin is transferred directly from person to person, with no banks in the middle. Someone can go online, go to an exchange site, and use their credit card to buy Bitcoins. Then, that person can buy and sell things using Bitcoin, essentially by sending an email. Purchases can be made completely anonymously. There are a limited number of Bitcoins, 21 million, and new ones cannot be created. All of these Bitcoin are tracked on the blockchain.

So, Bitcoin started taking off and things got crazy in a variety of ways. Imitation is the sincerest form of flattery and Satoshi, wherever he is, must be blushing because there are now over 1,000 cryptocurrencies that utilize blockchain technology. Considering there is no cost to launch a cryptocurrency, if you blink, there just may be 1,000 more. One that is catching on quite nicely is Ethereum.8 To create a cryptocurrency you need a few hours, and most of that time must be spent coming up with a cool name. The most popular cryptocurrencies, other than Bitcoin and Ethereum, are Zcash, Dash, Ripple and Monero.9

Blockchain is a great idea and will change the way a lot of records, contracts and transactions are handled. This is lasting technology and major corporations are investing heavily in its development. IBM has invested heavily in blockchain. Their CEO, Ginny Rometty, wrote to shareholders: “Blockchain brings together shared ledgers with smart contracts to allow the secure transfer of any asset — whether a physical asset like a shipping container, a financial asset like a bond or a digital asset like music — across any business network. Blockchain will do for trusted transactions what the Internet did for information.” IBM is working with Wal-Mart to utilize blockchain to track inventory. Wal-Mart said that blockchain trials had helped it narrow the time it took to trace the movement of fruit from seven days to two seconds. Blockchain is in its infancy, but it is here for good. If you are a client of Creative Planning, you already own companies that have invested heavily in this technology.

Crytpocurrencies are also likely here for good, too. But, it is likely over 99% of them will quickly become worthless.

That brings us back to Bitcoin. Bitcoin has soared from being worth zero in 2009 to over $10,000 this week. Some people say Bitcoin is worthless because it has no intrinsic value. Unlike real estate that produces income, bonds that spin off yield and stocks that pay out dividends, Bitcoin produces nothing. This is shortsighted though. Investors and collectors purchase paintings, which also do not spin off any income, but may rise in value simply because someone is willing to pay more. Bitcoin, though, reminds me of Las Vegas condos in 2008 or internet stocks in 1999. People were buying both at high prices that had no connection to reality, based on the assumption someone more stupid than them would pay more for it later, because that had repeatedly happened in the months and years prior. Such is the case with Bitcoin. While blockchain is real and cool, and cryptocurrencies are real, it is highly improbable that Bitcoin is going to emerge as a viable long-term currency solution. Most likely, it will end up in finance books a decade or two from now, as paragraph three, right after a discussion of investment bubbles, how they form, and how they ultimately collapse, bringing financial ruin to many.10

Also, let’s put a few things to bed that are out there. First, some say Bitcoin cannot be hacked because it is on the blockchain. The blockchain and its peripheral technology is new, it is not perfect, and it can be hacked. Peripheral software already has been. One investor had 50 million in Bitcoin stolen.11 And Bitcoin does not need to be hacked for people using it to lose money. The blockchain ensures everyone on the chain agrees with a transaction. It does not mean they are all right. Someone can potentially persuade them to all reach the wrong conclusion. Also, some argue that governments have not gotten involved, and that will likely stay the case. That is likely flawed thinking. The government likes regulation, control and taxes. The idea of a bunch of people anonymously doing all kinds of deals on their own is likely one that will catch the attention of the government eventually. In short, it is the wild west out there. Wear your bullet proof vest.

Now, just because it is improbable that Bitcoin will work out does not mean it is impossible, and it is this sliver of hope that encourages the speculators. Bitcoin is attractive to many because of the elimination of third party interference (the government can’t manipulate it by creating more, for example) and because of the anonymity that comes with it. These same benefits apply to over 1,000 other cryptocurrencies. The reality though is most people buying it have no plans to use it. They are buying it purely to speculate.

Ultimately, that is what most buying Bitcoin are doing. Speculation is defined as “guesses about something that is not known; activity in which someone buys and sells things in the hope of making a large profit but with the risk of a large loss.” This is in contrast to investing which is defined as: “expending money with the expectation of achieving a profit or material result by putting it into financial strategies, shares, or property.” Buying an apartment complex that is 90% occupied is investing. Buying land on the moon because you think it will be inhabited one day is speculating. Bitcoin has already dropped over 80% on three occasions, but each time has rocketed to new highs. This week, “buy Bitcoin with credit card” became a popular search on Google. People are piling on the ship to the promised land.

As with all bubbles, there will likely be as many people on the ship as possible before it goes down.

 

1It took me forever to get this far, so it could be a while.
2Blockchain, fortunately, is a non-partisan issue. For now, anyway.
3He usually includes a side note here and there asking me if I took English in grade school.
4Cryptography is essentially encryption, but encryptocurrency apparently didn’t sound as cool.
5Nothing this strange is going to be invented by someone with the name “Fred Smith”. It had to be something that sounds very cool, like Sathoshi Nakamoto. Or Elon Musk. A name like that would work too.
6Of course, right?
7That’s a big club these days.
8Which, to me, sounds like a synthetic drug someone would sell at a dance club.
9To take a break from this, I asked my 12 year olds to come up with their own cryptocurrency names. They came up with ZMoola, Faloos and Dorayme. Maybe it isn’t that easy to come up with a cryptocurrency.
10Paragraph one will be the dotcom bubble and paragraph two the real estate bubble.
11Easy come, easy go, I guess.