A couple of people asked me this week if they should be investing in Bitcoin. I didn’t quite know what to say but I get why they’re asking. The price of a Bitcoin jumped from $1000 to $17,000 this year. It was up almost 20% last week alone. (I wrote that a couple of days ago, and today it’s almost $19,000.) If you Google Bitcoin you’ll see a ton of links celebrating its arrival as a serious investment, telling you how to make millions on it, imploring you to shift your IRA to Bitcoin, etc.
The short safe answer to the question is, if you have to ask someone like me, then don’t do it unless it’s a pure lark—a trip to Vegas. The long explanation is below. Meanwhile, for God’s sake, don’t bet the retirement account.
Is It A Bubble Or Not?
A better question might be, should I jump in? Just because something might be a bubble it doesn’t necessarily mean that there isn’t money to be made if you get in and out at the right time. Either way, it is absolutely a bubble, no doubt about it–a bubble so perfect that it looks like lab experiment, which in some ways it is.
It’s not only a bubble, it’s also a Ponzi scheme, and I’m somewhat at a loss to explain why this isn’t obvious to everyone at a glance because its Ponzi scheme structure is unusually pure, in that there is no pretense that there is some underlying asset like a gold mine, a new manufacturing process, or a Saudi Arabia-scale oil strike in the offing. The supposed value is completely abstract and self-referential: it will simply be what it is now, i.e., increasingly valuable, forever, therefore it is valuable.
No matter how long it continues, for each person who walks away with a huge profit, many more hopefuls must put their money down. That’s just arithmetic. In any such scheme, when the reckoning comes, the majority must always be the crowd of hopefuls who have put in money but not yet cashed out, and that’s pretty much the definition of a Ponzi scheme.
Bitcoin won’t be one of those things where the money simply disappears when it blows up. For each dollar lost in Bitcoin, a good chunk of a dollar (minus the very substantial cost of operating the system) will have moved into some other trader’s hands. Because most people must lose, those hands are statistically not likely to be yours, but we’ll see below that in fact, they’re even less likely to be yours than the raw arithmetic suggests.
To be fair, even if it is mathematically impossible for the herd as a whole to make money on a bubble like this one, nothing says that a given person can’t. It’s like that right now with Bitcoin. You might curse me in the Spring, when it hits $50,000, for telling you not to invest and you’ll kick yourself for believing an idiot like me, but if the bubble has popped by then and you stayed out, or got in and then got out in time, you’ll call me a genius. It’s all perspective.
What follows isn’t the standard analysis, so take it with a grain of salt, but first, some oversimplified historical and technical background. You need to see where it came from to see why it’s explosive now.
The Problem it Solves
The early history of Bitcoin reads like a cheesy novel. It started in 2008 with a scientific paper and some software written by a mysterious computer-scientist/cryptographer who called himself Satoshi Nakamoto. Nakamoto’s true identity remains unknown and even today, some suspect that he is not a person at all, but rather a cabal of cryptographers and computer scientists. Either way, the paper dealt with what might seem like an obscure and pedestrian sounding problem: how can two people who don’t trust each other use cryptography to securely conduct a financial transaction across the Internet without involving a trusted third party? The term of art is “peer-to-peer transaction” because no organization like PayPal or Mastercard is in the middle.
Before Nakamoto, it was generally assumed that peer-to-peer monetary transactions over the Internet require some kind of trust between the parties, e.g., trust that the check is in the mail.
To be clear, peer-to-peer transactions between two parties who don’t trust each other are not a problem when the people involved meet face to face; you hand the other party a stack of money, they hand you the illegal drugs, and you’re done. There are other risks, for instance, the other party might shoot you and take it all, but the actual giving and receiving of the money is logically risk free: first you had the money and they didn’t, then they have the money and you don’t—there’s no in-between stage where the cash won’t be honored or opportunity for you to go out and spend the same money again and again, etc. That kind of risk comes only when the two parties are physically separated, such as by the Internet.
Nakamoto’s ingenious solution obviates any need for trust, either of each other or of a third party. He showed how you can use asymmetric key encryption and some other cryptographic tricks to create a true digital currency that allows people to pay each other directly and even anonymously, just as if they were handing each other bags of cash, face-to-face.
The Mechanics
The full story of how it works is complicated, but a quick summary follows. You can Google up the details if you want a more complete explanation–I’ll just give the highlights emphasizing the parts that are relevant to my argument.
People who want to spend digital money must have a digital “wallet” to keep it in. This is not a physical wallet, just a logical construct that is yours alone. The most important components of the wallet are a unique ID and an asymmetric encryption key-pair similar to what you probably already use on your computer for SSL secure communications.
Unlike classic symmetric key encryption, which uses the same key to encrypt and decrypt, asymmetric key encryption uses two keys; what you encrypt with either one can only be decrypted with the other. For most purposes, everyone involved only keeps one of their keys secret, while the other key (known as the public key) anyone may know, and in fact, the public key may literally be published in an online directory. Thus, anyone who has your public key can send you an encrypted message that only you can decrypt with your secret key. You can reply in the same way, of course, and voilà, you have securely communicated round-trip without needing to prearrange an exchange of keys. Turned the other way around, you can encrypt a message with your secret key that the receiver can be certain came from you because only your secret key can encrypt something that your public key can decrypt—it’s a forgery-proof digital signature. If you nest the encryption, i.e., first encrypt a message with your friend’s public key and then encrypt the result with your own private key, you have sent a message that is guaranteed to be from you and only your friend can read.
The second part of the mechanism is that number of independent voluntary agents across the Internet maintain a public ledger, i.e, the famous “blockchain,” that records the identity of the current wallet that is associated with each Bitcoin. The current owner of record in the blockchain is the owner, period. Human identities don’t appear in the blockchain–just the IDs of wallets, which are like numbered Swiss bank accounts except that there is no bank.
When a transaction with a Bitcoin is attempted, asymmetric key encryption is used to ensure that the coin is actually in the wallet of the person trying to spend it. When the transaction is complete, the Bitcoin will be associated with the wallet of the new owner, who will have secured the sole right to dispose of it.
You might object that if the blockchain is the arbiter of ownership, we now have the problem that someone could hack the ledger to make a transaction disappear and magically get their Bitcoin back or pull some other monkey business. If the blockchain were an ordinary ledger you’d be right. What the blockchain adds is making the ledger of transaction records unhackable. This is done using a process called cryptographic hashing, that deterministically cooks a hunk of data down into a small pseudo-random number that functions like a fingerprint that is as good as unique to the corresponding hunk of data. I say “as good as” because while it is mathematically probable that many other hunks of data have the same fingerprint, the “cryptographic” part means that it is insanely hard to find any such match. It would take millennia of computer time to find even one.
Like asymmetric keys, cryptographic hashing is nothing new or unique to Bitcoin. The brilliance is in how they are used. Many transactions are grouped into a block, and for each of these blocks, the process rolls into a cryptographic hash all of the relevant information on the Bitcoins and wallets involved, plus one more thing, which is the cryptographic hash that resulted from computing the previous block. The previous block is likewise linked to the block that preceded it, and so on, all the way back to the beginning.
The hashing and the linking, as described, would be pretty trivial in terms of computation, so one more thing–a single meaningless number called a nonce–is added to the mix. The nonce starts at 0, and the maintainers of the blockchain must hash and rehash, adding one to the nonce each time, until they find a hash that has a specified number (call it N) of leading 0-bits. The hashes are pseudo-random, and each bit can have one of two values, so the average number of hashes you need to do to get a result with N leading zeros is two raised to the N’th power, a number that gets large very quickly as N gets bigger. N automatically increases as time goes by and has grown large enough now to require a stupendous amount of crunching for each block.
That’s where the magic is. If you tried to change even a single bit anywhere in the chain, every subsequent block along with all those hashes would have to be recomputed because all the subsequent hashes would be thrown off. And even if you could do such a massive computation, you would still have to control more than half of the mining computers in the world, or the others miners would automatically invalidate your results out as erroneous. For practical purposes, the blockchain is unhackable.
Is Bitcoin Really Money?
The upshot is, only the person who has the key to a given wallet can spend its contents, just as only the person who holds a particular dollar bill can spend that dollar at the store. Once a Bitcoin transaction completes, the coin is gone from your wallet–there’s nobody to call to tell not to honor the transaction, anymore than you could call someone in the Federal Government to ask them not to honor a dollar bill you just spent or call a gold mine in South Africa to tell them not to honor the Krugerrands you just put down on that lemon of an armored Humvee. This is what makes Bitcoin a digital currency.
It’s exciting to think about digital currency being a new kind of money in part because it’s inherently exciting to discover anything that’s a new kind of something else. It brings the nature of that something else into focus. But there are so big differences, too. For one thing, the purest forms of money—gold and silver—have value independent of any government or even the passage of time. Paper money is the next best thing. It depends on the continued existence of the government that prints it, and their responsible management, but in the near and medium term, it’s like gold in that it’s anonymous and portable; you can’t turn it off remotely.
Digital currencies aren’t like that. For one thing, they leave an indelible trace of at least one side of every transaction. For another, they exist only in the context of an elaborate online infrastructure and the system can be turned off at will. And they don’t even work in a blackout.
How the Miners Get Paid
The voluntary maintainers of the blockchain get paid for their efforts in Bitcoins that they “mine” by doing the hashing required for linking the blocks. The hashes mentioned above are where the work is. This strange scheme not only provides an incentive for people to do the work of maintaining the blockchain and makes hacking the blockchain prohibitively expensive, it also provides a way to dribble new coins into the world at a rate that can’t spin out of control like the government of Venezuela printing Bolivars.
At one time you could mine them for a fraction of a cent each using a laptop, but the number of leading bits required goes up periodically, making it exponentially harder and harder to compute new coins as time goes by. In NY c. 2015, for instance, where electricity cost $0.21/KWH and a coin was worth about $230, the electricity to mine a coin cost approximately as much as a coin was worth, even when using dedicated custom hardware that does the computation millions of times faster than a conventional computer. Today, at the average cost of electricity in the US, and using state-of-the-art ASIC hardware, a single coin costs about $1500 each in electricity alone–enough oil to heat a house in New England for a year.
The logic of Bitcoin caps the total number of coins that there can ever be at 21 million, of which about 18 million have now been mined, but because the amount of computation necessary to mine a coin grows exponentially, the end of new Bitcoins and some other way to pay the miners is still a ways off. In the early days, however, when they were still easy to mine, people easily amassed huge numbers of coins. Nakamoto himself apparently generated a million of them in the course of spinning the system up before making it public. Nobody except Nakamoto knows if these coins still exist. He (or they) may have simply discarded them because no transactions using them have ever shown up in the blockchain. If he did discard them, there is no way anyone but him could ever recompute them because the process of generating them again would require knowing the secret keys that he used. That first million coins were worth exactly nothing back in the early days and for a considerable time afterward, coins continued to be worth pennies or even less, but if Nakamoto did keep them, they would now be worth something like seventeen billion dollars at today’s exchange rate.
So, Why All The Fuss?
You might say, “Great, but I use PayPal and credit cards all the time and it’s not a problem–so what’s all the fuss about?” I would tend to agree with you, but this is where ideology comes in. Bitcoin comes from a corner of Silicon Valley that is Libertarian like rural Alabama is Republican. There’s a widespread feeling that Government either is actively the enemy of freedom or will be soon and that conventional paper money, contemptuously referred to as “fiat currency” is not only their potent instrument of control but a fraud as well. It’s not just Libertarians—there’s a host of similar but even further-out fringe groups who comprise a sort of latter-day Woodstock Nation of technology. It’s as if all those people dancing in the mud suddenly grew IQs of 160 and got PhDs in computer science. Nakamoto’s paper and software landed on fertile ground and was quickly and passionately taken up by this community.
Fast Forward
So let’s speed this up—back in 2009, when it first became public, Bitcoin was a sort of academic experiment, an exercise, almost a toy, but it caught on. For a long time the value of a Bitcoin was pennies or even less, but by five years later, 2014, the price had risen to the forty-dollar range, which put the total paper value all the Bitcoins in the world into the low hundreds of millions. People, a lot of them unsavory people, were using them to buy, sell, and move money around outside of the banking system. (Bitcoin isn’t actually as anonymous as cash, but it’s close, so it is very appealing for doing illegal deals and laundering money.)
Then something interesting happened. Almost overnight, the market price of a Bitcoin shot up to over $1000, and the paper value of the world’s Bitcoin was more like tens of billions. This doesn’t happen because guys are using them for buying Viagra on Silk Road—an overnight 20x price surge can only be about speculation.
So here’s where it gets interesting. Almost as quickly as it had ballooned to $1000, the price plummeted. Although some people did use them to buy and sell (mostly illegal or quasi-legal) stuff, the majority were held for speculation, so I assumed that the crash would result in a fatal loss of faith, ending the experiment.
Surprisingly, however, the price stopped dropping at around $230, more or less held there, and then gradually began crawling upward again at a measured pace. The question isn’t so much why did the price drop as why wasn’t the crash fatal? Who would put money into them or accept them for exchange if their value can fall by 3/4 almost overnight?
Aquatic Metaphors
The answer is two-fold. Firstly, Bitcoin isn’t just another financial instrument to the people who are into them. For many of the early adopters, they are an object of almost religious belief—a righteous blow against the empire. For this reason, there is an unreasonable faith by Bitcoin holders that would never apply to a normal financial instrument not backed by any concrete asset. More importantly, unbeknownst to most of the people who used them and traded in them, the universe of Bitcoins was like an iceberg. Some were in play, but the preponderance was held underwater, out of sight, by the owners known as “the whales,” i.e., a handful of huge players.
The so-called market price was real in the sense that you could reliably buy or sell a few at that price, but that price was set by the relatively few coins in play. If just a few players who also have a ton of dollar-denominated money control most of the coins, they can manipulate the market price and more. For one thing, they can act as market-makers, guaranteeing that there is always a buyer or seller, giving liquidity to the market. They can also push the price down at any time by dumping coin or conversely, arrest a sudden drop or alleviate market skittishness by buying. It’s hard to do this in a normal securities market because too many people are independently acting in their own interests. If Bitcoin ownership had been like that, the price would have run a quick race to the bottom each price drop eroded faith further and the owners desperately tried to salvage whatever they could in a market with few buyers.
The flip side of this is that the whales held (and still hold) so much coin that even a single one of them attempting to liquidate would crush the market, rendering everyone’s coins worthless. Instead, they banded together and sat on their coins allowing the price to stabilize and recover. You can’t prove it, but they almost certainly also bought strategically to head off popular despair. A thoughtful market manipulator doesn’t have to hold the market up like Atlas—all it takes is enough buying to allay fear, and if all goes well, the manipulator’s virtue is soon rewarded, because the instruments purchased will eventually recover their value.
The behavior of the Bitcoin market didn’t usually get described quite this way in the press, but that’s primarily because at the time it was a niche interest and most of the people with any real understanding of Bitcoin had no motivation to put it that way, but it’s important to understand why it is becoming explosive.
Today
The spike and subsequent crash were in 2014. By last year, the market price of Bitcoins had crept back up to the level of its former $1000 peak and during those two years, the idea of an alternative digital currency had become more mainstream. Quadrupling in value in just two years is already suspiciously fast growth, but for whatever reason, about a year ago more mainstream speculators began to take it seriously and the price took flight again, this time shooting up to $17,500 in just one year. Today it can bounce around by a thousand dollars in a day and not raise eyebrows. This should be alarming, as normal financial instruments don’t increase in value by 1,700% per year, but hey, digital currency is brand new–maybe it’s a normal part of growing up.
A number of things make this surge in price different from the 2014 surge. One is that Bitcoin has reached some critical point where ordinary Joes and Janes see it as an investment opportunity; this new price surge is coming from outside money flooding in.
Another is that people today barely talk about Bitcoin’s use as money anymore, although they still are used that way. The market isn’t driven by Bitcoin aficionados or the Dark Web anymore–the money is now pouring in from outside but it’s still chasing relatively few available coins, so the price keeps rising.
If it were the gold market, a mere doubling of the prevailing price would call earrings, bracelets, and watches out of jewelry boxes around the world and the rise would be quickly checked by the inflow of previously unavailable product. This hasn’t happened with Bitcoin because ordinary small-time investors and users only have but so much, and many of them are true believers, holding back their relatively modest stashes in hope that the price will rocket even higher. In other words, a lot of money is chasing a few coins.
The market for Bitcoin (right now) is more like the diamond market. Diamonds have never been remotely rare enough to justify their insane prices. The price is what it is because a powerful cartel keeps metric tons of them locked in vaults and off the market. The cartel would love to convert them all to cash at the current price of diamonds but you can move only just so many a year without depressing the price. Therefore, they dribble them out at a rate that maximizes the amount of money cartel members jointly make over time. Likewise the whales–they would love to get out at these insanely favorable prices, but they are constrained to liquidating at a measured pace, lest they kill the golden goose.
Nervous Work
The minor investors are having a thrilling ride, hourly weighing the risk of holding on against the certainty of profits taken today, but the whales, like the diamond cartel, are constrained by the sheer volume they hold. It must be frustrating because selling at today’s prices would make the least of them rich beyond dreams of avarice, but they must perforce move slowly, gnawing their fingernails in fear that the bubble will burst while they still have millions of coins unredeemed.
It will take a stupendous and sustained flow of outside money to mask the liquidation of the volume of coins held by the big guys, the paper value of which even today is in the hundreds of billions of dollars. The position of the whales is ironically somewhat like that of the Treasury Department, which could simply print up sixteen trillion dollars to pay off the national debt, but in so doing would inflate away and destroy the value of the dollar. The money at stake is incomprehensibly huge. Most of their holdings cost almost nothing compared to today’s prices, so every coin liquidated is almost pure profit, and if they can get out completely they will be among the richest people on earth.
Becoming a Real Market
As the great and silent liquidation moves glacially along, the steady broadening of the base of investors means that Bitcoin will inevitably behave more and more like a normal financial instrument, as the proportion of the world’s coins that are owned by people with either an ideological interest or a share large enough to ballast the market shrinks away. It’s a balancing act to get as much of the hoard converted to dollars as possible before something happens to derail the money machine.
So, how long before there are enough coins are in enough hands that Bitcoin acts like a free market and becomes subject to popping? Nobody can say for sure because we’re in new territory. We could be there already. For one thing, at current prices and trading volumes, it would take much more money to stabilize price collapse than it did three years ago, so the market may already be beyond control. Also, Bitcoin isn’t like shares in the South Sea Company or 2000’s real estate because, in modest quantities, it is liquid. This means that people can and do spend them directly in the course of transactions on the dark web, trading in artworks, laundering money, etc. Nobody knows how extensive is this practical, non-speculative interest in the instrument or how it affects the psychology of the market. Probably the most important factor right now is how long the current extraordinary wave of excitement can be sustained to keep the new money flowing in. 17X in one year is a pretty sweet sales pitch, and I’m seeing ads encouraging people to move their retirement funds into it. The ads are appealing to a huge population of suckers out there who didn’t buy Microsoft, didn’t buy Cisco, didn’t buy Amazon, then passed on Google, and now are determined not to miss this one. There’s another source of cash too. More and more people know about it so the secret market for baubles of the rich could soak up a huge amount. Trillions of dollars worth of paintings, jewelry, Rolls Royces, etc. live and are traded in a netherworld of freeports, safe deposit boxes, and similar schemes. Bitcoin is a great medium for this not exactly illegal, but certainly extralegal economy.
The upshot is, nobody really knows how much demand is out there or how sensitive it will be to panics. It’s anyone’s guess.
The current (December 12, 2017) paper value of the 18 million existing coins is around 300 billion, which would be a bit less than $1000 per person for every man, woman, and child in the United States. But that’s at today’s price. The paper value hitting a trillion is not out of the question; it would happen at about $55,555 per coin, which is only about three times what it is now. It went up more than 17x this year, so that’s not out of the question. This is the “market capitalization” you hear about, but it’s basically a nonsensical number. It’s a stock market term meaning the market price of the stock multiplied by the number out in the world. But with Bitcoin, a large proportion of the coins are not, in that sense, in the world—they function more like shares held back by a corporation for later sale.
Nakamoto designed in the rising cost of mining so that it would automatically throttle the entry of coins into the world. As the number of transactions increased, the number of coins would grow and a rough balance would be maintained. This design makes sense if the typical use of a coin were to circulate as money, but in fact, most coins have always been in the wallets of speculators waiting for the price to rise. Nobody knows how many of the existing coins have ever been in play, but nothing remotely like 300 billion dollars and goods have been exchanged for coins so far. This is very different from real money, where each dollar out in the world functions like many virtual dollars because of layers of credit, floats, and similar multipliers allow the same dollar to be counted many times. With Bitcoin, it’s the opposite. For each Bitcoin out there acting like money there are many lying quietly waiting for the price to rise. You can think of all those hidden Bitcoins as being like potential Bolivars that the government of Venezuela hasn’t printed yet, but could.
For investors to actually exchange that much money for coins could take quite a while—the process is unlikely to complete before it all blows up. But my guess (based on wetting my finger and holding it up in the air) is that in the natural course of events it’ll keep going up for at least months yet, but it could go on longer. There is talk about how the new Bitcoin derivatives will make it stable, etc, which could stretch its life out considerably because it makes it seem more plausibly real. With the economy strong and money flowing in it could continue to rise for a long time.
Until, of course, one day it doesn’t. Once it starts to fall, this time unbuoyed by either ideology or the inertia of the whales, it will accelerate rapidly downward as the innocent new investors panic.
The Hidden Bomb
Market forces alone won’t necessarily drive the price all the way to zero (they didn’t last time) but there’s something new going on now. Nobody outside the mining community knows exactly what mining costs today, but educated estimates put it at $500 to $1500 per coin. So here comes the punch line: if the value of a Bitcoin were to fall below the cost of mining them, at the current cost of power and hardware, the miners wouldn’t be able to run the blockchain for very long on spec, praying that the insanity will return. The aggregate cost of running the blockchain today is something like $170,000 per hour just for the electricity and increasing daily. If a big drop depresses the value a coin below the cost of mining one, eventually they’ll have no choice but to simply turn off the lights and go home, rendering Bitcoin non-functional and worthless.
Today’s price is something like 12 times the cost of mining, so it would take a heck of a drop to cross that line now, but nothing in real life keeps up with exponential growth for long, especially not the value of a completely artificial financial instruments. There’s talk of a fee for transactions, but I don’t see that helping much because the absolute cost of a transaction is still increasing exponentially, however you pay for it. The cost of mining must inevitably get closer and closer to the value of a coin, with the magnitude of price crash that the system can tolerate proportionately smaller.
Both the mining community and the whales will have have seen this coming because it’s an obvious consequence of the design. You can bet they know to the nickel what the magic number is where the two lines cross. Faced with the premature demise of the biggest free-money machine in history, you’d think the whales would be highly motivated to formulate a contingency plan to quietly subsidize mining to keep it going. The trouble is, the only rationale for them to subsidize the system with their own money is to allow them to continue to cash out, leaving Joe and Jane holding the bag. Such a move might be too brazen for even our current feckless federal government to overlook.
No, one way or another, Bitcoin must inevitably vanish in a puff shortly after the price of a Bitcoin heading down crosses paths with the cost of mining a Bitcoin going up. It will leave behind nothing but countless family stories about how Dad lost it all in Bitcoin back in 2019.
An Alternate Ending?
That less-than-rosy scenario assumes that the Federal government won’t come to its senses and simply shut the whole thing down, but such action seems unlikely. Despite the fact that Bitcoin’s primary purpose from the start was to evade the scrutiny of the law and the tax man, they have delayed for so long now that it is probably politically impossible; too many of the sheep are registered voters. Against all logic, the authorities world-wide seem determined to let nature take its course.
Bitcoin will live out its evanescent moment in the sun and then enter history as the most curious and possibly most destructive bubble of all time. Be sure you have a chair when the music stops.
Time and Material 