As Always…Look for the Facts

Jeffrey A. Mazer, CFA, JD

October 2017

If you picked up a financial newspaper or magazine in the past few months, you no doubt saw headlines that focused on blockchain technology or cryptocurrencies. You might have tried to ignore: “What is a Bitcoin?” or “There is going to be a Bitcoin crash!” or “It's a financial bubble!” or “Anyone, who knows anything, is using it!” or “No one in the financial industry is investing in it!” It’s been hard to avoid the outcry.

Everyone has an opinion. Financial gurus: Josh Brown (CEO of Ritzholtz Asset Management) and Mohammed El-Arian (former CEO of PIMCO) are skeptical. Kyle Bass (Hedge Fund Manager) says "it's here to stay." Senior banking professional: Jamie Dimon (CEO of JPMorgan/Chase) says "it's a fraud." Celebrities such as Paris Hilton and Ashton Kutchner are strong supporters.

We always see some confusion around the latest and newest. The confusion often comes from lack of understanding. Or, in some cases, a deliberate effort to sabotage a new idea. As Mark Twain said, in What Is Man?, “I am not one of those who, in expressing opinions, confine themselves to facts.” So, let's look at what I see as the facts.

The Facts. Bitcoin, an innovative currency, and Blockchain technology, its technological underpinnings, have taken over the airwaves. But the jury is still out on their sustainability. Because understanding the use of cryptocurrency requires real facts, it's critical to analyze Bitcoin and like offerings with skepticism. Let’s compare Bitcoin to government-backed currencies – the legal tender used every day to purchase goods and services.  

Some Positive Facts:

Transparency: Bitcoin is transparent because it is open source. That means that the supply of Bitcoin is part of its source code. It cannot increase or decrease, based on someone deciding to issue more Bitcoin. There is no central banker controlling the supply of Bitcoin. Its supply has no relationship to politics. In addition, any attempt to corner the Bitcoin market will fail, as thousands of Bitcoin investors and observers watch.

Accessible Finance: Bitcoin represents one form of the democratization of finance, according to Brook Pierce in American Banker. He states that he saw "crowdfunding as the first major leap in the democratization of the world of early-stage finance. I believe the tokenization (i.e., Bitcoin and other offerings) of it -- what we're doing -- is the next, even larger step." Venture capital investment firms see Bitcoin (and other similar offerings) as meaningful alternatives, and maybe even competition to their traditional business model. But, there is room for both in this new world of technological growth and entrepreneurship. And democracy may support the growth of great business ideas that don't appeal to the traditional Venture Capitalist.

No Politics: Bitcoin, and other forms of cryptocurrency, have no national allegiance or tie to any country’s economic situation. Once an offering is tied to cryptocurrency, its value hinges on the success of the underlying entity and trading of the currency, online and across borders. Cryptocurrency avoids geographic boundaries and national laws.

Frictionless: Bitcoin and other blockchain transactions are highly liquid. This means that significant trading occurs, at any time and moves on the blockchain within minutes -- even seconds. The "trading floor" is the internet. There are significant numbers of counter parties (buyers and sellers). There is no need for physical exchanges (like the NYSE). Because of its transparency, pricing information is immediately available. This efficiency provides algorithmic-traders, focused on generating profits through computer-generated trades, even more opportunity than most other investments. It may have contributed to the recent pricing gyrations of the Bitcoin market. On top of all that, Bitcoin trading is cheaper than most other investment vehicles.

Compared to government-backed currencies, Bitcoin and other cryptocurrencies are much more directly linked to, and in the control of, the investors. To gain this level of democratization, however, investors give up potentially important services. Reviewing how Bitcoin's characteristics fall short, compared to government-backed currencies, we see four basic challenges:

Weaknesses:

Use Case Need: the “Use-Application” of cryptocurrency defines and delivers its value. Government currencies already have a use case because currency can be readily exchanged for goods and services. Cryptocurrency, on the other hand requires “use” to have value. If the value of a specific cryptocurrency is tied to the development of a new cancer drug, the value will increase, as R&D and clinical tests support its effectiveness with certain cancers. If research finds that the drug is less effective than expected, the value will drop. Often, the value of a Bitcoin offering is dependent on an “idea” to develop a new app or market an innovative computer application for a specific business. The less tested and tangible the offering, the more potential volatility in price. The risk, however, is no greater than that taken by a venture capital firm that might invest in the same idea. The venture capital firm, however, has more experience evaluating the risk, more control in managing it and earns significant fees to compensate it for taking the risk.

Limited Regulatory Oversight: legal changes may strongly impact the value of cryptocurrency. At this point, there is limited regulatory control over the Blockchain environment in most parts of the world. China recently eliminated Bitcoin exchanges from operating in their country. This decision seems to have negatively affected Bitcoin pricing, in the short-term. In the US, only one regulatory agency, the Commodity Futures Trading Commission (CFTC) has ruled on cryptocurrency oversight. It granted LedgerX (NY) a license to operate as a derivatives clearing organization for digital currencies. Many believe this ruling will broaden investment in cryptocurrencies by institutional investment managers and their clients. This change in direction could lead to stronger, rather than weaker Bitcoin prices. As these changes occur, there will inevitably be disruptions in these new markets that investors will be forced to weather.

Sensitivity to Technical Modifications: technological change does not typically affect overall commodity or financial market pricing directly – but can dramatically affect cryptocurrency prices. For example, in July and August of this year, the price of Bitcoin dropped markedly driven by a technological controversy. Once the controversy – focused on a question about changing the underlying code to improve transaction time – was settled and the change completed, the Bitcoin prices shot up from $2,700 to $4,000 in two weeks. Conversely, news reports about serious hacking incidents, have often led to drops in cryptocurrency prices.

Instability: price volatility will continue to be present in all cryptocurrency trading. The dramatic price appreciation experienced in these new blockchain offerings makes them particularly sensitive to bad news. And bad news can be factual or not. It’s all in the eyes of investors and their perceptions of what’s important to success. This new market offers great opportunity for gains, but risk is inherent in its underpinnings.

Apart from the noise, one thing is clear. As the digital revolution continues to upend our world, no institutions are sacred. While we watch car companies in Detroit relent to Silicon Valley and Portland ride-sharing start-ups or see Amazon eviscerate what is left of retail, I wonder if a full-scale disruption of financial intermediation is not far behind? One thing is very clear: the current financial institutions and practices we know today are ripe for disruption and democratization.

Jeffrey Mazer