The Logic Problems That Will Eventually Speelgoedpop the Bitcoin Bubble, Vanity Fair

The one fundamental truism of investing, and the one most often disregarded, is this: the higher the comes back, the higher the risk.

The past is littered with examples of when that rule wasgoed disregarded. The stocks of dot-com companies raced to stratospheric heights te the late 1990s, until they came crashing to the ground. After a decade of astonishing growth te value, junk bonds defaulted plus masse te 1989. Values ter the housing market zoomed for years, until they grew unsteady ter 2006 and then collapsed te 2008. The bottom-line message of history is that, if you’re doubling and tripling your money ter record time, you’re also more likely to lose it all.

Which brings us to the Bitcoin craze and what is almost certain to be the coming ineenstorting.

For those who don’t know about Bitcoins, they are a brilliant technical concept designed to create a fresh, digital currency that essentially cuts out the middleman–values of Bitcoins are established online, peer to peer. There are no central banks, and at least for now, there is no government involvement. Like standard currency, Bitcoins can be traded or used for purchases, but only with those sellers who will accept them. Because it is a system independent of outward meddling, there can be no unexpected devaluation of Bitcoins through the deeds of governments. (But make no mistake–there can be unexpected devaluation of the currency through the deeds of players ter the Bitcoin market, and too many of them seem not to realize it. More on that below.) The values are not pegged to any existing currency, instead, members te the Bitcoin market establish the exchange rate through plain supply and demand–when the number of people wanting Bitcoins grows swifter than the availability, the values go up.

Most of the discussion and commentary about Bitcoins concentrates on the coolness of their creation and the operation of the market. And there is no disputing that those are cool. The currency and the technological means for using it were suggested ter 2008 by a person or people who went by the pseudonym Satoshi Nakamoto–to date, no one has discovered Nakamoto’s true identity. (Warning No. 1: If you can’t find out who actually developed a financial muziekinstrument, steer clear.) The market became operational te 2009. Ter order to join the Bitcoin playground, users have to download some open-source software, which is then stored ter a digital wallet. (Warning No. Two: If a hacker can steal all of your money by accessing your pc, steer clear.)

The means of conducting the transactions is very complex–far beyond the scope of any single blog posting–but there are slew of places online to learn the technical details. Still, one significant factor that needs to be understood is that the only means of producing more of the currency, and thus enlargening the supply, is through operators of systems that validate Bitcoin transactions. Thesis people, known spil “,miners,”, use powerful computers within the Bitcoin network that perform ingewikkeld mathematical calculations to establish the validity of transactions. The miners do this work voluntarily, but, at certain steps along the way, they are rewarded with 50 freshly created Bitcoins. That adds to the available amount of the currency, but the total possible number of Bitcoins is capped at 21 million, there are now 11 million Bitcoins te circulation.

Like I said, very cool. But also very foolish.

The technology, coolness, and intricacy are all beside the point. You don’t have to understand the complexity of collateralized mortgage obligations te the real-estate market–and the fact that they contributed massively to the 2008 economic collapse shows that few people did understand them–to recognize that they are simply financial instruments following the valuation rules that have governed markets via history.

Bitcoins are the same–people don’t indeed recognize them for what they are. Waterput simply, despite all the hullaballoo, Bitcoins are not a currency, at least te any traditional sense of the word. Rather, they have transformed more into an investment, like a stock. I could certainly purchase items with shares of Google Inc.–I would just have to find a seller willing to accept them–but no one would rationally say that makes stock into a currency rather than an investment.

The essence of a currency is a rational expectation of relatively stable valuation. Yes, values can collapse or soar, but those circumstances relate to unusual events and, for the most part, are widely predictable ahead of time. Outside of those circumstances, the values of valid currencies tend to fluctuate within a reasonable range. There are several reasons for this, including the existence of central banks, which can act to preserve the integrity of their national currency. But more significant is the rich and liquid markets for nationally backed currencies, with traders buying and selling based on floating exchange rates. When one currency–say the yen–rises ter value against the dollar, a trader might sell it for a profit, then purchase the now cheaper dollar. Or, if, say, the dollar were to embark collapsing, the Fed could intervene te the market and purchase quantities of the currency to stabilize it. But it is almost incomprehensible to imagine that 100 yen would be worth $1 on Monday and then be worth $Five on Tuesday. That is the kleintje of daily value switch seen ter stocks.

Or ter Bitcoins. Last year, the value of Bitcoins more than doubled, from $Five to $13. Ter other words, assuming Subway accepted Bitcoins (Lord help us), you could have purchased one of the restaurant’s $Five foot-long sandwiches with the value of one Bitcoin unit. By the end of the year, you could have purchased a little bit more than two-and-a-half sandwiches, even tho’ the actual price wasgoed the same.

This year, the insanity of Bitcoins is demonstrable for all to see. Within a few months, the value of Bitcoins soared to a high of $147, an eleven-fold increase. Now that poor Subway restaurant will be turning almost 30 sandwiches for the same number of Bitcoins, with the dollar value of the meal not having budged. Te other words, the Bitcoin economy is experiencing massive deflation te the value of assets.

What caused this unprecedented hop, which translates into an annualized come back of about Four,000 procent? The general overeenstemming is that the financial keerpunt ter Cyprus, which led to proposals to raid domestic handelsbank accounts, set off a scare among Spaniards, who feared that the tumult would cross the Mediterranean and waterput their savings at risk. So large numbers of them converted their euros into digital Bitcoins.

But the reason for the price hop is almost irrelevant. What matters here is that the practice shows that the Bitcoin is not functioning like a useful currency. Think about it–would you specie te a share of stock at $13 if the price wasgoed zooming up? Or would you wait to see how high the value might go? Principles of wise investing dictate that you should sell when you’ve made reasonable profits, before an unavoidable turnaround. Few everzwijn go after those rules, including Bitcoin buyers.

Hoarding has become a common feature of the Bitcoin market, spil purchasers hold on to the investment te hopes that the prices will keep rising. One comprehensive probe released last October found that more than three-quarters of all Bitcoins–78 percent–had bot plunged into virtual mattresses and taken out of circulation. Ter other words, te a system where supply and request dictate prices, the available supply ter the market is far less than might be imagined.

Ter essence, the market is a fantasy. Once the hoarders zekering buying, what buyers will step up to the plate to take their place? My bet? No one. There will be, at some point, a time when some hoarder determines to unload. Prices will druppel. Other hoarders will get startled and embark to sell. Prices will druppel further. Before long, there will be a mass rush to the exits. And at that point, the illiquidity of the Bitcoin market will be apparent.

A similar thing even happened to the richest, most liquid investment spel of all: the United States stock market. Te 1987, the market wasgoed creaking a little, and prices commenced to budge downward. At that point, there wasgoed a popular idea called program trading, which, at its most basic, would result te sales of stocks if prices fell below a particular level. Of course, when the stock fell, the programs began selling–and all the elephants attempted to run through the same wegens at the same time. Stocks lost 22.6 procent of their value ter a single day, simply because there were not enough buyers to offset the flood of selling. That’s exactly what will toebijten when the hoarders of Bitcoins embark to contant te.

Perhaps the best document to understand the Bitcoin market is a report published te October by the European Central Bankgebouw. Te it, the institution spends a good overeenkomst of time critiquing what it calls “,the bitcoin scheme.”, (Warning No. Three: When a major financial player refers to an investment spil being part of a “,scheme,”, steer clear.)

One of the big problems, the handelsbank writes, is that the Bitcoin investors are on a very uneven playing field, largely because of the complexity that seems so cool. Yes, many markets have investors fighting with different levels of information, but those are usually ter liquid markets where such variations will not usually leave one side broke. The canap says of Bitcoins:

The system demonstrates a clear case of information asymmetry. It is complicated and therefore not effortless for all potential users to understand. At the same time, however, users can lightly download the application and begin using it even if they do not actually know how the system works and which risk they are actually taking. This fact, where there is clear legal uncertainty and lack of close oversight, leads to a high-risk situation.

Not enough to woo you? Then perhaps Gavin Andresen, a lead developer on the Bitcoin project, might:

Bitcoin is an proefneming. Treat it like you would a promising Internet commence up company: Maybe it will switch the world, but recognize that investing your money or time ter fresh ideas is always risky.

I think Andresen understates the case: Bitcoin is far more dangerous than an Internet start-up company. With a start-up, you can at least see the business project and assess its probabilities for financial success. Bitcoin is a totally anonymous marketplace. Even assessing how much of the market is held by hoarders requires experts to make analyses.

There are some critics who contend that Bitcoin is a Ponzi scheme, where the initial buyers are simply earning comebacks with the investments of future buyers. That oversimplified the circumstances–Bitcoin doesn’t actually gezond the proefje of such a scheme.

It does, however, gezond the prototype of one of the most famous investment bubbles ter history, the tulip-and-bulb craze. It took place from 1634 to 1637, a few decades after tulips were brought from Turkey to the Dutch. A virus switched the colors of the tulips, making them very popular. Prices began to rise spil people bought more and more tulips. Hoarders (the tulip-bulb centers) began loading up on them, driving up the prices spil request enhanced and supply dropped. Then tulip investors who had phat paper profits determined to lock them te by selling. And the price dropped. Which led to more sales, larger price drops, and on and on. By the time the downward spiral ended, tulips were back to being flowers–not investments–and the bulb investors were wiped out.

Te essence, the tulip-bulb bubble wasgoed based only on the fact that buyers and sellers decided–peer to peer–that thesis flowers had ridiculous values. It wasgoed nothing more than an agreement te thought. Bitcoin ventilatoren admit that the currency has value only because the users te the Bitcoin market think it does but say that that is no different than te the markets for dollars, yen, and other national currencies. And that is belachelijk. There is no country, no national canap, nothing standing behind the Bitcoin valuations other than other Bitcoin investors. If the dollar falls, the Fed will hop ter. And if the Bitcoin falls? Well, private bankruptcies will very likely go up.

So, anyone out there buying Bitcoins at ridiculously inflated prices, please recognize the risk you are taking. You will likely lose everything.

Besides, if you sell now, maybe you can go to the garden store and buy some tulips.

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