Lighthouse - Bitcoin Phenomenon - 2017-12

Lighthouse Investment Management

Crypto-Currency Crunch The Bitcoin Phenomenon

December 2017

Crypto-Currency Crunch - December 2017

Page 1

Lighthouse Investment Management The Bitcoin Phenomenon Bitcoin has seen a meteoric rise from $0.30 in 2011 to $19,697 on December 7th, 2017, reaching a total market capitalization of over $300 billion.

For some odd reason, every newspaper or online article about Bitcoin features an image of a coin, usually a golden one (like on the previous page). That does not exist. It’s as if every article about electricity would feature a picture of a lightning bolt. Crypto-Currency Crunch - December 2017

Page 2

Lighthouse Investment Management So what is Bitcoin? Bitcoin is a digital crypto-currency and a payment system based on blockchain technology. It is distributed over a decentralized network without central authority. Its integrity is based on a difficult to perform, but easy to verify, hash function called double SHA-256. What does that mean? “Decentralized”: There is no central authority issuing the currency (like a central bank). Bitcoin exists inside a peer-to-peer network. There are no banks involved. “Electronic”: Bitcoin only exists as bits and bytes. There are no actual coins. So is it virtual money that doesn’t exist? Most of our current monetary system works the same way. For example, there are $1.5 trillion dollars in “Federal Reserve Notes” (dollar bills) in circulation. Monetary base M1, which includes demand deposits, amounts to $3.5 trillion. M2, which includes savings deposits and Money Market Mutual Funds, stands at $13.5 trillion. Adding dollars created by non-US banks outside the US (so-called Eurodollars) the amount increases by one third. Including the notional value of derivatives outstanding we get to more than $200 trillion. What does “crypto” mean? “Crypto” means concealed, secret. Cryptography means ‘technology for secure communication’. Can you explain that technology without getting technical? No. But we can try to keep it as short and simple as possible. What is a hash function, and what is double SHA-256? A hash function takes a chunk of data and shrinks it down, in this case, to 256 bits. SHA stands for “secure hash algorithm”. Double SHA means the function is applied twice for increased security. Here’s an example for double SHA-256 encoding of the string “hello”: 2cf24dba5fb0a30e26e83b2ac5b9e29e1b161e5c1fa7425e73043362938b9824 (first round) 9595c9df90075148eb06860365df33584b75bff782a510c6cd4883a419833d50 (second round) Why do we need a hash function? Put simply, the hash function takes some input and turns it into output. For example: Input = 1234 Function = add all digits Crypto-Currency Crunch - December 2017

Page 3

Lighthouse Investment Management Output = 10 (1 + 2 + 3 + 4) You can easily verify that 10 is the sum of 1 +2 + 3 + 4. But, and here comes the important part, it is not easy to guess from the result (10) what the exact input numbers were (it could have been 1 + 3 + 3 + 3). You might find the correct input numbers by simply guessing enough times. Why can’t people with computers guess the SHA-256 input? That’s what they are doing. It’s called mining. But the function is hard. The chance of guessing the correct input is 1 in 1019. It would be easier to find a particular grain of sand among all the grains of sand on earth. It would take a personal computer 35,000 years to mine a block. What if people use supercomputers? That’s what they are doing. In the beginning, people were using laptops to mine Bitcoins. But once a certain number of Bitcoins have been mined, the difficulty of mining increases. So people started mining with (more powerful) GPU’s (graphics processing units). In the meantime, mining has moved to ASIC’s (application specific integrated circuits), purpose-built computer chips doing nothing else but performing SHA-256 calculations. Some can achieve over one trillion hashes per second. What if people gang up and mine together? That’s what they are doing. So called mining-pools are working together to increase the chances for an individual to share the rewards of mining. What is a “block”? Since there is no central authority, a system had to be devised to verify transactions. This is the second job of miners. They receive small rewards for verifying transactions. A couple of hundred transactions together form a block. What is a “blockchain”? A newly created block gets simply attached to an existing chain of blocks, building a blockchain. All prior transactions therefore remain “stored” in the memory of the blockchain. Can Bitcoin be forged? It is very unlikely. Why?


Page 4

Lighthouse Investment Management The Bitcoin protocol specifies that in order to produce a valid block, a miner must submit proof that he expended a certain amount of processing power (and hence time) in the creation of the block. In practice this means miners have to solve a complex math problem, which can only be done by running random numbers through an equation over and over again until the correct answer is found. The difficulty of this math problem is calibrated so that on average, only one miner will solve this math problem every ten minutes. It is designed so that blocks can be found much quicker collectively rather than individually. An individual has very little chance against mining pools of adding a block. Older blocks in the blockchain have been verified multiple times and are hence more trustworthy. Is Bitcoin money? Money is defined as being a unit of account, a medium of exchange and a store of value. Is Bitcoin a unit of account? Yes (a Satoshi is one hundred millionth of a Bitcoin, the smallest unit, currently worth 0.017 US cents. You can count things in Bitcoin (but not, for example, in Picassos, because each one is unique). Is Bitcoin a medium of exchange? Yes. People all over the world can exchange Bitcoin easily. Is Bitcoin a store of value? Here is where opinions differ. Many people wonder how something this volatile could be a store of value. My take: we are in the early years. If Bitcoin replaces fiat currencies, it will be a store of value. For something to have value, it (usually) must be scarce. The maximum number of Bitcoin outstanding will be 21 million, so it is a scarce object. Most fiat currencies do not qualify as ‘store of value’ in the long run; the US dollar has lost more than 96% of its purchasing value since 1913:


Page 5

Lighthouse Investment Management

But Bitcoin is backed by nothing; it has no intrinsic value! True, but so is the US dollar. And that doesn’t prevent the dollar from having value. But Bitcoin is no legal tender! True. But more and more merchants are accepting Bitcoin (1-800-Flowers, Amazon, Apple App Store, CVS Pharmacy, Dell, Dish Network, Expedia, Home Depot, Kmart, LOT Polish Airlines, Microsoft, PayPal, Sears, Subway, T-Mobile Poland, Target, Tesla, Victoria’s Secret, Whole Foods). Bitcoin could, theoretically, become de-facto legal tender as more and more businesses accept it for payment. There are no barriers of entry. Anybody can issue a crypto-currency, so where is Bitcoins value? That were my initial thoughts, too. And there indeed are more than 1,300 different crypto-currencies. But, as with most digital services, it could be a “winner-takes-all” competition. Facebook killed MySpace. Groupon killed their copy cats. Lyft and Uber are still fighting it out. Just as it doesn’t make sense to have two different social media sites for sharing pictures with friends, it does not make much sense to keep money in more than one or two different crypto-currencies. But who guarantees that Bitcoin be the winner? Netscape had an early lead in the market for Internet Browsers, and remember Nokia in mobile phones? This is a valid point. We simply don’t know. Bitcoin has a first-mover advantage and attracts the most publicity. But it also suffers from its own success; slow pace is the result of the large number of transactions. Other crypto-currencies will run into similar problems. They will, however, have the advantage of having observed how Bitcoin dealt with those problems. Crypto-Currency Crunch - December 2017

Page 6

Lighthouse Investment Management What prevents the US Treasury or Chase Bank from issuing their own crypto-currency? Decentralized crypto-currencies have no single issuer. That is one of the main features. The US Treasury as well as private banks already issue their own digital currency (the US dollar). But is Bitcoin secure? There have been so many stories about hacks and millions stolen! Bitcoin has not been hacked a single time. It is the exchanges that get hacked (most famously Mt. Gox). But you don’t need an exchange to keep your Bitcoin, you don’t need a central custodian. You can keep Bitcoin in an electronic wallet, and the risk of getting hacked are very, very small. Because the hackers are concentrating on the centralized custodians. What about the insane amounts of energy consumed by Bitcoin miners already today? The estimated energy consumption of global Bitcoin mining operations was around 32 TWh (Terawatt hours) per year on December 6, enough to power 3 million US households or the entire energy consumption of Serbia. On top of that, energy consumption increased by 23% compared to a month earlier. Each Bitcoin transaction consumes as much energy as needed to power more than 8 US homes. What a waste of energy! Yes and no. VISA data centers consume energy equal to 50,000 US homes. Think about all the banks, the branches, heating, light, air conditioning etc. If Bitcoin replaced all of those it could be a net energy saving. Bitcoin miners are migrating to places with the cheapest energy – often next to Chinese steel plants, which enjoy state-subsidized energy. Is that fair? If the government wants to subsidize certain sectors it means potentially transferring taxpayer money to Bitcoin miners, yes. But think about alternative energy: one of the biggest problems is the variance in availability of wind and solar and insufficient storage possibilities for oversupply of produced energy. One could imagine miners sitting next to alternative energy plants, springing into action only during times of oversupply (and cheap electricity prices). Electricity produced would then not be lost, but transferred into value in form of Bitcoin. It would even be possible for electricity producers to enter the business of mining directly, and create additional revenues from the sale of Bitcoin. What does Bitcoin mean for banks? Banks are not needed for saving or exchanging Bitcoin. Should crypto-currencies replace fiat money, banks would have a very difficult time. It seems to be one of the largest digital disruptions of our time. Banks could still make loans in fiat currency, as they are not deposit- or reserve-constrained to do so. What would be interest rates in Bitcoin?


Page 7

Lighthouse Investment Management I am not sure there would be even interest rates in Bitcoin. How can you even lend Bitcoin? A Bitcoin can only be at one place. There is no double-accounting (as with fiat currency). The only way I could imagine Bitcoin lending is with repurchase-agreements. But that would make additional bilateral agreements necessary. Why would people prefer saving in Bitcoin? In our current fiat currency system, one person’s savings are, automatically, another person’s liabilities. Looking at the system as a whole, there are no liability-free savings. As individuals, corporations and governments add more and more debt (and a few rich accumulate savings) the system becomes unstable. If debtors fail under the load, some savings must be erased, too. In order to keep such a system sustainable, central banks must engineer a certain amount of inflation, so debtors do not have to pay back the full amount in real terms. This is to the detriment of the saver. Bitcoin would be a very saver-friendly currency. It is probably deflationary as its issuance is strictly limited. We would likely see technological advances being passed on to the consumer in form of declining prices. A deflationary environment makes it, of course, harder for debtors to pay back their debt. Many entities with a lot of debt (corporations, governments) would likely go bankrupt. But would this be allowed to happen? Probably not, since the economic and social calamity would be enormous. So how will this be avoided? There are only three ways to reduce debt: 1. Pay it back (impossible for highly indebted entities), 2. Default (undesirable because of socio-economic consequences), 3. Inflate it away. But since Bitcoin will be deflationary, fiat currencies will have to be inflated. Meaning the price of Bitcoin in US dollars will rise further. There is no possibility of an official exchange into Bitcoin (like Deutschmark into Euros), because where would the Bitcoin be coming from? It seems that the last ones to hold fiat currency will be the ones to pay the highest price for Bitcoin (or whichever crypto-currency it will be). So wait a minute, if governments cannot issue Bitcoin, how would they finance their fiscal deficits? Good point. They won’t. Since Bitcoin creates debt-free savings, there is no corresponding debt available. They will try to issue fiat currency debt until nobody is willing to purchase it. And then? And then governments will have to live with balances budgets. Isn’t that deflationary? Yes.


Page 8

Lighthouse Investment Management Now what about gold? That is a good question. Savings in gold are debt-free, too. Gold is also a very scarce resource. Higher demand for gold gets solved mostly via price. It has many of the saver-friendly characteristics of Bitcoin, but resides in the analog world. So it seems Bitcoin and gold could be competing for savings. What consequences does this have for the gold price? It depends in which currency. Since fiat currencies will probably have to be inflated to save the world from mass-defaults, gold will go up measured in those paper currencies. Measured in Bitcoin, gold could move in a similar fashion, as the amount “mined” per year is roughly similar. How high could the price of Bitcoin go? Just as a mental exercise, let’s take US M2 monetary base, and assume the entire $13.5 trillion are being switched into Bitcoin. With roughly 17 million Bitcoin outstanding that would equal a price of $794,118 per Bitcoin. And this doesn’t even account for money outstanding in the rest of the world. Who will be the early adopters of crypto-currencies? For people in emerging markets with unstable currencies and / or no bank account the advantages are very obvious. A close second are citizens of countries with foreign exchange controls (Venezuela, for example). People in industrialized nations do not have a recent experience of hyperinflation, so they will likely be the last ones to adapt. What about ICO’s (Initial Coin Offerings)? Those are not to be confused with crypto-currencies. A lot of them are scams. Few are being used to fund the development of a new crypto-currency, with the hope those tokens will later be convertible into an initial batch of currency. The SEC (US Securities and Exchange Commission) has warned that they will view those offerings as securities, which, if offered to US investors, have to be accompanies by a prospectus. Lack of registration will make them illegal. What about taxes? The IRS (Internal Revenue Service) has already declared that gains from trading crypto-currencies create taxable events. There is no guidance on how those gains are to be reported. However I don’t if taxes would apply to a situation where you purchase, for example, a car with Bitcoin at current prices ($17,000) when you have acquired those Bitcoin at a much lower price. So what is the take-away message? In short, crypto-currencies are nothing short of a huge disruption of almost every aspect of life, especially economy and particularly banking. It is hard to underestimate the consequences. Innovation


Page 9

Lighthouse Investment Management will explode, and applications be invented which we today cannot yet imagine. Crypto-currencies are still in their infancy, and the landscape is not yet sculpted. Caution is advisable, as it is easy to get sucked into the frenzy. Prices of crypto-currencies are likely to have frequent buying bursts and crashes. Many people forget, but Bitcoin first rose to $1,000 in December 2013. It then fell back to $200, and it took until March 2017 to see the $1,000 mark again. If you are not prepared to temporarily lose 80% and having to wait a few years this market is not for you. Disclaimer: This report is for informational and educational purposes only and shall not be taken as investment advice. Nothing posted here shall constitute a solicitation, recommendation or endorsement to buy or sell any security or other financial instrument. Accounts managed by Lighthouse Investment Management or the author may have financial interests in any instruments mentioned in these posts. We may buy or sell at any time, might not disclose those actions and we might not necessarily disclose updated information should we discover a fault with our analysis. The author has no obligation to update any information posted here. We reserve the right to make investment decisions inconsistent with the views expressed here. We can't make any representations or warranties as to the accuracy, completeness or timeliness of the information posted. All liability for errors, omissions, misinterpretation or misuse of any information posted is excluded.


Page 10

Lighthouse - Bitcoin Phenomenon - 2017-12

Recommend Documents