Financial Cryptography

(C) The ABC of Making the Bitcoin Investment Decision - part C first - Currency, buy the Coin!

Preamble. In the last recent months I've seen a lot of interest in the question of what makes a good Bitcoin investment. I may not be the best person to make this call, but as I'm a reluctant skeptic, I may not be the worst person either. Most of the people I speak to are either confirmed believers, or they are people who are afraid of missing the boat. In either case, they haven't got a lot of critical analysis to offer, and as I've been there several times already, it seems I might have. I've been speaking on this issue at the moment in multiple fora, so I've been forced to put my thoughts in order. (Fair Warning. Long post ahead...)

Call this my ABC of Bitcoin investment. In reverse order, C for Currency. Put your coin on the table, and read on!

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The first decision that hits the erstwhile investor in Bitcoin is this: to bet on the currency or to bet on the business?

Currency or business ?

can be seen as a diversification question. If you buy the coin, you are investing in the entire market, because, as the theory goes, it goes up with the fortunes of everyone, and comes down alike.

Diversification is a good strategy, and according to the efficient market hypothesis it is the only strategy that makes sense to a non-insider. In the stock market, this means buying a stock index fund, which is hated by the banks because they can't push your trades around and make fees off you. Which alone tells you diversification is a winner, and for these and other reasons, index funds typically perform in the top half of funds.

The strategy could be considered a good thing. Buying the currency could make you a smart investor!

It is also rather unique. For example, when you bought into that Internet boom in a big way in the 1990s, or the social networking of the 2000s, it wasn't possible to "buy the net!" Then, you had to make a more precise investment decision e.g., B for Business, which I leave to another post.

This time around, you can buy the coin literally, and see afar from everyone else's tall shoulders. What could make more sense?

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I would however like to raise a bit of a red flag. Buying the coin might actually make a lot less sense than at first blanche. Let's work it through.

Unlike the stock market, the Bitcoin unit hasn't got the same longevity. The LSE, NASDAQ, Nikkei, etc will be around next year, in 10 years, and in some form in 100 years. Bitcoin might not be. It might be the Ripple or the Ethereum or the Bitcoin2.0 or any other strange and interesting name. Or Bitcoin might be a totally regulated thing, or it might be only traded in China, or it might be illegal or ...

The point being that there are a lot of potential futures. Which leads to issue number 1:

it's more a speculation than an investment

That part is obvious, but if it is so short-term, why does it gain in value? Bitcoin is rising in value rapidly because people are piling money into it on the expectation of future rewards.

We have a word for this: bubble.

Then, the second problem with investing in the currency, and holding it, is that you are now participating in the expectation of a rise of value for no work put in. Indeed, by deciding to invest, you are confirming that it is a bubble. Hence, caveat #2:

you are now part of the bubble!

Being part of a bubble isn't necessarily bad, yet. People participate in the stock market bubble or the real estate bubble all the time, and life goes on. Entire countries participate in the pension bubble, and nobody blinks!

As long as you don't lose money, you're fine. And, as long as you have no explaining to do, you're fine. If you're in a fund where risk taking is the idea, then this is a good thing. If however you feel that you need to explain to your upstream investors how you made your decisions on investment, and bubbles do not form part of that explanation, you might want to try an alternate strategy. Institutional or pension money might want to steer clear, whereas VC and hedgefund money might see this as the green light.

Let's assume today I am writing to angels and VCs, and let's pursue those bubble rewards.

There is, excitingly or sadly, more to come. Bitcoin is currently in a sort of early life crisis. As lifecycles go, it's discovered limbs and crawling and attempts at walking. And typically we get a lot of flailing and yelling and falling. Mt Gox is the canonical case, and it looks just like that, a toddler getting a few steps down the hall before collapsing in a heap. Then, tears.

Which highlights a particular difficulty. It is easy to buy Bitcoin, but it is harder to sell it. It turns out that the market is perhaps more illiquid than the glossy website stats indicate, for reasons of depth (lack of big buyers), fraud (which is what Mt Gox probably is) and gross mismanagement (ditto).

Unlike stock markets, if you've just put $75m of VC cash into Bitcoin currency, you have just purchased yourself a rather nasty little problem #3:

you can't sell out!

At an absolute minimum, you may not be able to shift the value without moving the market so far it loses your value, an issue investors in the HFT game know well. In practice, you may not be able to sell it at all, or you may have to wait months, or you may watch the value go down the tubes, to the point where you're left with pennies on the coin.

Or you may discover it was for sale, but now it's nowhere to be found.

Now you have more explaining to do. If you hold a cash instrument that can't be shifted, you can't mark it to market, you can't book it as liquid. You haven't got cash, it's starting to look just as liquid as holding startup stock (that is, not liquid), but without the business rationale backing it.

Did we say speculation or investment?

Worse, your upstream investors aren't going to buy that story, as they'll be watching the price on exchanges and ask you why you didn't shift it? They'll give you plenty of advice about who has the hottest exchange this month, but it will be you who is hitting the send button and relying on the promises of that shiny new website with the street address you can't pronounce.

Which leads us to the next problem:

can you pick the burst of the bubble?

Bubbles always burst. You the venture capitalist might be measured more on the fall from the peak than the rise from original investment, which will be booked as profit well before you get lucky on that score. So you are now on a very wild ride, where your decision will cast your future in an entirely positive light, or a disaster.

Let's cut to the chase: the only theory that we know of about picking the bursting of the bubble is the one of being lucky. Someone always sells just before the peak, and close investigation reveals that those people are often saying the same thing that everyone else is saying. When we strip out the factors we can scientifically identify, we're left with mostly luck.

Are you lucky?

To avoid the curse of excessive luck we typically suggest ... wait for it ... Diversification! And therein lies the rub. Although you've diversified from the risk of business collapse, you've just picked up other risks, being bubble popping, liquidity and fraud. Indeed, given the nature of Bitcoin, I think we can pretty much dismiss /buying the coin/ as a diversified strategy across the business of Bitcoin.

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We are talking then not about a diversified strategy at all. Rather, buying the coin is a precise investment on a particular instrument -- the herd. Which means two things.

Firstly, blowing the bubble, as opposed to pricking the bubble. This is the pernicious issue of the mechanics of a bubble -- ever wonder why everyone in the Bitcoin community is a total believer? Now you're about to find out.

You've staked your future on the Bitcoin bubble. The only way that a bubble grows is if more people come in than go out. Or, more money, in than out.

As you are now invested in a bubble this means your incentives are now aligned with growing the bubble.

Where do those people and their money come from, once you personally are "all in"? Well, as it's not an economics simulation or a government policy, these new people do not exist in isolation or as mere statistics. You can't just push a button or wind up a knob or make a campaign promise, now you have to make it happen.

New investors are probably people you know, in your world. If you're a VC, new people are other VCs you chat to at the bar. If you're an angel, it's all the others in the angel meetup.

As you're now aligned to growing the bubble, *you want your friends in* !

And that's the crux. Having invested in a bubble, you now want people to pump up your investment. Which leads to two paths in your life:

Path one is the believer. You decide that there is no bubble, and therefore no bursting, or you consider it isn't relevant or will pass or it's a momentary hiccup or somesuch. You can comfortably turn your entire philosophy over to Bitcoinmania, and this is the future. You are a believer, and no analysis to the contrary is necessary or applicable.

Path two is the opportunist. You agree there is a bubble, and it will burst, but you are gambling that you can get out before it bursts.

Either way, in the meantime, the fundamental is true:

you have to recruit all your friends, relatives, partners, contacts, school buddies, pastor, teachers, mentors, ... EVERYONE!

This choice is a disastrous one for integrity. Every person you are selling into the market is a new victim to the eventual bubble burst. You're choice is dire. Dispose of all analytical skills and simply believe, in which case you'll never spot the top because you cannot believe and not believe at the same time;

OR, know that the top is coming, watch it ferociously, plan its every snap up and your flip out, but have to sell everyone else around you on a lie.

Sounds a bit drastic? Over the top?

Well, yes. It is drastic. But here's the clanger: the history of pyramid schemes, bubbles and ponzis predicts exactly that. We've been here before, hundreds of times. It doesn't matter where bubbles come from, when they get going, the herd phenomena is frightening. Friends trick each other, families consume themselves, businesses get sucked in, investment blows out.

And generally, what we find when we investigate the complaints is that everyone knew it was a bubble. Everyone believed. Everyone knew it was the opportunity of a life time. And everyone turned on their friends and families and pulled them into it.

This might be the sort of risk appetite that you like. If so, holding on to the currency as an investment is for you. If for example, you are a VC and you see 9 other VCs thinking seriously about going in, then there's an easy call for you -- in you go, quicker than them, and out you go if you can spot the top. You might see this as the bread and butter of your work.

And the scare reasons above might actually be just ranting or philosophising and can be ignored. Let's give it one more go.

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There is one final reason why investing in the currency might actually be a bad bet. It is this: by investing in the currency, you are actually de-investing in the global Bitcoin community. Unlike buying the stock market index, by taking currency and hoarding it, it is no longer available to circulate and to provide new capital to the new business. As new capital is the only fundamental way, sans bubble, of making future investment returns, such a choice, buying the bubble, is reducing the float in the economy, and therefore reducing the overall growth, and the aggregate returns. Buy holding the currency, you are ensuring the bubble pops earlier rather than later.

Which is to say, your apparent prisoners' dilemma result of cheating not only rides on the backs of others' work, it also makes it harder to develop the market in the long run with /fundamental returns/. Only new value circulating as capital in the market can make it grow. It is a mathematical certainty that if you take money out of the market by hoarding it, you are reducing its ability to grow, and this is repeatedly demonstrated every time the central bank winds the knob to strip the cash out of the currency in order to cool it down.

Indeed, this force is so dramatic that when you as investor announce your intention to hold currency, positive investors should leave the room. They should ostracize you, they should shout at you, they should do all but shoot you! How dare you call yourself an investor when you are de-investing in Bitcoin? While everyone else is working hard to make the market work, you're dragging it down by withdrawing capital?

You are a negative investor.

You're actually doing more damage to the returns of the Bitcoin world than any government can.

I personally think that the investment in the currency is the worst of all options. In short sweet summary, it's lowering overall returns, it's not diversified at all, and it creates incentives to turn off the one thing I thought I valued above all else -- my brain. Indeed it is the sort of approach where you might have to hide your strategy because serious Bitcoiners -- those who've understood the potential of cryptocurrencies without losing sight of the reality of business investment -- are going to blackball you. And if I've learnt one thing in two decades in the financial cryptography game, it is this: In the money game, dirty hidden secrets have a way of biting you, hard.

If this all makes sense, then I'd suggest you look at the opportunity in investing directly in Bitcoin businesses, and not the currency. More on that in another post, labelled B for Business.

Posted by iang at April 22, 2014 06:53 PM | TrackBack