Bubble Logic

I have been reading a lot about cryptocurrencies lately. Before I go any further I must recommend two podcasts. They are:

Hash Power Part 1

Hash Power Part 2

These are impressive pieces of work. They were produced by Patrick O’Shaughnessy of the very excellent Investor’s Field Guide (you should also subscribe to Patrick’s regular podcast, Invest Like the Best). What I appreciated most about the podcasts is that they feature a number of intelligent, level-headed people trying their hardest to crack the toughest investment puzzle in recent history. These are not scumbag stock promoter types pumping and dumping ICOs. If you are interested in this kind of thing you should really check it out.

Anyway, back to the salient question(s). Are cryptocurrencies actually worth anything? If so, what are they worth?

I took a stab at this myself not too long ago. It was a useful exercise although it did not exactly end with concrete results. So despite having learned even more about blockchain and cryptocurrencies in the meantime, I remain stuck.

How am I supposed to invest in something that I cannot value?

Now, there is a pragmatic solution I have not really discussed (also mentioned by one of Patrick’s interviewees). That is, you can simply look at cryptocurrencies as call options (or, if you prefer less financial jargon, as lottery tickets). Viewed through the lens of portfolio construction this is far and away the best way of approaching the problem given the dramatic skew in the distribution of potential returns. Max downside is 100% of the original investment. And max upside is what? A 1000x gain? More? That is a pretty attractive option.

Yet it still doesn’t sit right with me. It feels too much like gambling. Which isn’t the worst thing in the world. I enjoy the occasional trip to the casino. However, conflating investing and gambling does not seem like a real answer. In fact it seems like bubble logic: gamble a little so you won’t miss out and regret it.

ICOs, Rigged Games & Frontier Justice

I want to spend a few moments ruminating on a timeless truth of finance and investing: smart money loves a rigged game.

In the aftermath of the 2008 financial crisis nothing better exemplified this than a hedge fund called Magnetar. While other investors were content to bet that toxic mortgage-backed securities and their issuers would fail, Magnetar helped structure and issue toxic securities and then bet those same securities would fail. You see the advantage? In the first instance you hope a security will go to $0. In the second instance you know it will go to $0, because you designed it that way.

Fast forward to today and Bloomberg is reporting on “hedge funds” flipping ICOs:

More than 80 percent of ICOs are doing presales, according to Lex Sokolin, global director of fintech strategy at Autonomous NEXT. For most of the 500 or so tokens launched and listed on exchanges this year, flipping “is very prevalent,” said Lucas Nuzzi, senior analyst at Digital Asset Research. “This has been a problem in this industry, and one of the reasons why there is an overwhelming amount of low-grade ICOs being launched.”

Some 148 startups have raised $2.2 billion this year, according to CoinSchedule. And sorting winners from losers is already hard, since most startups are doing ICOs armed only with a white paper outlining their idea and not much else.

That’s raised red flags with authorities trying to figure out how to protect consumers in what’s been an unregulated corner of the markets. In July, the U.S. Securities and Exchange Commission warned investors to beware of fraudulent practices and said any tokens sold as a stake in a company rather than ones tied to an application must abide by securities regulations.

“It would shock me if you don’t see pump-and-dump schemes in the initial coin offering space,” SEC Chairman Jay Clayton said Sept. 28. “This is an area where I’m concerned about what’s going to happen to retail investors.”

Here is the scam game. There is nothing dumb retail money likes to buy more than lottery ticket type assets. You saw it with tech stocks in the ’90s and you see it with ICOs now. It’s the reason unsophisticated investors trade small cap biotechs and penny marijuana stocks.

The smart money knows this. However, the smart money prefers not to play the lottery. Playing the ICO lottery would do nothing but put smart money on a level playing field with dumb retail money, which is self-defeating. Hence a great deal (but certainly not all) of the smart money has absolutely zero interest in holding any digital asset for the long term.

But what if the smart money could be the lottery? After all, it is much better to be in the business of selling lottery tickets than the business of buying them. ICO flipping gets you pretty close without actually requiring you to commit fraud.

This is The Greater Fool Trade. The fundamentals of the asset as an investment are irrelevant. You are scalping tickets and for an investor of modest sophistication that is an attractive position. You are arbitraging the greed and stupidity of others. Add 2-3x leverage and you’ve got yourself a “hedge fund.”

Frontier Justice

Before you despair of capital markets, consider that if the majority of ICOs are as fundamentally worthless as they seem, The Greater Fool Trade will eventually end in a catastrophic blowup (see also: tulips; pets.com). One day we will wake from a fitful slumber and there will simply be no one willing to bid any higher. The whole ICO complex will collapse. This is the logical end to any investment strategy that trades on the first derivative of greed. Many of the ICO flipping “hedge funds” will be destroyed in this cataclysm, precisely because they will have gotten too greedy themselves. They will stay in the trade for too long and with too much leverage.

Thinking on this symmetry I am reminded of these lines from late in the movie Unforgiven:

Will Munny: Hell of a thing, killin’ a man. You take away all he’s got and all he’s ever gonna have.

The Schofield Kid: Yeah, well, I guess he had it comin’.

Will Munny: We all got it comin’, kid.

Why Do The Chinese Love BitCoin?

This is a quick follow-on from my longer valuing BitCoin post.

The volume of BitCoin transactions originating in China is simply enormous. A New York Times article referenced in my prior post contains the following infographic (this is a little dated):

BTC_FLOWS.PNG
Source: New York Times via Chainalysis

Note the vast difference in volumes between China, the US and Europe. Why do the Chinese love BitCoin so much?

I want to link this to an older macroeconomic analysis from John Hempton. In a post from several years ago, Hempton asserted that China is a kleptocracy made possible by state-owned enterprises’ ability to fund themselves at negative real interest rates. In a follow-on post Hempton theorized that this means there should also be significant retail investor demand for gold in China.

He wrote:

In my kleptocracy post I described how the range of investments available to the median Chinese family is limited. They can’t take their money offshore (unless they are rich enough to afford casino junkets). The local stock market is rigged. There is no worthwhile mutual fund market. They can own see-through apartments. But their main saving mechanism is bank accounts and life insurance contracts (life insurance being a bank account proxy).

Rates are regulated – low. Inflation is high and ex-ante the return to Chinese savers is negative.

Despite negative real returns Chinese save in huge quantity. This may be because of the “four grandparent policy” as described in the kleptocracy post or because of gender imbalance (as described in the follow up post).

Whatever: in China we have huge quantities of savings at ex-ante negative real returns in some sense compelled by local social and political structures.

This pool of savings (part of what Ben Bernanke once described as the “excess of global savings”) has global implications – and these will be explored in a forthcoming posts.

But here I state the obvious.

If you were forced to save huge amounts of money at negative real rates of return wouldn’t gold look attractive?

And, I would add, wouldn’t BitCoins now look even more attractive than gold? If you are an average Chinese household hoarding gold, that strikes me as a tremendous undertaking. You would have to find a way to store the gold, secure the gold — on top of that it is not particularly easy to transact in gold.

BitCoin presents a convenient solution to these issues. Who cares if the Chinese government officially bans cryptocurrency exchanges? For BitCoin at least the whole point is to own an asset that is independent of conventional monetary policy (and, one might add, conventional capital controls). The storage costs strike me as much, much lower. In Cuba people circulated banned American media on flash drives. In China, hoarding BitCoins would be similarly straightforward.

Recall that when Jamie Dimon let loose with his tirade against BitCoin, he also said the following:

The only good argument I’ve ever heard … is that if you were in Venezuela or Ecuador or North Korea.. or if you were a drug dealer, a murderer, stuff like that, you are better off dealing in bitcoin than in US dollars, you are better off bypassing the system of your country even if what I just said is true. There may be a market for that but it’s a limited market.

My question: should China also be on that list?

Valuing A BitCoin

This is not a post about what BitCoin is worth today, or will be worth in the future. No part of this should be construed as a recommendation to buy, sell, or hold BitCoins. If you landed here because you are wondering whether you should buy, sell or hold BitCoins, you need to do research elsewhere or consult with a trusted financial advisor, who can render an opinion based on your unique financial circumstances.

What this post is about are three different mental models one might use or adapt in analyzing the current price of BitCoin or another digital asset with similar characteristics.

First some background. I am fortunate to be friends with some very smart people with diverse sets of interests. We enjoy nerding out over similar topics: business strategy, financial analysis, technology, markets, entrepreneurship. If we can nerd out in person over a bottle of whiskey, all the better. Unfortunately now many years out of college several of us live in different cities. So we created a Slack group where we more or less maintain a running dialogue. Several of the longest running threads in our Slack group deal with cryptocurrencies.

I am not going to spend time or energy on background information in this post. There are smarter and more knowledgeable people than me all over the internet who can bring you up to speed on cyrptocurrencies. However, you should read the original BitCoin whitepaper. Primary sources matter. It doesn’t matter if you don’t understand every last detail. I certainly don’t.

The specific problem we were confronting on Slack was which type of mental model one might apply to a cryptocurrency like BitCoin to determine whether it is overpriced or underpriced at current market rates.

For example, there is an old saw about bank stocks that goes something like this: buy them at 1x book value and sell them at 2x book value. Whether 1x or 2x is the right multiple is irrelevant for the purposes of this discussion. The point is that the mental model for a bank or finance company revolves around the book value of its equity.

So what mental models might apply to cryptocurrency? We debated three on Slack:

1.       Purchasing Power Parity (PPP)

2.       Relative Value vs. Gold

3.       Supply/Demand Balance

Purchasing Power Parity

Purchasing power parity is the classic approach to assessing whether one currency is overvalued or undervalued relative to another (the key underlying assumption here is that BitCoin should be treated as a currency). PPP asserts that similar baskets of goods and services should trade for similar prices around the world. The Economist half-jokingly created The Big Mac Index in 1986 to analyze currency valuations around the world. Today The Economist has a dedicated web page devoted to Big Mac Index data, and the data has formed the basis for many books and academic studies. Here is what the Big Mac Index looks like today:

BigMacIndex.PNG
Source: The Economist

Pros: Intuitive, straightforward, much of the data is readily available. Captures the fact that BitCoin inflation should remain subdued versus fiat currencies over time (the supply of BitCoins is fixed at around 21 million whereas there is no limit on the amount of cash a government can print).

Cons: Goods and services are not priced “natively” in BitCoin. Starbucks does not say “a Grande Mocha costs $4 or 1 BTC” (indeed if that were the case BTC at $3,500 would seem wildly overvalued). This essentially blows up the PPP approach. Although personally I believe that if cryptocurrency truly goes mainstream, we will eventually get to the point where goods and services are priced natively in BTC and the PPP approach may have more analytical utility.

Relative Value vs. Gold

This was a simple thought experiment I conducted. Would I rather have an ounce of gold or 1 BitCoin? At the time I asked this question an ounce of gold was trading for about $1,300 and 1 BTC was trading for around $3,500. The intuition here is that gold and BitCoins essentially function as stores of value, where the market simply “agrees” on the value to assign each unit.

Pros: Exceptionally straightforward. Captures the notion that both gold and BitCoins have value more or less “because we agreed they have value” (if someone can explain to me why gold is considered to be a store of value, please drop me a line in the comments. Sorry gold bugs — I must confess I have never really understood why gold is so revered as a store of value).

Cons: Differences in unit measures. My comparison above makes 1 BTC look overvalued versus one ounce gold. But if you looked at the total value of the respective markets, BTC is worth an aggregate $50 billion while gold is worth an aggregate $9 trillion or so. On that basis, gold looks wildly expensive versus BTC.

We went around in circles on this for a long time. Personally, I still feel it is a useful thought experiment, though it raises hackles with others.

Supply/Demand Balance

A commodity like oil trades where supply and demand balance. On the demand side, human civilization requires a certain number of barrels of oil per day to function. This is something that can be estimated. On the supply side, it costs an exploration and production company a certain amount of money to get the oil out of the ground. So if it costs $50 to get a barrel worth of oil out of the ground, over the long term that sets a kind of floor for oil prices. Below that level, companies will not be able to cover their costs, more and more will go bankrupt and eventually the price will correct back toward an equilibrium level. This is of course a massive simplification but it illustrates the key principles.

Likewise, the BitCoin infrastructure is underpinned by the “miners” of the coins. Miners deploy the computing power that powers the network. They are incentivized to do this through the award of BTC for verifying transactions. The interesting wrinkle is that the system adjusts dynamically so that as more computing power is deployed on the network, it becomes more difficult to mine BTC (the awards get relatively smaller). At the same time, the miners’ costs rise, primarily due to ever-increasing electricity consumption. The reverse happens as computing power leaves the network (say, if unprofitable mining operations shut down). Several years ago you could mine BitCoin economically on a commercial laptop. Now profitable BitCoin mining requires significant scale and capital investment.

BitCoin’s supply side economics are relatively straightforward to understand at a high level. The demand side is more challenging. For me the most significant impediment to modeling the demand side is that the majority of BitCoin transaction activity currently appears to be speculative trading. If the data in the linked article is to be believed, less than 1% of transactions are related to actual payment processing, with exponentially higher volumes driven by trading activity. This creates some reflexivity as relates to “network fundamentals.” More trading activity -> more transactions -> implies higher demand. However, that self-reinforcing momentum can easily unwind again on the way back down. I do not have an easy answer for how to deal with this, but I have the sense that it is of critical importance.

Conclusions (Such That They Are)

If you are a BitCoin trading enthusiast, and you are still reading this, I imagine that you are thinking something along the lines of “this idiot spent 1,000 words on that!? I am no closer to understanding whether now is a good time to buy!”

To reiterate: this is not a post about what BitCoin is worth today, or will be worth in the future. No part of this should be construed as a recommendation to buy, sell, or hold BitCoins. If you landed here because you are wondering whether you should buy, sell or hold BitCoins, you need to do research elsewhere and consult with a trusted financial advisor, who can render an opinion based on your unique financial circumstances.

All useful analysis is rooted in finding the right questions to ask. Looking at a simple bank stock, for example, the right questions are along these lines: what is a fair estimate of book value per share? Is the quality of the loan book truly reflected on the balance sheet? If not, how do I adjust those numbers to more accurately reflect reality? Usually these questions will lead you to further questions centered on the breakdown of the bank’s loan book and the quality of its underwriting standards.

Similarly, the first step toward assessing whether BitCoin is overpriced or underpriced involves identifying the right questions to ask about its fundamentals.

What do you think?