Bitcoin Smells Like a Tulip


Tulips are a beautiful flower with a rich history.  They were introduced to Europe in the mid-1500’s from the Ottoman Empire.  They gained popularity in what became the Netherlands in the late 1500’s and became a status symbol due to their unique colors.  After a virus caused petals to incorporate multiple colors, they became even more desirable and their growing cycle helped keep supply growth low.

In response to scarcity, bulb buyers hoarded inventory ahead of the growing season.  This led to further upward price pressure.  In 1634, speculators entered the market and florists (tulip traders) began to sign contracts to buy tulips at the end of the growing season.  By 1635, a sale of 40 bulbs for 100,000 florins (also known as Dutch guilders) was recorded.  By comparison, a skilled laborer might earn 150-350 florins a year.

As word spread rapidly and rising tulip prices escalated, the Dutch established a stock exchange that made the bulbs easier to trade for everyone.  People were trading their lifetime possessions for the bulbs expecting that someone else, likely unenlightened foreigners, would be there to further drive up prices.

The good times ended abruptly in February 1637 when buyers didn’t show up for a routine bulb auction and prices plummeted.  Some were left holding contracts with prices more than ten times higher than the open market.  Many lost their life savings and the Dutch economy stagnated, partly from reduced tulip trade.

Bitcoin is a digital currency created in 2009.  It follows the ideas set out in a white paper by the mysterious Satoshi Nakamoto, whose identity has yet to be verified.  It was founded on the belief that “fiat” currencies, issued by government central banks, like the dollar or euro, are subject to manipulation and therefore are dubious stores of value.  It was also believed Bitcoin would be superior as a medium of exchange because the processing power of the decentralized Cloud would lead to very low transaction costs.

Bitcoin is a type of “cryptocurrency” as balances are kept using public and private “keys” based on a mathematical encryption algorithm used to create them.  The public key serves as the address published to the world where bitcoins can be sent, analogous to a bank account.  The private key is meant to be a guarded secret and is used to authorize Bitcoin transactions, like the PIN for an ATM card.

The system relies on motivation to earn bitcoins by processing transactions as part of a “block.”  Blocks are files where data pertaining to the Bitcoin network and its transactions are recorded.  Block files are maintained in multiple locations across the Cloud and once completed are permanent and cannot be altered.  To earn bitcoins a computer works on a difficult mathematical problem with the motivation to complete the block which triggers earning bitcoin.  Once the block is completed a new one is created, and the work of recording transactions continues.  This process is called “mining.”

Bitcoin has a self-imposed limit of 21 million coins.  Initially, mining was easy as anyone with a simple personal computer could do it.  To illustrate, one of the first notable transactions was a 10,000 payment for two Papa John’s pizzas (that’s $180 million at recent bitcoin prices)!  Over time, the payment in bitcoin for completing blocks has decreased while the computing power and energy needed to solve the increasingly difficult mathematical problems is suitable for only the most advanced computers.  According to the website blockchain.info, about 16.7 million bitcoins have been issued.  It is estimated that after the year 2020, the rate of growth of new bitcoin will decline to less than 2% per year and sometime around 2140, the last new bitcoin will be mined.

Bitcoin is not meeting its objective as a medium of exchange because the currency is simply too volatile.  After periods where the currency enjoyed rapid appreciation, it has experienced bear markets, dropping 93% in 2010-11 and 84% in 2013-15.  Since 2012, the price of bitcoin has moved an average of 3% a day, and more than 10% on 5% of those days.  In that period, gold moved an average 0.7% a day and the dollar 0.3% against a basket of currencies.  This level of volatility makes bitcoin a poor medium of exchange because the financial system wants the value of money to stay roughly the same over time.  To illustrate, imagine you borrowed 30 bitcoins from a family member at the end of 2016 when, according to coindesk.com, one bitcoin was trading at $968.23 (a $29,000 obligation).  With bitcoin now trading in the $16,000-$17,000 range, you would owe about $500,000!

There are also problems with processing transactions.  Recently, the popular video-game marketplace Steam stopped taking bitcoin not only due to price volatility, but elevated fees that are now close to $20 per transaction.  Further, the time to process a transaction has increased to minutes.  Today, there are about 337,000 Bitcoin transactions a day per blockchain.info.  While this sounds impressive, it is peanuts compared to the 468 million per day processed by Visa in the third quarter of 2017.

There is a better argument for Bitcoin as a store of value, akin to gold.  However, gold has built its reputation over thousands of years while most people have never even heard of Bitcoin.  Further, Bitcoin will have to fend off new competition as money is pouring into the creation of new cryptocurrencies.  Initial coin offerings, a cross between a traditional initial public offering and crowdfunding where new digital currency is offered for dollars, has surged past the $4 billion mark after recording just $225 million in 2016, according to data provider Autonomous Research.  Given the highly competitive nature of technology, will Bitcoin be able to sustain its #1 position, or will it become an also-ran like myspace.com in social media?

There are parallels between the tulip bulb bubble and Bitcoin.  The very nature of Bitcoin’s limited supply is attracting people who are hoarding the currency like the bulb buyers.  Last year, China made up the bulk of trading in Bitcoin before its government clamped down.  However, according to research firm CryptoCompare, by November 2017, nearly 80% of Bitcoin trading activity was coming from Japan, South Korea, and Vietnam.  U.S. investors are now pouring in; perhaps we are now the “unenlightened foreigners?”

It is impossible to predict when the Bitcoin bubble will burst but there are many risk factors that could trigger a selloff.  Government regulation is slow to catch up to rapidly changing technology, but it would be easy for countries to ban the convertibility of Bitcoin or any digital currency into their own.  Grounds for doing so are easy, as the currency has a history of transactions with criminals and other shady characters.  Bitcoin is subject to hackers, malware, and operational glitches.  According to Wikipedia, there have been 19 thefts and exchange shutdowns since the creation of Bitcoin.  There is no insurance like the FDIC provides on your bank account and no fraud protection as the permanent nature of Bitcoin transactions is comparable to using cash.

If you gave me a choice between bitcoin and tulips, I really like the Flaming Flag Triumph tulip, available for $6.00 from Tulipworld.com.

 

Daniel J. Boyle, CFA