Months ago I learned about the Bitcoin, and was immediately fascinated by the flawed economics that backed it. If I was going to design a currency that was 100% certain to fail, I would have pretty much designed it just like the Bitcoin. The fatal flaw of the Bitcoin is that it is designed to be perfectly inelastic, meaning that at its completion, the supply of Bitcoins will be fixed, and no force of nature will be able to produce more Bitcoins. It is the anti-Fed currency. Where the Fed can "print money out of thin air," nothing, not even a hacker, can print more Bitcoins after a certain quantity and date is reached. Sounds great I know, but that is a certain disaster if you understand monetary policy and basic economics.
By making the Bitcoin perfectly inelastic, the designer has created the perfect bubble instrument. Perfectly inelastic items are subject to huge price swings, and ideal for creating bubbles because it is possible to corner the market when the supplies are limited. Bitcoin is even better than gold because unlike gold, you can't dig up more Bitcoins as the price of them increases. Bitcoin is like fine art. Once the artist is dead, no more art can be produced. The maximum supply is permanently fixed, and slowly dwindles over time through decay, loss, fire and other reasons.
Disclaimer: In no way do I intend my analysis of the Bitcoin ETF to be an endorsement or recommendation. I would avoid it like the plague. I do however believe that if the ETF gets SEC approval, it will almost certainly result in a bubble being created in the Bitcoin and some people will make and lose fortunes. The Bitcoin is simple a gambling instrument and should not be considered an investment. The Bitcoin ETF will be essentially a virtual game of musical chairs, where "investors" will try to ride the bubble as long as they can before it pops, hoping to be the last one to find the greater fool to sell their shares to. The Bitcoin ETF will make the gold bubble look like amateur night.
It because of these obvious flaws that I seriously doubt that it will ever get SEC approval. As I will detail in this article, the flaws in this product are simply way too obvious. Additionally, a Bitcoin is simply a computer entry, generated by a code written by an unknown programmer, and administered through a network of unregulated Bitcoin exchanges. The "E" in SEC stands for exchange. The SEC regulates exchanges, none of which trade the Bitcoin. The Bitcoin was in fact designed to be a currency that exists outside the realm of government oversight, and a large part of its appeal is that it isn't regulated. It is simply unimaginable to me that the SEC will allow an ETF that consists of a financial instrument that was designed largely in part to avoid its regulatory authority. The cruel irony of this entire story is that the Bitcoin's unregulated design is likely to be the very reason it fails, and the regulatory body that the Bitcoin was designed to avoid could have made it a success.
I can say that with such certainty because either accidentally or intentionally there are deeply flawed economics supporting the Bitcoin almost guarantee it. The Bitcoin is a product of the "End the Fed" anti-fiat pro-competing currency libertarian political philosophy and supported by the misguided monetary theory of the Austrian School of Economics. At its root is an erroneous belief that an inelastic deflationary currency is superior to the elastic slightly inflationary paper money. What is nice about this Bitcoin ETF is that I'm pretty sure it will end this debate and my use of the term "erroneous" will eventually be considered a monumental understatement. Here is why I say that.
The Bitcoin is considered a "currency." The main function of a currency is a means of exchange, or a tool to use in transactions. The Bitcoin is widely used to buy guns, porn and on something called the "Silk Road" to buy illegal drugs. You are probably thinking right now, "wow, that is just the kind of investment I've been looking for, a questionably legal currency used for illegal trade." "How did the markets ever exist without a Bitcoin ETF," you must be thinking. But wait, it only gets better.
The Bitcoin is designed to be a perfectly inelastic currency, a very bad design to begin with, but it will be catastrophic when combined with the fact that it is used to purchase illegal drugs and other items that have inelastic demands. In economics this is an Armageddon scenario, and the outcome is highly predictable.
This is the most likely lifecycle of the Bitcoin ETF.
Stage one: The people creating the Bitcoin will buy up Bitcoins in advance of forming the ETF.
Stage two: The ETF is formed, providing a new, almost unlimited supply of capital to fuel demand for the Bitcoin.
Stage three: The ETF buys up large amounts of the perfectly inelastic supply of the Bitcoin.
Stage four: The increase in buying sends the price of the inelastic Bitcoin to heights previously considered impossible.
Stage five: The surging Bitcoin hyper-bubble attracts more and more buyers, and more and more Bitcoins are taken out of circulation, sending the price even higher. The Bitcoin is cornering the Bitcoin market. The creators to the ETF are most likely using the surging demand as an opportunity to exit their positions.
Stage six: Reality sets in and the flaw of the Bitcoin becomes obvious. If the ETF is cornering the market, it is taking the Bitcoin out of circulation. If the Bitcoin is being taken out of circulation, Bitcoin users can't access them to buy their guns, drugs and porn. If the Bitcoin users can't use the Bitcoin as a currency, it ceases to have value.
Stage seven: A competing currency is introduced, most likely created by the evil mastermind that created the Bitcoin, and the value of the Bitcoin disappears as people rush to the Bitcoin 2.0 to buy their drugs, guns and porn.
Stage eight: The existing Bitcoin ETF shareholders will lose almost everything overnight. The drop is value will be monumental, both in scale and quickness. My bet is the crisis in the Bitcoin will occur over a weekend so "investors" aren't given an opportunity to even try to minimize the cost. The Bitcoin has already seen episodes where it has traded over $260 and under $100 in a single day. The volatility is almost certain to greatly increase with the introduction of the ETF.
Stage nine: The SEC steps in, discovers that they should never have approved the Bitcoin ETF, and the courts have to decide how to prosecute a Fisk and Gould market cornering case when the guilty party is an ETF and its millions of shareholders.
Speculation vs Realty:
Consider what is written above with what is really happening. It is because of this fatal flaw that I was amazed to see such wealthy and apparently intelligent and honest people showing an interest in Bitcoin. When I first read in July about the Winklevoss twins investing in the Bitcoins I thought to myself, "have they lost their freakin minds?" That however was before I understood why they were investing in the Bitcoin. The Winklevoss twins apparently either accidentally or intentionally want to be modern day Fisk and Goulds. I doubt they would ever admit that, and that may not be their intention, but the economics of this one are pretty clear, whether the Winklevoss Twins understand that or not.
It's nearly impossible to project how much money the Winklevoss twins could make from this venture. They stand to profit in two ways. First they will take an unspecified percent of every transaction as a fee for their proprietary system of storing Bitcoins. The other way they could profit is through the increase in value of the Bitcoins they already hold. Recently the Winklevoss brothers were said to own roughly 1% or $10 million worth of the virtual currency.
The Winklevoss twins already own a large number of Bitcoins, and are now creating an ETF that will use other people's money to drive the price of a Bitcoin higher. What makes the Bitcoin so ideal for this scheme is that you can literally corner the market in Bitcoins, you can literally buy up every single Bitcoin in existence. Bitcoins, once they reach their maximum supply are like Mona Lisas, Statues of David, Eiffel Towers and Hope Diamonds. They are one-of-a-kind, and once gone, they are gone, and to get one, you really have to pay up for it. The Bitcoin is the perfect tool to use when cornering a market, and if the Winklevoss Twins don't know that now, they are sure to soon find out if their ETF gets approved.
In conclusion, whether or not the Winklevoss Twins intend to corner the Bitcoin market is not known, and I in no way am making that implication, but the economics of the Bitcoin are undeniable. With a fixed supply of Bitcoins, and the unlimited buying power that an ETF can deliver, the expected result can be found in every single Economics 101 text book every published. If this Bitcoin ETF gets to market, it is almost certain to create a bubble in the Bitcoin market, and the Winklevoss Twins stand to make a fortune. The problem is, it is too obvious, and I'm sure that the SEC has some economists on staff pointing this out. I would not be surprised to see the SEC block this ETF, and if they don't I'm almost certain it will eventually be involved in an investigation of the cornering of the Bitcoin market. My original article claimed that the Bitcoin was a "possible" fraud. Now that I'm beginning to see how things are developing I'm pretty sure this was a fraud from the beginning. It simply was designed in a manner that made it the perfect instrument to manipulate. I doubt that happened by accident. What will make this an interesting case to follow is that unlike past efforts to corner the market it was easy to identify the villain. This time, the people cornering the market will be countless investors in an ETF. I doubt that will be enough to shield the instigators from prosecution, but it will make an interesting defense and court hearing.
Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.