The Fatal Flaw In The Bitcoin Thesis And The Concept Of Purchasing Power

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About: Bitcoin Investment Trust (GBTC), COIN, Includes: BTC-USD
by: FundSpec.IO
Summary

Bitcoin hits new highs above $7000.

Investors must make a distinction between the technology and the first implementation (proof of concept) of the said technology.

The fatal flaw in the Bitcoin thesis and the concept of purchasing power.

As I write this article, I am reading a news alert from Seeking Alpha that Bitcoin for the first time traded above $7000 last week. I am not even sure if it will be able to stay at these levels by the time this article is published and to me this is just the latest indication that this mania is getting out of hand.

This recent rally is because Bitcoin speculators are getting excited about the announcement of the launch of Bitcoin futures by CME. According to Coinbase, it added a 100,000 new users within 24 hrs after this announcement! Firstly, all else equal, this indeed would be considered a very positive development because it signals the acceptance of the instrument into the broader financial system. Currently, your only options apart from holding Bitcoins in your wallet would be through a trust such as the Bitcoin Investment Trust (OTCQX:GBTC) and perhaps in the future, the proposed Bitcoin ETF (COIN). However there are some fundamental issues with Bitcoin that the speculators are ignoring or choosing to ignore. I will talk about some of these in this article.

Chart ^NYB data by YCharts

First, the technology: Blockchain != Bitcoin

Proponents of Bitcoin often talk about how the Blockchain technology has the potential to eliminate a lot of friction in financial transactions and revolutionize international commerce. I think to some extent, they are right. It certainly has the potential although a lot of the friction can be eliminated simply by adopting the latest technology for financial transactions.

I experienced some of this first hand recently when I took a trip to China. I was warned that a lot of businesses outside the big cities may not accept international credit cards and wanted to carry some Chinese Renminbi with me. I decided to go to my bank (I won't name them but they are a large National Bank in the U.S.) and asked to exchange a few thousand U.S. dollars to CNY. I was surprised that the best they could offer me was almost 10% below the spot rate! Their rate would still beat what I would get at the airport FX counters so I just decided to take it. Now while in China, I was fascinated by the large volume of bicycles on the streets from bicycle sharing companies such as Ofo and Mobike and wanted to try it out. I decided to create an Ofo account and it required me to make a deposit of 200RMB and I used my visa card to pay for it. I was surprised when it charged me just about $30 which was almost exactly the spot rate even for a low dollar transaction such as this! This is the impact technology can have and we will move to this future irrespective of how big a role Blockchain plays in it.

Another thing that surprised me on my China trip was how everyone, and I mean everyone, from a small street vendor to the largest stores in the malls accepted cashless mobile payments. You have to see it to believe it. I even had some trouble spending my Renminbi because people would look at me funny when I offered them cash! People in the U.S. may have a hard time relating to this because admittedly, cash is still used extensively at least for small transactions here in the U.S. However, consider the below chart from FT about the growth estimates for mobile payments in U.S. vs China. Cashless payments are clearly the future but the most important point here is that this revolution is happening even without the use of the Blockchain technology.

China vs US Mobile payments growth Source: FT

Now coming back to Bitcoin, it is basically just an implementation of the Blockchain technology, in some ways like a proof of concept. It is significant historically because of this fact, but in itself, it doesn't make Bitcoin valuable. Bitcoin's technology is opensource. There is nothing proprietary here that is unique to Bitcoin. If you have looked at the universe of so called "Alt-coins", you know how easily this concept can be replicated. Clearly, it is not the technology itself that gives Bitcoin any intrinsic value.

The fatal flaw in the Bitcoin thesis and the concept of purchasing power

This brings me to the main topic I want to discuss. A lot of people believe the biggest strength of Bitcoin is that no single entity, be it a Sovereign State or financial institution, can control it. Some people think of it as the "Gold for the technology age". However this idea just shows a lack of understanding of the financial system.

Firstly, I am no fan of Gold. I do not believe Gold has any practical use in today's society at anywhere close to the levels it is currently trading at. However I understand the argument the other side is making. Gold has traditionally been used a store of value and purchasing power for thousands of years. But more importantly, today's central banks have large holdings in gold as shown below. What gives Gold value today is not any intrinsic value or its history, but the fact that the largest central banks in the world today hold Gold as a store of value!

Gold Reserves by Country Source: Smaulgld

For example, lets say Apple (NASDAQ:AAPL), the largest company in the world today, decides to create its own currency - Apple coin. Apple coin is worthless in your day to day transactions but all transactions involving purchase of goods and services from Apple can only be completed in Apple coin. You can convert your local currency to Apple coins in order to make the purchase. Now, the moment Apple releases Apple coin, it will have value by default because Apple is only allowing access to its goods and services via Apple coin. It is the fact that Apple is issuing Apple coin that would give it value, not anything else. All the Fiat currencies in the world today are somewhat similar except at a much larger scale.

So what does that say about Bitcoin? Well, the first question you should ask yourself if you are thinking about purchasing Bitcoin is what your primary motivation is behind the purchase. Are you looking to buy it to protect your purchasing power in the event of an hyperinflation in the U.S. dollar or any other Fiat currency? I suspect not. You most likely want to purchase Bitcoin because you believe it will appreciate in value and you want to sell it at a higher price and convert it back to U.S. dollars at a later date. Well, if you expect the U.S. dollar (or any other Fiat currency) to still represent your primary store of purchasing power in the future, what is the reason for Bitcoin to appreciate in value relative to it?

The reality is that Bitcoin is worthless not because it doesn't have any intrinsic value, but because the entire concept of purchasing power is made up. The only reason the U.S. dollar is considered a store of value and purchasing power is because it is backed by the economic and military might of the United States of America. When people talk about how Bitcoin is not affiliated to any Sovereign State or institution, that is not its biggest strength, it is its biggest weakness. This is the fatal flaw in the Bitcoin thesis.

Most if not all the news driving positive sentiment in Bitcoin these days are indications that it may be accepted into the broader financial system. However there is absolutely no reason to believe this is possible. Recently, Bitcoin prices took a tumble after news that Chinese authorities plan to shut down domestic Bitcoin exchanges. Soon afterwards, it rallied on rumors that China would reverse its decision. Well, that is not going to happen and it is not that hard to figure out why.

All countries like to monitor capital flow across their borders. Currently, Chinese banks are required to report every transaction that exceeds 1000RMB (~$147) to the authorities. Does anyone seriously believe that they will allow a form of exchange that will allow users to engage in transactions orders of magnitude higher with no ability to regulate it?

Currently Bitcoin is small enough where large institutions and Sovereign States are not taking it too seriously but this is changing fast. For example, consider the below excerpt from a recent DEA report talking about the impact of these unregulated virtual currencies on money laundering (emphasis is mine).

Primary methods for laundering illicit proceeds have remained the same over the past several years and include: bulk cash smuggling, trade-based money laundering, money value transfer systems, and laundering through the formal banking sector. Emerging as a money laundering threat, virtual currencies, such as Bitcoin, enable TCOs to easily transfer illicit proceeds internationally.
- DEA Report

If Bitcoin continues to grow in value, this threat will only grow bigger and it won't be long before it will be shutdown everywhere. I do not see anyway this can end well for Bitcoin in its current form. Now, is it possible that you can make a lot of money if you get in and out of Bitcoin at the right time as this mania plays out before it all collapses? Sure. But if you end up holding the bag, you will only have yourself to blame.

Disclosure: I/we 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.

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