The Fate Of Bitcoin And Gold

by: Dzhafer Medzhakhed


Two alternate valuation approaches show bitcoin should be 50% lower.

Bitcoin has several issues that will make it difficult to reach another 10x increase to 100k$, as it happened so many times before.

The current Bitcoin rally will impact negatively gold prices.

I have been an investor in bitcoin and other crypto currencies since 2013, and like many other cautious investors I exited bitcoin way too early and surely missed this amazing rally. This rally has had many people puzzled, trying to understand what is bitcoin and assess its real value. Bitcoin has breached $10000 (currently $11k) per coin and a market cap above $100B. One could think that the rise in price of Bitcoin is the result of an increased popularity. However, by looking at two metrics, we can see signs that most probably bitcoin is overpriced. First, when we look at Google trends, we see that the search interest for bitcoin has increased only 2 to 4 times as compared to the November 2013 peak (when it broke $1000), and not by more than 10x times as the price increase suggests. So by this method, we could assess a more accurate price for bitcoin should be in between $2000 and $5000. The only caveat to this method is that a big part of the demand for bitcoin comes from Asia and therefore we are not seeing in this picture all of the Asian searches (searches in Baidu and others).

The second approach is to look at the number of unique transactions per day. As we can see, the number of transactions per day has also grown but not 10 times more as the price did. At the peak in November 2013, there were 70k-90k transactions per day, while at the current peak we are reaching about 400k (typically less) transactions per day. Here again, a more accurate ratio is between 3-6 times, which would suggest a price between $3000-$6000.

By these two means, we can suspect that current bitcoin is overheated and a 50% correction, would be technically justified. However, the current view of many bitcoin bulls is that bitcoin price should go to "infinity", that is to say, that we should get at least another increase by 10x-50x from here to reach several trillion dollars in market cap value ($100k to $500k per bitcoin). I do not believe that this will occur and I have tried to summarize the main issues I see currently with bitcoin below:

  1. Bitcoin has nothing proprietary and a huge counter-party risk

The open source nature of bitcoin that is mandatory to fulfill its core value of transparency has a significant drawback: anybody can create their bitcoin if they want. I do not mean here mine bitcoin and receive it as reward, I mean here create a copy of the code behind bitcoin, create a small network of mining, and basically launch an alternative bitcoin. Yes, you can "copy paste" Bitcoin. And many people have: there have been hundreds of alternative cryptocurrencies created over the years based on the source code of bitcoin. Some of them have included serious and in-depth rethinking and improvement to the Bitcoin protocol. Usually, the main argument of Bitcoin bulls against this fact is to say that Bitcoin is backed by the huge hash-power of the miners, that's what differentiates it from its copycats. But since all major mining companies can switch overnight to mining another cryptocurrency (provided it uses SHA-256), this issue remains very serious. In addition, the algorithm of Bitcoin makes it that the combined miners that hold 50% or more of the hashing power "control bitcoin" and they can decide at any moment to change its code and algorithm. for instance, they could change the limitation to 21M bitcoin (see all the forks). This makes Bitcoin extremely risky for its investors and requires a daily monitoring of such an investment.

2. Governments are catching up

In my view, the future is not bitcoin everywhere, the future is blockchain everywhere. The technology behind cryptocurrencies is basically like an update to currencies or currency 2.0. A currency in the internet age has to have money supply transparency, operating algorithms, smart contracts and personal electronic offline ownership. In addition, financial markets based on such a currency must be tradable 24/7. This is the new standard that cryptocurrencies are setting and this is now challenging the current main currencies and their underlying financial systems. All of the current central banks rely on fiat currencies and operate the money supply as they wish. But the $10000 bitcoin is telling us that a new era in central banking is required: the supply of money should be auditable by the people and governments should not have the freedom to extend deficits by means of money printing as freely as they do currently. Moreover, more advanced functionalities should be available with currencies: money must become "programmable" (functionality that Ethereum, among others, offers in the cryptocurrency world). But slowly governments are already catching up: for instance, there are some indications that Russia will be issuing a crypto-ruble in the near future. We have no doubt that other countries are looking into it. Jamie Dimon in an interview at the India Investor Summit 2017 said this:

Countries form their currency, they like to control the currency so right now, I say these cryptocurrency is kind of novelty; people think they are kind of neat but the bigger they get, the more government is going to close them down and they also use a lot for illicit purposes. So you are seeing China going after them so that is why I have said that. You can like it or not like it, my own view is that eventually, the government is going to close it down; they like to control their currency like who has it, where it goes, why it goes when it goes, they like to see it and the cryptocurrency is the opposite. So again I prefer digital, you might have to have cryptodollar, I would prefer that than a cryptocurrency.

Governments understand that Bitcoin is a way to evade taxes and a great tool for black market activity. The latest spike in the price of Bitcoin is certainly attracting the attention of regulators and signaling to governments that the risk is real and increasing. One can expect that soon the "empire will strike back". Apart from a crypto-dollar or crypto-ruble, we can also easily imagine that governments will start forbidding mining (as counterfeit money) and make it illegal to acquire it or transact in it. Will they let the price of Bitcoin reach $100k before they do? In our view, this is coming much faster.

3. Bitcoin is extremely inefficient

Bitcoin is extremely inefficient at what it does. Current estimates show that every bitcoin transaction costs ~200kWh, while a Visa transaction requires several orders of magnitude less per transaction. You may say that that is the price of independence, but we can easily imagine that crypto-dollars could achieve a much better efficiency. I am deeply convinced that blockchain technology can be implemented with a much lower energy cost for its maintenance.

4. Transaction costs

extremely low cost of transactions has always been an advantage of bitcoin, but now the average cost of transacting in bitcoin is starting to skyrocket. This despite the fact that miners are mostly earning from the appreciation of bitcoin. The current situation does not seem sustainable.

5. Thievery built-in

cryptocurrencies are like the Wild West. Evil can be rewarded. For every company and for the individual, there are high thievery risks all-around of owning bitcoin. For a company, having a bitcoin wallet puts you at risk, since any employee, if he gets access to this wallet, can steal the money, and you will never prove that he did it since it could easily be that hackers did it. So you need people with strong ethics to handle transactions in bitcoin and you will be testing their ethics every day. For individuals, having any cryptocurrency in a company (broker, online wallet, etc) is a huge risk, because such companies will always be tempted to earn by stealing (much more profitable) than by working. Episodes such as MtGox are an example of this. Having a cryptocurrency in a wallet on your computer is also an issue since your computer can get hacked. And this is an issue for both companies and individuals. So either you need to be an expert in IT security or you will be sleeping with this risk in mind. For companies, it means hiring IT security specialists or consultants, which not every company can afford. The last option is to put your bitcoins offline. This is a workable option but it means that, if you forget your password or lost the physical drive, you just lost all your money. It also means that you are not using your bitcoins.

6. Bitcoin has no army and no intelligence

Any state exists only because it has an army or it is protected by the army of another state. Where is the army of bitcoin? Bitcoin is competing against the governments of the world. If the governments of the world start seeing bitcoin as an enemy, they can start not only forbidding it, but more importantly they can assign resources (probably unofficially of course) to attack it, to sabotage its operations (for instance attack the miners), to discredit its leaders, to build propaganda campaigns against it. And in this, all governments would be united, so they could unite resources for such a task.

7. SHA-256 could break

Bitcoin is based on the cryptography protocol SHA-256. Keys of 256 bits in length mean that you would need to make 10 power 76 (1e+77) permutations to find the key to a bitcoin wallet/transaction. This is a huge number of permutations, however, the higher the valuation of Bitcoin, the higher the incentive to try to brute force it, and there are many supercomputers out there, especially at the hands of governments (see p.6). There is a project called the "large bitcoin collider" at aims exactly at this.

On a side note, bitcoin and some of the alternative cryptocurrencies contain a financial innovation that has not been much highlighted: the idea of "infinite deflation". The reason why all current currency systems are inflationary is related to the technical difficulties of scaling down precious metal coins (or any other means of exchange) and to the fact that additional money supply generation occurred through conquest and mining. When paper money was established, the idea that money must be inflationary was already deeply embedded in the minds and it is very difficult to imagine paper notes that would start in the quadrillion units and then go down in time. Crypto-currencies have no limits in dividing units and this allows for a fully deflationary economy, where lending could occur at zero interest or even negative interest.

From a trading point of view, we like being short of Bitcoin and long Ethereum, but this is a very speculative position and must be allocated very small in a portfolio.

In our view, the current huge rally in bitcoin has a serious side effect on gold that has not been reflected in the price of gold. Basically, bitcoin has taken the shine out of gold. Gold function as a hedge against the financial system and a store of value remains, but we believe that a big part of the investment demand targeting these functions is moving away from gold towards bitcoin, especially on the side of retail. Bitcoin has replaced gold as the favorite instrument to hedge against governments, and this is not at all priced currently in our humble opinion. We are convinced that part of the portfolio allocations into bitcoin will be done to the detriment of gold and silver allocations. On top of that, the growth of the U.S. economy, the rise in interest rates and the decrease in the balance sheet of the fed, are all very negative factors for gold. The only thing holding gold at current levels is the fear of a war between the U.S. and North Korea. Therefore, we expect sudden sharp moves to the downside in gold and silver. We believe that gold will be going back to test the area around $1000 per ounce (Silver the area around $10 per ounce) in the near future (Q1'18) as shown on the charts. We will be looking to buy gold and silver once they reach these levels, for a short rebound and possibly a bottom of the cycle. We believe that gold and silver allocation in a portfolio must be reduced.

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.

Additional disclosure: I am currently long physical gold and silver though reducing my positions and short bitcoin and long ethereum
This article is in no way a recommendation to buy or sell any of the financial instruments mentioned. I am not responsible for any trading decisions or investments you make based on this article. Trade at your own risk.