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Bitcoin - The Next Major Currency Or Just Another Ponzi Scheme?

All money is an illusion.

It's an artificial construct whose value was once tied to a guarantee that you could exchange it for some precious metal.

A Pound Sterling was once actually tradeable at the British Royal Treasury for one pound of sterling silver. That was the whole point, the government was the trusted party who would hold and protect the metal while the citizens could go about their business carrying just those little IOUs in their pocket for "trade."

Then trade became commerce and commerce became credit and some clever business man said "Well, I don't have to ACTUALLY have 1,000 pounds of silver, do I? You just have to believe I am CAPABLE of getting 1,000 pounds of silver for you and so does the person you trade all or parts of your IOU to." That led to private industry out-printing their Governments for a while but then the Governments got back in on the action by moving off metal standards and now the whole system is based on nothing but faith.

Faith in what, though? The only thing we have left to have faith in is that these IOUs are not printed out to the point of being worthless. That's why Government debt is such a concern - not the debt itself but the possibility that the Government would choose to relive itself of that debt by printing more money - thereby reducing the value of the money that remains in circulation.

This is what drives people back to metals - there is a relatively fixed supply so the metal seems more stable then currencies but what does the average gold buyer really understand about the supply? ABX has 140M ounces of proven gold reserves - they own it - it's theirs. At $1,600 per ounce that's $224Bn yet the whole company can be bought for $26.7Bn.

They may discover more gold in their existing mines or they may use their cash flow to buy more reserves so a nice bonus possibility as well.

If gold goes to $5,000 an ounce, then ABX will be sitting on $800Bn worth. Does that make sense? Every time you pay another $100 for gold, someone(s) has to give ABX another $1.4Bn. Of course ABX isn't the only miner - let's say they are 10% so figure there's another $2.2Tn of gold sitting in reserves (1.4Bn ounces) and there are estimated to be 6Bn ounces in circulation.

A pretty steady 2,500 tons of gold (80M ounces) are mined each year and, of course, more gold is discovered constantly so there's no "peak gold" but 2,500 tons doesn't put a huge dent in the 165,000 tons that have already been mined (1.5%) and that's still rare enough that there is only enough gold in the world for all 7Bn of us to have 5 gold rings each.

The reason gold is so popular is that it's relatively hard to get and impossible to counterfeit. Money attempts to replicate that model as does Bitcoin but Bitcoin PLANS to double the supply and even sells mining equipment (and now has mining viruses) which is going to flood the market with Bitcoins A LOT faster than the 1.5% increase in the supply of gold.

Do not lose sight of the fact that Bitcoin was and still is a pyramid scheme. Bitcoins are produced by getting a computer to crunch complex algorithms. Once a certain amount of work is done, you create a brand new Bitcoin. That amount of work was very quick and easy early in the piece, so early adopters were able to churn out large numbers of coins. But the algorithms (created by an anonymous team) are designed to become progressively more difficult over time, until a point some time around 2040 when the supply will be capped forever at around 21 million Bitcoins.

The anonymous team that created Bitcoins and anyone who got in early were able to churn out thousands of coins for their own accounts. Even now, they sell "mining equipment" that - IF the price of Bitcoins holds - can be a very profitable business venture, even for current entrants (with another 10M coins still to be "discovered").

Bitcoins were worth literally nothing back when the system went online in January 2009. They were trading for less than 0.10 back in September 2010, and only broke the $1 mark in February 2011. They spiked up to $27 in May 2011, then crashed down to $3.50 within a couple of months when Mt.Gox and MyBitcoin were hacked. Now, as we get to May 2013, all that is forgotten and Bitcoins are hitting $190. That's $190 x 10M existing coins or $1.9Bn of real money that will need to be exchanged for Bitcoins for the current value to hold and, in 2040, when they plan to be at 21M - then over $4Bn of real money will have to be exchanged for Bitcoin-holders to cash out.

I guess $4Bn isn't a lot of money and there's a whole lot of suckers out there. Lincoln said you CAN fool some of the people all of the time and ALL of the people some of the time and that's all any currency needs to succeed - same as any IPO - scarce supply and lots of interest can get you pretty far so I wouldn't be shorting Bitcoins until there are 4 or 5 of them out there and then it will become truly ridiculous - even if the Government doesn't shut it all down first.

Disclosure: I am long ABX, GDX. 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: Positions as indicated but subject to change (fairly bearish mix of long and short positions - see previous posts for other trade ideas). Commodity positions are very short-term and not tradeable by the time you read this.