The Investment Case for Bitcoin

February 1, 2014

2014 promises to be an interesting year. Legacy financial markets are off to a rocky start, with emerging markets tumbling as the Fed dials back Quantitative Easing.

Meanwhile, the cryptocurrency economy continues to expand, its value stable and seemingly unaffected by the external turmoil.

This report examines these two trends in greater detail, presenting an opportunity suggested by their intersection and projecting the likely outcome of their continuation.

Bitcoin Price is Driven by Network Growth

Google searches for “bitcoin” as a measure of popular interest (expressed as % from peak)
Mount Gox price on a log chart (searches and price are imperfectly synced in time).

As seen above, price spikes generate intense public curiosity. A likely cause is increased traditional and social media coverage of Bitcoin’s profitability around these times. The notable point is that public interest forms a higher plateau after each dip. This is encouraging given that Bitcoin’s success must ultimately be measured by its adoption rate – interest being the necessary first step to usage.

For more on the relation between network growth and Bitcoin price, BitcoinTalk member “gbianchi” has put forward an intruiging (but complex) correlation between price and number of addresses.

From an investment perspective, remember this growth in price and awareness (certainly there is feedback between the two) has taken place within the context of a rising stock market. The question of how Bitcoin will behave through a downturn in the wider market may soon be answered… Since 2008, the year before Bitcoin’s public release, equities have been driven primarily by the provision of cheap money by central banks:

Legacy Markets are Driven by (Decreasing) Central Bank Stimulus

The S&P 500 index is highly correlated to the Fed’s total asset holdings.

The Fed’s recent decision to withdraw another $10 billion in monthly liquidity injection, despite the adverse reaction by equities and emerging markets, suggests commitment to further tightening. This 5 year liquidity-driven rally now seems overdue for at least a minor correction.

High levels of global economic angst, unprecedented in our lifetimes, suggest that even minor downside will inflict disproportionate damage on the system. An old stock market maxim has it that “as goes January, so goes the rest of the year,” and this has been the worst January since 2009. The trouble stems primarily from the sudden withdrawal of billions of Dollars worth of freshly-printed fiat from the emerging market (EM).

Emerging Markets and Fiat Currency Weakness

Long recipients of freshly-printed fiat borrowed in core economies at close to zero rates, EM currencies, debt and equities were boosted by investment flows as their relatively high interest rates guaranteed profit. They now face the unwinding of this trade. They are not happy.

Investors are taking profit, converting their investments back to Dollars and Euros. This spurs rapid of depreciation of EM currencies, nullifying the remaining opportunities to be had from emerging market investments.

What Austrian economists say about inevitable monetary over-supply by central banks leading to wasteful mal-investment which creates asset bubbles that burst to the benefit of insiders and detriment of society? The Fed’s actions have made this view more globally relevant than ever before.

Opportunity: Bitcoin Removes Fiat Currency Risk from Emerging Market Investment

EM nations tend to feature plentiful resources and low-cost labour. Weakness in their currencies only makes their resources and labour cheaper to foreigners. The current situation therefore presents an opportunity to invest via cryptocurrency into cryptocurrency-accepting exporters in EM economies. The challenge for such investors is finding trustworthy, experienced partners within these regions, whose products are desired by the Bitcoin community.

To use an example from my own Bitcoin business: in 2013 every 1 USD bought 10 ZAR worth of leather. This year, $1 buys R11 worth and before the end of the 2014, probably R12 – R13 worth. As critical imports like food and fuel rise rise in Rand terms, there will be an lagging knock-on effect. In the months ahead, all local prices, including leather and labour, will become more expensive and I’ll have to raise my prices. In the meantime, my goods are more competitive in the overseas market.

However, should I wish to expand my business to exploit this competitive advantage by building a tannery, the necessary credit is drying up. The local central bank is raising rates to offset currency depreciation so my cost to borrow from a bank is rising fast. Or, should I want to borrow fiat from foreigners, they’re less willing to lend given the “unwind” scenario explained above – I would have to earn a lot more Rands to repay them in (for example) USD.

I’m not currently proposing my small business as an investment opportunity. But something like a Turkish tobacco farm could work beautifully. Bitcoin investment could be converted to Liras at a favourable premium via the Turkish chapter of LocalBitcoins, those fiats then used to purchase land and equipment and hire labourers. Cigarettes could then below for Bitcoin below the current world average price and investors paid back in cryptocurrency.

An international, frictionless currency like Bitcoin allows such business even in an otherwise unfavourable environment. No middlemen are required either, meaning the tobacco farmer and his investors need not dilute their profits. Further, such stories of Bitcoin investors supporting businesses in emerging markets (while “carry traders” drop them like hot potatoes) may attract favourable publicity. The major risk to such an enterprise, Bitcoin’s volatility, is increasingly manageable through the emergence of sophisticated crypto-financial services.

Failing Banks and Falling Markets may Boost Bitcoin

While I’m not making any specific predictions for the future shape of the world, markets are signalling that risk is rising. Core economies may well be dragged down by any significant chaos in emerging markets. There are discernible echoes of the Asian Contagion, which brought markets low in the late ‘90s. And central banks have far less monetary ammunition remaining to ameliorate future shocks.

As banks in the developed world are currently paying pitiful interest on deposits, and as their fractional reserve nature ensures losses beyond what any central bank or FDIC-style insurance could make good in the event of a bank run, why would any rational person “invest” their money in a Western bank? And if emerging market banks are out, where is there to go?

Traditional hedges against economic and political uncertainty are making a comeback: collectable art is setting new highs as the rich invest in tasteful paint splodges. Prime real estate is also in fierce demand. And while the paper gold price may be suppressed, Asian economies are accumulating the metal into a horde that’d impress Smaug.

In this environment, particularly given Europe’s bail-in template and Obama’s ongoing attempts to centrally-plan the US economy, I believe Bitcoin has a role to play. Like gold, Bitcoin’s value benefits from sovereign debt defaults and currency devaluations. Unlike art, it’s divisible and suitable for trade outside of snob circles. And unlike property, Bitcoin is eminently transportable; virtually impervious to exchange controls in the event of national implosion.

My prediction is that, if Bitcoin continues to hold its value or even appreciate as fiat investments flounder, it may receive significant media attention as a safe haven investment. This may well fuel the next major Bitcoin spike, which previous cycles suggest will occur around May of this year. Previous percentage rises suggest my 2014 price target of $3000 may well be overly conservative.

Mt. Gox Bitcoin logarithmic price chart showing historic cycles.

But what are the risks inherent in Bitcoin? Certainly there are known drawbacks, but in my view recent events demonstrate some are over-stated:

1) Charlie Shrem and Volatility

In bizarro world, a board member of a major financial institution, HSBC perhaps, gets arrested for laundering cartel money and the bank’s share price crashes. In the real world, guys like Charlie Shrem get arrested for indirect support to mom ‘n’ pot stores and… Bitcoin sells off a bit then claws it all back the next day.

Bitcoin’s international, decentralised nature makes it resilient to all but the most catastrophic events. It is independent of individuals and institutions. Even if the lead developers were taken out, others would rise in their place. While broken fiat-financial entities rely on increasingly at-risk governments to stave off their collapse, Bitcoin is too viral to fail. Its price will fluctuate as the market establishes fair value but, unlike the legacy system, its underlying structure is resilient.

The following chart, courtesy of Coinometrics, reveals that even price volatility is moderating.

BitVIX, Coinometric’s Bitcoin Volatility Index.


As a trader, I can attest that the Bitcoin market has been mostly sideways and dull for the last fornight or so. But putting on my long-term investor hat, I’m happy to be exposed to further volatility as I expect it to be mostly to the upside and result in further network expansion – perhaps reaching the tipping point at which cryptocurrency begins to replace fiat.

2) China and Bitcoin Security

Although they channel and doubtless monitor inflows, the Chinese state does not seem fundamentally opposed to Bitcoin. Citizens are permitted to purchase it. This is a bigger deal than people realise.

We live in times of seldom-declared cyberwar. China now reciprocally spurns American hardware and software for fear of compromise. Recent earnings reports from Cisco and IBM confirm slashed sales worldwide, but particularly in China. In such an environment, given the paranoia of militaristic superpowers, I consider it certain that Chinese scientists have pored over the Bitcoin code. If the NSA owned the encryption as some sceptical critics claim, would the Chinese Communist Party have given Bitcoin the green light?

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Last modified (UTC): February 1, 2014 22:35

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