Kerr Neilson ponders on the intriguing rise of Bitcoin, the digital currency, how it works, what its allures and shortcomings are, and what its future might hold.
This is a truly remarkable phenomenon. In the face of a meltdown in the gold price (off from $1,811 to $1,200 per ounce in 30 months), this digital currency has risen in price from $12 to over $1,000 and now back to $700 in a single year. It is a remarkably clever concept, seductively so for tech geeks.
Some may be confused by all the excitement around ‘tapering’. We have just had the outcome of the late December meeting of the Fed and a reduction of buying US government and mortgage-backed bonds is to begin in January, accompanied by the promise of a protracted period of very low short-term rates. Having watched the live coverage of Fed Chairman Bernanke’s testimony, it was clear that the Fed is troubled by low price increases in the face of enthusiastic Quantitative Easing (QE). The concern has shifted to the potential of deflation.
Having known a period of chronic inflation in the early 1970s, it is confounding to hear of the need to do everything in one’s power to ensure that there is an erosion of one’s currencies purchasing power. At that time there was over-regulation of most things which reduced competition and led to insular anti-competitive behaviour, be it labour or international trade. The subsequent extended period of deregulation and flourishing global competition, accompanied by the explosive growth of consumer credit was the very antithesis of that earlier period and led to excessive financial leverage. This is being gradually reversed now but stable or falling prices would exacerbate the consumer’s ability to reduce this burden and hence the current thinking regarding the difficult choice of punishing the frugal for the benefit of the many.
For all the media coverage, it is nevertheless true that the US economy has achieved job growth of the order of 146,000 per month since October 2009. The underlying numbers show a gross total of 7.8 million new jobs having been created, while 663,000 government-related jobs have been eliminated. Unemployment in the US is now at 7% but as an indication of the politicising of the Federal Reserve, this great achievement is seen as too little by the political elite and media. This four year recovery has witnessed annualised growth of 2.3% which contrasts with more energetic outcomes in previous cycles - but what did we expect?
The more interesting aspect of all this is that US monetary policy has, through transmission effects, forced easy monetary policy on other economies. With the prospect of rates rising in the US, the dollar could rise which will adversely affect the translation of offshore profits (and be a depressant on prices in general). The adverse effect of low inflation for corporations lies in its reduced pricing flexibility and the prospect of a reversion of profits to a lower share of the economy. At present this is at a record high level and yet the market is placing these earnings on 17 times which itself is above the long-term average of 15 times.
Why so, one asks? Liquidity is the most common explanation and we are inclined to believe that until the market becomes more unsettled about corporate pricing power, liquidity will reign supreme. Indications of this lie in the all-time record use of margin credit, the switch from cash and bonds into equities and other remarkable developments such as the explosion in the growth of trading in volatility futures. There are now Exchange Traded Funds (ETFs) on the VIXS (VIX is the Chicago Board Options Exchange Market Volatility Index) and a plethora of alternative vehicles by which to play it. The product that intrigues us most is the fantastic rise of Bitcoin and a host of its emulators - some 27 going by names like Litecoin, Peercoin and Namecoin.
This is a truly remarkable phenomenon. In the face of a meltdown in the gold price (off from $1,811 to $1,200 per ounce in 30 months), this digital currency has risen in price from $12 to over $1,000 and now back to $700 in a single year. It is a remarkably clever concept, seductively so for tech geeks. There is a limit to the number of coins that can be produced, which is 21 million, and over half are already in circulation at a value of US$7 billion. Every transaction in the history of the Bitcoin economy is recorded on a distributed public log – the innovation of the Bitcoin system - and one records/transfers one’s own holdings by virtue of public/private key encryption. The integrity of the log is enforced by the implementation of a hashing algorithm to form a mathematical puzzle that is used to both produce new coins and to verify transactions. Importantly, pending transactions that are yet to find their way onto the public log are packaged into blocks (at the discretion of the miner) and are verified/audited by means of solving a progressively more complicated calculation1 to a standard algorithm. The so-called miner who solves the problem first is rewarded with an ever decreasing amount of new coinage2 and in some instances may get a transaction fee from transactors who wish to expedite the recording of their transaction3. This open system thus breeds in an environment of frenetically competitive mathematical-problem solving which results in the reward of acquiring Bitcoins. It is this vibrant competition that is supposed to nurture the system and ensure that all transactions are verified and added to the log, ultimately proving their authenticity and disallowing the double spending of Bitcoins.
Once a block has been mined (solved), the block is broadcast to the network and added to the public record4. As the solution to the working block’s puzzle is dependent on the solution (hash) of the previous block, this systematically forms a chain of blocks that expands as usage grows, with each transaction carried in subsequent blocks. Furthermore, to modify the block chain at a point in time would incur immense (and practically infeasible) computational expense as each subsequent block will need to be re-solved5. The difficulty in modifying the public record is a central feature to the Bitcoin system and allows its participants to place trust in the digital protocol, as opposed to being in the hands of government.
To a novice this all seems a rather cumbersome way to record one’s payments when there are cheap or free traditional means of exchange. The difficulty of tracing transactions has been the principal driver in the use of Bitcoins thus far. However, for on-line commerce, the case is made that transaction fees are too high with card-based settlements, that Bitcoin ensures that there are no charge-backs to the merchant and that Bitcoin is unimpeded by government snooping. However, Bitcoin has its own short comings, the confirmation of transactions typically take 10 minutes and sometimes a lot longer; fees, though still infinitesimal, may need to grow to keep miners motivated as the number of coins reaches the termination number and the integrity of the system depends on no one having more than 50% of the current computing power on the network. More prosaic issues like the huge swings in the value of this fiat medium of exchange, the absence of income on deposits, the perceived need to protect consumers and the loss of seigniorage6 (by the State), do not seem to bother the aficionados. They have their eyes firmly set on the low cost of acquiring the ASIC-based algorithm solvers and the excitement of the chase to mine coins.
Governments are already responding with well-publicised raids of some sites that were deemed to be trading in illicit goods, while China has banned further trade in Bitcoins and the Norwegians are treating gains as taxable. One suspects that the heavy hand of State will nip this Tulip in the bud and if not, it will probably prove an interesting marker for current market excesses, complementary to the art market and high-end property.
DISCLAIMER: The above information is commentary only (i.e. our general thoughts). It is not intended to be, nor should it be construed as, investment advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances. The above material may not be reproduced, in whole or in part, without the prior written consent of Platinum Investment Management Limited.
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