This article first appeared in The Edge Malaysia Weekly on December 25, 2017 - December 31, 2017
IS bitcoin, like tulips, the most obvious bubble ever? Or is it a precursor of a dramatic shift from sovereign fiat currencies to digital ones? How long before the bubble bursts? Will bitcoin have any value or a role after the bust?
If you want to understand the cryptocurrency mania, look no further than South Korea, the world’s most wired nation and home to the speediest internet. Koreans, true to their reputation of being early tech adopters, have taken to digital currencies like fish to water. The world’s largest bitcoin exchanges are located in Seoul and more than 1.2 million Koreans have registered accounts with a cryptocurrency exchange. The average Korean makes several cryptocurrency exchange transactions a week. Over the past two weeks, Koreans accounted for nearly a third of all bitcoin trades globally. Add in Japan, and you get close to 65% of all bitcoin trades, or up to 75% on a good day.
Koreans blame it all on the lhneun geos-idulyeowo syndrome, the equivalent of “kiasu” in Hokkien or FOMO, fear of missing out. With Japan deeming bitcoin as legal tender in April, 2017 will probably be remembered as bitcoin’s and, indeed, cryptocurrencies’ coming-out party. The digital currency’s value surpassed US$20,000 (RM81,680) on Dec 17. Bitcoin is up more than 20-fold this year alone in a parabolic hockey stick-style surge, and the momentum behind it shows no sign of abating. The total combined market value of cryptocurrencies is now more than US$600 billion, or 0.75% of the global GDP.
Two weeks ago, Cboe, the world’s largest options exchange, began trading bitcoin futures, the biggest of the 1,300 cryptocurrencies. On Dec 17, its crosstown rival Chicago Mercantile Exchange went live with crypto futures. The Nasdaq is expected to launch its own bitcoin-related products by the middle of next year. Trading on major exchanges is likely to help bitcoin gain further momentum, thereby increasing its appeal.
Coinbase, a free app that lets people buy and sell cryptocurrencies, is one of the most downloaded in Apple’s App Store, ahead of even Snapchat and Tinder. In the US, the media has been highlighting stories about people using their home-equity line of credit, or essentially increasing the loan value of their mortgage, to buy bitcoin on margin. Customers at brokerages such as Charles Schwab have increased margin borrowing against their equity portfolios to bet on the rise and rise of bitcoin. With the benchmark Standard & Poor’s 500 index up 19% and Nasdaq Composite up 29% this year, investors believe they can take a bit more risk and punt on digital currencies such as bitcoin.
Is the cryptocurrency surge the opening act of a new economic disruption or is it a fad? Sceptics say bitcoin lacks intrinsic economic value because it is not backed by public or private guarantees or collateral. As the bubble has burgeoned, the voices of naysayers have only grown louder. Jamie Dimon, the blunt-talking CEO of JPMorgan Chase, describes bitcoin as a “fraud” and said recently that people “stupid enough to buy it” will pay a price for their stupidity. Berkshire Hathaway CEO Warren Buffett has coined cryptocurrencies a “mirage”. Jack Bogle, founder of The Vanguard Group and pioneer of index investing, says retail investors should “avoid bitcoin like the plague”. Yet, the US Securities and Exchange Commission (SEC) is now looking at several new applications for exchange-traded funds based on crypto assets, though it has twice rejected applications for ETFs created by twins Cameron and Tyler Winklevoss, among the co-founders of Facebook.
Bitcoin emerged in late 2008 in the aftermath of the global financial crisis as an experiment in monetary theory, enabling users to move a digital-only currency between holders on a decentralised, peer-to-peer network. Someone, or a group of people, using the nom de plume Satoshi Nakamoto published a paper through an obscure internet mailing list detailing a design for the world’s first blockchain: a public database distributed and synchronised every few minutes across thousands of computers, accessible to anyone and yet hackable by no one. Its raison d’être was to provide a decentralised, bulletproof record of exchange for a new digital currency dubbed bitcoin.
All about trust
International Monetary Fund chief Christine Lagarde, who was France’s Finance Minister during the crisis, is one of the few top officials who have spoken out in favour of cryptocurrencies such as bitcoin, saying they “might just give existing currencies and monetary policy a run for their money”.
Because of her background, Lagarde “understands that bitcoin is the antidote to the human errors that took place in the global monetary policy that triggered the crisis”, Catherine Wood, chief investment officer (CIO) of tech-focused asset management group ARK Investment Management in New York, which invests in bitcoin, tells The Edge Singapore. “What happened in 2009 was that people lost trust in the old system. Bitcoin is really about building a new system based on trust. For the first time, there is a system built on global trust, where two parties can transact without worrying about things like monetary authorities or, in some countries, hyperinflation.”
Bitcoin users “trust the math and technology” rather than humans, says Jessica Lessin, who runs tech blog The Information. “When we use a dollar or a euro, we decide that we trust the US or the EU,” she notes. “When you buy bitcoin, you are choosing to trust the community of people who maintain the software and system that keeps track of the transactions or the ledger.”
Is bitcoin a currency, an asset or a commodity? The South Korean central bank has classified it as a commodity. The US SEC treats initial coin offerings — the crowdfunding model used to fund many cryptocurrency-related start-ups — as securities or assets. Bitcoin is best described as a currency, says Aswath Damodaran, a professor and valuation expert at New York University’s Stern School of Business. “A currency is a medium of exchange or a store of value,” he argues. “A commodity is an input into a process that has a utilitarian function. Oil and coal derive their value from the fact that they can be used to produce energy.” The commodity definition does not fit bitcoin, he says.
The way Damodaran sees it, bitcoin is still in the early stages of its evolution. He believes that, in the continuing debate on bitcoin, the focus needs to be on the needs that it is filling and its long-term staying power. “We also need to separate the arguments about blockchains and smart contracts from arguments about cryptocurrencies, since you can have one without the other.” Moreover, he argues, there is a need to differentiate between cryptocurrencies, rather than defend or condemn them as a bundle, because they “are different from each other, not only in structure but also in terms of the endgame”.
One reason behind the rise and rise of bitcoin is its scarcity value. Only 21 million bitcoins will ever be in existence. To “find” them, you have to mine, using a sophisticated computer with a powerful graphic chip and a lot of electricity to solve math problems that unlock bitcoins as a reward. So far, only 16 million of 21 million bitcoins have been put into circulation — of those, 4.5 million have been “lost” by people who have since thrown away computers or hard drives or forgotten the passwords to retrieve them. It will be another 27 years before the remaining five million are mined.
Regulating cryptocurrencies
If cryptocurrencies become more money-like, what will it mean for the sovereign role of central banks in managing the money supply, setting interest rates and controlling inflation or deflation? Rob Subbaraman, Asia economist at Nomura, argues that the underlying blockchain technology will eventually drive significant productivity gains in the financial sector and a host of other industries. “It could also speed up the timing of countries moving to fully fledged official digital payments systems which, arguably, could increase the efficacy of monetary policy, including removing the current lower bound limit of slightly negative interest rates, if there is no longer hard cash to substitute,” he tells The Edge Singapore.
Can governments regulate the cryptocurrency and blockchain ecosystem without stifling innovation? So far, global regulators have been focused on how to regulate bitcoin and other digital assets under existing rules. “Regulation almost always lags innovation but, in places like Korea and Japan, where bitcoin trading is being driven by retail investors, regulators need to catch up to protect retail investors,” says Daniele Bianchi, assistant professor of finance at Warwick Business School. “We are seeing huge price gains that make regulators nervous around the world,” Richard Levin, chair of fintech and regulation practice at Polsinelli, a prominent Washington, DC law firm, tells The Edge Singapore. As digital currencies become more mainstream, the concern is that less sophisticated investors may be harmed.
Traditionally, in the aftermath of financial crises, governments have helped bail out financial institutions, citing consequences of systemic failures if they did not step in. In the case of bitcoin, because it is the retail investors that are most exposed, the concern is that governments are looking the other way as the bubble gets bigger and are unlikely to bail out investors the way they bailed out the likes of Citigroup and Royal Bank of Scotland, whose shareholders and bondholders either just took a haircut or saw their interests diluted but were not wiped out. “In moments of financial crisis, governments have stepped in and acted to stabilise the economy,” says Levin. “At times, that involves purchasing securities, but the purpose is mainly to stabilise the situation and prevent a financial catastrophe.” He does not believe that retail investors are the only ones behind the appreciation of bitcoin. “There are a lot of institutions, investment firms, funds that have been investing in bitcoin,” he notes. “That we have bitcoin futures being traded tells me that institutions are in the game.”
So, just how high could bitcoin go? The current consensus is that the bubble has room to run. Prominent Wall Street strategist Thomas Lee of Fundstrat Global thinks bitcoin can hit US$55,000 by 2030. Venture capitalist Chamath Palihapitiya, a former Facebook executive and a scion of Sri Lankan Canadians, CEO of Social Capital Hedosophia Holdings, who bought bitcoin at an average cost of US$100, plonking down US$5 million on it, believes bitcoin will be “$100,000 in three to four years and, in the next 20 years, $1 million a coin”.
But talking about how much bitcoin has appreciated, or just how much more upside it might have, misses the big picture, argues The Information’s Lessin. “Cryptocurrencies are technology products and networks that should be evaluated just like any other software or service, she says. “Each cryptocurrency is built on different concepts around how it is created and distributed. Picking one currency over another involves understanding those rules and contingencies in the same way that a venture capitalist might bet on Facebook or Snap.”
Like gold, bitcoin is gradually becoming a store of value with digital glitter. Bulls say governments — having seen the benefits of cryptocurrencies, including their strong security, and ability to trace transactions and prevent money laundering and fraud — will ultimately gravitate towards some form of digital currency rather than rely on the outdated system of current currencies, which has its own set of challenges. Japan, Russia, Venezuela and China are looking at their own blockchain-backed digital currencies. “The transformation from traditional currencies to digital ones is a process that is already underway,” says Polsinelli’s Levin, a veteran corporate lawyer.
Yet, governments worldwide are more likely to create their own cryptocurrencies rather than adopt existing ones. If “FedCoin” in the US or Japan’s “NipponCoin” is the way to go, why would bitcoin have any value? “I don’t believe that bitcoin will go to zero after a crash,” says Levin. “It might correct sharply, but there will still be some value left.” Wood argues that, even with a 50% correction, bitcoin will be in a secular bull market. “Bitcoin is the first really global currency.” That’s part of the reason it exists, she argues.
Levin believes we will see a world in which there are cryptocurrencies such as bitcoin, digital currencies issued by central banks, some traditional currencies as well as credit cards and digital payment systems such as Apple Pay and Alipay. “Digital currencies will just be a new system of storing wealth, transferring wealth and conducting commerce,” he says.
Still, resistance to cryptocurrencies remains strong. “It’s natural to have scepticism as we move towards a new world order,” says ARK Investment’s Wood. “Governments don’t like bitcoin because they risk losing their gatekeeping roles,” notes Lessin. “Bankers and traders resist because a world in which money is run by software threatens their whole purpose.” The big idea behind cryptocurrencies, says Lessin, is that “software can improve finance”.
Throwing baby out with bathwater
Although bitcoin, or the underlying blockchain, has never ever been hacked, reports that hackers had stolen US$70 million worth of bitcoins from digital wallets have been twisted to fan rumours that bitcoin is insecure and vulnerable to hacking. Indeed, digital currencies are more secure than most existing financial services, including legacy banking platforms such as SWIFT, which has repeatedly been compromised by hackers. The hacking of digital wallets where bitcoins are stored is often the result of carelessness on the part of the owners, or incompetency or dishonesty of the companies they used to store their coins. “The hacks have been on some of the badly written software applications that sit on top of the bitcoin blockchain,” says Wood, who argues that the ecosystem is actually becoming more secure over time.
Citing the hacking of digital wallets to ban bitcoin is like throwing the baby out with the bathwater, says Levin. If someone steals your wallet, you would not blame the currency issuer or the central bank. So, why blame bitcoin’s security for a wallet’s hacking? “Most of the security issues with digital currencies are rooted in people’s using less technology as part of their security built-in than they should have,” Levin says.
Cryptocurrency detractors have used the media to perpetuate the lie that, because bitcoin is anonymous, it might somehow lead to more financial crimes or that bitcoin is used mostly by criminals to avoid detection. Bitcoin uses an identifier. You can adopt any pseudonym but, eventually, the blockchain will trace the transaction to you. When Ross Ulbricht, operator of criminal drug syndicate Silk Road, was arrested four years ago, the US Federal Bureau of Investigation was able to associate him with a device that had stored bitcoins because he had left a digital trace. When corrupt FBI agents later misappropriated some of the bitcoins in that Silk Road haul, the FBI tracked down those agents and recovered the stolen cryptocurrency because the transactions left a digital trail.
“Blockchain actually creates an audit trail that is extremely powerful, for the purposes of surveillance and for facilitating money laundering compliance,” says Levin. “When you open a bank account, the bank has your name and assigns you an account number or a pseudonym equivalent. You can’t transfer money anonymously because your account number is your identifier.” To say that bitcoin facilitates criminal activity or blockchain is used mostly by criminals would be as preposterous as saying bank account numbers allow criminals to hide within the banking system.
Nailing fugitives like Jho Low
Indeed, it will be easier to identify corrupt officials or money launderers such as Jho Low, the main culprit identified by the US Department of Justice in the 1MDB case. Clearly, his complex money trail will leave identifiable digital prints all over the place. “Authorities can track suspicious activity such as money laundering much more easily when a digital currency is being used than they can in a cash-based system,” Wood says. She recalls meeting a senior FBI agent at a conference on cryptocurrencies last year, who told her that bitcoin’s emergence was one of the best things that have happened to law enforcement agencies because they can now nail down cases through a clear trail.
Wood notes that, 20 years ago, IDD calls were expensive; now, voice calls are almost free because we have Voice over Internet Protocol. “Blockchain enables money over IP,” she says. “There are so many middlemen, so many points of friction in financial services that it is ripe for disruption.” With a fee structure of 7% or 8%, the $600 billion remittance market might be the first to see an explosion of transactions as the costs drop towards 1%, she says. “Money transmission is just digits over the internet. So, why should someone charge 8% for remittances?” Even forcing Filipina maids or Bangladeshi workers to pay 1% for remittance is too much. She adds, “Bitcoin blockchain is making it free, and that’s why banks don’t like it.”
Says Levin: “If we are looking to bring banking to the unbanked, smartphones, blockchain and digital currencies have tremendous potential.”
What’s next? Wood believes bitcoin will eventually fork into two kinds of cryptos: one a store of value, which is what it is now, and the other a medium of exchange. Aside from major cryptocurrencies such as ether and Ripple, most of the smaller, 1,200 cryptos are likely to meet the fate of the short-lived pets.com. “I would say more than half of the smaller cryptos will die,” says Wood.
Bubble’s pop
Bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria. Bitcoin bulls say it is in the optimism stage or a notch below euphoric levels. Few have lived through a bubble burst as severe as that endured by Seattle-based legendary tech fund manager Paul Meeks, who ran a technology-focused portfolio of US$8 billion for Merrill Lynch in the lead-up to the dotcom crash in 2000. “A 20-fold increase in 2017 in bitcoin is egregious,” Meek, now CIO at Sloy, Dahl & Holst in Portland, Oregon, tells The Edge Singapore. “It is clearly a bubble.” Still, he argues, digital currencies are inevitable. “It makes no sense to have a paper currency in the internet era.”
The bubble’s ending, whenever it comes, is likely to be ugly. “It will end in tears,” Vanguard’s Bogle said in a recent TV interview. “There is nothing to support bitcoin except the hope that you will sell it to someone for more than you paid for it. Bonds have an interest coupon, stocks have earnings and dividends, real estate has rents, gold has nothing, bitcoin has nothing.”
Even the bursting of the bitcoin bubble may have a silver lining. “Most of the benefits of cryptocurrencies will play out of the back-end of the financial system,” says Lessin.You might still transact with your credit card or use Alipay or Apple Pay on your smartphone, but everything that happens once you swipe your card or tap your phone will be different. Whether the bitcoin price falls 50% or 90%, the underlying technology behind cryptocurrencies will help change the financial system for the better. And from the rubble of the burst, a handful of winners might emerge. In the aftermath of the dotcom bubble, Amazon.com stock plunged from more than US$90 to under US$10 as what was then merely an online bookseller struggled to stay afloat. Today, Amazon stock is up 119-fold at US$1,190. For much of its life as a listed company, Amazon has defied critics, short sellers and naysayers and sold at stratospheric valuations. Whether Amazon was in a bubble during the 2000 internet boom or is, indeed, in a bubble now is moot. Investors believe it is worth what they are paying for.
Could the cryptocurrency crash be a Black Swan event that upends the Goldilocks synchronised global growth story? Deutsche Bank has cited a bitcoin burst as one of the biggest risks to global economy in 2018. Nomura’s Subbaraman begs to differ. “I don’t expect cryptocurrencies to have a significant impact on the global economy or Asian economies in 2018,” he says.
Still, Southeast Asian economies need to tread carefully as they navigate the debate around cryptocurrencies. Already left behind by the rise and rise of China, they risk losing out if they fail to nurture an ecosystem that evolves into a foundational aspect of the future global economy.
Wood remains optimistic about the long-term potential of bitcoin, though she concedes that it will experience growing pains as it evolves. As a portfolio manager, she would like to see “a good correction” after the huge run-up bitcoin has had this year. Whether it undergoes a 30% or 60% correction next year, “five years from now, there will still be a bitcoin and we will also have digital currencies issued by central banks”, she adds.
Assif Shameen is a technology writer based in North America
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