Thursday, April 22, 2021

Peak Bitcoin?

Have we reached peak bitcoin?

Yes--I think we have, at least for this year.

I feel very strange saying that, seeing as I've been an enthusiastic bitcoin bull for many years. But now I'm bearish and have recently sold half my hoard. The reasons are various--some concern our current circumstances, but others reflect a changed understanding I have about the whole crypto phenomenon.

There is the old market saw: Buy the rumor. Sell the news. The idea is that the market goes up as rumors swirl, but by the time they actually become true the trend is already priced in. Then it's time to sell--or at least stop buying.

For months two big rumors have been making the rounds. First, big institutions have started buying bitcoin--most famously Tesla purchased $1.5 billion worth. Other companies are following suit, and many of the big money-center banks are jumping aboard. Options and other derivatives now widely available, and it's just a matter of time before an exchange-traded fund (ETF) is offered.

In other words, institutional involvement in bitcoin is no longer a rumor--it's a fact.

The second rumor--now news--was the prospective IPO of Coinbase. Coinbase is the largest crypto exchange in the United States--it's the place to go if you want to buy or sell bitcoin. Its going public represents a coming of age--the crypto debutante has arrived at the ball. And come of age it did--Coinbase is now traded on the NASDAQ and has a market cap of about $62 billion. Unlike many new public offerings, it's a profitable company.

The Coinbase reality has not quite lived up to the hype. Bitcoin rose to nearly $65,000 per coin leading up to the IPO--afterwards it fell to about $51K (now back up to $54K). Coinbase is priced in--the news will no longer move the market by much.

So the two big rumors that have been driving the bitcoin market for the past six months or so are now priced in. What's taking their place? Nothing that I can see. Yes, there are stories about progress in the DeFi space, or in Lightning applications. Have you heard of those? No? I didn't think so. They're just rumors of rumors--vaporware, if you will--without enough substance to push up the price.

That could change--and eventually I think it will. But for now there are few reasons to think bitcoin will go up.

A second reason I'm now bearish is precisely because of the aforementioned institutions. Institutional investors--banks, pension funds, insurance companies, hedge funds--behave differently from retail investors like you and me. We retail folks make one-directional bets--we buy the coin because we think the price is going up. If it goes down, we're pissed.

Institutions don't always do that--they make two-directional bets so that they can profit whether bitcoin goes up or down. They lose money when the price doesn't move much at all. How they do this is complicated--and since I'm not an institution I don't follow all the details--but it's got a lot to do with options and short-selling. The point is, they're not betting on bitcoin, instead they're betting on the volatility of bitcoin.

So bitcoin is wonderful for volatility investors--it goes up ten-fold one day, and crashes 80% the next--and institutions make money both on the way up, and then again on the way down. It's good work if you don't mind sitting in front of a computer screen 24/7. What they're really doing is arbitraging volatility--or oversimplifying it another way, they buy low and sell high.

The result is that bitcoin's low prices get higher, and the high prices get lower--the institutions squeeze the volatility out of the system. Thus bitcoin is now unlikely to crash by 80%--aren't you happy? But the other side of the bitcoin is also true--it's unlikely to go up by 1000%, or maybe not even 50%. In other words, bitcoin just becomes another boring investment, kind of like gold. OK, maybe not yet that boring, but it's getting there.

So I think reality has squashed the upside, and institutions have limited the downside. It's not gonna go up because nothing is driving the market, and it's not going down because institutions are buying on the dips. So there's little left for the one-directional, retail investor like me, and what is left is mostly on the down side. I think bitcoin is in a trading range, perhaps between $40K and $60K, and absent some big new rumor it will stay there until at least the New Year.

I finally came out as a bear after hearing a talk by Raoul Pal (paywalled) entitled The Exponential Age: Crypto's Fast and Furious Rise. As the title suggests, it's a breathless argument for the continued steep rise in cryptocurrencies, including bitcoin. We're all gonna become billionaires if we just hodl long enough! I thought it was way over the top, and it convinced me that the coin had topped out.

There is one argument for bitcoin that until a few weeks ago I subscribed to, but now I think it's wrong. The claim goes that bitcoin will eventually replace the dollar as the world's reserve currency. At first glance that seems reasonable, but on closer examination it completely falls apart.

Bitcoin will never become the world's reserve currency. Indeed, the very term is a misnomer.

There are two parts to this reserve currency business, and it's important to keep them straight. The first is the currency in which world trade is denominated--currently it is the US dollar, or more precisely, US dollars deposited in foreign banks known as eurodollars. If the only constraint on global trade was denominating it in the proper currency, then yes, bitcoin could solve all our problems. So could gold, or euros, or even toothpicks. The choice of currency is at some level arbitrary.

But that's not the essential feature of a reserve currency. A reserve currency has to finance global trade, not just denominate it. To oversimplify, some countries run trade surpluses while others run trade deficits. The surplus countries have to lend money to the deficit countries. In part this is just an accounting principle--the balance of payments has to balance.

Suppose Thailand ran a surplus in it's trade with Paraguay. Then for that bilateral trade to continue Thailand would have to invest in Paraguayan government bonds--along with all the other countries with which it ran a surplus. This is completely impractical. What happens instead is that Paraguay borrows money from a bank, while Thailand lends (deposits) money to that same bank--and the bank makes sure that all the numbers worldwide add up to a zero net balance of payments.

So what do you want in a bank? It has to be solvent--nobody wants to invest in a bankrupt bank. It has to be honest--that is the bank can't trade too much on its own account. And it has to be secure--no bank robber is gonna get away with the cash.

So who is the bank for today's global trade? It's the United States of America. We're definitely solvent--don't let anybody ever tell you otherwise. We're completely self-sufficient in food and fuel. Indeed, we have most of the natural resources we need. We have lots of people--the third largest in the world. Our population is younger than any other developed country.

We're (relatively) honest. For the most part we don't play favorites among nations, and when we do (e.g., impose sanctions) it's to widespread international complaint. We're honest in major part because international trade is a small percentage of our GDP--again, the smallest of any large nation. We're so self-sufficient we don't need to cheat.

And we're certainly secure--we have by a big margin the world's most powerful military. And our geography is a huge advantage--neither of our neighbors is a geopolitical rival. Nobody is capable of invading us. We have no territorial disputes with anybody.

Bitcoin is a computer program. The USA is a country. It's an apples & oranges comparison--and it should be obvious that bitcoin can't finance global trade any more than little green pieces of paper could do so by themselves without the full faith and credit of the USA. A so-called reserve currency isn't really a currency at all--it's really a very big bank. Only the USA is big enough to fit the bill.

I think crypto technology will dramatically change finance and property transactions, and so it will make things cheaper and better for everybody. Bitcoin is an indirect investment in that change, and as such it will gain value. That's why I'm still long-term bullish. But the rhetoric has gotten way out of hand, and expectations need to come down a few notches.

So I've sold half my stake--and I'm keeping the other half in case I'm wrong, and also for whatever long-term gains still remain. Though I think the big gains from crypto are probably behind us.

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