JANUARY 2018

Bitcoin: A Testament to Impotence


In the first of a two-part Market Comment we discuss the rise of bitcoin and its equally virtual and mysterious London-based predecessor, the Eurodollar.

Mathematician, astronomer,  geographer in the ‘House of Wisdom’ the Persian Musa al-Khwarizm, is considered the father of Algebra, a cornerstone of a modern education. Adelard of Bath translated the works of al-Khwarizm, whose latinised name became ‘al-gorithm’, a 1,000 year old word that is now omnipresent in our digital realm. Even the National Security Agency is part of al-Kharizim’s world having designed the cryptographic secure hash algorithm - SHA-256. Why is this algorithm particularly important? Well it safeguards the integrity of communicated data and sits at the heart of blockchain, protecting and ordering all cryptocurrency transactions. But how to easily explain blockchain?

Imagine five friends eating out every week; they run an internal tab and all settle the bill at the end of the month. The chain of who owes what to whom is trusted, given they are friends. Now five strangers join the dinner every week. How can the tab continue to run? How can the (block)chain be trusted? Enter SHA-256. This algorithm verifies the chain and makes it unalterable and trustworthy. But in order to pay for this protection a crypto-token (a bitcoin) is awarded to the chain’s guardians. In the case of blockchain the guardians are computer ‘miners’ that need to solve algorithmic puzzles; the solving of these puzzles prove that the work protecting the chain has been done. There is no need to trust the strangers, just trust the NSA and their SHA-256.

A simple mining operation.
The earning of these bitcoins requires an enormous amount of computing power and hence an enormous amount of electricity. The cost of mining the bitcoin is the same as for any metals’ miner, it is the energy required to produce the commodity. As long as the value of the bitcoin is greater than the cost of energy for producing it then it is a profitable activity.

Like any miner, the key is to keep the cost of energy low. So bitcoins are mined where the cost of electricity is the cheapest. The higher the market value of the bitcoin, the harder is the algorithmic puzzle to be solved and the more electricity will be used. Hence currently bitcoins are mostly mined in China, whose electricity is produced by subsidised coal. One view can be that bitcoin represents an electricity spread between the market value of the bitcoin and the market value of the cost of energy - a simple electricity arbitrage.

A new gold?
But the promoters of bitcoin have frequently likened it to an older asset - gold. It is an interesting and helpful comparison as they do share certain attributes; they are under no central authority and they grow at a slow pace, putting a limit on a sudden quantity growth. The vital difference is that gold was used (and still can be used) as a key collateral against which other investments were issued and priced.

Today bitcoin is not a collateral and can only become a collateral if it is both an asset and a liability. Bitcoin sits very low in the hierarchy of money, below all assets that can be collateralised, below the main central bank currencies, below all commodities and below real estate.

To continue the gold analogy, the global financial architecture fundamentally changed in 1971 when gold, previously the lodestar of global money was delinked to the US Dollar by Nixon; thereafter gold ran up in value 30x in eight years. It became the nemesis of central banks, as the public viewed gold's rise as illustrating central bank failure. It ushered in an era of consumer inflation, again a testament to the impotence of central banks. Their power was reimposed only after the US Treasury became the new master of global finance and the gold price went into hibernation for decades.

The current surge of bitcoin does resemble gold in this respect, but it is asset inflation and not consumer inflation that it embodies. From the time bitcoin became tradable, if we can superimpose a gold-esque 30x rise, then its peak would be around $21,000. Subsequently, gold fell 65% and languished there for decades. Of course, in our modern super-charged financial system this could happen over 8 months rather than 8 years.

Virtual credit money
The concept that Bitcoin represents the ‘brave new world’ of virtual money is overstated, and perhaps more applicable for a retail mindset. On an institutional level a virtual money contender has existed for over 50 years and whose foundation myth is even more mysterious than Satoshi Nakamoto’s Bitcoin white paper. And it is on this five-decade-old virtual instrument that our current financial credit-driven system is built…the Eurodollar.

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