Omar´s Outlook - Nov 2017

The Cryptocurrency Revolution

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When spam & scam messages like the one above recently started appearing in my e-mail spam box, it has become quite obvious that the previously obscure area of cryptocurrencies has well and truly hit the mainstream.

Unfortunately, while without a doubt being an amazing innovation, the sector (if it can be called that) is at least for the time being a scammer’s dream, because hardly anyone understands it to an extent sufficient to be able to make informed decisions, and because the growth in value of its initial representative, bitcoin, has made pretty much every other type of investment look very ordinary indeed – as the chart below illustrates.

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Yes, your eyes are not hallucinating: Bitcoin (or BTC, as it's abbreviated), has gone from 5 US cents in July 2010 to $5,734 (US) as of yesterday.

Many a multi-millionaire has been made amongst the original IT “geeks” and other early adopters. It is amusing now to read stories about one of the very first purchases made using bitcoin in 2010, when a pizza was bought for BTC 10,000.

That same amount of bitcoins would now be worth more than 74 million Australian dollars! I suspect the pizza buyer has since wished to instead keep the bitcoin and go hungry on that one occasion!

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So what is this phenomenal invention that has rocketed from total obscurity to being one of the hottest topics in finance?

The idea of a decentralised, peer-to-peer, “trustless” digital payment system originates with a person (or persons) whose identity is not known to this day.

In 2008, using a pseudonym Satoshi Nakamoto, he/she/they posted the original reference implementation for such a system on an internet forum frequented by cryptography enthusiasts. Shortly thereafter, Nakamoto released Version 0.1 of bitcoin software on the open source program repository Sourceforge and continued being involved with the project in a key role until 2010, when he disappeared.

Bitcoin itself is truly revolutionary, because it is the first functional implementation of a fully digital payment system, which does not rely on “trusted middlemen” (i.e. the banks). Instead, transactions take place between individual users directly, are verified by computer network nodes and recorded in a public distributed ledger called a blockchain.

New BTC units are created by computers maintaining and verifying the network; the so-called miners. The miners also add new bitcoin “blocks” when a specific mathematical problem is successfully solved.

I will not go into the details of exactly how bitcoin mining works; it is quite technical and, after all, there are plenty of sources on the internet for anyone who's interested to find out more. However it is worth mentioning that due to the design of the underlying algorithm, mining becomes more difficult as time goes on and the maximum number of bitcoins ever mined is capped at 21 million; although the units themselves are divisible all the way down to one hundred millionth of a single bitcoin – known as the “satoshi”.

Because of those features, bitcoin has at times been compared to gold. Unlike “normal” money, no government can print it at will and its final supply has a hard limit. Like a gold-backed currency, it will therefore be deflationary over time – meaning its purchasing power will increase, rather than dwindle, as happens with the existing inflationary government fiat currencies, and its value over time will be determined strictly by market forces, not by central banks or government bureaucracies.

The cost of computer hardware and electricity used in mining also auto-regulates the speed with which new units are added, thus preventing rapid inflation from being able to occur at any one time.

This has expressed itself already, in shifting mining activities to specialised “server farms”, rather than by amateur home users as used to be possible in the early days.

Also, countries like Iceland are now the hotspots for mining, thanks to their very cheap electricity – on that front, Australia is well and truly out of the race! You won’t get to mine too many bitcoins if you have to wait for the wind to blow at the right speed first…!

Growing “brand recognition” of bitcoin has seen an increasing number of merchants accept it as payment. Here in Australia, we now have several bitcoin ATMs, and it is even possible to purchase physical gold with it (or vice-versa) through Ainslie Bullion in Brisbane.

Just recently, the government of Vanuatu has become the first in the world to offer foreign nationals the option to purchase that country’s citizenship using bitcoin.

The “crypto-revolution” has not been limited to bitcoin alone. A number of other cryptocurrencies, sometimes collectively known as “alt-coins” have since been developed, many of them with more even advanced features than the original.

Most of these will likely fail over time, and it is quite possible yet that so will bitcoin itself. As an investment idea, it is therefore incredibly speculative and certainly not for the faint-hearted.

Regardless of whether or not bitcoin itself will survive, the blockchain technology is undoubtedly here to stay, and numerous major financial institutions as well as governments are developing their own versions of it.

Despite the massive returns bitcoin and some other cryptocurrencies have generated for early adopters, in my opinion by far the most “disruptive” aspect of this sector is the potential to offer some protection from ever-growing, confiscatory governments.

To give a pertinent example, the evolving economic crisis in Venezuela has seen the use of bitcoin and its younger “sibling” litecoin literally explode. It is easy to see why – in this year alone, the inflation rate of the “bolivar”, the country’s official currency, has approached 700%:

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Similarly, while visiting Argentina in January this year, inflation was reported to be in excess of 65%. Bitcoins, and of course, like everywhere in Latin America, US dollars, were also readily accepted by numerous businesses.

Not too many people realise that, as Milton Friedmann famously said, inflation is a purely monetary phenomenon. In other words, adding too many monetary units (dollars, pesos, whatever) to an economy will eventually lead to an increase in prices; although precisely where this increase will occur cannot be predicted with any certainty.

The mad “printing” of the global central banks which occurred over the last decade has so far mainly found an outlet in massively overvalued asset markets (shares, bonds, property), but eventually it is likely to spill over to consumer goods as well. As an example, the Australian broad money supply (M3) has over the last 10 years almost tripled:

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One of the main features of “money” is to be a store of value. If you bake a loaf of bread, sell it for five dollars and then save those, the savings represent the ingredients, the effort and the time you have put into making the bread. If you live in Venezuela and the saving will only be good to buy a half loaf after a few weeks, you will not be very pleased – and perhaps save in BTC instead!

By abrogating the monopoly to money creation, and by severing the link to gold so as to be able to create unlimited supply of it, governments everywhere are now in the position best compared to that of a counterfeiter.

The politicians can promise things that they know the country can’t afford, but they will pay for it by deficit spending (issuing bonds) and then having the central bank “print” currency out of thin air (“Quantitative Easing”) to buy those bonds.

This is a form of hidden tax, because over time it steals from the users of the government currency some of their buying power – the same way a counterfeiter gets to purchase real goods and services without having to produce anything of value in return.

As if that were not enough, many of the developing countries’ governments, including Australia’s, have in recent years made increasingly loud noises about banning cash. The pretext, as always, it to “combat the black economy” and “cash is only used by criminals”.

This would deprive ordinary people of their very last line of defence – no way to take money out of the bank if the government decides to impose negative interest rates or outright confiscate deposits to bail out the banking system (like recent events in Cyprus have demonstrated).

Furthermore, the government would then know about absolutely everything about us: What we buy, what we eat, whether we drink or smoke, whether we eat healthy food or not and so on. It could then tax and regulate / socially engineer at a level the Communist central planners could have only dreamed of!

A dystopia even George Orwell could not envisage.

Bitcoin and other cryptocurrencies, as well as the nascent decentralised, peer-to-peer trading platforms like OpenBazaar, are the defence mechanism of what little remains to us of the free market.

It is no accident that after similar – and mostly failed – attempts to ban bitcoin in China, communist Vietnam is the most recent government that has announced its intention to do the same.

I am quite certain that the only thing that precludes the likes of our government from going down the same path is the fact they have not yet been able to work out how exactly such a ban could work!

I can only conclude this monthly commentary by saying “...watch this space – it has barely got started yet!”