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Bitcoin: Irrationality dawns again

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By Harsh Raj

Its been six years since the burst of the housing bubble that the financial world has had a taste of another “IRRATIONAL EXUBERANCE”. Well there might be one around the corner. The stage is set and the new superstar (or villain I honestly don’t know) is BITCOIN , a cryptocurrency. It’s the hottest trading so called asset in the market or may be the new financial weapon of mass destruction who knows! Before we delve into the intricacies lets understands how bitcoin works.

A bitcoin is actually an e-currency generated by exchanging it with real currencies. Every bitcoin user is provided with a bitcion wallet (an app) on their phone or or PC which has a unique private key. Transactions occur through cryptographically secured block chains and to make sure all transactions in the block chain take place in chronological order and none of them take place twice. Now this is hell lot of technical stuff, digging deep further into its technical intricacies might force you to take aspirin. So lets not get into that.

Bitcion  became popular (for good reasons) because they don’t have to go through any legal security procedures of banks and institutions which result in excessively low transaction charges. Till now everything sounds alright so where’s the crack? Lets have a look!

Actually if we take common sense into account the whole bitcoin structure looks fundamentally flawed. The only fundamental it brags about is its “LIMITED EDITION” nature. As only 21 million bitcions can be produced (12 million already into existence), it resembles gold in asset class. Now if you read Jeremy Seigel’s “Stocks For The Long Run” you will discover that gold itself doesn’t qualify well into the asset class. This is the first overlooked flaw though a smaller one.

The real stark problem is the institutional back up. The real currencies used are backed by government and financial institutions and their valuations and their valuation depends on certain macroeconomic factors like GDP, inflation, interest rates, unemployment etc. Now the fun part is that the the valuation of bitcoin depends only on trust. Its official website says “All that is required of money to hold value is trust and adoption. This sounds fancy but way off of reality.

In a few months the value of bitcoin has rocketed from a few dollars to $1200 and the total market capitalization is around $13 billion and the punch line is that it has no earning power. Let’s analyse things with a layman’s example. Suppose you go to an ice cream parlour and ask for an ice cream. The owner of the parlour issues you a token in lieu of Rs 100, the only twist is that you win a jackpot exotic flavor ice cream which can be bought by only a special token and  fortunately you get it. You go to the sales boy for the ice cream but suddenly someone else comes to you and offers Rs 120 for the token  and as its the only one in existence so you crack a deal and make a profit of 20%. The news of the new flavor spreads and now everyone wants that ice cream. The same case happens with the other person and he too makes a handsome profit. Suddenly people realize that trading the token is making them money so they forget about the ice cream and keep trading the token and during the course the price rises to Rs 1000. Now here’s the catch, the PRICE rises not the VALUE. During all this madness the value of token is only Rs 100 but who cares till they make some bucks. Remember price is what you pay and value is what you get. This price value disconnect is another  crack in the bitcoin wall.

Now, the biggest problem. Despite of all its discrepancies, bitcoin is slowly entering into the payment and transaction sector and many companies especially the e-commerce sector are accepting is as a currency whose real value might sink to zero. This will prove to be devastating for the business and economy. As the transactions don’t reveal the identity of the people behind it, it’s like a Christmas party for the black market. It’s very convenient for drug market deals and money laundering as well and who knows what help it can bring for terrorists.

All this merrymaking looks somewhat like the internet stock bubble when every company with .com linked to it was worth diamonds but ultimately perished to graphite. History does repeat itself but not in the same form and governments have learned lessons. Due to its highly speculative and volatile nature most of the governments have warned people against the risks involved in using bitcoins. Certain countries including China have banned companies to use it as a currency. Well its another matter that the biggest bitcion exchange unit is in China.  China, I think is the synonym for paradox, so can’t help it. Many renowned money manages and business people have also shown their concerns and worries. Allen Greenspan ex fed chairman has called it a bubble. Charlie Munger Vice president of Berkshire & Hathaway has called it “RAT POISON”. As far as the greatest money manager of this era Mr. Buffett is concerned he simply doesn’t understand it. Often rationality and logic fall apart in the face of greed. This is simple human psychology and  something that explains the “follow the herd nature”. It seems to be one of those cases.

Long time ago the US was revolutionized with the great governance notion, “To the people, For the people, By the people” which eventually went on to redefine world politics. I think bitcoin is playing around that idea but it still has a long way go. On a positive note bitcoin can have an impact similar to that of credit cards, one of the greatest inventions of the financial world (even they created a lot of mayhem). The wise, I guess should wait patiently and let the storm settle and then cash on the opportunities if any.

In  the end I’ll  wrap it up by a popular quote penned down by the investment wizard Benjamin Graham decades ago,

” In the short term the financial market is a voting machine but in the long term its a weighting machine”.

Right now the popularity of bitcoin is fetching it popular votes but the real question is, will it be able to bear the weight of the fundamentals when it’ll actually matter? Doesn’t look like that though!

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