Bitcoin, blockchain and bubbles

By Mike van der Westhuizen and Nishlen Govender Time of article published Sep 24, 2017

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Bitcoin's appeal is that it operates independently of any central bank. As such, it is seen as heralding a new age of global payments. Bitcoin comprises just under half of the $100-billion cryptocurrency universe. 

Blockchain, the technology behind Bitcoin, is, in our view, a far more powerful platform than Bitcoin itself. A specialist in financial technology said on question-and-answer website Quora: “Blockchain technology creates a decentralised digital public record of transactions that is secure, anonymous, tamper-proof and unchangeable. Instead of a bank or other intermediary maintaining a private database of records, blockchain technology makes all records public.” 

But how should Bitcoin be valued? If we assume that Bitcoin is a currency, we would try to ascertain its long-term fair value by using various models: relative purchasing power parity, inflation differentials or interest rate differentials. But these values are impossible to ascertain for Bitcoin, because a central bank is not involved, and a defined domicile and any associated economic fundamentals are absent. 

If we treat Bitcoin as a basic security, there are no fundamentals to assess it, so we are unable to reach an appropriate valuation.

If we cannot estimate value using traditional criteria, we can still assess a tradeable asset based on its supply and demand. Bitcoin participants can be broken down into two broad categories: those who use Bitcoin for trading and speculators. We know from anecdotal evidence that Bitcoin is not widely used as legal tender.

Additionally,  it is extremely volatile and an unlikely means of long-term wealth preservation.

If the only way we can value Bitcoin is based on supply and demand, and if those who use Bitcoin as legal tender comprise just a small part of its demand, a large portion of the demand for Bitcoin is speculative.

With no viable way to determine the price at which Bitcoin, or any cryptocurrency, should be trading, based on usual valuation criteria, if demand were to slump, it could result in spectacular losses similar to those seen during previous bubbles (which is true even in Bitcoin’s relatively short history).

We believe the hype surrounding, and the price appreciation of, some cryptocurrencies belies any of the underlying traits that we would look for in a sound investment, and instead feeds on optimism about the future of cryptocurrencies.

We cannot say whether or not these currencies are expensive, but we believe that, without this knowledge, it is impossible for us to invest in an asset class that seems to trade purely on momentum and sentiment.  

In addition, there are headwinds that could prevent Bitcoin from being rapidly and widely accepted. These include:

• Bitcoin’s transaction processing is relatively slow, handling up to seven transactions a second, whereas service providers such as Visa and Mastercard can handle thousands a second;

• Without acceptance by regulatory authorities, involvement in cryptocurrencies by large institutional players and governments will remain limited;

• It is unlikely that Bitcoin will replace money in the near to medium term, because governments have far too much to lose from this; and

• Bitcoin’s high volatility negates the definition of a currency as a store of value.

Mike van der Westhuizen is a portfolio manager and Nishlen Govender is an investment analyst at Citadel.

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