Bitcoin’s Achilles Heel

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Cryptocurrencies are all the rage with bitcoin (BTC) leading the pack. As I write, BTC blew past a 1,000% return year to date and posted its first trade above $10,000. Experts claim BTC could increase another 400% between now and the end of next year to $40,000 or more! If that doesn’t make your eyes water, remember BTC traded at a $1 in early 2011. I don’t know about you, but this is nosebleed territory.

Bitcoin will continue growing until 21,000,000 BTC exist. Actually, the programming to mine BTC stops 3 bitcents shy of the 21 million mark, which at the current growth rate could be worth a few million dollars. It will take until 2140 to complete the BTC mining process. On June 1st, 2017 there were 16,366,275 BTC in existence, if that is the right word to use. (It isn’t.) More BTC has been mined since June 1st.

This means the total value of BTC is approaching $200 billion in value. If BTC climbs 400% in the next year, as some suggest, the total value of BTC will approach $800 billion and the market cap of Apple!* When all 21 million BTC are mined, if the price is $40,000 to 1 BTC the total value of all BTC will reach $840 billion. Then it gets absurd.




The Insane Logic

If you bought BTC seven years ago (early 2011) for $1 per BTC I salute you; you are a genius. Unfortunately, schmucks buying today will never see those kinds on return in seven years or a thousand! The starry-eyed fools jumping in today looking for similar returns will need BTC to climb another 10,000 times. Okay. Let’s add all the zeros. BTC is at 10,000. Add four more zeros and you get $100,000,000 per BTC!

Well, it could happen!

Of course when you multiple $100 million by 21 million BTC you get, well, more money than currently exists by a very large margin! ($2.1 quadrillion if I calculated it right.  You have to forgive any errors. Other than my own investment account, I’m not used to playing with such large numbers.)

I can hear you already. It doesn’t have to climb another 10,000 times to turn a tidy profit. I agree. However, name anything that rose so far so fast without ending in tears?

I’ve seen this stunt several times in my short lifetime. As a child I watched the Nifty Fifty crash and burn in the 1970s. The dotcom bloodbath at the turn of the millennium should have provided lessons for today’s investors. The housing and banking collapse of 2008-9 should be fresh in everyone’s mind as it happened less than a decade ago. But memories are short when stupidity runs rampant, I guess.

This Time is Different

As with every bubble, this time is different. The tulip bulb mania of the early 17th Century (1636-7) was different. In all honesty, tulip bulbs always had value and best I can tell are still around. I can pick up a large bag at my local garden center for a few dollars. Tulip bulb prices ended up where they started. There was always value, just not the insane valuations. This is our first lesson. There is a grain (or bulb) of truth in every bubble.

The U.S stock market of the late 1920s is another example of value turning into a buying frenzy at any price.

Just because a volcano is quiet doesn’t mean it’s safe.

Tears. Remember it ended in tears.

The stock market is a favorite vehicle for bubble creation. The Nifty Fifty of the late 1960s and early 1970s were stocks people felt could be bought at any price and held forever without worry. By 1974 there was worry. The only stock I can image did well was Kimberly-Clark, the maker of Kleenex tissues.

The stock market pump was over-primed in the mid-1980s ending in the biggest percentage loss for one day in market history on a fateful October day in 1987.

But this time is different.

Once again as the millennium raced toward the finish line stocks went insane. Dotcom stocks traded for hundreds of times revenue (not profits!) if they had any revenue at all. But many stocks (companies) did have real value so this time is different.

Then came housing in 2008. Fed Chair, Ben Bernanke, said housing prices would continue climbing only at a slower pace. Good call, Ben. And he was an expert.

For some reason people never learn. They go from one hot stock to another. People get killed in a bubble collapse, take a decade to rebuild reserves and go at it again with their battle cry, “THIS TIME IS DIFFERENT!” No it’s not.




Where is the Value?

In most bubbles of the past there was underlying value. Tulip bulbs were worth something. Not much, but something. Stocks (publicly traded “businesses”) certainly have value.

Today we have several expanding bubbles due to the massive money creation of central banks around the globe. Bonds are arguably overpriced. How else can you explain bond yields less than inflation?

We can go into other possible bubbles, but BTC is turning out to be a doozy by historical standards. Boys and girls, you might live through a bubble spike bigger than any other in recorded human history on an item worth absolutely nothing!

Bitcoin’s real value?

Stocks, bonds, real estate and even tulip bulbs have some intrinsic value. But what about BTC? Does BTC really have any value? Let’s examine.

What is a bitcoin? Some call it a pyramid scheme, but it really doesn’t resemble one. Is it a currency? Economists say a currency has three characteristics: a medium of exchange, a store of value and a unit of account. BTC doesn’t exhibit any of these features to any large extent. Yes, BTC is used in a small percentage of transactions, mostly involving nefarious transfers. The massive price fluctuations make BTC more a speculative investment than a store of value or unit of account.

Think about it this way. Why would anyone buy something with BTC? To do so when BTC prices are climbing triple digits or more each year is industrial strength stupid. Only a fool would do that! Using dollars to buy stuff and pay for services because your BTC will be worth more tomorrow seems the smart move when BTC is such an awesome investment. Just read the news, they’ll tell you.

Compare BTC to dollars. Yes, dollars are fiat money, backed by nothing more than faith in the government and the economy to give you value. No physical commodity supports fiat currencies. The U.S. government can tax more to pay back its debts if necessary. And currency IS debt. It says so right on paper currency: Federal Reserve Note. A note is a loan! (Ie. you have a mortgage note.)

BTC has no government or economy supporting it. BTC is fiat money**! No physical commodity backs its value. Scarcity doesn’t imply value as many buying BTC today contend. There might be a limited supply (intentionally) of plaid shirts. That doesn’t mean plaid shirts are worth more and more every day due to this limited supply!

BTC is supported by nothing and is fiat money. When BTC collapses who will want to accept BTC as payment for goods and services? When the price rises who in their right mind would use BTC to buy something; that’s a de facto sale.

There is no government or economy supporting BTC. BTC has value because people say it has value. Just like gold has value because people say it has value. (And because it’s pretty, useful in art and industry.)

When someone decides there is nothing but air underneath BTC the rush for the door will not be pretty. Most will not get out as the building burns. If you think the rush to buy is tremendous, just wait until fear sets in.

This is BTC’s Achilles heel.




Signs of a Bubble

I don’t want to dissuade anyone from investing in BTC if that is their heart’s desire. All I urge is caution.

Here are a few indications the party may be nearing its end. Over the preceding long Thanksgiving weekend here in the States over 300,000 new accounts were opened to buy BTC. BTC jumped over 10% during the long weekend. People are buying BTC with credit cards they are so desperate to get in.

Hedge funds are starting to invest in BTC, not use it as a currency. ETFs and futures contracts are ready to debut in the BTC arena. On December 10th when futures begin trading on BTC it could actually hurt BTC pricing! With a futures market you can play BTC without actually buying BTC. With such an easy vehicle to trade BTC without owning it could be a catalyst for problems. I’m not making a prediction, only offering insight. Like program trading in the 1980s, it might take a few years before BTC has its October 19, 1987. Or it could happen much, much sooner.

Taxes on BTC

This part of the discussion is for U.S. readers and those subject to U.S. taxes.

The IRS has clarified the tax treatment of bitcoin and other cryptocurrencies in Notice 2014-21.

Real money?

Under tax law, BTC is NOT considered a currency! It is considered property. If you pay employees with BTC you still include the amount of U.S. dollar equivalent on their W-2. If a merchant accepts BTC as payment, the amount received at fair market value on the date of receipt is income. A miner of BTC includes BTC received as income and may be subject to self-employment tax.

Here is where it can get ugly. Most people are buying BTC to hold as an investment. If you buy something with BTC you may have a gain or loss on the transaction, technically a sale of BTC to buy said product or service. If you sell BTC at a gain you get either long- or short-term capital gain consideration.

If you sell BTC at a loss you can only claim the loss against other capital gains, plus $3,000 per year against other income. People buying into the hype could face serious losses and those losses may not be deductible for a very long time, if ever. You can carry unused losses forward. However, when you die, the capital loss carry forwards die with you. Ouch!

I’ve been in this business for a very long time. (The first one to leave a comment on my age gets one in the puss.) I remember the mess caused by stock options when the dotcom bubble burst. The Alternative Minimum Tax (AMT) issues were incredible. It took special action by Congress to offer relief to some of the victims. They suffered years before help arrived.

The good news is that this accountant sees no AMT issues (other than normal AMT issues) with BTC. The real issue with BTC is that losses could be strung out on tax returns for decades or longer. People who borrowed money will need to earn money, pay tax on the earned money and use the remainder to pay off debt lost trading BTC.




Coda

I am unqualified to call the future price of BTC.  I could be wrong and this time could be different. Amazon was caught in the dotcom mess and did pretty darn well if I don’t say so myself. However, BTC is not Amazon. It’s not even a currency technically.

BTC has no real value. BTCs entire value is built on faith and faith has a habit of letting people down when they need help the most. At best BTC is fiat money; at worst it’s a fool’s game.

For BTC to continue climbing in price, more buyers willing to pay a higher price, need to step forward. The day will come when nobody wants to pay a higher price. That is the day we find out if BTC is for real or another chapter in the history book of insane bubbles. With no intrinsic value I have a bad feeling where this is going to end.

 

* Remember, more BTC are created every day so the supply keeps going up. If BTC continues to rocket higher, the total value of all BTC will climb faster as more BTC are available at the higher price.

** This isn’t really true. Fiat money is technically “from decree”. In this instance I use fiat as meaning a currency without the backing of any commodity or government taxing authority.



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Keith Schroeder

32 Comments

  1. Actuaryonfire on November 29, 2017 at 6:41 am

    There is a difference between speculation and investment. As you point out,without intrinsic value BTC is speculation and not investment. Other than the inbuilt scarcity of the number of BTC there is nothing controlling the ‘price’ other than speculators. There is no real store of wealth.
    Fraud is a huge issue as well. People don’t understand how to keep their wallets safe and where there is money there will be sharks. Stay safe!

    • Keith Schroeder on November 29, 2017 at 7:31 am

      I didn’t touch on fraud, Actuary due to the already 2,000 words to this post. I didn’t touch on blockchain technology either and I wanted to. Blockchain will be a serious part of our future; BTC is less clear.

  2. shawn lee devoooght on November 29, 2017 at 6:49 am

    when/if btc falls it could be the beginning of the apocalypse.

    apocalypse= correction

  3. FullTimeFinance on November 29, 2017 at 6:57 am

    It’s certainly a speculative play especially when you consider it’s the technology underlying bitcoin that’s revolutionary not the currency itself. So the technology may be the future and the currency itself may disappear some day. Betamax anyone?

    • Keith Schroeder on November 29, 2017 at 7:32 am

      My thoughts exactly, FTF.

    • El Bruce on November 29, 2017 at 11:24 am

      How is the currency not revolutionary? You need more research.. It’s entirely revolutionary. It’s been subject to attack for 8 years, the highest level attacks imaginable, and has never been compromised to this day. It exists as a decentralized, 24/7 network to boot. It’s the best store of value ever created. Whether it becomes currency like fiat, nobody can say. What we CAN say is that it is already legal tender in Japan and accepted by 250k merchants. Sound like currency to me – its just not the same paper based USD we are used to and it doesn’t need to be. That is why it is THE change agent of our time. It is looking as if there will be many currencies, many tokenized ecosystems, and the winner will all be “more than just blockchain.” It’s going to be a wild ride, but as a new asset class, you better goddam get a % of your stack in to hedge.

      • Keith Schroeder on November 29, 2017 at 11:32 am

        El, few consider BTC currency. Blockchain technology IS revolutionary, but a new currency is nothing new. I understand the strong feelings involving BTC especially if they have skin in the game. We will have to wait to see where this all settles out, but I have a feeling we will not have long to wait before the first massive shakeout occurs. This post is to inform and caution new investors only. Sophisticated investors probably know all I’ve said here. Not all considering BTC are sophisticated and they are the ones concerning me.

        • el Bruce on November 29, 2017 at 12:34 pm

          ..there will definitely be booms and busts.. maybe even crashes.. but cryptos are here to stay and digital currencies are here to stay.. trillion(s) are likely to flow into this market, instead of out.. i say get a seat near the exits of the theater in case of fire either way, at a minimum.. new ETFs being born.. institutional money flowing in.. leveraged futures trading.. feels more likely to stabilize volatility wise..

          The sad part is that a lot of the people buying bitcoin today fresh off the fiat boat are going to panic sell when the market drops 20-30% (or more) and that’s the real tragedy.

  4. Kristine @ Frugasaurus on November 29, 2017 at 7:01 am

    Interesting. I certainly don’t know enough about cryptocurrency to even consider buying it. Thanks for the food for thought!

  5. Sam Hain on November 29, 2017 at 7:23 am

    Nice article. Bitcoin could very well be in for a strong correction from current highs, but I think there are good reasons to believe in it long term.

    Bitcoin has value over other fiat currencies because it decentralizes power and control of currency. No longer are you subject to the whims of a central bank, operated by humans with political biases that can and do change the rules whenever they please. Central bank monetary policy is full of unpredictable events (e.g. QE, rate changes, etc.) which create uncertainty and risk.

    One of the main features you want of a currency is predictability. You want to know that the price of a good, ceteris paribus, won’t change based on monetary policy. You don’t have that assurance with centralized currencies. The Federal Reserve implemented QE and just look at the asset bubbles it created.

    Bitcoin avoids that and gives you a completely transparent monetary supply. You know exactly how many bitcoin there will be and it can never be changed. And because money supply is fixed it means the purchasing power of any savings you have will only increase over time. Compare that to the dollar that has lost something like 96% of its purchasing power in the last 100 years.

    Bitcoin may be due for a short term correction but I think it’s a mistake to consider it the same as other fiat currencies. It’s fundamentally different and will decentralize currency in the same way that the internet decentralized communication.

  6. Dave @ Married with Money on November 29, 2017 at 8:34 am

    You raise some valid points, but I’m still very interested to see how it all goes. I think the idea of a cryptocurrency is fascinating if nothing else 🙂

  7. Zac on November 29, 2017 at 9:15 am

    You wrote, “BTCs entire value is built on faith and faith has a habit of letting people down when they need help the most.” The word ‘faith’ was your very definition of a fiat currency like the US dollar. The difference between the two though, and what makes BTC behave somewhat like commodity money, is that there is no government to manipulate it and ‘let people down’. That is it’s true value, which makes it (eventually) a fantastic currency for people around the world living in crumbling economies and currencies.

    It’s biggest problem has always been stability. That probably is likely to change over the next twelve months as institutional money pours in and levels things out. After that, things could get a bit more odd in the world…

    • Keith Schroeder on November 29, 2017 at 11:01 am

      Time will tell, Zac. It’s going to be an interesting ride. That’s why I was cautious about telling readers to either buy or sell. I don’t know where this is going. History is my only guide. I’m still trying to wrap my head around where the real value is with cryptocurrency.

      • el Bruce on November 29, 2017 at 12:37 pm

        ..amazon.. so I’ll point you to a few incredible potential innovative projects that can change the world with blockchain based solutions – crypto just gives you access to their ecosystems.. crowdfunding.. use from tokenized ownership vs stacks of stock paper.. Power Ledger and Substratum. One seeks to create the world’s largest tokenized energy trading platform.. the other a decentralized web (centralization has massive drawbacks to privacy, security, and control).

        Good luck!

    • Margin of Saving on December 2, 2017 at 2:26 pm

      I can assure you institutional money will not pour into BTC in the next twelve months. It’s too speculative to put real money in right now. BTC exchanges go down all the time. The swings are too volatile. There’s no history, so I don’t know how it’ll trade in different economic environments. Some institutional investors are dipping their toes, but it’ll be some time before it goes from speculative bet to an actual investment.

  8. Shannon Golden on November 29, 2017 at 10:19 am

    This is a great article, Keith. My experience with investing in cryptocurrency(Bitcoin and Altcoins) has been an interesting journey thus far. The cryptocurrency industry is still in its infancy and investors(novice and veterans) are lining up to snatch profits. A lot of coins are popping up like weeds and, of course, there is lack of regulation (think fraud and abuse on many levels). In addition, the transaction fees to exchange USD to BTC is HIGH! And to top it off, folks in bitcoin land are NOT considering the tax side of the investment until much later. At least folks won’t lose their home this time.

    • Keith Schroeder on November 29, 2017 at 10:59 am

      Unless, they borrowed against their home to buy bitcoin, Shannon. Let’s hope people only used mad money to invest in bitcoin.

  9. Shannon Golden on November 29, 2017 at 10:34 am

    Hey Keith. FYI, I clicked on the “Notice 2014-21” link and it took me to Investopedia and not the intended IRS link.

    • Keith Schroeder on November 29, 2017 at 10:58 am

      Fixed.

  10. Tawcan on November 29, 2017 at 12:50 pm

    This is one of the most informative bitcoin articles I’ve read in a while. You raised so many great points. It’s pretty scary that people are buying bitcoins with credit cards and taking out loans.

  11. Jim on November 29, 2017 at 3:11 pm

    I remember when tickle me Elmo’s and beanie babies were going for 10 times their “actual value ” now look at them… I see bitcoin as a fad just like so many before it.

  12. ashu on November 29, 2017 at 3:51 pm

    What is your opinion on trading with ‘limits’ so that they are sold if price falls below an acceptable threshold?

    • Keith Schroeder on November 29, 2017 at 5:42 pm

      The problem is the speed at which BTC can fall. Today alone BTC dropped 18% from its high. If your stop triggers the next trade could be 5% lower. That said, what other options are available to limit risk? Limits seem reasonable if someone must play with BTC.

  13. Jeff @ Maximum Cents on November 29, 2017 at 3:54 pm

    Good post on the inherent dangers of Bitcoin. You can tell this is a bubble because of the exponetial rise and price and the public interest. What about the issue of being able to redeem Bitcoin for dollars? Is there even a way to do that? Seems like a lot of people will end up holding the bag when this eventually craters.

    • Andy on November 29, 2017 at 5:30 pm

      Good question. How do people redeem? Does it get ACH to a bank account? Interesting stuff indeed but I’ll stick with my index funds.

  14. Roman on November 29, 2017 at 4:38 pm

    First, thank you for calling me a genius good sir. Very timely article considering valuation dropped almost 3K in a matter of hours this afternoon. Although I believe the bubble is not bursted just yet the volatility is outrageous not to even get into the potential for manipulation. DASH or a similarly designed alt coin is likely to have more long term value (not necessarily valuation) as it contains the blockchain technology along with more potential to use for day to day transactions and thus making it more suitable as a true fiat currency.

    • Keith Schroeder on November 29, 2017 at 5:38 pm

      Some people hit it right, Roman. I’d think the smart money bought years ago and are selling into the current strength.

    • Mike @ Balanced Dividends on November 29, 2017 at 7:49 pm

      As Roman mentioned, extremely timely article. The change this afternoon was incredible but perhaps not surprising (admittedly, no one knew when this would likely happen or when it will happen again). I’m still glad to be on the sidelines (and intend to be there).

  15. Steve Adams on December 1, 2017 at 10:51 am

    Who thinks we will still be using the same tools for currency in the next 50 to 100 years?

    Paper cash probably dies. Digital of some sort lives – probably some version that can’t be printed by politicians. People of Venezuela and other despots accept it first. Then others decide their politicians deserve less money too and acceptance spreads.

    Maybe it’s bitcoin, maybe it’s something else but there are pretty solid economics that will push that way. Gresham’s law: bad money drives out good

  16. Phil on December 9, 2017 at 12:49 pm

    I will leave a comment about your age: With age comes much wisdom. Thanks for sharing it.

    And I completely agree with the statement you made earlier: “Blockchain will be a serious part of our future; BTC is less clear.”

    Bitcoin’s blockchain isn’t scalable.

    • Keith Schroeder on December 9, 2017 at 1:30 pm

      I’m no expert on blockchain, Phil. What I read is concerning. It seems the energy consumption required to mine and maintain a blockchain is massive and growing. That said, I like the idea for security reasons. Also read recently the Federal Reserve may start a blockchain type currency. It feels like blockchain is here to stay and the next step in security and transactional commerce.

      And thanks for stroking the ego of the wise old guy.

      • Phil on December 9, 2017 at 2:50 pm

        Yes, the blockchain concept is likely here to stay. But Bitcoin’s blockchain technology isn’t scalable. A better solution is badly needed. Aside from the growing energy consumption (which the world cannot afford), it can’t support high transaction rates and will therefore get in the way of its core purpose. So I’m agreeing with you completely: “Blockchain will be a serious part of our future; BTC is less clear.”

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