Crypto-Currency and Network Effects: Winners Usually Stay Winners
Bitcoin prices dropped 15.6% in minutes on Friday after the SEC refused to change its rules to accommodate a new Bitcoin Exchange-Traded Fund. The Bitcoin ETF would have allowed investors to buy and sell Bitcoin through a normal brokerage account, rather than buying it directly through a Bitcoin-specific site.
The price has since recovered to -4.5% from its pre-announcement price. It’s now up a mere 198% year-on-year. Bitcoin has always responded strangely to bad news; there are crashes and jumps, but they’re often pretty random. Events like the seizure of the Silk Road, which could theoretically have killed Bitcoin, actually sparked one of its largest rallies ever. In this case, the SEC not only refused to approve the Bitcoin trust: they disapproved on the grounds that Bitcoin exchanges are not regulated, and thus can’t have a surveillance-sharing agreement with the exchange trading the ETF. Given the legal status of Bitcoin exchanges (often overseas, sometimes with unknown ownership), this is a fatal critique: either the SEC will change its mind, or Bitcoin ETFs won’t happen. So why are most of the gains from the great “there will be a Bitcoin ETF” rally still intact?
There’s a reasonable argument that the SEC will change its mind. The criticism they have of Bitcoin could easily apply to, say, oil: while there are some regulated exchanges (CME: the Coinbase of oil), marginal price changes are also driven by an incredibly opaque and unregulated cartel. And yet, US consumers are allowed to trade oil ETFs.
The price response is not just because traders are rethinking the ETF, though. In large part, it’s because the Bitcoin ETF does not make a huge difference to the long-term bull thesis on Bitcoin. Bitcoin is a unique asset class with a unique pitch: it will probably lose value, since the price is driven by speculation. In the event that it doesn’t, the equilibrium price is hard to measure but significantly higher than the current price. You can think of the price of Bitcoin as being determined by three things:
The market value of Bitcoin if it becomes a pseudo reserve currency, like the Swiss Franc or gold. (Gold’s market cap, for reference, is around $7 trillion.)
The odds that this happens.
The first one doesn’t fluctuate much. The third is a rounding error: any time far enough in the future to make a difference is also an implausible forecast. All of Bitcoin’s volatility comes from the second — the odds that Bitcoin will be treated as a stable store of wealth, something that endowment funds, financial advisors, and central banks feel obligated to own at least a little of.
In theory, you could argue that Bitcoin will exist in some intermediate form: it won’t be worthless, but it won’t be a reserve currency. People will use it for some kinds of transactions, but will still prefer to denominate their savings the old-fashioned way.
That’s unlikely. Bitcoin’s pseudonymity means that it’s a tempting means for illicit transactions, but the fact that it’s pseudonymous and not anonymous means that, given enough time and computing power, people who conduct lots of illegal business in Bitcoin will get caught. And if your Bitcoin might be legally tainted, you’ll have an incentive not to own Bitcoin; if your exchange might get shut down by FinCEN, you have reason to avoid the exchange. As Bitcoin gets more valuable, it becomes relatively less useful for nefarious behavior as it becomes increasingly useful for legitimate business. So over a long time period, criminals will use the products that are tailor-made for criminal behavior: high-denomination Euro and USD notes.
I don’t know if the drug cartels have lobbyists — marijuana is illegal, so probably — but if they do they should really give up on swapping Harriet Tubman for Hamilton on the ten dollar bill, and get her onto a new thousand-dollar bill instead.
How do you judge the odds that Bitcoin becomes a new reserve currency? There are a lot of signals you could use, but there’s only one that’s hard to fake: price. When Bitcoin goes up, more people are treating it as a potential reserve currency. And a reserve currency is defined as a currency that people treat as a reserve currency. This makes Bitcoin one of the few assets that really should trade as a momentum asset. Its value is determined by whether or not people think it’ll be worth something in the future, and that’s measured by what they’re willing to buy it for now.
A Bitcoin ETF would help Bitcoin adoption. Savers are more willing to save in terms of something they can sell easily, and online brokers still have Bitcoin exchanges beat on the UI front. But a Bitcoin ETF is a symptom, not a cause: in the event that Bitcoin succeeds, it’s inevitable; in the event that Bitcoin fails, it’s impossible. The traders betting on an ETF approval deserve what happened — especially if they sold at $1,085 right after the announcement, and missed the rally back to $1,224. Bitcoin is naturally volatile, and will stay that way; the good news is gradual and the only meaningful bad news is catastrophically bad.
Disclosure: I am long Bitcoin. I’ve done some consulting work for SolidX, which has also filed an S-1 for a Bitcoin ETF.