Friday, October 27, 2017

Bitcoin Backlash: Back to the Drawing Board?

My last post on Bitcoin got me some push back and I am glad that it did. I would rather be read, and disagreed with, than not read at all. I have been told that I know very little about crypto currencies and that I have much to learn, and I agree. The crux of the disagreements though lay in my classifying Bitcoin as a currency, not as an asset or as a commodity. Since this classification is central to how you should think about investing versus trading, and value versus price, and goes well beyond Bitcoin, I decided to dig deeper into the classification and provide even more ammunition for those who disagree with me to tell me how wrong I am.

Classifying Investment: The What and the Why
We are products of our own world views, and mine, for better or worse, are built around my interest in valuation. It is that perspective that led me to classifying investments into cash flow generating assets, commodities, currencies and collectibles. To value an investment, I need that investment to generate future cashflows (at least on an expected basis) and that was my basis for separating cash flow generating assets (which range the spectrum from a bond to a stock to a business) from the rest.

The pushback that I got did not surprised me, partly because my definition may be at odds with the definitions used by other entities. Accountants, for instance, classify items as assets that I think are pure fiction, such as goodwill. There are others who argue that any investment on which you can make money is an asset, broadening it to include just about everything from baseball cards to government bonds. In fact, crypto currencies have been at the center of many of these disagreements, with the SEC recently deciding to treat ICOs as securities (and thus assets) and the Korean central bank categorizing Bitcoin as a commodity. Since the judgment made by these entities have regulatory and tax consequences, I am sure that they will be debated, discussed and disagreed with.  

Why Bitcoin is a currency and not an asset..
One reason that people are uncomfortable drawing the line between currency, commodity and asset is that the line can sometimes shift quickly. Take the US dollar, for instance. Its primary purpose is to serve as a medium of exchange and as a store of value, and it is thus a currency. However, you can lend US dollars to a business or individual and generate interest income. That is true, but it is not the currency that is then the asset, but the loan that you make with it, or the bond that is denominated in it. Building further, if I create a bank that takes in deposits in dollars (and pays an interest rate on them) and lends out those dollars as loans, I have a business and that business is an asset. I can value the loan and the bond based upon the interest rate you earn and the default risk that you face, or the bank, based upon the interest rate spread it earns and the risk of default that it faces on its collective portfolio, but I cannot value the US dollar.

Can I construct investments denominated in Bitcoin or another crypto currency that earn me interest or a return? Of course, but I can do that in any currency, and it is in fact one of the functions of a currency. That does not make Bitcoin an asset! You can already see that the question of whether Initial Coin Offerings (ICO) are currencies or assets becomes trickier, because an ICO can be constructed to give you a share of the ownership in a business (and the cash flows from that business), making it more of an asset than a currency (thus giving credence to the SEC's view that it is a security). The lack of standardization in ICO structures, though, makes it difficult to generalize, since loosely put, an ICO can be constructed to be anything from a donation (at least, according to Kathleen Breitman at Tezos) to quasi common stock (without the voting rights).

A few of you have pointed to the networking benefits that might create value for Bitcoin, but I am afraid that I don't see that as a basis for assigning value to it. A network can become an asset, but only when you can make money off the network. The value of Facebook to me, as an investor, is not that I am part of the Facebook network (I am not, since I have not posted on Facebook in almost three years) but that I get a share of the money made from selling advertising to those on the network. Unless you can trace monetary benefits to being part of the Bitcoin network, there is no value to being part of the network. (Visa and MasterCard are assets, not because they have wide networks and are accepted globally, but because every time they are used, they make 1-2% of the transaction value.) To the argument that Bitcoin miners can make money as the network expands, that value is for providing a service, not for holding Bitcoin.

Why Bitcoin is more currency than commodity
The essence of a currency is that its primary uses are as a medium of exchange or as a store of value. The key to a commodity is that it is an input into a process that has a utilitarian function. Oil and coal are clearly commodities, since they derive their value from the fact that they can be used to produce energy. It is true, as with currencies, that you can create an asset based upon a commodity. A share of an oil well is an asset not because you like or even need oil, it is because you hope to sell the oil to generate cash flows. It is also true that gold is a commodity, but as I noted in the prior post, I think it is more currency than commodity, because the quantity of gold that we have on the face of the earth vastly exceeds whatever utilitarian needs it might serve. It is shiny, durable, makes beautiful jewelry and has some industrial uses, but if that is all we valued gold for, it would be worth a lot less than it is trading for, and there would be less of it around. 

The question with Bitcoin then becomes whether it can become (or perhaps already is) like gold. Here is my test: If tomorrow, humanity collectively decided to abandon its attachment to gold as a value store, would its price go to zero? I don't think so, because it does have uses and while its price will drop, it will be priced based on those uses. Applying the same test to Bitcoin, I am left nonplussed about what value to attach to a digital currency if at the end, no one uses it in transactions, it has no aesthetic value and it produces nothing utilitarian.

A Commodity Argument for Crypto Currencies (but perhaps not for Bitcoin)
Some of you have pointed to Bitcoin's scarcity (created by the hard cap on production) and the fact that time and energy are spent on its production. Scarcity is neither a sufficient nor even a necessary condition for something to be a commodity. Sand is a scarce resource but it is not a commodity because I cannot think of a good use for it; so is bull manure, but that is a discussion for another time and day. The fact that time and energy went into the production of Bitcoin cannot be used to justify paying for it unless you can show that it is necessary for something that does create utility or value.   If, as argued by someone who commented on my last post, Bitcoin is a synthetic commodity, I can see that it is synthetic but what conceivable use does it have that makes it a commodity? Therein lies an opening for a “crypto currency as commodity” defense, though it works better for crypto currencies like Ethereum than it does for Bitcoin, and it require three building blocks: 
  1. Block Chains and Smart Contracts will create large disruptions in businesses: You have to believe that block chains and the smart contracts that emerge from them will replace conventional contracts in many businesses, and that will generate cash flows to the contract providers. Your argument can be based upon either economic (that the transactions costs willl be lower) or security (that the contracts will be more secure) rationales.
  2. Crypto Currencies are the lubricants for smart contracting: The discussion of block chains and crypto currency have become entangled into one discussion, but it is worth remembering that block chains predate crypto currencies and can work with fiat currencies. Thus, you will have to argue that crypto currencies are a necessary ingredient to make smart contracts work efficiently, and that the demand for them will then rise as smart contracting expands. 
  3. “Your” crypto currency will be one of the winners: Even if you can make the first two legs of this argument, it remains an argument for growth in digital or crypto currencies, not an argument for a specific one. To seal the deal, you will have to explain why your crypto currency of choice (Bitcoin, Ethereum etc.) will become the winner or at least one of the winners in the smart contracting currency race, perhaps because it has the “best technology” for smart contracting or has the most buy in by the institutional players in the game.
I think that the first leg of this argument will be easy to make, the second leg a little more difficult and the third leg will need the most convincing. Even if you can show, based upon today's technology, that you have the "best" smart contracting currency, how do you build barriers to entry that prevent you being pre-empted by another innovation or technology down the road? 

The game is still early, and there is much that we do not know about crypto currencies. I remain willing to learn both from people who know more than I do (and there are many out there) as well as events on the ground. As you listen to arguments for or against crypto currencies, my only advice is that you go back to basics about the needs that they are filling and that you ask questions about their long term staying power. I think it is also time for us to separate arguments about block chains/smart contracts from arguments about crypto currencies, since you can have one without the other, and to differentiate between crypto currencies, rather than defend them or abandon them all, as a bundle. To me, Bitcoin, Ethereum, Ripple and  ICOs are different enough from each other, not only in structure but also in terms of end game, that they need to be assessed independently.

YouTube Video

Past Blog Posts on Crypto Currencies


econoclast said...

Does it really matter how you classify BTC? The most interesting question is surely: what is it worth, and why is it worth what you say it's worth? Some people -- for example, Vitalik Buterin, the co-founder of Ethereum has pointed to the quantity theory of money as an avenue for valuing BTC (see Others have used what seem rather simplistic models, such as: wealth held in the US dollar amounts to x; if y% of this was held in BTC, BTC would be worth z. Still others have tried to value BTC based on how much it costs to mine (in the same way that the cost of mining gold has some relevance to its market value). Have you looked at any of these methods, professor, and if so have you drawn any conclusions?
PS I think I know the answer: you have, and they don't stand up to scrutiny!

Leandro Vilela said...

Hi. Take a look a this article, it has a very interesting point of view on this topic.
I am really curious to hear your views on the concept he presents, this new form of organization called decentralized applications. In a way matches with your view of crypto as "lubrificants".
Best regards,
Leandro (from Sao Paulo, Brazil)

Anonymous said...

Great and Powerful, Aswath! How about an analysis of the proposed Disney and Fox merger?

I know from your lectures you have stated mergers result often in negative or, at best, zero synergy.

Instinctually it seems like a huge culture-clash with two disparate products, also liabilities regarding Fox's politics, which regardless of the measure of their objective accuracy, are often the focus of public criticism, but I'm curious about your thoughts on this one!

Argonautas said...

Hello Professor,
I think there is a little misunderstanding about your conclusion of “Bitcoin is not an asset”, because “it does not generate cash flows” alone. Let make a point clear: bitcoin is an asset, but it is not an asset that generate cash flow. You are restricting a concept that is broader. See, in your book “Damodaran on valuation” you rated assets into three groups: assets that are either generating cash flows currently or are expected to do so in the near future; assets that are not generating cash flows currently but could in the future in the event of a contingency; and assets that will never generate cash flows.
So it is not correct to conclude that “Bitcoin is not an asset”, because “it does not generate cash flows”.

Msc. Arthur Mesquita Camargo
Catholic University of Brasília