On October 3rd, Goldman Sachs (GS) CEO put out the following comment on Twitter about Bitcoin.
Still thinking about#Bitcoin. No conclusion - not endorsing/rejecting. Know that folks also were skeptical when paper money displaced gold.
- Lloyd Blankfein (@lloydblankfein) October 3, 2017
The statement is in sharp contrast to the position taken by Jamie Dimon of JPMorgan (JPM) who said when speaking at a conference in early September 2017 that "Bitcoin is a fraud that ultimately will blow up."
On October 31st, the CME Group Inc., the world's largest derivative exchange operator, said it would provide a regulated trading venue for the cryptocurrency market and would launch the new derivatives in the fourth quarter of 2017.
When the CEOs of the two largest financial institutions in the world take opposing views on a small, controversial change in the financial marketplace, and the CME announces plans to trade derivatives on the cryptocurrency, it is worth some time to investigate what is going on.
Contrary Positions May Be Built On Differing Business Models
Why would two of the largest financial institutions in the world take contrary positions about Bitcoin? The answer to this question may be linked to business model motivation. Goldman Sachs makes a large portion of their profits on trading, and word on the Street is that they are contemplating opening a Bitcoin trading desk. Doing so, given Goldman's large presence in the financial markets around the world would give the fledgling Fintech currency another major boost in credibility, and very likely attract even larger volumes of speculative traders.
JPMorgan, on the other hand, is the biggest market maker in US Treasuries in the world, and therefore, has a large self-preservation interest in defending the value of the dollar. Calling Bitcoin a "fraud," as Jamie Dimon did in September, is a very harsh assessment. However, Bitcoin does hold many of the properties of an asset bubble and anyone trying to play this market needs to be fully clear about the risks they are taking.
Personally, I see Bitcoin as a technology that has very high speculative momentum in the financial market today. The phenomenon is being driven by ECB, BOJ and Fed excessive liquidity actions, which have inflated risk assets priced in these currencies beyond rational pricing models.
The natural and rational market reaction in this situation is for excess money to overflow to assets with "limited liquidity pools" where short-term momentum can build and attract ever-higher prices, regardless of chances that the asset can sustain the value over the long term. The technology market has a history of supplying these types of speculative bets when monetary conditions are loose.
Like many investors that probably read my articles, I experienced a similar technology phenomenon in 1999 as the dot.com boom was in full swing (I lived and worked in a network technology start-up in Silicon Valley at the time). A good analog to the Bitcoin phenomenon today is Sycamore Networks, which went public is 1999 on $0 revenue and losses expected for the indefinite future. But, these well-known facts did not stop the initial IPO price to pop of over 50% creating a valuation of over $45B. The company was liquidated in 2013. Many other tech start-ups from this time period suffered the same demise.
I should add, having been involved directly in the funding process for a major start-up, a big source of funds available to drive such high speculation came from overseas - US dollars looking for a place to be preserved as a result of the ever-expanding trade deficits.
The one major difference between Sycamore Networks and Bitcoin is that Sycamore Networks was a going concern, at least until 2013, which was expected to derive value from its future returns relative to its risk as an investment. Bitcoin, on the other hand, is a "radical element" in the world financial system.
What is Bitcoin?
Is Bitcoin a company? No, Bitcoin will never report a profit or loss. In fact, the cost of making Bitcoin available to the investing world is marginal, driven by the ever-lower cost of computing technology.
Is Bitcoin a currency? The founders claim that it is because the technology can be used as a payment system. However, I don't see it meeting any of the criteria for being a currency. For one, currencies are readily accepted as a medium of exchange within a definable subset of people or entities and provide stability in value relative to other goods and services within that sub-system.
Bitcoin dramatically fails these tests. The only way it can be confused as being a currency is that it can be exchanged into US dollars or some other currency on an exchange. But so can cattle, oil or gold when they are bought or sold in one currency and then exchanged into another.
What Bitcoin is, in my assessment, is a financial commodity. It can potentially become the ultimate financial derivative where its owners can buy or sell a financial asset with virtually zero holding and trading cost, but plenty of valuation risk (volatility) depending on the demand for Bitcoins.
The size of the Bitcoin "liquidity pool" which can be bought or sold is set by Bitcoin mining. Bitcoin mining is the process through which Bitcoins are released to come into circulation. It involves solving a computationally difficult puzzle to discover a new block, which is added to the blockchain, and receiving a reward in the form of few Bitcoins. The block reward was 50 new Bitcoins in 2009; it decreases every four years. As more and more Bitcoins are created, the difficulty of the mining process and the amount of computing power involved increases.
The mining difficulty began at 1.0 with Bitcoin's debut back in 2009; at the end of the year, it was only 1.18. As of April 2017, the mining difficulty is over 4.24 billion. Once, an ordinary desktop computer sufficed for the mining process; now, to combat the difficulty level, miners must use faster computer hardware.
The characteristics of Bitcoin as a financial asset have attracted the attention of governments and financial regulators around the world.
Why Did China Move To Shutdown Bitcoin Trading?
In September of 2017, China made the move to shutdown Bitcoin exchanges because they have a serious problem in keeping capital within its borders denominated in Yuan. China can control its exchange rate against other fiat currencies, and easily manipulate the currency relative to the USD through capital controls and buying and selling of US Treasuries, and they do on a continuous basis.
However, Bitcoin, which has taken hold as a limited supply (as opposed to fiat government controlled) financial derivative, needed to be arrested quickly by Chinese authorities in order to maintain control over the continuous pressure for capital outflows out of the Yuan and into another store of value. It was the threat of competition to the Yuan that led to the Chinese regulatory action.
The question now is whether the US Treasury sees a similar threat in the market for people holding the US Dollar. If so, you can expect regulatory action to limit Goldman Sachs' effort to open a trading desk and expand the reach of the electronic currency. Action by the US Treasury to regulate Bitcoin out of existence, or a Goldman decision not to proceed would be a harsh blow to the prospects for the currency business model. But, it would also be a sign that the capital control measures being used in the United States over the last 8 years are getting harder to maintain.
A Potentially Troubling Aspect Of Goldman's Position
One aspect of Lloyd Blankfein's statement that is both interesting and possibly troubling for the US Treasury is that he said in the Tweet - "folks also were skeptical when paper money displaced gold."
I find it very interesting that Lloyd's tweet went all the way to imagine that a cryptocurrency like Bitcoin could potential supplant paper money much like fiat currencies displaced gold back in 1970. The potential trading desk motivation for Bitcoin at Goldman Sachs is easy to understand. But, why is the Goldman Sachs CEO referencing the early 1970s' era when the US abandoned the gold standard (GLD) for international trade transactions?
Does Goldman Sachs foresee a future where, as the CEO statement clearly shows, a cryptocurrency like Bitcoin will displace the value of the mighty US paper dollar as the reserve currency for international trade? If so, get ready for a very tumultuous time in the financial market.
This is an interesting question that may eventually be answered by Goldman. But I see two primary driving financial forces behind the Bitcoin phenomenon, both of which involve international-based transactions today.
One, current and potential mega-owners of Bitcoin most likely do not want their identity to be exposed. By design the electronic cryptocurrency protects the identity of its users. Whereas the US dollar, being used as primary reserve currency for international trade transactions today, is traceable to its owner by the US government anywhere in the world if held in an electronic account. Many foreign entities find this hegemony unjust and can infringe on their rights as a sovereign nation. Some of these countries are not good friends of the US government presently.
Most likely Goldman does not want to be painted as aiding and abetting a dirty clientele just for the possibility of opening a Bitcoin trading desk. Although private transactions are indeed a by-product of the design, and one that benefits a sector of the world which some may wish to control, it is not a business model for a global bank. If this were the case, then Jamie Dimon and other critics are easily the winners in the argument, and every major government in the world will be quick to take action like China and outlaw trading in the currency.
The second force driving Bitcoin support is its possibility as major shift in future international currency exchange markets, similar to the late 1960s when the US no longer had enough gold in reserve to maintain the standard system the world had used since the end of WWII. We are currently experiencing the limitations of the amount of debt the US can foist onto the International market as collateral for trade purposes.
This trend is only going to get worse in the future. If a transaction payment system using a cryptocurrency model were implemented for international settlements, manipulating currency values for the purpose of trade advantage might become impossible.
However, the current excessive use of US Treasuries as collateral for trade purposes would also become problematic for interest rates and financing the US Debt. Any shift would definitely cause chaos, probably similar to the 1970s' post Nixon's decision to take the US off the Gold Standard.
Will The Party End Soon For Bitcoin?
Bitcoin has all of the classic characteristics of a speculative asset bubble.
The price of Bitcoin has recently risen rapidly over a very short period of time. The rise in value is very much driven by a psychological phenomenon where trading volumes beget even higher trading volumes in the asset, with expectations of ever-higher values reinforced. Evidence suggests that many investors are now entering the market so as "not to miss the boat" on the high returns which they believe others are making.
Since Bitcoin has no intrinsic or fundamental value from which to derive a valuation at the present time, the risk is very high that the traded value can deflate rapidly due to a cascade of sell orders. The value is completely up to the whims of Bitcoin owners. If Bitcoins become worthless in the future because the market determines it is all hype and the initial owners who rode the elevator up have sold out, the value could crash to $0 like Sycamore Networks.
On the other hand, Bitcoin has staying power in the financial world that companies like Sycamore Networks and tech IPOs in the late 1990s did not. Bitcoin will have value as a traded financial derivative as long as there are people who want to own Bitcoins, and there is an exchange available to do so. That staying power is derived from its conceptual possibility as a displacement for fiat government-sponsored paper money system, and a very low cost to keep the technology available, unless it is regulated out of existence, for the indefinite future.
My assessment is that Bitcoin is here to stay, but expect wild and volatile movements in its value that are very unpredictable. There is also a high risk of the market expanding in unforeseen ways as CME futures become available. Availability of Bitcoin futures will allow institutional investors to buy into the digital currency market without directly investing in Bitcoin, which regulations prohibit them from doing today.
This activity, similar to the sub-prime mortgage derivatives prior to the 2008 financial crash, can potentially cause the Bitcoin market to swell to a size much larger than it presently is in the world today. Since the underlying asset is subject to the whims of the actual Bitcoin owners, it may be highly subject to manipulation of a few rogue governmental entities. Buyers beware of this risk going forward.
I personally do not care to jump into the Bitcoin market and buy an electronic coin for $6600 today. However, I am paying close attention to the phenomenon as a signal the current stock market party needs to be arrested soon, lest Central Bankers want to lose complete confidence in their fiat currencies as a store of value when the market (SPY) (DIA) (QQQ) eventually comes crashing down.
Daniel Moore is the author of the book Theory of Financial Relativity. All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.
Daniel R Moore
Daniel Moore is the creator of FinancialRelativity.com, a web portal created for the purpose of tracking the status of financial markets and providing investment analysis and portfolio management insights to investors. Based on the systematic investment research, he writes about the market and publishes his views through internet market publications. He has over 25 years of management experience in corporate finance in a variety of high technology start-ups and public companies. A graduate of Duke University’s Fuqua School of Business in 1988, he has spent the last 10 years managing investment portfolios seeking high risk reward returns for fixed income investors.
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