Tuesday, June 1, 2021

The Bitcoin See-Saw

There is a reason why Bitcoin shoots up and down in price - and not a good reason.

In recent years, the stock market has taken on the air of a carnival barker.  This is not to say that the entire game is fixed, only that there are a lot of bad bargains out there and some folks are not acting in good faith.  We've seen various scandals over the years - the Enron debacle, the Madoff scam, the 2008 blowup of mortgage-backed securities, and the various "tech" IPOs that came crashing to the ground.

In some instances, such as Enron, fraud was committed to keep the company going, when financial results were dismal.  People did odious things rather than admit failure.  In other cases, such as Madoff, it was just basic fraud - there was never any intention of running a legitimate company or even the pretense of doing so.  Just take the money and run - until they catch you.  Not a very good business plan.

The mortgage-backed securities thing was a different animal.  When people were incentivized to write as many mortgages as possible, they did.  Mortgage brokers and bankers got paid for how many loans they originated, not how many good loans they originated.   Investment bankers then bundled these loans together - good and bad - and sold them as top-rated securities, backed by real estate!  What could possibly go wrong?  Safe as houses! But as I noted before, when you create a system of rewards, people can either reap the rewards their hard work, or they can work the system to get even more rewards.  It doesn't matter what system it is, either - it could be loan origination rewards, or the production quota at the Patent Office.  Some will work hard, others will work the system.

In recent years - the last two decades or so - we've seen another animal, the "tech" IPO.  I had a front-row seat to this nonsense when I worked (briefly) at the odious large law firm.  Coming from the real world, where companies sold stock to raise capital to build factories to make widgets, and then pay dividends (you know, the "imaginary economy") I didn't understand this "new paradigm" until I figured out it was just a front for fraud.

You start a company, perhaps selling pet supplies online.  You raise venture capital and do a lot of splashy ads on television, including a multi-million dollar Superbowl "buy".  You sell pet supplies through your website for below cost, hoping to strike it big and edge out the competition.  Well, that's the theory, anyway.   Then you do an IPO, but instead of selling off 95% of the company (as Alexander Graham Bell did) you sell off 5% and keep 95% for yourself, as Martha Stewart and Facebook did. 

The purpose of the IPO isn't to raise capital to build factories, or even to buy more flashy Superbowl ads, but rather to "provide a vehicle to market shares in the company" as one prospectus boldly proclaimed.   In other words, allow the founders to cash out.  The local Ferrari dealer and the local builder of mini-mansions won't take dot-com stock in payment.

Some of these companies actually became successful.  Their model of "go big! go fast!" edged out the competition - for the most part - and early losses were later made up by wild profits.  But those examples are a minority.  What people realized is that even when they failed, these dot-com IPOs made a lot of money for the founders, the early investors, and the hangers on - including the odious law firm I was working for at the time.

Again, I was too dense to see this at the time - but the scales fell from my eyes rather quickly.  I mean, in the abstract, it makes no freaking sense whatsoever!   WillGrowCo "drops" its IPO at $25 a share.  Insiders, including the underwriter and his friends, are sold shares for $25 and immediately they are res-sold on the secondary market for $50 as the stock "pops" on the first day.  To an "old school" guy like me, this makes no sense - WillGrowCo is leaving money on the table!  They could have sold at $50 a share and raised twice as much money.  That would have bought twice as many widget factories!

But that was not the point - to raise money to build and expand. They were selling off a token amount of the company not to raise capital, but to create a market for the shares, so the founders could cash-out.  And we, the small investors of America, went along with this, whether it was Groupon, or ZipCar, or whatever.  Sure, some of us "little people" made a buck or two in the margins, if we bought at a dip and sold at a peak.  But for the most part, the insiders made scandalous amounts of money and we little people each lost a little bit.

If you could steal a dollar from every person in the United States, you'd have 330 million dollars - and likely never be caught or prosecuted.  After all, who would miss a lousy dollar?  That's the theory behind this.  "Investors" (chumps) like you and me throw $500 at some IPO using our low-cost trading platform, and we shrug our shoulders when it doesn't pan out.

Of course, these models still required some sort of business plan or product - even if it was just something as stupid as selling pet supplies online or an idiotic three-wheeled car that had no chance of ever making it into production.   Venture Capitalists sought out the tech geeks of America and pumped them for "the next big thing!" no matter how implausible it might seem.   It didn't matter if the idea was doomed to failure, they needed a "hook" to ensnare the small investors and a pretense - at least a plausible one - for the IPO.   So long as it is plausible, and you don't outright lie in the prospectus, this stuff is considered "legal."  Immoral, perhaps, but not illegal.

But then someone had a brilliant idea!  A very nasty, mean-spirited, naughty, and brilliant idea!   Why not cut to the chase and set up one of these schemes with no product or service or other idea attached to it?   Why not just sell the idea of investing itself, rather than tying it to messy factories or products or services - most of which are doomed to failure anyway?  Why spend all that money on advertisements, when the thing will advertise itself?   And why do an IPO where the SEC might take a hard look at your numbers and representations?

And thus, Bitcoin was born.   In a way, it is beautiful in its perfect evil.  No one even knows for sure who created it or who is running it or managing it - it is distributed across the globe in "mining" computers and coin "exchanges."  It is utterly unregulated, utterly untraceable, and represents nothing whatsoever.

Sure, early on, they sold this as the idea of a "currency" - that it would replace the dollar and euro and people would start buying things with their Bitcoin "wallet."  But that never happened.  A few tech companies tried to be trendy and hip by saying they accepted Bitcoin as payment.   They also claimed to be hiring minorities in order to be "diverse".   Both flashy promises, made with dramatic press releases, are later quietly forgotten, of course. One by one, the companies claiming to accept Bitcoin have dropped out of the coinverse - if they were ever in it.  Even the Bitcoin convention in Miami didn't accept Bitcoin as payment.

And it isn't hard to see why.  Simple transactions could take several minutes, early on, and as the system gets older and older, the transaction times increased to the point now where it can be an hour to consummate a transaction.  And the costs - once touted as free - are turning out to be in the tens, then hundreds of dollars.  Old-fashioned wire transfers are turning out to be faster and cheaper.

The only "real" use has been as ransom payment or for other illegal things, such as selling drugs, guns, or children, and transferring money to odious people (terrorists, for example) across the globe.  How long before governments shut that down?  And they can shut it down, not by outlawing Bitcoin, but by severely regulating the "exchanges" to the point where you would have a hard time getting your money out.  China already seems poised to do this.

The other thing that has hindered Bitcoin is the volatility. While in general its price has steadily increased over time, in any given year, it can go up and down by 50% or more - usually within days, which can result in huge losses if you consummate a transaction in Bitcoin and fail to take your proceeds out in local currency quickly.

Since Bitcoin hasn't worked well as a legitimate currency, proponents - and there are many, usually people who own a lot of coins or who are paid by people who own a lot of coins - are selling Bitcoin as a "virtual investment" - an investment in nothing or basically investing in scarcity itself.   "This thing we created is scarce.  It has no use, and you can't even see or touch it, but since it is scarce, it is valuable!"  It takes Gold-buggery to its logical conclusion.

But recently, Bitcoin shot up to over $60,000 a "coin" and then dropped to $30,000 a "coin" within a very short period of time.  What happened?  Some blame Musk for pumping up the value by making specious announcements that Tesla will accept Bitcoin as payment - and then quickly backtracking.  Musk got in trouble for pumping Tesla stock - the SEC regulates that!  But Bitcoin?  You can pump-and-dump all day long and its perfectly legal.

I suspect, however, that the volatility of Bitcoin is inherent in its design and is by design.  It is a See-Saw where the insiders who own most of the coin (by some accounts, only about 1,000 people) wait for one of these "peaks" in price and then wisely sell some of their "coins" to cash in on the deal.  The insiders flood the market a bit, so supply exceeds demand, and the price plummets.  They wait a few more months and plant some more stories in the "financial press" about how Bitcoin is going to hit a billion-bazillion-trillion dollars, and wait for the price to go up again - and the process repeats.  Up, Down, Up, Down.  See, Saw, See, Saw.  It is predictable.

Think of it this way.  I mentioned before how "Market Cap" is utter nonsense.  Bill Gates is "The Richest Man In The World(tm)" or was at one time, because of the cumulative value of all his Microsoft stock.  But as I pointed out, this "Market Cap" number is merely what the last chump paid for a share of that stock.  It doesn't represent the value of the company in most cases.   Sure, once in a while a company is bought out by another, when it is undervalued.  But these sky-high valuations of Apple, Microsoft, Facebook, Linked-In or whatever, are often irrational numbers.

If Gates decided to "sell out" and put all his Microsoft shares up for sale in a "Market" sell order, the price would plummet.   Not only would people wonder why he was selling (what does he know?) but there would not be enough people to buy up all those shares.  Supply would exceed demand by a factor of ten, and the price would drop to nothing.  It is how I bought Avis stock for 74 cents a share - people dumped the stock when bankruptcy rumors were floated.  Few bought.

Supply and demand determine prices far more than actual value.

Bill Gates - and Zuckerberg and Musk and the rest of them have sold shares of their company's stock, in order to pay their bills and buy fancy houses and whatnot.   But they smartly sell off only a small portion at a time, regularly, and thus not depress the price of their investment.  In IPO situations, there is often a "lockout" period to prevent insiders - or at least some insiders - from cashing out too soon.  Usually the employees paid in stock options are locked out, but the real players are not.   Yea, act shocked.

With Bitcoin, the same is true, but there is no hierarchy or organization or lockout period to prevent panic selling of the coin.  This sort of is like a version of the prisoner's dilemma - you can sell your Bitcoin when it hits an all-time high, but by doing so, you depress the price of the coin, and thus damage your fellow coin-owners investment and any remaining investment you have.   Perhaps it is more akin to a cartel like OPEC, where if everyone obeys the rules and only sells a little oil at a time, they can get really high prices for the oil and make more money.   But if one person cheats, the whole deal is off.   And what we learned in economics (and real life) is that cartels eventually break down, as OPEC has, again and again, as each nation cheats on the other.

And in the past, there have been events where someone "accidentally" sold off a huge chunk of Bitcoin and caused the price to plummet in a matter of minutes, because despite all the hype, it  actually is pretty thinly traded.  The price recovered in a matter of hours, but it illustrates how one big "sell" order can cause the price to drop dramatically.  It explains why the price has dropped in recent weeks - someone is selling off their hoard, or a good portion of it.

Some folks would look at the price chart above and say, "Well, look, overall the price has gone up, up, up!  There have merely been some adjustments here and there!"   But if you look at the smaller peaks and valleys, and blow them up, they look exactly like the recent peak and crash.  The dollar amount of price make no real difference. If you "invested" $5000 in Bitcoin at $18,000 a "coin" in December of 2017, and then sold it for $3300 a "coin" in December 2018, you lost most of your money - like 4/5th of it.  That "smaller" peak-and-valley represents an even greater loss than the recent 50% price drop.

It just seems smaller when you look at the larger chart and the previous gains and losses look more like system noise than signal.

But the question remains - will Bitcoin go up in value?  And will it crash yet again?   See.  Saw.  See.  Saw.  You can kind of bank on it.  But eventually, there will have to be some "there" there for Bitcoin.  In the case of ZipCar, it was eventually bought out by Avis.  There was some underlying value in the company, although a lot less than the vaunted "Market Cap" after the IPO.  Where did all that equity evaporate to?  It never existed, of course.

My take on it?   Each successive pop (or bubble) in the price of Bitcoin will be harder and harder to achieve.  If you google Bitcoin, you will get "hits" for tons of articles by "professional analysts" who say it will hit $100,000 a coin or even a million dollars a coin.  When you read these articles, the "logic" they present amounts to, "I just said it would, can't you read?  Are you stupid or something?"   And that is about the extent of the reasoning, as unlike traditional investments, which can be quantified by rate of return, retained earnings, or dividend ratio or even liquidation value, there is no real way to quantify Bitcoin, as it is an investment in scarcity itself.

There is a distinct possibility that eventually even the insiders will tire of this game and walk away. They will pump and dump and try to maximize the realization of their outcome by selling off their coins in dribs and drabs, until there is no one left to buy the damn things.  Or maybe one day, people will wake up and say, what the heck were we thinking?  Investing in nothing whatsoever?  What drugs were we taking when we believed this "virtual gold" nonsense?

Maybe. But I doubt it. A more likely scenario is that like a child with a shiny new toy, the small investor will be distracted by a newer, shinier toy, and discard Bitcoin in the sandbox as just another passing fancy.  A fad.  A trend.

We'll just have to wait and see.  Personally, I would not touch this nonsense with a ten-foot pole.  While others (a very few people) will make tons of money off it, the rest of us - including me - would lose a little - or a lot.

Mr. Madoff - you had the right idea, just the wrong vehicle for it!