Bitcoin’s Uncomfortable Similarity to Some Shady Episodes in Financial History

Alex Daley, Chief Technology Investment Strategist

There is simply no way I can let this week pass and not comment on Bitcoin. It would be criminal… (though certainly not the first criminal thing associated with Bitcoin).

First of all, I have to say I applaud the movement. In fact, I even cheer for the movement. Bitcoin itself needs serious work if it is to find a place in that movement long term. It lacks community governance, certification, accountability, regulatory tension, and insurance—all of which are necessary for a currency to be successful in the long run. And precisely why the past week has seen:

  • $400+ million worth of bitcoins stolen from—or by depending on how you look at it—the Japanese outfit Mt. Gox.
  • Online wallet provider Flexcoin was hacked for a mere $580,000 in bitcoins, forcing it into liquidation. That anyone would trust their company with a deposit manager with such limited liquidity is beyond me, but that’s part and parcel of the way Bitcoin operates.
  • Poloniex, another exchange provider, was hacked by means of an exploit in poorly written withdrawal software, and at least 12% of its coins appear to have been taken.

That the underlying technology was never at issue in these attacks and the many dozens of attacks that have preceded them is neither here nor there. The structure of the Bitcoin world is such that each implementation brings its own unique flaws and exploits. And when those systems are breached, your money is gone. You will. Never. See. It. Again. Because Bitcoin is a bearer instrument, once someone controls the machine that holds the bitcoins, they are free to transfer them to themselves.

Still, the idea that there could be a currency free from the whims of autocrats or bureaucrats without all the many drawbacks of using commodities like gold in this digital age is tempting. In reality a more evolved version of the currency will need come about for the dream to come true. It’d have to be one that is managed privately with input from several governments, but no authority over it from any single one. Which would be a remarkable advancement if it can be achieved.

Still, before any such real adoption can happen, we’ll have to eventually give up on this notion that the average person will own or manage bitcoins in an obvious and direct way. This is flawed logic that derives from an underlying misunderstanding of just how Bitcoin works. I can tell you this because I’ve spent hours on the phone explaining and re-explaining the concept to reporters in the past few days, the ones who are trying to quickly come up to speed on the technology in the wake of the Mt. Gox fraud. At least they’re truly trying to understand what happened, as opposed to those who blindly report back the many press releases and sound bites spouted unchallenged by the Bitcoin investor community.

What’s become obvious in those conversations is that too many more people (media and individuals alike) are all content to swallow the line, “Don’t worry—the technology ensures Bitcoin’s security.” Uh huh. The last time someone told you not to worry, your money was perfectly safe, what happened?

“These price increases largely reflect strong economic fundamentals,” Ben Bernanke observed about housing in October 2005, when working for President Bush’s housing program

“No! No! No! Bear Stearns is not in trouble. If anything, they’re more likely to be taken over. Don’t move your money from Bear,” Jim Cramer told viewers of Mad Money at the onset of the financial crisis.

Exactly.

Bitcoin may make it through the current turbulent times intact. It may not. Regardless, during any such crisis, it’s important to look to history. The past has taught us numerous lessons about hanging on to one’s newfound wealth. After all, examples abound of people and their paper fortunes being rapidly parted during turbulent times.

Let’s see what we can learn from a few of them.

Bitcoin Savings and Trust

I love this former company’s name. Really, I do. Basically it says, “Trust us! We’re called a savings and loan, after all.” Anyone who lived through the 1980s outside of diapers—and in the Bitcoin community I’ve come across many an “expert” who did not—knows of the S&L scandals that shook the banking industry to its core.

Bailing out Security Pacific National Bank cost taxpayers $628 million. Imperial Savings: $1.6 billion. Silverado Savings and Loan: $1.3 billion. Midwest Federal Savings & Loan: $1.2 billion. Home State Savings Bank. Old Court Savings and Loans. Lincoln Savings and Loan. You get the point.

Many safe-sounding investments have proven—not just in the S&L scandal, but over many hundreds of years—to be little more than money pits. That scenario has played out in the Bitcoin world, too. A total lack of governance—even from the community which purports to “manage” the standard—has allowed for dozens and dozens of faulty implementations that resulted in massive thefts of bitcoins.

If we learned any lesson from 1986 or 2008, it should have been that there needs to be some regulatory tension: someone whose bread is buttered by ensuring that any malfeasance or negligence is uncovered.

That doesn’t have to come from governments per se, but absent countervailing market forces they are the one-stop shop for creating it. By introducing private transaction insurers into the chain, Bitcoin could achieve the same. Instead, the system is based around trust in control, and when control fraud or negligence happens, it is the most dangerous of any type. In this case, the Bitcoin community collectively turned a blind eye to known problems, with multiple implications for the client, for going on two years now—allowing the system to operate without any real attempt to force fixes in the core code.

Further, the executives of the wallets that have been hacked presented themselves as safe and secure ways to stash valuable goods in the Cloud. That they would introduce such flawed systems to the Web with a promise like that attached will inevitably lead to civil, if not criminal, liability. But that takes a long time to happen, and will probably end just like the S&L scandal, the mortgage scandal, and all the rest, with one or two unlucky ducks in jail and most sipping Mai Tais on a beach somewhere.

So take a page from the playbook so many investors have utilized, and diversify, diversify, diversify. If you invest in bitcoins, don’t overload. If the category fails, they’ll all go together.

Even if Bitcoin makes it through—and I’m betting it will—there are other risks to consider.

The Ukrainian Riots and Italian Border Guards

Political unrest is nothing new to students of the monetary markets—currencies and gold both. Governments go through all sorts of wild swings in their attempts to hang on to power in a changing world. Some gas their own citizens; others just spend tax dollars buying their cronies’ bad investments.

The tie that binds is that they love to tax things. Everything. And they ensure they can reach everything by only allowing those things they already know how to tax… which is where Bitcoin comes in. Right now, Bitcoin is a curiosity, but as the price of the coins grows—these days it’s like $650 per coin, or $8 billion in market cap created from nowhere—that curiosity becomes a potential tax dodge.

Believe it or not, if you made part of those $8 billion in capital gains (i.e., you sold) and live in the US, Canada, the EU, Japan, et al., chances are you owe taxes. No new legislation is required for that. Just because the transactions happen off the radar of the feds doesn’t mean it’s free money. Whether or not they come knocking simply boils down to how desperate the government is this year.

Just ask the Italians who had made their money in gold, off the radar of the tax authorities. One of them tried to drive a truck across the border with a few hundred million euros in gold on board when Italy was cracking down on tax dodges at the height of its troubles. On any normal day, it would have gone unnoticed. But that time, they were looking for tax dodgers.

Of course, in order to catch you making money in most black or gray markets, the feds have to nab you red-handed with cash. But with Bitcoin, they could conceivably trace the profits right back to you.

Did you file FinCEN Form 114 for your account on BTC-E, Mt, Gox, or Bitstamp (all foreign financial accounts)? Whoops. Now you’re facing penalties of up to $10,000 for your accidental nondisclosure. You knew about it and still didn’t file? Darn. Now it’s willful, and the fine goes up to $100,000 and 50% of the assets in that account.

Right now, Bitcoin is a currency that paints a target on the back of all its users via its inherent traceability. Don’t expect it to be long before the feds see that target as juicier and juicier.

If mining, trading, or accepting Bitcoin, be sure you are taking the full legal picture into account. Otherwise, you’re likely to hold on to those bitcoins, but end up with nothing else left for your trouble.

Ponzi, Madoff, the Hunts, and Demand Outstripping Supply

This story has been told a million times, so I won’t belabor it. One man promises outsized returns. ten more believe him. And soon enough, 100 fools are parted from their money.

Well, like it or not, every bull market shares one thing in common with the work of Charles Ponzi: more demand than supply. Ponzi schemes work, again and again, for the very reason that people tend to chase after what they believe other people are already making money on. When that thing they chase after is in ample supply, then that demand is quickly sated, and things collapse quickly. But if the mastermind of a scheme has the wherewithal to limit the supply—as Bernie Madoff famously did by turning down huge investments while waiting for even huger ones—then things can go on much longer. So long as demand sufficiently outstrips supply to the extent that each new buyer is willing to pay a little more than the last one, any pyramid scheme can continue indefinitely.

This same principle applies to non-crooked schemes, as well. Stock in a company, for instance, has a relatively fixed supply. At any given time there are only so many shares outstanding, and even fewer available for purchase as many holders are content to stay just that way. In order for a market to continually rise for a long time, supply has to be kept in check. So, for a stock like Tesla, for instance, which now trades at 6x what it did a year ago, the run up will usually be supported by a commensurate increase in volume, like the one you see here:

Bitcoins share a similar dynamic with Tesla. They stayed low for a long time before beginning a steady ramp upward on rising demand. That ramp has had some spikes and dips along the way, sure, but smoothed out, it looks like a hockey stick. That’s because demand for both steadily outstrips supply.

In the case of Bitcoin, much of that demand comes from a handful of sources.

One is the liquidity driven by day trading in Bitcoin markets. Currency arbitrage in a market not meant to fulfill any business need is an ironic child of the modern world. Today’s commodity and currency exchanges were originally invented to provide price stability and liquidity to producers and consumers. However, in modern years they have been taken over, and the majority of their volume is now dedicated solely to speculation. There’s nothing wrong with some pure speculation in commodities markets, mind you. In fact, it’s generally healthy, as it improves price discovery and liquidity when managed appropriately.

But Bitcoin trading markets are quite the opposite. They were built predominantly for the purposes of speculation, and the overwhelming majority of users have no plans to use the underlying item (not unlike commodity markets). This does not make them bad per se, but let’s just say that speculating that others will continue to speculate is one of the core underpinnings of the market, not industrial value.

If the music stopped, as they say, what would the value of a bitcoin underneath really be? If speculative trading—which many estimates peg at 90% or so of the daily volume in Bitcoin—were to be shut down tomorrow, would bitcoins still have a $650 sticker price? (There’s no way to know how accurate that 90% figure is, by the way, since the exchanges don’t all disclose data, there are dark pools, and inside most exchanges only balances change, not actual bitcoins until withdrawals are requested, as that would be too slow. So the number could be higher.)

The price of Bitcoin, simply put, is the digital embodiment of the “greater fool theory.” It’s driven by all of its predicted uses and by all the demand that has built up, but not by any underlying value. Bitcoins are just spent computer cycles, which are in ample supply and can easily be spent again and again. You can’t burn it like oil, or turn it into flatware or electronics.

In a twisted, Escheresque logic, its value lies only in the demand lopsided liquidity bestowed upon it from its perceived future value.

With speculation accounting for the bulk of the volume in the Bitcoin market, not much comes in or out of the exchanges each day. In fact, given the transaction volume—actual bitcoin transactions between various “wallets” the single most popular recipients of bitcoins today, according to tracking firm blockchain.info—these are not currency exchanges at all.

Nope, and now that the Silk Road, Sheep, and Silk Road II illicit goods marketplaces have been shut down, it’s not that either.

Second in volume to the exchanges is now gambling… as if that’s much different. In particular, one strange gambling destination named for the mythic founder of Bitcoin: SatoshiDICE.com. Its wallets, which have to be known publicly for the site to work, account for 8 of the top 10 bitcoin transfer addresses in the world today. One Bitcoin wiki lists at least 50 sites similar to it.

The “game” at SatoshiDICE is simple. Send it your bitcoin, and it sends you back more if you win. Odds and payouts are posted on the site:

Who runs this game, and are they regulated by any gaming board? Just because they publish the odds, do you believe they’re real? The site contains no physical address, no company name, no owner information—nothing of any value. They mask their domain name for the public. The one clue I could find in a cursory search is that the terms of service refers to Canada.

I wonder what Canadian authorities might think of them operating this game of chance… or countries like the US offering it to its citizens.

While the site shows only a few hundred bitcoins bet, according to blockchain data, it’s sending and receiving hundreds of thousands of bets per day (though most for small fractions of bitcoins). In theory, thanks to the public blockchain, one could deduce if the game pays out as much as it purports to—and the odds are such that the house always wins, so it is quite possible. But because of the pseudonymous nature of the system, there’s no way to be sure the wallets getting paid prize money aren’t in fact owned by the site itself.

The game could appear legitimate to the outsider who inspects it, even while being completely crooked. It could just be the classic shell game from the streets of any old city, repurposed for the digital age.

If your goal is to make money, sending your bitcoins to an unregulated gambling site with no corporate info is the quickest way I can think of to achieve the opposite.

All of this is simply to say that, yes, Bitcoin may continue to go up in value from here. But even if it does, know that what underpins that rise are long-known market dynamics which support overzealous speculation and outright scams—and eventually that runway does run out. Will you be the one stuck holding the bag when it does?

Bury Your Bitcoins in the Yard

Of course, if you made the bet on SatoshiDICE “Below 4” and won 15,990 times your bet—about $10 million at today’s rates if you bet one bitcoin—then your primary concern is probably keeping your money safe.

The most obvious and simple way to achieve that is to transfer your bitcoin wealth back to cash, and put it into an insured institution: an NCUA-insured credit union; an FDIC-insured bank; an SIPC-insured brokerage; etc. While some of these insurance programs operate with relatively thin margins of safety for a really big crash, they do work remarkably well against the everyday mismanagement that leads to literally dozens of bank failures in the US every year (the FDIC took over 25 troubled banks in 2013).

Money, no matter where you keep it, is never 100% safe. But at least avail yourself of insurance programs and the power of the civil courts by keeping it local and under regulated entities, versus in some far-flung Bulgarian currency trading platform where your recourse on failure will be exactly zilch.

If the insurance shakiness truly scares you, then consider gold and silver. Even if a little volatile in the short run, they make for ideal long-term wealth storage.

If you must keep your money in Bitcoin, your best bet is to manage it locally. Bitcoin is meant as a peer-to-peer system, so it should be used that way. Storing large amounts of bitcoins in a central repository only paints a big target on your digital wealth—all the better to rob the bank than stick up the patrons one by one.

Even when stored locally, though, don’t be complacent. Use two-factor authentication or store your private key offline. Assume your computer will be hacked, and act accordingly. It’s the only way to be safe in a world where transfer is permanent and nonreversible, where security flaws are everywhere, and where no one will insure you against the risk you are taking. Bitcoin is just like cash.

The argument that many proponents fall back on when they talk about the security of Bitcoin is that the underlying algorithm has stood up to endless attacks over the last few years, and that it’s only poorly implemented systems and moronic users who’ve been fleeced. This is sort of like the argument that someone who was carrying a lot of cash on the subway late at night deserved to be robbed.

At the end of the day, all computer systems are vulnerable to attack; and bitcoin stashes are a tempting target. Even if Bitcoin holds up against this onslaught, will the small startup trusted with your coins do so, too? At best, the answer would be “maybe.” So if you want to play this game, just be very careful.

Mar 06, 2014
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