The Bitcoin Crash: Now you can buy in

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(Readers are urged to read the post on Bitcoins preceding this one, which you can reach using the link below)

Called it.

As I predicted in a post around a week ago, the Bitcoin bubble finally popped. Though it took slightly longer than I anticipating, reaching an unheard high of $256 a coin before collapsing. The greatest indicator of the inevitable doom, I would say, was the endless media attention. Once something enters the news cycle, then the countdown clock goes into overdrive.

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In my previous post, I explained Bitcoin’s nature and numerous weaknesses, including:

  1. No controlling authority.
  2. Not tied to any physical asset
  3. Price is driven entirely by user speculation.
  4. Open to wide-scale manipulation.
  5. It’s hackable, as are all things on the Internet.
  6. Governments will eventually get involved one way or another and attempt to regulate or control the currency.

Obviously, this isn’t good. If the purpose of Bitcoin is to be a currency which people will use to buy and sell and sell goods, then that requires the currency to be relatively stable. If the price of Bitcoins relative to the dollar is extremely volatile (shooting up to over $200 and then crashing down is NOT an encouraging sign), then few people would use it. A natural consequence of it being untethered to any real asset. John Angel, a professor at Georgetown University, expressed his thoughts in an article on Ars Technia:

“Even if there is a speculative element [with traditional commodities], at the end of the day you expect the price to have a gravitational pull towards the true value.”

“We have models for valuing stocks and bonds, so we can get a sense of what it’s worth. But I really have no way of figuring out what a Bitcoin is worth. Sure, I can go to exchanges and see what the current price is, but how do I know that that price tells me anything? If I look at the price of the euro, I know what I can buy with euros. I know how many euros it takes to get a Big Mac in Paris or a hotel room in Frankfurt. We have this idea called ‘purchasing power parity’ that says that sooner or later exchange rates should reflect prices across different exchanges. We don’t have that with Bitcoin.”

“Plus, traditional commodities like gold, oil, wheat, and others have practical value beyond their monetary value. Gold can be used as jewelry, or manipulated industrially to manufacture semiconductors. Oil can be used to power machinery or refined for gasoline. Bitcoins have zero inherent utility.”

The question of Bitcoin’s lack of intrinsic value is only the tip of the iceberg. After all, the United States dollar isn’t back on anything either. But as Ars Technica points out…

…it has a massive infrastructure designed to regulate and safeguard its function as a currency through institutions like the Federal Reserve, the Treasury Department, the Securities and Exchange Commission, the Commodity Futures Trading Commission and other entities.

Bitcoins does not have this sort of infrastructure. As Prof. Angel points out: “The bank that is storing my money is highly regulated by federal regulators and backed by a government with a huge army behind it.”

So Bitcoins, as a currency, has no intrinsic worth, has no worth based on solid trust, lacks regulation, can be manipulated, can be hacked, and so forth. You might as well be trading monopoly money for real money. And absent from the above list is something important I forgot to mention, which only adds to the number of issues that Bitcoin faces as a currency.

In my earlier post, I explained that you can buy Bitcoins on specialized online currency exchanges. The largest of these, Mt.Gox, handles 80% of all Bitcoin trades. So if the website were to go down, then the currency would quite literally be cut off.

This is precisely what happened.

Yesterday, as the price of Bitcoins hit new highs, people started selling Bitcoins en masse in order to rake in their profits. Naturally, as the selling intensified, the price of the coins started dropping radically. The bubble had begun to pop. Mt.Gox, in an attempt to calm things down and let the market “cool down”, stopped all trading. The result was predictable: massive panic, with people selling on the other exchanges. A friend of mine gave me this image, which aptly describes the situation:

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Now what?

Since the crash meant that people were rapidly losing money, people immediately demanded (read: begged) that the market be controlled or shut down. Amazingly, this represents a critical betrayal of the very principles that Bitcoin is supposed to stand for: a completely free market, unregulated or uncontrolled by anyone. Now, these same users are lambasting that “people are manipulating the market” (which was obviously from the beginning to anyone who bothered researching the nature of Bitcoins) and that there should be tighter controls on the trading of Bitcoins.

As a friend of mine said “It’s like watching 2008 all over again except this time with more stupidity”. In a moment, principles and belief in a non-centralized, non-controlled currency have been thrown out the window. The majority of people, it would seem, value their own personal money above the sanctity and ideology of the system they praised. I am sure there is much introspection going on right now, as people realize that their own greed led to this incident (except, of course, for those who insist this entire crash was an elaborate conspiracy).

But is Bitcoin dead? To put it simply: No. In fact, this is just the beginning. As The Economist argues, we are witnessing the emergence of something new here: math-based currency.

Bitcoin isn’t the only virtual cryptocurrency in town. There already exits a knockoff, Litecoin, which is in development. Of greater interest is Ripple, another tech-currency startup which will officially begin in May. If it is successful enough, argues The Economist:

If Ripple gains traction, even bigger financial players may enter the fray. A firm such as Visa could create its own cheap instant international-payments system, notes BitPay’s Mr Gallippi. And what if a country were to issue algorithmic money?

At that point, we would begin the transition from fiat currency to math-based currency. Something quite spectacular to look forward to.

Can we make money from this?

Well absolutely! In my previous post, I did leave a link indicating that Bitcoins could be shorted.

Currently, Bitcoins are floating around the mid-70s (USD) per Bitcoin. There seems to a resistance at $69 a coin, but it is yet to be determined if this is rock-bottom price. Regardless, now that the bubble has popped, wise and big investors should be considering whether or not to invest into Bitcoins at a relatively low price. The same applies for Litecoins, once the price stabilizes.

As for Ripple, The Economist makes an important point (emphasis is me):

OpenCoin is expected to start handing out Ripples to the public in May. It has created 100 billion, a number it promises never to increase. To give the new currency momentum, OpenCoin plans eventually to give away 75% of the supply. Existing Bitcoin users can already claim free Ripples and eventually anyone opening an OpenCoin account will also receive some.

The 25% retained by OpenCoin will give it a huge incentive to make sure that the Ripple is strong: the higher its value, the bigger the reward for OpenCoin’s investors when the firm cashes out. On April 10th several blue-chip venture-capital firms, including the ultra-hip Andreessen Horowitz, announced that they had invested in OpenCoin.

In short: plenty of opportunity exists, even though Bitcoin has just crashed. In the words of legendary investor Warren Buffett:

Be earful when others are greedy, and be greedy when others are fearful.

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2 responses to “The Bitcoin Crash: Now you can buy in

  1. “It has created 100 billion, a number it promises never to increase.”

    Hahahahahahahaha!

    Yeah, right up until a mob or government (but I repeat myself) puts guns to their heads or the heads of loved ones, or they just get greedy.

    Bitcoins CANNOT be increased beyond the built-in mining. That’s worth gazillions of someone’s “promise”.

  2. Arguably, that’s also one of greatest weaknesses of both Bitcoin and Ripple.

    We have to remember that currency is used to enter transactions; the more transactions there are, the more of the money you need. As the economy grows, a fixed-supply currency (like Bitcoin and Ripple) becomes worth more in terms of goods and services, and people begin to hoard it, expecting that if they wait a little longer, they will be able to buy more. Once hoarding takes over, circulation ends, and with it the function of the currency. Hoarding accounts for the large recent increase in the value of Bitcoins. This could be a problem.

    An even bigger fundamental problem with Bitcoins, and any other such currency (Ripple included), is that there is no way to limit its supply. True: Bitcoins cannot be manufactured beyond the limits set by Satoshi Nakamoto. But there is no way to prevent people from creating Bitcoin alternatives, like Litecoin and Ripple. If merchants are willing to accept Bitcoins, then they have no reason to say “no” to these alternatives, especially as Bitcoins become scarce and consumers scramble for alternatives.
    Nakamoto must have realized this, because there are certainly not enough Bitcoins to substitute for the currencies around the world (can 21 million Bitcoins REALLY be shared by billions of people?). A currency can only succeed in the long term if it is expanded or supplemented. But if there are no constraints on alternative digital currencies, then the value of Bitcoins will plummet as soon as a limitless alternative begins to circulate. And once it becomes clear that there is no limit, people will begin to realize that their holdings could potentially become worthless at any moment, and demand for Bitcoins and the other currencies would collapse, effectively killing the entire thing.

    It’s extremely risky to limit currencies, especially at a relative low number.

    Besides, nobody has any idea who Satoshi Nakamoto is, so his “promise” (ie: that limit that he set at 21 million Bitcoins) could be considered equally worthless as to the makers of Ripple. For all we know, Nakamoto could be: a group of eccentric academic researchers, mischievous Fed economists, DARPA using the public as guinea pigs, banking globalizers in black helicopters, a criminal syndicate, or even a supremely bored 15-year-old Ukrainian genius. If Nakamoto were to be as amoral as he/they are ingenious, then he/they pocketed the early Bitcoins and possibly laughed himself/themselves to the bank.

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