Guest post by Lane Miller, Martin Capital Management
To call Bitcoin a boondoggle is, admittedly, hyperbole. The crypto-currency has spurred a fascinating exploration into the relevance of “blockchain”[1] technology for reorganizing financial services.
A currency untethered from central bankers is precisely what proponents of gold have advocated for decades. Conveniently, computer code is far easier to transport than metal. The blockchain could sideline whole departments of global banks as financial settlement could be near-instantaneous and immutable. There are potential benefits to the progeny of the Bitcoin revolution. “Investing” in Bitcoin itself, however, is a very different matter.
Traditional investing seeks to make a return on the deployment of capital, ideally by buying a company, security, or tangible asset that is expected to become more valuable over time for a price that’s congenial to that goal. Investment and speculation can often look identical in practice, though both require the purchase of something.
Into that grey zone has leapt a proliferating assortment of smartphone apps—Acorn, Robinhood, Wealthfront, Betterment, etc. The list goes on. Robinhood aside, they are largely riding the wave of the ETF boom and have succeeded in eliminating nearly any obstacle to entering the stock market for the cell phone-savvy generation—assuming they have money to invest.
Enter Coinbase. Attracting 50,000 new users a day last December, the app was one of the Internet’s most popular during the Bitcoin boom. Whatever you may think about ETFs, a lower barrier to entry into the crypto-currency space is a horse of a different color. Once the purview of computer nerds (rechristened “crypto bros”), Bitcoin, Bitcoin Cash, Ethereum, Ethereum Classic, LiteCoin, and dozens of others via lesser known apps, are now quite literally a click, swipe, and tap away from your pocket. For those without money to invest (even the 20%-plus gain on the S&P last year looks insufficient if you’re one of the 61% of millennials with less than $1,000 in savings), cryptos may have seemed a tantalizingly effective way to play catch-up in the money game.
Needless to say, despite the few relatively logical arguments floating through the blogosphere that advocated a future for today’s cryptos, December saw massive speculation in the crypto space. If any doubt remains, see the last six months.[2] Even if some rationale for long-term holding were valid (an engagement with which is not the point of this post), the massive price retreat clearly demonstrates the extensive froth in the crypto markets.
If you’ve come to our blog for commentary on investing, this examination of speculation may seem tangential. The crypto saga, however, is something of a microcosm of financial-market themes. Its dynamics are instructive, and we would be wise to notice their application beyond the crypto-sphere.
App Sellers and Bank Tellers
The app world has a short attention span. Angry Birds had its day. The original teenage adherents now play Candy Crush and give Angry Bird stuffed animals to their children.[3] Coinbase too no longer garners the same downloads it did last December. Not surprisingly, crypto prices are down. This is the first dynamic of the microcosm: the politics of distraction.[4] The buying of Bitcoin can feel like the playing of Angry Birds when times are good. I mean this both literally and phenomenologically.
First, both apps require a tactile sequence—click, swipe, and tap—that literally stimulates our brains in similar ways. They shared, at least until December 2017, a continual and rapid accumulation of points, levels, or prices, all of which create powerful, positive feedback that reinforces the behavior.
Second, on a phenomenological level, the appeal of smartphone apps distracts from an ugly, inescapable reality of loss. Angry Birds encouraged a surprisingly large waste of precious time (I’m not the only one to have sacrificed the wee hours for a few more levels). Coinbase, behind its fantastically appealing interface, encouraged the loss of very real money—assuming you weren’t one of the lucky buyers who suffered the pain of mere paper losses. The job of an app seller is to create positive feelings of immediate gratification, not to care for users’ long-term well-being.[5] Unfortunately, as with all vices, the distraction of the former can cost us dearly down the road.
In this, apps function very much like derivative markets. All analogies have their limits, so please bear with my delineation here.
In the early stages of the global financial crisis of 2008–09, liquidity was a far greater concern than that of solvency; few asset-backed security products experienced real losses. The liquidity issues were caused in no small measure by unintended consequences in the derivatives market. This is because—to simplify immensely—a pension fund could buy a $1 billion AAA-rated tranche of a mortgage bond from a bank with 10% down and borrow the remainder through money markets, using the assets behind the bond as prime collateral.[6] While no one ever expected a money market to refuse lending against that mortgage bond, a cautious fund holding the above position could have guarded against a margin call from a decline in the bond’s mark-to-market value, by buying a credit default swap (CDS). Reassured by this clever system that the banks devised, a pension manager could sit back and watch the steady returns of his leveraged position grow from the comfort of his screen.
Essentially, the derivatives created a positive feeling of safety and, much like the apps above, distracted from the inherent instability of the funding mechanism and obscured the possibility of loss. They made the leverage feel OK. (It turned out that the sellers of the CDS contracts never allocated capital to back up their guarantees.)
Distraction is a dangerous foe in the managing of money.
Contraindications for Correlations
On December 10, 2017, the Chicago Board of Exchange launched trading in Bitcoin futures. It moved up its launch date to beat that of the CME Group, which was scheduled a week later. The price fell precipitously, further encouraged by the February crash in stocks.
Since then, the trading of Bitcoin has gone mainstream. You can now buy it commission-free on Robinhood. The crypto hedge fund is no longer novel. Bitcoin mutual funds are seeking approval by the SEC. The crypto bros have moved from the suburbs to Wall Street.
Perhaps the clearest indicator that Bitcoin is making a move into mainstream finance is the discussion of correlations across the financial press. The likes of Forbes notes with apparent interest that crypto-currencies are “not correlated with other assets,” making them a potentially attractive addition to a portfolio.[7] Regardless of whatever future crypto has, let us dwell for a moment on the absurdity of the logic for inclusion being correlation.
First, crypto-currencies have been widely traded for only the last two years. The table below shows the number of initial coin offerings (ICOs) by year and the amounts raised next to the Bitcoin price.
| ICOs | Amount (mm) | Bitcoin Price (Jan 1) | |
| 2014 | 2 | $16 | $803 |
| 2015 | 3 | $6 | $284 |
| 2016 | 29 | $90 | $435 |
| 2017 | 873 | $6,137 | $909 |
| 2018 | 1045 | $6,794 | $17,099 |
*Figures gathered from ICOdata.io
You can see where public interest took off (and why futures traders had an easy bet to make that Bitcoin would fall). Any serious correlation must be based on historical relationships, of which, by definition, there are no substantial ones to reference. Crypto prices, a recent working paper determined, are affected by “cryptocurrency market specific factors.” Crypto-currencies have gained Wall Street and Main Street attention, however, only to the extent that they paralleled the epic bull market run of 2017. That is not history; it is still hearsay. No one knows what happens to Bitcoin in a bear market. No one knows how crypto responds to higher than our historically (and unprecedented) low interest rates. It is not even clear how the products are taxed!
The problem of history, however, is an elementary objection. The real issue is that of relationship. The inverse correlation between stocks and bonds (irrespective of whether you concur with the theory) is predicated on the idea—and often observed reality—that bonds trade up in price when stocks fall.
Although correlations exist, their stability is limited. Stocks and bonds, crude and the U.S. dollar, and the two-year Treasury yield and LIBOR (London Interbank Offered Rate) do not always move in tandem. Even when they do, correlations are often not well understood by many market participants, making them potentially quite dangerous.
For example, the aforementioned leveraged AAA-rated mortgage bonds that were pledged as money market collateral did not actually trade very often. Since money markets are required to mark their assets to market every day, they needed a means of valuing the bonds. They turned to the CDS market. Since the CDS was insurance on the bond, surely the insurer knew the value of the underlying asset. CDSs traded with frequency, so the money market value attributed to the bond was inferred not from its own credit-worthiness, but its pricing in the insurance market.
But when banks stopped writing CDSs due to, among other things, their exposure to subprime losses, the price for insurance on all mortgage bonds skyrocketed.[8] Subsequently, markets perceived an increased risk in the AAA bonds and would no longer take them as collateral. Finally, leveraged holders of those bonds could no longer finance them. The house of cards collapsed, despite no rising defaults in AAA bonds. If the fuel was the ubiquity of leveraged bonds, the power of correlation was an accelerant to the fire of the crisis.
Correlation is a bad way to price things.
What comfort, thus, is there in any correlation to Bitcoin? If correlation (or inverse correlation) exists, it can work against a portfolio in unexpected ways, as it did in the CDS example. If it is wholly uncorrelated, perhaps it is because its history is too brief to say otherwise. Or, perhaps, it is as real an asset as cotton candy. They both lack property, means of production, cash flow, and a variety of other features. Judging by the last nine months, they are both also poor at storing value.
Finally, if you want to buy Bitcoin, go ahead. Full disclosure: I have ($100 in April 2017 that I sold for nearly double that amount just two months later). Speculation is endemic to human nature, but if you’re judicious with the inclination and hit it lucky, you might make some money. That is not investing, however. And the conflation of the two is perhaps the most instructive lesson the story of crypto offers the financial markets today.
[1] Blockchain is the technology that underpins digital currency; it’s a database shared across a network of computers.
[2] Note from Frank: We introduced the subject, “The Bitcoin Premonition,” to our readers on December 15, 2017, featuring guest writer Edward Chancellor. The present post was written by my able associate, Lane Miller.
[3] For the uninitiated, Angry Birds and Candy Crush are two popular smartphone games. Any further description is best substituted by a Google Images search.
[4] Speculative bubbles often enjoy the introduction of some new technology to catalyze their explosive growth. John Law used paper currency, which entered wide use only some 20 years before he founded his bank. The financial crisis stemmed largely from the use of CDSs (credit default swaps), which were created just 14 years before the fall of Lehman Brothers. Bitcoin was first launched in 2009.
[5] I admit that the smartphone may increase productivity in some ways, but the device is not a technology intent on making us productive. It is a technology intent on having us use it. Therefore, its value-add to life is up to the user to maintain, usually at the expense of valuable and limited self-control. Its benefit is far from a given.
[6] For the technically inclined, see Jeffery Snider’s recent interview on macrovoices.com, August 9, 2018.
[7] https://www.forbes.com/sites/chuckjones/2018/08/11/one-chart-explains-why-you-should-own-bitcoin-and-other-cryptocurrencies/
[8] For the technically inclined, this was particularly true of the subprime and AAA-rated tranches of the market. Since the AAAs were collateral deeply involved in liquidity instruments (repo and money markets), CDS spikes caused global liquidity issues.