Mirror, mirror on the wall,
Who is the fairest of them all？
The Real Thing Is Blockchain/DLT
Since its birth more than ten years ago, Bitcoin has been regarded as a financial phenomenon. Today, we begin to see the far greater impact that the underlying blockchain technology will have on human and society. China has named it as one of the five pillars that are driving a revolution that will usher in a new era of cyber-integrated social ecology.
The other four pillars are:
1. big data
2. super-computing clouds
3. automated deep-learning and artificial intelligence
4. quantum communication
One of the existing five pillars that will usher in the next revolution is also the Internet of Things （“IoT”）. Quantum communication is a future factor, at least a few years away, not one of the present five pillars. The advent of 15-bit and 20-bit quantum computers will revolutionize all five pillars yet again, and we will officially be in the post-internet age.
Together with blockchain technology, they are developing symbiotically in geometric scale. The resultant socio-industrial ecology will supercede all previous modes of social evolution, qualitatively and quantitatively. In other words, we are about to enter a Big Bang, a whole new reality.
I am sounding like a sci-fi writer, whom I am not. So I will stick to Bitcoin, the purported currency, which it intrinsically is not. This post will hopefully refresh your financial knowledge with some history and insight into human market psychology.
An Unintentional Reflection
The current Bitcoin phenomenon is, in my opinion, a reflection on the world’s currencies. If you take out the word “coin”, it would have been just a computer game, very original and sophisticated at its inception. Similar games using blockchain techniques have come out in recent years, such as Breed Your Personal Pets in China, which allows players to “conceive and give birth to” virtual pets with distinct genetic IDs. They can breed with others, replicating their DNAs, resulting in offspring that patently belongs to you. From there, you can invent your activities and transactions.
When they insert the word “coin” and set up the Bitcoin game’s virtual reality plot as mining of ore, like you are digging for gold, and start hawking your finds as money.
That took off as something else altogether. The virtual and the real converge. What is virtual becomes real, as what is real becomes virtual. And humans create all sorts of strange phenomena – for example, now with remaining supply dwindling, the competitive miners are installing “tools” that are burning up more and more electricity, and the sharp ones are moving into China’s hinterland where the price of electricity is dirt-cheap.
The notion of Bitcoin as a crytocurrency is only secondary. Its functional qualification as money is far from adequate (see post “What Is Money” from a few years ago). Primarily, the Bitcoin phenomenon serves as a mirror on what we use as our money, in the case of the US, the Federal Reserve Note (aka the US Dollar). But it casts a similar reflection in other currency jurisdictions as well. Mind you that by far the largest market in Bitcoin is China, then Korea and Japan.
After the 2008 financial tsunami, all the central banks behind the world’s major currencies have issued massive amounts of additional money, breaking all the rules of prudence and basic tenets of central banking along the way. Everybody wonders, but few would dare ask： So what are the consequences of this behavior？
Bitcoin had been in existence for a few years before the 2008 financial tsunami. Because of the unusual shroud of secrecy surrounding it at the time, I even suspected that it could have been a government-sponsored live experiment on the feasibility and technical nuances of operating a regime of totally electronic form of money. For an experiment like that to work, the government must of course not disclose it until circumstances are appropriate （this is not unlike testing ultra-sensitive weaponry systems）.
Sure enough, the big firms on Wall Street, those that had dominated the Federal Reserve System, later announced a joint project on applying blockchain technology in the financial sectors. It reminded me of the days in the mid-1980s when I was involved in the exclusive circle on Wall Street exploring the new products of swaps, swaptions, hybrid and synthetic financial intruments, that eventually ushered in the age of derivatives. Everything was quite hushed up until all the kinks were worked out.
Unwittingly, with Bitcoin, events took on a life of its own after the 2008 financial disaster. The unexpected flooding of money supply mentioned above presented a scenario that was unscripted. Analogous to Frankenstein coming to life, Bitcoin became a sensation. Or rather, humans behaved with Bitcoin like they did during previous speculative episodes – the Tulip Bubble, the South Sea Bubble, the Dotcom Bubble, etc. Once again, speculative profit became real money, as cash in the bank seemed sub-par and other financial instruments were distrusted.
To enough people, Bitcoin showed up as Snow White in the mirror.
The US Dollar
So what is Bitcoin really？ Before we answer that, we should examine the reality of fiat currencies, of which the US Dollar is a prime example. Bitcoin investors are typically cynics of fiat currencies, the US Dollar being the flagship. But what is wrong with the Dollar？
a. Historical Background
To begin with, the current version of the US Dollar was born amid controversial circumstances. Two days before Christmas in 1913, the US Congress passed the Federal Reserve Act that created and established the Federal Reserve System, effectively the central banking system of the country, with the authority to issue Federal Reserve Notes (commonly known as the US Dollar) as the country’s exclusive legal tender.
What we should be cognizant of is that the US did not always have a central bank in its history, and that the Federal Reserve Bank is substantially privately-owned （even though the Federal Reserve System is a legislative compromise that involves multiple mechanisms and bodies designed to provide checks and balances）. Many of our earlier presidents, notably Jefferson and Jackson, were against having a central bank, and many political leaders opposed the idea of a central bank that is privately-owned. That historical root remains in today’s popular mistrust of bankers, and of their collusion and control of the politicians.
For almost a century, The Bank Of England was privately-owned and controlled by the Rothschild family. In fact, many argued that this centralized power in the hands of private bankers facilitated the Industrial Revolution. Others argued that it was the ascent of financial capitalism that led directly to imperialism, the global slave trade and colonisation, propelling dramatic industrial and economic boom in the advanced countries. A necessary tool of that was central banking, and the formation of unified currency as the efficient means to exchange for and determine the terms of trade. The American Revolution was the first successful rebellion under that regime. But the European industrial bankers never left the scene. The sharp ones among them naturally eyed up the new republic as the frontier of the next industrial boom. The strong resistance to a central bank among early American politicians proved to be a tough obstacle.
The Rothschilds eventually abandoned their control of the BOE, as they sensed the post-imperial decline of England as dynastic. The British central bank is now government-owned. But they and other 19th century European industrial bankers did not give up the idea of controlling central banks, in countries where it is worthwhile. By the middle of the 19th century, they viewed the US as the future of industrialisation （much as many would view China today）.
Some historians argue that the US Civil War was financed directly and indirectly by these bankers, primarily to push the US into industrialisation and central banking. In the aftermath of the Civil War, industrialisation indeed took off. But private-ownership of the US central banking system did not become reality until 1913, when Congress finally passed Federal Reserve Act. This was done amidst much controversies, notably the alleged Jekyll Island Conspiracy of political collusion and influence peddling at the bankers’ secret conclave. President Woodrow Wilson lamented later that he was duped by the New York bankers, a realisation that some historians attribute as the main cause of his mental depression in the remainder of his life.
b. Neither Federal Nor Well-Reserved
Despite the controversy, and many think that the Act is unconstitutional, the Federal Reserve System has been responsible for the country’s money since. And it lived through ups and downs, with the nature and substance of the US Dollar changing during them.
In my opinion, the Fed had worked very well in certain periods, notably from 1944 to 1973, under the Bretton Woods system of fixed exchange rates anchored by a Gold Exchange Standard of the US Dollar. The US pledged to support an international fixed-rate currency regime, by fixing the exchange of gold to the US Dollar at $35/ounce, with other countries’ currencies then pegged to the Dollar at fixed rates. That provided the post-WWII world with stability and effective funding for economic recovery. Over almost thirty years, economies in the Dollar-anchored world grew and there was practically no inflation！
For a host of reasons, including chronic trade deficits and heavy drain on our Treasury by the Vietnam War, President Nixon decided in 1971 to abandon the Gold Exchange Standard for the US Dollar and allowed it to fluctuate against other currencies. That ended the fixed foreign exchange rate regime and ushered in the floating rate era that has continued to this day.
Over the last 45 years, the Dollar has lost over 95% of its purchasing power, due to inflation and exchange rate fluctuations. As we ran massive budget and trade deficits chronically over the years, especially during the past two decades, the Fed as Uncle Sam’s banker had to increase the money supply geometrically,. The US Dollar or Federal Reserve Note is just an IOU of the Fed, an entity that has a miniscule amount of capital against its total outstanding liability. What the Fed has in assets are principally Uncle Sam’s debt, or Treasury bills, notes and bonds. To increase the money supply, the FED issues its IOU in return for Uncle Sam’s IOU, with neither the better for credit, only maybe worse. It helps when countries like China, Japan and oil-rich Middle Eastern kingdoms buy a chunk of the Treasuries, relieving the Fed’s strained balance sheet.
So there is nothing nowadays backing the US Dollar, like gold or silver. As a so-called fiat currency, or legal money, the US Dollar is backed by the credit of the United States Of America. In fact, on each dollar bill is printed “In God We Trust” and signed by whoever happened to be the Treasury Secretary at the time of its issuance. In theory, unless you question God, you should not question the integrity of the US government in honoring its IOU, indirectly through the FED. Or should you？ If you persist, you would be looking at the guns of the US military, whose defense of the US Dollar would precede freedom or any other slogans.
Nowadays, many do have questions on how Uncle Sam will be able to repay its debt. Well, I am not going to go into that question because I do not like to debate speculative issues, such as whether the current level of national debt in excess of 100% of annual GDP is too high, or chronic trillion-dollar annual budget deficits are sustainable, or what to do with the upcoming social security payouts for the ballooning Baby-Boomer retirees, spiraling healthcare costs, or upkeeping a military infrastructure that consumes over $700 billion a year and still asking for more. All I can say is that where there is the will, there is a way. At the moment, there does not seem to be the will. So we have not set out to solve the problems, as yet. We assume money can be created, meaning borrowed, endlessly.
That reality does not escape some smart kids, who are the typical original players/ operators in the Bitcoin game. They try to transact without the Fed as the “middle man” and set up many ways and means to use Bitcoin as if it is a currency. In truth, that is not what is happening. At one end of a Bitcoin transaction, there is eventually US Dollars being credited and debited, because that is typically what it settles in, despite nominal “bartering” in between. So in essence, the Bitcoin is an alternative form of a US Dollar carrier. Its players, consciously or not, are making believe otherwise. Bitcoin is not money itself. It is essentially just another investment vehicle, like stocks, bonds and other financial instruments, just a lot more esoteric and/or flaky.
Inadvertently, the Bitcoin players, through their fervent activities and inventive experimentation, elevated the underlying blockchain mechanism into a threshold technology of the future. It points the way to infinite possibilities beyond so-called crytocurrency （for example, China is already testing it to use for licensing administration）. That may be their true contribution to mankind.
Bitcoin As Super-Speculative Asset
If you think the US Dollar is bad in terms of having nothing concrete backing it as a currency, Bitcoin is far worse. But as a form of asset, has it not a solid form of backing, to the extent there is a market out there with people willing to accept it as payment and others willing to offer a higher price to “invest” in it? Besides, does it not store value better if it had yielded 1,600 percent return over the last year, whereas Treasury bonds barely yielded 3.5 percent?
What we have to differentiate here are the forms of value, avoiding the term “real”. There is no intrinsic value in a Bitcoin. There is no hard assets backing it. But it has been proven to have plenty of speculative value, comprised of tangible components such as time value, esoteric option value, volatility value . What is hard to analyze or substantiate are the variables that determine such components. Everybody admits that these values may be highly elusive, but you cannot deny they exist, because humans are who they are and do what they do.
As the Chicago Board of Option Exchange began offering exchange-regulated Bitcoin futures recently, and Goldman Sachs entered as a primary dealer, the market is become more mature. The number of people wanting to speculate on Bitcoin is likely to increase. After all, if you have say US $10,000 to “buy” one Bitcoin, you only need a fraction of that in margin deposit to “long” one Bitcoin futures contract. That provides leverage, sometimes as much as 10 times, or more if you borrow money on the side for the margin deposit. If Bitcoin price rises to US $12,000 in the cash market, that would mean 20% profit for the cash investor, but as much as 200% or more for the futures investor. That attracts a lot of gamblers and hedge funds.
That is precisely what is happening in China, and why the government is stepping in to decide how to regulate Bitcoin activities. The effect of leverage works both ways. If Bitcoin’s cash price falls to US $7,000 say, the cash investor would be losing 30%, but the futures investor will have to put up multiple times his initial margin deposit to cover his position, potentially losing hundreds of, even thousands, percent. In addition to disrupting the financial markets, it opens up the tap on real foreign currency funding, as Bitcoin futures settle in US Dollar.
So like tulips in past history, Bitcoin is the object of a typical speculative bubble. And like tulips, the bubble will eventually burst. But tulips are tulips. It will not be worth nothing, even if it is worth very little. Prescient observers are already saying that Bitcoin, given its limited supply, will be worth something as a collectors’ item. But wait a second, there is no real physical coin （even though you can make up all forms of Bitcoin “tokens”）. The real McCoy is just a long string of electronic digits in cyberspace that you can neither touch nor feel … unless you are really weird.
Perhaps someone should start making t-shirts that say “I once made and lost $ 2 billion in Bitcoin”. There may be some real money in it.