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Entering the Crypt(o)
By Will Myers
“Never invest in a business you cannot understand” - Warren Buffet
For those of you that are short on time, or have already lost interest, that opening quote pretty much sums up the point that I am going to be trying to get across. Not to mention the fact that Warren Buffet said it, which makes it the investors equivalent of being written on stone and brought down from Mount Sinai. It is however an important starting point, and indeed one of the standard questions that everyone at Cadence get asked on a daily basis, often almost sheepishly… “out of interest, what do you think about Bitcoin?”, accompanied invariably with a wild financial success story from one of their peers, but, when pressed, there is generally very little in the way of knowledge about what it actually is, just that it appears to make money.
I shall therefore attempt to have a go at explaining what it is. Firstly, the concept of “Blockchain”, (which is a phrase that definitely sounds like an 80s 8-bit platform game) is important to distinguish from “Bitcoin” as it has other derivations in innovation and forms the basis of how Bitcoin trades as a currency, indeed Bitcoin was its first application. (Are we all ok if I stop putting the words in quotation marks now?) Blockchain is basically a digital leger able to track infinitely fast trades and transactions and so now that technology is applied to things as far reaching as banking, healthcare and supply chain. In it’s simplest terms, Bitcoin (or Cryptocurrency if you want to use another, incredibly nerd-from-a-Spielberg-film sounding word, it means the same thing) is a unit of measurement for services or digital trade stored on a public leger-i.e. the new age equivalent of a miserly man with a counting cap scribbling on a notepad.
Bitcoin was invented in 2008 by Satoshi Nakomoto as a way of bypassing government regulation, third party transaction costs, mediating very fast payments that are easy to keep anonymous, and was reputedly set up to pay for digital services rendered, where the participants agree on the validity of the trade via a “consensus”. (Quote marks are ok there as that is actually the term). There are a whole myriad of other terms and concepts as to how that value is derived, but, to those of you that have got past the opening quote, this is probably enough now. So this new currency became a very fast way of being able to trade goods, services and err… information across the Dark Web (literally everything sounds like its from Star Trek) without it being traced, needing to have the exchange regulated, observed by authorities or centralised by a governmental bank. So yes, Bitcoin became the currency of choice for people wanting to share resources with other people who did not want any authorities to see what was being traded.
Notwithstanding the connotations above, having no regulation brings about an immediate issue, especially when people declare they are “investing” in Bitcoin-exactly what are you investing in? Whilst the days of holding a Ten Pound note and declaring that you could walk into the Bank of England and demand that much in gold have moved to urban myth, it is true that each note is essentially a bearer bond with a government backing behind it; there is a ratified jurisdiction that guarantees the value of what is otherwise an odd bit of colourful (non-vegan) plastic. Cryptocurrencies do not have that backing (as yet) and so no one really knows what is underpinning that noted value; at present the value against mainstream currency indices is almost exclusively based on what the market (in this case demand for it) decides it is. Whilst we will come to this in greater depth later on in the piece, that is one of the reasons for the well-publicised and wild fluctuations in price (for example dropping up to 40% in 24 hours on January 16th (source: Morningstar))-there is no tangible expression of value against it’s governmentally backed peers. One of the reasons that this notion of regulation became so important in following the Noel-Edmund’s-career-esque peaks and troughs in this infant currency is that it was the threat of banning or the movement to do so in the large Asian economies that caused the tailspin. China had originally seen nine tenths of global virtual currency exchange movement, until the government shut down the trading altogether last year. Now that is not to say that China is perhaps the most renowned country for freedom of speech or interpretation, however it is telling that the oldest (I’m aware this is a maximum of 10 years) market has led to suspension. Whilst the Japanese have had a little more leniency and have taken over from the Chinese as the largest exchange market for cryptocurrency, they have famously suffered their own scandal when Mt. Gox (a large Japanese based exchange) collapsed. The Japanese government have since offered 11 licences for Bitcoin, and have some semblance of quality control, though the driving issue remains; there is still no tangible entity to the value.
The purpose of this article is to give some sort of logic to the Cadence view on Bitcoin, and I feel compelled to return to that structure without getting lost in a Dark (meandering) Web of my own, so to establish where we are so far-no regulation, no tangibility and wild volatility based on governmental conjecture and market sentiment. We all there? Good, lets carry on.
So, if the majority of people don’t really don’t know what Bitcoin actually is, there is yet no denying that an awful lot of people have made (or currently hold…) an awful lot of money from them, how can that be? An excellent answer to my own posed question (funny how that can happen) comes from Charles Kindleberger, author of “Manias, Panics and Crashes” which focusses on the theory of economical bubbles and their cycles where he states:
“There is nothing so disturbing to one’s wellbeing and judgement as to see a friend get rich”
I like this an awful lot and has hit me as so utterly pertinent as to the a) the buoyancy of the market and b) the incredible variety in value. As alluded to at the top of the piece, our advisors are asked all the time about investing in Crypto, and largely it’s because someone they know has made a fortune; everyone wants it and so they must get involved before it is too late. This however can only increase its volatility, especially when people either lose their appetite for it, the value changes too dramatically, there is a scandal, or, importantly, when people get bored.
The classic model of a bubble (developed by Kindleberger after it’s original theorising by Hyman Minsky) has five stages; Displacement, Boom, Euphoria, Distress and Revulsion. It is the Euphoria stage I particularly am eager to note in relation to the elaborations above. In Minsky’s theoretical definition “people buy because others are buying and because they anticipate being able to sell quickly at a higher price”, it is not difficult even in your own experiences with Bitcoin (I’m sure) to find a relatable anecdote to that supposition. It is also here that you begin to get differing attitudes with Bitcoin “investors”. There will be firebrand ambassadors who declare that they will stick with their lot regardless of market fluctuation and that it will come good in the end, anxious new individuals with unforeseen riches who see their wealth melting before their very eyes (important as ever to note that until an investment is realised it is not worth anything) then nervously sell en masse, accepting the current value, and finally prospectors who look to take advantage of the perceived (and enjoyably etymological) Dead Cat Bounce to make some quick cash.
This is not to say that it is my (or indeed Cadence’s view) that we are yet in the Distress stage, but I would certainly opine that we are approaching it, and again, would encourage those of our clients that are fervently adamant that they want to invest into the Crypto space to treat it as a trip to Cheltenham; only put in something they are willing to lose and have a date or amount that they are happy to get to. And then get out.
I guess my overall view on Bitcoin has not been exactly hidden over these last few paragraphs, but my real issue is that the vast majority of the holders of the asset do not really know what Bitcoin is, and my fear for those clients that I look after who have Crypto as part of their overall wealth accumulation portfolio have real exposure into something that is even almost entirely driven by sentiment, not by any sort of rationale. Of course, economic theory is exactly that, and life has much greater nuances than can be put forth in a textbook, however I firmly believe that the Bubble model fits. We have seen one of the greatest boom periods in any period of history (The Dutch Tulip Bulbs, Mississippi and DotCom to name but a few) and they have uniformly followed the same pattern. My advice to would be Bitcoin prospectors is to carefully look at where we are likely to be in the cycle, and for those who already have their gold, to think about their profit as it stands and the significance of that figure to them. No one wants revulsion, by any definition.
I will bookend this article with another quote from a renowned genius, this one of the 17th and 18th Century who lost a significant part of his fortune in the notably absent South Sea boom from the analogue above, Sir Isaac Newton, saying on the matter “I can calculate the motion of heavenly bodies, but not the madness of people”. Perhaps more pertinent would have been to heed his own words “what goes up, must come down”.