Bitcoin inventor Satoshi Nakamura closely monitors the launch of Bitcoin futures (photo via @vexmark)


In the land of milk and honey
You must put them on the table

You go back Jack do it again
Wheel turnin’ ’round and ’round
Steely Dan

I’m a bit of a Bitcoin skeptic. I think it’s a bubble and at some point the dancing stops and some folks get left holding a very very virtual bag. If you’re one of those who thinks the real bagholders will be the ones owning dollars in the ‘legacy financial system’ after the advent of millennial kingdom come, you can stop reading.

Nevertheless I’m very bullish on blockchain. Maybe we’ve barely scratched the surface and it will be as ubiquitous as the Internet.

Cutting to the chase, I think $10,000 is at the high end of plausible valuations. If Bitcoin is a manipulated market, which may be the case, this week’s launch of Bitcoin futures could very well pop the bubble and crash the market. Because for the first time, you can have real price discovery from smart money, that can bet big, go short in any size at any price where it can find a counterparty, and doesn’t have to worry about counterparty risk, custody w/cybersecurity etc.

Futures could also turn out to be a debacle with no institutional interest, no clean basis arb between ‘physical’ and futures, no arbs, no volume, shenanigans bringing the contract into disrepute (See also Craig Pirrong, the Streetwise Professor and Nassim Taleb).

But wouldn’t it be ironic if futures cost less to trade than Bitcoin on the blockchain with better liquidity, less risk? Maybe you actual need brokers, exchanges, central clearing, daily settlement, custody, credit, margin, in order to have a complete, safe market? Who knew?

Somehow, Bitcoin manages to be slower and more expensive to trade than ‘legacy’ trading venues, with none of the liquidity or mitigation of sundry operational risks. Not to mention that recurring staple of Bitcoin news, the record-breaking heist.

Turns out the devil is in the details of market structure. The magic of the blockchain notwithstanding, most Bitcoin trading may take place off the blockchain and look a lot like traditional financial markets.

If Bitcoin is not a manipulated market, maybe the bubble has farther to go. But how much farther, realistically?

If Bitcoin is a currency, then compare its current ~$300b market cap to pre-QE USD base money of ~$1,000b. Seems like a lot for a ‘currency’ that has minimal legitimate real-economy transaction footprint, vs. something that ran a then-$14t GDP economy backed by nukes and aircraft carriers. Actually, an order of magnitude more real-economy transactions throughout the production chain, plus a lot of black-market and foreign transactions that don’t show up in GDP, and never mind financial transactions.

Demand for a currency as a medium of exchange is a function of the real-economy transactions it enables.

Of course Bitcoin is the most obvious bubble ever. And the bubble makes it risky for real economy transactions. Everyone who ever spent 10,000 BTC to buy a cheese pizza is crying in their beer now. Until volatility settles down, people will be reluctant to transact with it and tend to hoard it. That’s what deflation does. If your currency will buy more tomorrow you won’t spend today. It’s great for a financial asset but terrible for an economy and a currency and a payment system. Modest, predictable inflation is indispensable grease in the wheels of an economy at the mercy of menu frictions and behavioral heuristics like loss aversion and money illusion.

It’s a catch-22. The volatility and constant rise in price make it unsuitable for real-economy transactions, which mean it can’t justify the ever-rising price.

The price has achieved escape velocity from reality.

I think people who say Bitcoin should go to $400,000 are either making simplistic arguments to get on TV or talking their book. They aren’t doing anyone any favors. Except maybe ICO con artists swindling their marks.

It’s hard to value Bitcoin as long as it’s untethered from the (legitimate) real economy. Have you ever seen someone wearing jewelry made of Bitcoin? Is Bitcoin going to fill your teeth or coat your windows or make your electronics corrosion-free? How much use will Bitcoin really be after the apocalypse? Outside of paying for contraband and malware ransoms and evading capital controls, what real use is it? Without any linkage to the real economy, why is the low single digits of financial wealth in gold the correct comparable to come up with $400,000 per coin, which would mean $8t total outstanding or 1/3 of US stock market cap?

In what ways is Bitcoin equal to, let alone superior to gold in liquidity and long-term reliability as a value store, linked to the real economy? Shouldn’t there be some discount in case a digital asset superior to Bitcoin 0.x turns up? Isn’t it some function of what real wealth alternatives are available, what their relative utility is for yield and risk expectations and real-world acceptance, how much the market demands of each?

What is an appropriate valuation metric? Let’s start with the novelty value. $10b is a round number. That’s order of magnitude for Beanie Babies or Pet Rocks, adjusted for inflation, and the more interesting experiments richer geeks can do with Bitcoin.

Add an appropriate valuation for the Bitcoin needed by black markets. This may vary widely over time, depending on adoption, depending on whether there has been a recent crackdown on the latest Silk Road / Alpha Bay, depending on current money laundering flows to/from capital controlled jurisdictions. But you can handle a lot of transactions in a year with each unit of Bitcoin. $100b of Bitcoin you could probably recycle through at least ~$1t of transactions per year with not much velocity-optimizing financial technology infrastructure.

Pulling a wild-ass guess out of my you-know-what, the largest market cap I can justify for black-market transactions is on the order of $100b. This is considering the size of black markets, what percentage of transactions might start to be done in Bitcoin in the not too-distant future, some reasonable velocity, comparing to the number of large-denomination USD and euro bills outstanding, the gold inventories that back financial instruments.

As a store of value, if you want to use gold as a comparable, you have to exclude gold that isn’t a private financial asset. You have to think about how the market will shake out between gold and Bitcoin if they are close substitutes. You can’t just assume Bitcoin replaces gold 1 for 1, or expands the market for ‘hard pseudo-currency store of value’ 2 for 1.

Bitcoin for black market transactions and as a store-of-value has issues: volatility, significant transaction lags and fees, the fact that it’s not as anonymous as you may think, the fact that authorities probably can and will crack down on it hard when it’s worth more to them dead than alive.

So you need to apply some discount for the possibility that cryptocurrencies will take only a small chunk of that market, or other alt-coins will come out on top. And maybe some premium for the likelihood of mainstream adoption in legit markets.

True, Bitcoin is more transportable than gold and can even be used for electronic payment. On the other hand the link to the real economy and long-term reliability as a store of value are weaknesses. Frequent flier miles, gift cards, and other forms of private electronic scrip are not an investable asset class. Scarcity value can be mitigated by other cryptocurrencies popping up.

I’m still a skeptic. If Bitcoin gains traction in the real economy, it has to be stopped, or highly regulated. Because governments rely on taxes. They don’t like giving up seignorage, management of economic policy, and use (abuse?) of the financial system for law enforcement, sanctions, foreign policy purposes. And China, for now, has shown that you can actually bring your entire Internet under state control. It’s technically feasible to stamp Bitcoin out or at least, repress it to within an inch of its life.

It’s also politically feasible. FDR banned personal ownership of gold, and he is nevertheless not generally regarded as a tyrant in circles that aren’t populated by rabid mouth-frothers. Politicians will cry that Bitcoin facilitates illicit drugs and international terrorism.

Governments will bring Bitcoin to heel if it challenges fiat currencies. So Bitcoin as a financial system outside state control is an oxymoron. Either it’s a marginal black-market construct, or it’s a tightly controlled appendage to government currency markets, like gold. It cannot be both mainstream and outside state control.

I could be wrong, but my wild-ass guess for the reasonable order-of-magnitude ‘terminal’ value for Bitcoin is in the $1000-$10,000 range (market cap of $20b-$200b, order of magnitude). I don’t have high confidence, maybe 50%. Visibility into the demand for black market activity and as a store of value is pretty limited. Maybe Bitcoin gets superseded or stamped out almost entirely. Or maybe there is something more to the store-of-value argument than I’m seeing. Aswath Damodaran wrote the book on valuation, and he says you can’t value Bitcoin. But his definition may be narrower than mine and surely you can place some order of magnitude limits on a plausible relative price.

I think Bitcoin valuation and prospects for mainstream adoption are overblown. I think the 2017 runup is due to bubble dynamics. It’s the most perfect bubble ever. There is no value metric, no intrinsic value, no PE, no interest to collect on it. If you think it supersedes the ‘legacy’ financial system, there is no valuation too high.

But let’s talk about why I love the blockchain.

Blockchain is a secure distributed database service. In the old days a database meant something like Oracle. Then the Internet came along, and because Oracle technology and pay-whatever-we-can-extort enterprise pricing didn’t work for something like Yahoo, we got open-source databases. Open source just means tech companies like Google, Facebook, all the way down the chain, develop standards and norms and software in areas where they don’t compete because competition would stymie progress and profits in the whole ecosystem.

Even competitors cooperate some of the time. Warring nations have conventions against chemical weapons or first use of nukes. If you violate them you may win the war but you may not have a planet to live on.

Buying Microsoft or Oracle software and giving them a big vig and strategic power is a nonstarter. Every company building their own proprietary stack of OS, database etc. is also a nonstarter. So they support efforts like Web standards, Linux, Apache, and MySQL and share the technology around them, which is not very strategic, and focus on competing further up the value chain.

MySQL is a funny case. Because MySQL was bought by Oracle. Even in the open source world, you cannot escape a principal-agent problem. You back an open-source software project, the developers and the managers of the legal entity can sell you out. Now you still have a software license but you have an exit/voice decision, where exit means forking the project. (Anybody remember CDDB? The most blatant fencing of digital commons to date, privatizing something people built as a public good.)

Blockchain takes the open-source paradigm to a meta level. In ancient times, suppose some folks started an open-air market for securities under a buttonwood tree. They develop ways of doing business, they eventually find the need to invest in infrastructure, to document and formalize practices. They create a legal entity and build a nice building with a pediment and a frieze. Now you potentially have a principal-agent problem if the board and folks who run it can make big bucks and run it for their own benefit or a club of insiders.

Software is eating the world, and blockchain is how it eats this sort of coordination problem. You enshrine the rules of the exchange in peer-to-peer software which every exchange member runs and which uses a common blockchain distributed over all members’ computers.

Now you don’t need an exchange floor, and you don’t need a rules committee, or much of an organization at all, the rules are enshrined in the software, and the members run all the IT. Now, no matter what political shenanigans ensue, no one can change the rules unless everyone agrees to run new software. If only some of them switch, you have a fork, and effectively two exchanges competing until one wins. The exit-voice problem is turned on its head. In order to change the rules of the game, you have to get everyone to agree to run the new software.

If you were starting an exchange, or any kind of market design today, frequent-flier miles, Wikipedia, organ transplants, would you rather enshrine the rules and data in a legal form, in a central organization, or in software?

For many collective action problems, software is just better. Not necessarily because it works better, but because it’s transparent and has built-in resistance to shenanigans. (Here’s a good explainer.)

Does it eliminate shenanigans completely? No, you still have governance, politics. But it moves everything into the software and the blockchain where it’s transparent, and no one can unilaterally change the deal. This is has potential to be a proverbial Big Deal, a game-changer.

Is blockchain better in every way? No. Anything that can be done on the blockchain can be done much more simply, much more efficiently in a centralized database. But that database is a nexus of principal-agent problems. It can be hijacked. Blockchain is a CAP tradeoff to perform very well in terms of availability and surviving network outages, but poorly in that consistency is potentially very eventual when it’s under strain. When the database is distributed among the users, it’s highly resistant to shenanigans but not necessarily highly performant.

How much does performance and efficiency matter? Communists made the argument that capitalism is not very efficient. Capitalists spend enormous resources on advertising to get people to consume, you have dozens of varieties of corn flakes, you have four gas stations competing on four corners of an intersection. What a waste!

But capitalism is extremely effective at giving people incentives, at innovating, at searching the solution space for best practices. In other words, at evolving.

As Darwin said, “It’s not the strongest of the species that survive, nor the most intelligent, but those that are the most responsive to change.”

Sexual reproduction wastes a huge amount of energy that could possibly be better put to use acquiring food and resources for survival. But it allows the species to rapidly mix and match features, to evolve rapidly.

In a similar way blockchains may be quite complex and inefficient in computational resources, but they may be a catalyst to allowing many institutions to evolve, to rapidly test a large number of new organizational models and incentive structures.

Technology seems to advance by alternately taking things apart and then putting them back together. We went from highly centralized and integrated mainframes to distributed PCs, back to cloud computing, which is an evolved mainframe model built on virtualized PCs emulated in software. (Predicting that in 1984 would have been a 1-way ticket to the loony bin.) We went from AOL and Compuserve to the unbundled, distributed Web and back to Facebook and Google walled gardens. Mammals replaced dinosaurs, and at each iteration capabilities improved.

Unbundled, modular, open systems evolve faster because we can rapidly add and improve individual parts, like Unix or an industry standard architecture PC with expansion slots. When we reach a point of diminishing returns, when we have fully explored the search space, when we have figured out best practices, we can usually improve it by building a highly integrated system, like an iPhone. Integration makes it possible to simultaneously optimize all the hardware and software components to work well together.

Eventually, technology will evolve again, and perhaps a more open system will regain an edge in mobile devices. But when a highly refined, integrated and optimized system works, it’s a thing of brutal beauty that destroys everything that competes with it. (I’m thinking of the old IBM, Microsoft Windows, and the iPhone).

More likely than something replacing these apex predators, they become commoditized and cells in higher-level, even more evolved organisms. (Artificially intelligent robot swarms coordinating peer-to-per? Everyone living in a virtual reality matrix? Who knows what the next level of evolution may bring.)

I think Bitcoin and blockchain should be seen in the light of this dichotomy, this swing of the pendulum between open and distributed v. centralized and integrated. The pendulum has swung too far towards centralized cloud services and the ‘Fearsome Foursome’ of Facebook, Apple, Google and Amazon (maybe the ‘Frightful Five’ with Microsoft) owning our lives.

Over the next decade I foresee huge pushback against the Facebook/Google/Apple mobile/cloud model, and crypto, blockchain, peer-to-peer apps will be a big part of that.

The smartphone/cloud (and especially Facebook) is Huxley’s soma – we are addicted to notifications and ‘likes’.

The smartphone (and especially Facebook) is also Orwell’s telescreen. You carry it everywhere in your pocket and it monitors all your communications, everywhere you go, whoever you interact with, even in real life.

Some people buy cloud microphones for their kitchens and bedrooms and pay big tech companies to spy on them. Even Orwell wouldn’t have dreamed of that.

Big Brother uses AI to learn your greatest fears and desires and what to show you when, to optimize you for engagement and manipulate you into clicking.

The level of data collection is more than a risk, it’s a practical guarantee of totalitarianism. The only question is whether it’s techbros and rogue AIs who are going to watch everything you do and create the rules of the marketplace to determine what you see and watch; or the state; or thugs who hijack it to gain power.

And the drive for clicks drives extremism, because extremism = engagement.

The beauty of 30 years of open market free-for-all tech evolution and exploration is giving way to brutal centralization and integration. That’s why a free and open internet in the form of net neutrality is so important, and the need to resist authoritarianism in all its manifestations.

I think 20 years from now the Bitcoin frenzy may be looked upon as a fad. Bitcoin isn’t going to topple the financial system. Blockchain will be adopted as a sustaining innovation by banks and governments. To some extent, after the crash, Bitcoin might survive in various niches at a plausible market value, and slowly start a climb up the slope of enlightenment to the plateau of productivity.

But the frenzy also reflects a desire to challenge centralized power structures. People are dissatisfied with institutions. Wealth and power are centralizing and gaining commanding technological advantage over the individual. Blockchain and peer-to-peer crypto paradigms will challenge centralized power structures in unforeseen ways.

Imagine a boot, stamping on a Bitcoin symbol, forever.

God bless us, every one – Tiny Tim (and Andrea Bocelli)