A response to Rory Gillen’s views on Bitcoin

Over recent weeks months, several high profile figures in the banking and finance world have taken time out to comment on Bitcoin. Their message has been singular: Bitcoin is worthless and its recent rise is value is a speculative bubble.

There has been lots of commentary from the Bitcoin community challenging this view, which can be reviewed elsewhere. I’m going to specifically address the views raised by Rory Gillen, of the Irish investment company, Gillen Markets. Rory published an article in August this year in which he elucidated his understanding of Bitcoin, and why it isn’t “sound money”. The article can be view here. I going to quote it and respond to each quote in turn.

“..an understanding of what constitutes ‘Sound Money’ is more important here than any understanding of technology in trying to determine whether bitcoins are a currency, an asset or a mirage.”

Let’s be clear. The technology behind Bitcoin is absolutely central to its value, and an understanding of the technology is just as important as understanding “sound money”. Why? Because it is the technology that creates the features of Bitcoin that make it more appealing to people than fiat currency. It is the technology that allows Bitcoin to be used without Counter Party Risk (your bank losing your deposits); it is the technology that makes Bitcoin secure; it is the technology that limits the supply of Bitcoin; it is the technology that allows Bitcoin transactions remain more anonymous that banking transactions; it is the technology that allows Bitcoin to be used economically for micro-payments. To suggest that Bitcoin is just a more technologically advanced version of fiat demonstrates an immediate misunderstanding of Bitcoin’s appeal and potential.

“Paper money and credit facilitates trade, and,  to be accepted as payment, each must be trusted and have intrinsic value.”

This is incorrect. The US dollar has no intrinsic value, but is the world’s reserve currency. To be accepted as payment, a currency must retain only characteristic, which as Rory points out, is trust. More about this later.

The next couple of paragraphs in Rory’s piece make no sense to me. He tells us that the Government’s ability to raise taxes underpins Central Banks, who in turn underpin bank deposits, and that bank deposits are therefore “Sound Money”.

However…

“…as paper money can be created at will,  not all paper currencies have  acted as a store of value – think of the German Reichsmark after WW1 and, more recently, the Argentinian peso and the Zimbabwean dollar – all worthless as a store of value due to the fact that their governments spent recklessly and printed money in huge quantities to try and pay for that spending.”

So, no, the fact that Governments can raise taxes is quite obviously not a guarantee that bank deposits are “Sound Money”.

Having left the question reliability of fiat currency hanging, Rory moves on to Gold.

“When you accept gold in settlement of a trade you have an asset whose value is not dependent on a third party…Gold is an excellent store of value, but it has never been an ideal medium of exchange.”

Correct, and correct, and now on to Bitcoin.

“Bitcoins are earned by those who verify transactions using blockchain technology over the Internet, so that one could suggest that a base intrinsic value for a bitcoin is the value of  the programmer’s time.”

No, Bitcoin, like every other currency, has no intrinsic value. Also, Bitcoin is not generated by programmers. It is generated by computer processors solving math problems. That’s not really relevant, but let’s be accurate.

“Fans of bitcoins seem to be placing all their faith in the strictly limited supply.”

Firstly, the word “Fans” suggest that adopters, supporters and users of Bitcoin are aren’t really well enough versed in the minutiae of finance and economics to be taken seriously. On the contrary, the community of people across the world who manage the development of Bitcoin, who promote Bitcoin and who use Bitcoin retain a depth of economic, technical and social experience that would be difficult to match is any commercial bank of state department of finance.

Secondly, these ‘fans” are not placing all their faith in the limited supply of Bitcoin. Instead, Bitcoin users place their faith in Bitcoin because they foresee a time when ordinary people will no longer trust fiat currencies, and that in searching for an alternative, they will have regard to a variety of factors. Limited supply will be one of those, but not the only one. Of equal importance will be separation of the currency from the banking system, durability, security, portability, divisibility and perhaps most importantly, stability. Bitcoin ticks all those boxes bar one: stability. But stability is something that requires time, and Bitcoin is still less than 10 years old.

Rory now moves on the the subject most favored by Bitcoin detractors: its use in the criminal underworld:

“Given the abundance of illegal trade and the increasing volumes of it over the Internet there is a natural demand for transacting in a currency that has no trail….For crimes more readily targetted (sic) by law enforcement such as drug sales, the dark web and bitcoin provide an irresistable (sic) combination.”

Firstly, it is not true that Bitcoin transactions leave no trail. Transactions in the Bitcoin Public Ledger (the Blockchain) are recorded as cryptographic strings, rather than bank account numbers that can be readily traced to a person. But that does not mean that transactions are untraceable. The use of a private key in the Blockchain can be traced to the point where it transacts against a known entity, at which point the owner of the key can be revealed. This is not a simple process, but it can be done, and has been done to reveal high value criminal operations. The point is that this type of audit is only attempted in very serious cases, and is not worthwhile for the vast majority of transactions, which is why the average user of Bitcoin can be confident that their transactions are effectively anonymous.

Secondly, the use of Bitcoin in the criminal underworld is vastly overplayed, and represents a tiny, tiny fraction of the value of criminal transactions transacted using cash, the legitimacy of which is never questioned. Moreover, all mainstream Bitcoin exchanges, which must be used to convert Bitcoin to fiat currency, must observe anti-money laundering regulations, so relying on Bitcoin to underpin criminal activity is just as risky as using cash.

“If this is the attraction of bitcoins, then surely authorities will move to clamp down on such trade if or when the problem becomes big enough. Even if authorities are behind the curve, anonymity doesn’t quite explain why the supply of bitcoins has to be limited.”

OK, so criminality isn’t the attraction of Bitcoin, but an interesting question is raised here. Can authorities actually clamp down on Bitcoin? The answer isn’t straight-forward. It is certainly the case that authorities can’t clamp down on Bitcoin itself (other than by shutting down the Internet), as Bitcoin does not rely on any aspect of the State to exist.

However, authorities can clamp down on interactions between Bitcoin and the current banking system, which is controlled by the State. This manifests itself in authorities preventing banks dealing with Bitcoin exchanges, which means Bitcoin holders cannot convert their Bitcoin to fiat currency. This exists as an option only for as long as people want to convert Bitcoin to fiat currency, which they will not want to do forever, as their range of goods and services they can purchase with Bitcoin continues to expand.

So why have the authorities not done so already, if the window for doing so is gradually closing? There are various theories in play here.

Some believe the State is simply being complacent, albeit that authorities in China and New York have already regulated Bitcoin exchanges out of existence.

Others suggest that the authorities want to keep Bitcoin in the open, where it can be monitored, rather than forcing it underground where the technological community will put it beyond the reach of the State forever.

 Others suggest that clamping down on Bitcoin will stifle FinTech innovation, allowing banks to maintain their highly-profitable control over the monetary system, which is perennially unpopular.

Most likely, its a combination of all these things.

But back to Rory, who now broaches the question of the Bitcoin “bubble”.

“…we are simply witnessing a speculative development where the limited supply of bitcoins is leading to higher prices as the demand to own them multiplies, with these higher prices bringing in more speculators who drive the price still higher.  “

This is simplistic, and demonstrates a limited understanding of the wider philosophical nature of Bitcoin. 

Let me state clearly that most Bitcoin users believe that the value of Bitcoin at any time contains a speculative element, and that when Bitcoin experiences a surge in value, this is almost entirely explained by speculation.

 Where Bitcoin detractors go wrong is in believing that Bitcoin will ultimately fail because a portion of its value derives from speculation. The logic of this is difficult to fathom. All assets classes, including currencies, experience surges and falls in value. Real estate is probably the best example. Property price bubbles happen at least once per generation, but has anyone ever suggested that real estate will one day cease to have value?

But people will claim that Bitcoin’s surges and falls in value are far more dramatic than regular asset classes, and currencies in particular, making it unreliable as a means of exchange. This is true, but lets remember some other things. Bitcoin is less than 10 years old. Its still virgin territory, so fluctuations in value will be more frequent and pronounced. Moreover, Bitcoin’s total market capitalization is infintesimately small compared to fiat currencies, so the impact of larger transactions is greatly amplified in setting the spot price of Bitcoin. Again, these things will change as Bitcoin adoption continues to grow.

But does this address the question posed? Is Bitcoin a bubble?

The most straight-forward answer to this is as follows:

At any given time, the price of Bitcoin will be inflated by speculation, but as time passes, Bitcoin will arrive at a value that does not rise of fall any more rapidly than other Tier 1 currencies.

What that value is is unknown. It will either be very small, if Bitcoin retreats from whence it came, and is only held and used by a relatively small number of die-hard apostles, or very, very great, if Bitcoin continues on its current trajectory as an long term alternative to fiat currency.

“If bitcoin is a novel way to settle trades outside the banking system, then why limit the supply? If the supply is increased, as we think inevitable (there’ll be no shortage of new digital currencies), then the prices will fall to their intrinsic value, which in bitcoin’s case is far below today’s price.”

There are a few parts to this. The ability of Governments to increase the supply of Bitcoin to address political problems is regarded by Bitcoin users as a central flaw in fiat currency, so it obviously isn’t a feature of Bitcoin. Regarding the increase in supply that Rory thinks is inevitable, I am again struggling with the logic. There are multiple cryptocurrencies, but the supply of one does not impact the value of another, any more than the supply of the Danish Krona impacts on the value of the US Dollar. The value of any individual currency depends on the trust place in that currency, which is impacted by the amount of that currency in circulation, which is not impacted by the amount of any other currency in circulation.

The final quote from Rory’s piece is this: 

“If we have misunderstood the bitcoin revolution we stand ready to change our view.”

Let me try and explain the Bitcoin revolution as succinctly as possible.

Belief in Bitcoin does not stem from blind faith in Bitcoin’s features. In fact, Bitcoin has many flaws. Instead, belief in Bitcoin stems from an understanding that the current monetary system of politically-controlled, derivative-spawning and infinitely supplied fiat currency is unsustainable.

The 2008 financial crisis revealed just how vulnerable this system is. The crisis required the guarantors of the current system to deploy solutions that were previously unthinkable; solutions that can really only be deployed once, meaning that their armoury is virtually empty if they are required to deal with a similar crisis in the short to medium term.

If that understanding exists, it follows that Bitcoin users foresee a point in time when the current monetary system will face an existential crisis. If there is another shock to the system, will democratically controlled governments be allowed to bailout of the banks again? And if they are not, what alternatives are left other than to inflate the supply of currency, given that this is the most immediate and politically pain free solution to any deflationary crisis? This was the solution that many commentators proposed to the last crisis, and was used indirectly in the form of quantitive easing. If the next crisis presents a choice between deeper easing, and the lethal cocktail of bank bailouts and austerity, its difficult to see any Government opting for the latter.

So what happens then? Lets go back to that word “trust”. As ordinary people see their spending power, and the value of their savings, gradually began to erode, they will inevitable began to question their trust in the paper currency in their pockets. In the past, a retreat in trust was always stemmed by the absence of a workable alternative (they weren’t going to do their grocery shopping with gold). In the future, that will not be the case. There will be an alternative, that retains the “store of value” characteristics of gold, and the transact-ability of fiat currency.

In such circumstances, why would Bitcoin not prosper?

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