Bitcoin: Boom, Bubble and Bust

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One of the things I learned over 20 years in foreign exchange dealing rooms is that there is nothing magical about markets. A market is possible whenever two or more people disagree about the future value of something. That something can be a conventional thing, such as stock in a company or an interest bearing debt (bond), or it can be an unconventional thing. When I started in the forex market, every December saw a huge market develop...in party poppers. You know those little plastic things that pop and spit out streamers.

Almost everybody got involved and if you were asked for a price, it was a matter of honor to quote both a bid and an offer (or ask). The trick, of course, was to end up square by December 24th, the value date for all party popper deals. The last thing you wanted was to end up taking delivery of hundreds of boxes of the things, or to end up short and have to go and buy them at retail to make delivery. If you traded well, you made money, if not you lost, just like in our everyday job. What you were trading was irrelevant; buying low and selling high was the aim and, for a few weeks, party poppers became a virtual currency.

Bitcoins, it seems, are today’s party poppers. They were in the news again at the end of last week as Mt. Gox, one of the biggest exchanges of the peer-to-peer currency, faced questions about its ability to pay account holders who cashed out. The value of Bitcoins on the Mt. Gox exchange plummeted to around $270 over the weekend compared to over $620 elsewhere.

Like any currency, Bitcoins can be exchanged for goods and services. For conventional currencies there is a physical place where that exchange can be made; Yen can be exchanged for goods and services in Japan, for example, and Pesos in Mexico. Bitcoins have no one physical place where they can be exchanged, but they do have a virtual one; the internet. They aren’t backed by the full faith and credit of any government but, according to the adherents, this is an advantage. Their value, when expressed in terms of another currency such as US Dollars, is simply what people perceive them to be worth.

There is nothing wrong with that; once again it is the same as any other currency. There are, however, two problems with the Bitcoin market; lack of regulation and extreme volatility.

It may seem strange for a market devotee to bemoan the lack of regulation, but it really isn’t. For any market to function efficiently there must be rules. Most importantly, the traded instrument must be freely exchangeable for something else. Ultimately that something else must be the global base currency, US Dollars.

Would you buy stock if there was a question about whether you would receive your money when you sold it? I wouldn’t, and that is why I won’t be buying Bitcoins anytime soon. What I think of Bitcoins as an entity is irrelevant; until the brokers are regulated to some extent and you can be confident of getting your money back there is always a risk of total loss.

There are several ways in which Bitcoins are similar to other currencies, but there is one huge difference...the degree of volatility. Currency markets are notoriously volatile, but as a percentage the actual moves aren’t that huge. If you follow such things, for example, you are no doubt aware that there has been extreme volatility in the Turkish lira recently.

Lira

This much heralded collapse can be seen above. The number of Turkish Lira that 1 USD will buy went from around 1.75 a year ago to over 2.35 last month. This is a huge move in forex terms, but represents about a 35% loss in value for the Lira.

Bitcoin value, as the Mt. Gox story demonstrates, varies from exchange to exchange, but prices generally increased from just under $1 in 2011 to a peak of around $1200 at the end of last year, before collapsing to half of that so far in 2014. Now that’s what I call volatility! This bubble and bust behavior can be fun and profitable for some, but in order to get involved, you have to know that you can get out at any time.

Volatility is, from a trader’s perspective, usually a good thing; it means there is money to be made, but when it is combined with a potential lack of liquidity, as those that traded with Mt. Gox are seeing now, it is perfectly possible to have too much of a good thing.

As I said, I have nothing against Bitcoins or those that trade them. That would be somewhat hypocritical given my history of trading party poppers. The problem comes when I hear people talking of “investing” in Bitcoins. Right now they are, as far as I can see, just another novelty trading market. It may be that at some time in the future that market will mature but for now Bitcoins are purely a speculative instrument with serious liquidity problems and have no place in the portfolio of investors.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Forex and Currencies , Investing Ideas , US Markets

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