Bitcoin – hopes of the alternate currency acolytes now lay in tatters…

At the very inception of the creation of the virtual currency Bitcoin by the mysterious Satoshi Nakamoto, the e-currency was said to have characteristics that could make it a real rival to both gold and an alternative to paper currencies. A new means of payment free from Government intervention and debasement was the hope. With the events of last week and the collapse of the premier virtual exchange for the e-currency – Mt Gox, it seems the hopes of the early adopters now lays in tatters…

In recent months however, instead of being used by people as a medium of exchange, it has become just another instrument of speculation. As is usually the case in investment markets, the “shrewdies” who got in on the ground floor have made out well, while the “Johnny come-lates” have been left holding the bag. Tis always the case in the markets… What is surprising though is that none other than Mr Michael Novogatz from the highly respected fund managers Fortress Group was one of the relative latecomers and was caught out. Only last year he said that investors should “put a little money in Bitcoin… [and]come back in a few years and it’s going to be worth a lot”. Oooops!

The euphoria around this new investment product was in fact so great in late 2013 that from a mere few cents on the dollar it rose to more than $1,000. With these types of exponential returns being achieved, it is perhaps not surprising that institutional investors like Fortress also believed that they could not miss out on the opportunity. As the euphoria faded, the primary fundamental problem (and also its argued strength) behind the new creation came to the fore – that of it being completely unregulated. As is the case when dealing with human nature – the very worst of greed and criminality was allowed to flourish unchecked in this environment.

Fortress Group in fact bought $20 million of Bitcoin units during the last quarter of 2013 and which it marked down to $16.3 million at the end of the year. With MtGox imploding last week, the currency’s YTD decline now totals 25%, so delivering another $8 million knock to Fortress’ investment. Still, with a “fortress” like balance sheet of over $2.6 billion, we doubt they will notice anything other than a rounding error.

This loss does tell an important story that we should pay heed of though.

First of all, the so called “smart” money can also succumb to the base human emotions of greed and fear and be as dumb as the rest of us! Novogatz seems to have simply followed the buying frenzy that retail investors are want to do when anything moves.  Once more it is illustrative that our friends the “anal”-ysts and many fund managers are actually no better than retail investors  when it comes to investing. When the market is rising, as the saying goes – “ a rising tide lifts all boats” and so it can had many a poor fund manager. In contrast, when the market goes down, many so called hedge funds singularly fail to protect your capital on the downside. Drill in to the many complex strategies and they can be stripped down to plain naive junk, as the 2007-2009 crisis has shown us.

Secondly, we must say that the concept behind Bitcoin is actually an excellent project. It was conceived to replace international currencies like the US Dollar and to democratise money creation. Instead of being dependent on a central bank or a Government, Bitcoin was intended to create a competitive money supply which is in the hands of its very users and on equal proportions. Unlike traditional currencies, no singular all powerful entity can manipulate or debase it. The supply of new Bitcoins was structured with specific conditions that allowed it to only expand at a decreasing rate over time.

The main idea behind the virtual currency was really to assure that its purchasing power was kept safe over time.  On that point, the creators committed an error too. While inflation isn’t desirable for a payment currency, deflation isn’t also. Money supply should expand to accommodate demand. The very limited supply resulted in a skyrocketing appreciation of Bitcoin from the beginning, which in turn attracted investors and gamblers to the market. If this was Mr Nakamoto’s intention then we must say it was a stroke of pure genius – free from regulators to boot! But, as already relayed, it also attracted dubious intermediaries who were looking to exploit this lax regulation. It seems Mt Gox was, sadly, one of those…

In reality, Bitcoin is now most likely a dead project, at least in terms of an alternative means of payment. Bitcoin has been the target of pump-and-dump schemes that turned it into one of those “pink sheet” roller coasters. While it was fun for the speculators, we’re still in need of an alternative currency but, we suspect that only by backing it with a real asset can we build one, and that my friends puts gold in the frontline! 😉