BK's Two Cents

The announcement that Wiper (the disappearing messaging app) has added Bitcoin, inspired me to think a little deeper about what Bitcoin and the blockchain represent.  For those only interested in whether bitcoin (the currency) can replace its fiat competition, this post is not for you…or maybe it is, because thinking of the blockchain as a political system could greatly expand the use case for digital currencies - a technology with multiple uses could have a greater value.

For the uninitiated (aka those who have not read my book) at the core of Bitcoin and all digital currencies is the blockchain - a set of rules or protocol designed to allow people to vote on a message. The concept of voting on a message is by no means a new, but what is new is the ability for people who have never met to verify that the vote being cast is valid.  Much to the chagrin of some Chicagoans there is no stuffing the ballot box in digital currencies. Before Bitcoin the only solution to voter fraud was funneling all the votes through a trusted third party - this third party would ensure the one person / one vote rule. The Bitcoin protocol does the same thing, just without the need for a human being as the trusted third party. That’s it, that’s the big discovery and mystery that is Bitcoin - the blockchain securely automates voting.

Another way to say this is the blockchain allows a group of people to securely reach consensus on a subject.  Don’t let the simplicity of this description downplay the importance of this set of rules - never before in human history has voting been securely automated.  I am not just talking about voting on political issues, I am talking about voting on any message a group of people decide has value to them.

Heretofore, the focus of the blockchain has been its use as a currency - more specifically its use to fulfill one function of a currency - a medium of exchange. The message voted on by the users of Bitcoin is one of ownership.  Every ten minutes the Bitcoin network takes a vote on a message that reads “Alice transfers value to Bob”.  The ‘value’ is determined by the prices at which bitcoin (the currency) is trading on various exchanges. It is important to note that the Bitcoin network does not vote on value, it only votes on whether Alice possesses the right to transfer ownership to Bob.  The blockchain is silent on value which poses a challenge when trying to determine an intrinsic value for digital currencies - currently price is set by a third party, i.e. an exchange. When Alice and Bob agree to transfer ownership they reference an exchange price that is independent of the blockchain and this price multiplied by ownership units is value.

One might think of the digital currency exchanges as an independent ‘blockchain’ where every trade is a vote on value.  One difference between the exchange ‘blockchain’ and the Bitcoin blockchain is that the exchange requires only two confirmations - buyer and seller - to determine value.  On the other hand, a typical bitcoin transaction can take up to six confirmations to verify and process.  Taking the blockchain analogy one step further, digital currency exchanges are not the only exchanges that can be thought of as a ‘blockchain’. Global financial markets act the same way - every second of the trading day NYSE traders transfer ownership rights and agree on value - in fact every trade on the NYSE can be thought of as a ‘block’ and the ticker represents a real-time chain of blocks.  Of course, the primary difference is that to accomplish its task the NYSE relies on a web of carbon and silicon intermediaries while digital currencies simplify the task with full automation that is accessible to everyone.

Whether you choose to use the NYSE ‘blockchain’ or the Bitcoin blockchain to transfer ownership it is useless without a reference point for value. The NYSE has a built-in mechanism for determining and observing value - every ownership transfer is accompanied with an agreement on price - this price multiplied by ownership units transferred determines value.  Currently digital currencies lack the internal ability to observe and record price and thus they are dependent upon the exchanges for this function.  Moreover, the dual ‘blockchains’ of digital currencies and exchanges only communicate through a human interface.  It should be obvious that the Holy Grail of digital currencies would be a blockchain that also incorporates an exchange.  

So far I have focused a blockchain that contains a message about ownership or value - but what if we changed the message from “Alice transfers value to Bob” to “Alice votes for Bob”.  This linguistic sleight of hand turns Bitcoin into a political system - a system where a community can reach consensus on any subject without the need for a trusted third party.  It may help to think of a vote as a message with a non-monetary value attached. When Alice transfers one digital coin to Bob she is sending a message of support for Bob and we may naively hope that this support has an intangible non-monetary value to both parties.

The message that I am attempting to convey is that thinking of a blockchain as a political system adds multiple uses for the technology.  In fact, one could exponentially expand the capabilities by simply changing the message to “Alice votes for ____”.  In this way the possibilities for the blockchain become only limited by human imagination.

This is a quick post as I believe the subject of bitcoin as the currency of criminals needs to be addressed but not belabored. Yesterday Ross Ulbricht was convicted of being the operator of the online drug bazaar Silk Road. People have asked me what this means for bitcoin and whether this spells the end of digital currencies.

BK's answer:

Selling drugs and other illicit items is illegal whether one uses bitcoin, $100 bills, Yen, Euro, or wooden nickels. Therefore, suggesting that bitcoin was the reason for this crime is about as logical as shutting down the internet because Silk Road was website.

Bitcoin's price has crashed. There is simply no other way to describe the -40% price decline that occurred in the first two weeks of 2015.  It's dismal, it's disappointing and it's a normal part of a free and open market. While Bitcoin is a transformative technology, it is not immune to the greed and fear that permeate every financial market.  

Speculating on the true intentions of buyers and sellers in any market is a fool's errand, but we can identify some catalysts. In this case, there appears to be three events that could be to blame for the price crash: BitStamp, CEX.io, and Russia.

BitStamp

BitStamp is one of the largest bitcoin exchanges and it was hacked last week. Before the exchange realized what was going on it lost over $5m in bitcoins to the hackers. To its credit, BitStamp shut down operations and made every investor whole before re-opening with vastly improved security.  Nonetheless, the blow to confidence in undeniable and its seems plausible that some investors were spooked and liquidated holdings.

CEX.IO

CEX is one of the largest mining operations in the world - it operates the GHash mining pool and sells mining contracts via the cloud - in the digital currency industry this is called 'cloud mining'.  The recent price slump has made these mining contracts unprofitable and CEX has shut down these mining operations.  It's likely that owners of these contracts have liquidated in favor of fiat currency - weighing on the price of bitcoin. Coindesk has an excellent post on the subject here.

Russia

Russia has threatened to make Bitcoin illegal for the better part of 2014. However, it had not taken any action until recently.  This lack of action made bitcoin a hot investment as the Russian currency collapsed. Many speculated that wealthy Russians were using bitcoin as a way to withdraw money from Russia. In the last few days, Russia has begun to ban Bitcoin websites. For those interested in reading more, Engadget has a good post here.

Negative Feedback Loop

Unfortunately, these catalysts are conspiring to create negative feedback loop - the falling price is making more mining operations unprofitable, which in turn is resulting in more liquidation. This phenomenon is not unusual in markets and identifying these feedback loops can be quite profitable.  Until another catalyst forms and breaks the loop the price of bitcoin will remain depressed.  

I don't know when or what will break the loop, but I do know that this will not be the last time it occurs.  There are few guarantees in financial markets, but I am sure that bitcoin will experience irrational bubbles, crashes and feed back loops (positive and negative). This fact has nothing to do with bitcoin the currency or technology; it has everything to do with human nature. 

As the soft glow of holiday lights wane, it is tradition to shine a spotlight on the year ahead. Despite the inability of anyone to predict the future, no pundit would be caught dead without a list of predictions. As is my nature, I shall attempt to break from tradition and replace prediction with observation, while adding my interpretation of the likely outcome.  With this disclaimer I leave it up to the reader to twist these words into your market view...for better or worse.

My focus is on the divergent signals emitted by the financial markets. It appears to BK that 2015 will be a year of anomalies,divergences, and incongruities. Recall that 1998-1999 and 2006-2007 were also periods of time when incongruity reigned. Therefore, until equity market participants interpret the signals differently the US stock market has a tailwind. Below is a list of incongruities and the current market interpretation...

Make no mistake the world is currently engaged in a financial war and the Ruble collapse is just one battle. The 2008 Great Financial Crisis ushered in a new currency war that has morphed into a financial market war, with oil as the weapon of choice. I am not trying to be a fear monger, I am simply pointing out what is occurring in the financial markets. In the beginning, a financial war seems like a no-brainer, i.e., use financial might to damage your enemy’s economy. The flaw in this logic is it assumes no impact on the economy of the attacker. In the age of open economies investors are correct to be concerned about the collateral damage.

The latest battle in this financial war is the engineered drop in oil and subsequent collapse of the Russian Ruble. Now that this battle has been waged investors need to know what/where the next battlefield may be.

In order to answer this question we need to understand what has transpired over the last few days. Many have been shocked by the lack of intervention by the Central Bank of Russia (CBR) in the days leading up to the currency collapse. Implicitly or explicitly, it appears Putin has allowed a raid on the central bank currency reserves to benefit the oligarchs and state owned corporations. These corporations have issued debt in Rubles and either immediately converted into US Dollars or have used the debt as collateral at the CBR. The CBR had a choice to defend the Ruble and give its foreign currency reserves to speculators or give those reserves to the state owned corporations. The lack of serious currency intervention suggests the CBR has chosen the latter.

The economic impact of this decision is likely to be felt by Russian citizens as they encounter double digit inflation. If Putin does not handle the internal situation correctly then Russia could face social unrest which may threaten Putin’s leadership. Therefore, Putin’s next move will define the next battle in the global financial war. The leading battlefield candidates are the wheat market, US Treasuries and Gold.

The currency collapse could accelerate Russian aggression in Ukraine. In my view, the purpose of the invasion has always been to control the port cities along the Black Sea. Since roughly 30% of the global wheat supply moves through these ports, control gives Putin a formidable economic weapon. Since further aggression risks more economic sanctions it is unclear if this is the most probable move.

The most effective move would be a financial attack on the US Treasury market. Russia is one of the largest holders of US Treasury securities and with a push of a button it could begin to unload its position. This move would have two effects - Russia would get much needed foreign currency (US Dollars) and it would economically damage the United States by forcing interest rates higher. Once in possession of US Dollars, Russia could use it to defend the currency, pay off state owned corporate debt, or buy gold.

Defending the currency would have little impact as the CBR would continue to battle with speculators. Paying off corporate debt would benefit Russian corporations over the population. If indeed social unrest caused by inflation threatens Putin’s leadership, Russia would be well served to be the first country to back its currency with gold. This move would immediately solve the inflation problem and placate the population.

Of course, none of us know what the next move will be, but rest assured markets will try to anticipate. This is a game of probabilities not certainties. My concern is that politicians have not considered the full spectrum of a financial war. Perhaps the computer from the hit movie War Games said it best ... "The only winning move is not to play.”

The sharp run-up and subsequent -6% decline in Chinese equities warrants an investigation into the driver of the move. 

Folks have focused on the incredible run-up in Chinese equities and ascribed the gains to confidence in the Chinese economy. BK says not so fast Yīngxióng (hero). The economic data over the last few days suggests the Chinese economy continues to weaken. Exports were less than expected BUT more importantly imports fell dramatically. Since China is still a large manufacturing economy, falling imports suggest that future manufacturing data will remain weak as there are fewer inputs to make into widgets. 

The proximate cause of the massive run in Chinese equities is the fact that in the last month 1 million new brokerage accounts were opened in China. What do you do when you have a new toy? You use it...in this case to buy stocks.

However, there could be another reason why the wealthy Chinese are eager to exchange Yuan for Equities...yep, you guessed it...a devaluation of the Yuan.

This is another market inference that BK is making which will likely cause some to laugh and point fingers. Oddly, BK feels most comfortable when the crowd is blissfully unaware.

Since mid-October the offshore Yuan rate has DE-preciated by -1.1%...this is a big move for a managed currency.

BUT check out the APPRECIATION of the Yuan v the Yen since October...up a staggering +13.3%!!!!!!

While the huddled masses head to the mall, an early adopter subset of the American shopper is embracing bitcoin and getting a deal while wearing footy pj's.   Just two short years ago Bitcoin Black Friday did not exist and now its exploding!  Take a look at www.bitcoinblackfriday.com for all the deals you can get when you pay with bitcoin. 

How to Buy Bitcoin

But what if you don't have bitcoin and want to take advantage of the deals?  I have found the easiest way to buy bitcoin for either investment or usage is to go through Coinbase. They have made the entire process so much easier than when I first purchased bitcoin.  

What Can I Buy?

The bitcoin ecosystem system is expanding rapidly and this year you can buy everything from bike accessories to your own personal drone (yes please!!!).  

For my part, I am offering signed copies of my book The Bitcoin Big Bang when you buy with bitcoin.

The prominent feature of the recent rally in the US stock market has been a strong dollar, but that could be coming to an end.  The proximate cause of the strong dollar has been divergent monetary policy that has resulted in an influx of foreign capital. In fact, on November 18, 2014 the US Treasury reported that in September more foreign capital has moved into the US than any other time in the history of the Treasury International Capital data (aka TIC data). What's even more striking is that this inflow occurred BEFORE the Bank of Japan made its surprise move.

Since US dollar strength has been such a big driver of US equity market strength it has become essential to understand when the sentiment has become extreme.  That point may be now.

Reversion to the Mean

One of my preferred indicators that gives an early look at extreme sentiment is a regression channel.  The regression channel illustrates how far away the market has traveled away from the mean trend .  The following chart is the US Dollar vs the Japanese Yen with a regression channel drawn from the 2012 low.

The upper band is a two standard deviation move away from the mean trend, which indicates that a move beyond this point would be expected less than 5% of the time. I need to caution that this is a linear measurement being applied to a non-linear system - that is to say traditional probabilities need to be relied on with caution - markets can an do make fools out of smart folks with straight rulers. 

Dramatic Reversal

Despite its short-comings the regression channel can give a first look at extreme price moves.  What is most interesting about the move to this extreme is that it appears to be stalling.  Today (November 20, 2014) US economic data was supportive of a stronger dollar, yet as of this writing the USDJPY has reversed dramatically from its highs.

Markets tend to turn well before the data supports the move, therefore this failure at an extreme level is the first sign of trouble for dollar bulls. While BKCM LLC clients remain long the US dollar against most currencies, this is a place where I will begin to lock in profits.

Weaker Dollar - Weaker Stocks?

For those who do not trade currencies they would do well to recognize the relationship between the US Dollar/Japanese Yen rate and the S&P 500.

A new day has arrived...Tipping Tuesday is going viral and its all about making micropayments with bitcoin. One of the most exciting use cases for bitcoin is micro-payments - small payments that can be used as a tip or even to prevent spam. Imagine if a spammer had to pay a small amount each time they wanted to send you junk mail...with bitcoin micro-payments spam could be a thing of the past.

Today Coinbase announced a new Tip button, that will easily enable the monetization of content.  Have you ever read a great post and wanted to buy the writer a frosty adult beverage?  Well now you can...simply send her a Tip via Coinbase and the writer could be enjoying a cold one in just a few minutes!

As a launch partner you will see my Tip button at the end of each post and in my Tumblr page. My goal is to make my personal Tip button a zero sum game - that is to say whatever comes in will be re-tipped for great content on the web. So if you are out there producing great posts expect a tip from good ole BK!

Here is the link to get the Tip Button for your site:

https://www.coinbase.com/tip

When I first encountered Bitcoin I was convinced it was a bubble - and that's exactly why I bought it. I figured I could make a quick buck off of the Greater Fool Theory - all I needed was few people that were more foolish than me to take these "coins" off my hands at higher prices. But somewhere along the way I realized that I had stumbled onto the most important change in financial history. 

You read that correctly...I believe that Bitcoin is the most important technological breakthrough in the history of money. 

For more than 5,000 years our system of money has required a middleman - a trusted third party that verifies ownership and transfers value. From the Temples of Babylonia to Giovanni Medici to James Pierpont Morgan, banking dynasties have been built by serving as the middleman. 

The Middleman is Obsolete

With 31,000 lines of code, the creator of Bitcoin (Satoshi Nakamoto) made the middleman obsolete. Bitcoin does to the financial middleman what email did to the US Post Office. 

From Chapter 5 of The Bitcoin Big Bang - A Decentralized Financial System

Bitcoin has done what no other computer program has done in the history of financial systems—it has automated the role of the middleman. Moreover, the developers of Bitcoin have given it away for free. The Medici family gained power and wealth by making a simple improvement to the existing system. Imagine if they had invented a new system altogether.

The revolutionary accomplishment of Satoshi Nakamoto was to reduce the complicated tangle of global financial middlemen into an elegant software package that can be downloaded onto a smart phone. This feat is not just astounding it is unprecedented.

The history of business is replete with examples of industries that have been transformed beyond recognition by disintermediation. When was the last time you walked into a travel agent’s office? Or asked a real estate agent for a brochure? Or looked in the phone book? Because of the need for trust and security there is one industry that has been missing from the list—financial services. Now the Bitcoin protocol can disrupt the trusted third party of financial services allowing peer to peer lending, banking and transacting to flourish.

Historic Breakthrough

Money is an old technology that has not changed in over 5,000 years. The same centralized system of middlemen that existed during the Renaissance period still governs the modern financial system. Bitcoin (with a capital "B") is the technological breakthrough that will transform our system of money from centralized to decentralized.

A decentralized financial system is better, cheaper and faster - and it is these attributes that will serve as the foundation for historic change. The internet decentralized the transfer of information and gave people more access than any time in human history.  Bitcoin does the same thing for money.

Smart Money - Set It and Forget It

But wait there's more!  Bitcoin does not just remove the middleman, it allows us to program money.  For the first time ever, we can program money to work for us - allowing us to do more than any piece of paper could ever dream.  

For those interested in what the future of money could be, I highly recommend this presentation by the Winkelvoss': Money is Broken; Its Future is Not.

Make Your Milk Work for You

So how does Smart Money work and why should you care? Let's use the real world example of the carton of milk in your refrigerator.  The technology already exists that can sense when your milk is running low and can send you a reminder to buy more.

This means that you get an alert on your phone and have to stop at the grocery store and pay with paper or plastic.  With smart money, you can program the entire transaction into your carton of milk.

When the milk is running low, a message is sent to your grocery store to deliver more milk - along with this message is a payment in bitcoin. When you arrive home your milk is waiting for you and has already been paid for...just try doing that with a piece of paper. 

The Future of Money

Here is an updated version of a chart I have posted before. It is a plot of the 30 day rolling average of the number of transactions conducted in bitcoin against the 30 day price change. 

There continues to be a negative correlation between bitcoin usage and price appreciation. My guesstimate is that as new merchants accept bitcoin there is a flurry of transaction and the merchants immediately convert to fiat.  After the initial excitement dies down, the price of bitcoin begins to rise as the amount on conversions dissipate.

Thought I would post an interesting chart of US exports as a percentage of GDP ... at 13% they are the highest they have ever been.

The Central Bank of Russia has gone to a de facto free float, as Ruble weakness overwhelmed its ability to effectively intervene. Now there are reports that Russia may ban the circulation of US dollars (story here). 

USD v Russian Ruble

If this story is true, then wealthy Russians will need a way to convert Ruble holdings into US dollars.  One of the easiest and least transparent channels would be to buy bitcoin and then convert those holdings into other fiat currencies.

It appears this is already happening, as the Ruble price of bitcoin has been outpacing the gain in the US Dollar price of bitcoin.

Bitcoin Priced in USD and Ruble (log scale)

Recall that the enormous run in bitcoin during 2013 ($200-$1100) was partially fueled by wealthy Chinese using bitcoin as a channel to withdraw capital from China. Also recall that the price crash in bitcoin was a result of the Chinese government cracking down on this practice.

On the Friday edition of Fast Money, I was pretty fired up about the the Japanese decision to stimulate its economy via QQE and a change in GPIF investment allocation. If you would like to see for yourself here is the video   http://www.cnbc.com/id/102142553

For the time challenged here is my quote:

"It is going to have massive, massive ramifications. The U.S. stock market hasn't woken up to it yet, but they absolutely will..."

...and then I emphatically continued:

"However, I felt this way before—and it was during Bear Stearns. Everybody cheered that Bear Stearns got a bailout from the Fed. And within three days, they were out of business. So, this is Japan bailing themselves out. they had no choice. They have to raise taxes. They are now monetizing their debt—100 percent monetizing their debt, and buying stocks. They're buying REITs. They're buying ETFs. It's insane."

So why was BK so fired up? Is it a predisposition to be a fear-monger? Not at all. 

The passionate displeasure I expressed was rooted in the realization that the markets were only telling one side of the story and I believe that investors deserve to see and hear the entire movie.  First, BK would remind us all that it was a slide in the Japanese Yen that precipitated the 1997 Asian Financial Crisis. Second, the markets are missing the impact of competitive devaluations.

Japan is WalMart

Japan is in a lot of trouble. It has a stagnant economy, an enormous debt load, and must raise taxes.  A tax increase earlier this year has placed the Japanese economy on the path to recession. Similar to Bear Stearns, the country is essentially insolvent and levered to the gills.  Without the bailout orchestrated by the BoJ, the markets would have lost confidence in Japan and the country would eventually default on its debt.  So they had no choice, they had to bail themselves out.

But the other side of the story is that Japan does not operate in a silo - it is a player in the increasingly globalized economy. Japan's move will force other countries to act - specifically South Korea and China.  In laymen's terms, Japan has become the WalMart of the global economy. It has effectively announced "roll backs" and discounted prices on exports and the only way for competitors to survive is to match the price cuts.

But Lower Prices Help the Global Consumer, Correct BK?

Yes, lower prices are good for you and me - we will be able to buy more of the things we like, or (gasp) maybe even put a few bucks into a savings account because of lower gas prices. This is "good" deflation and can be stimulative.

But if prices are falling what is my incentive to buy today? Why not just wait a month for the price to drop even further? Herein lies the rub. "Bad" deflation has the effect of reducing demand as consumers put off purchases awaiting lower prices.  This reduction in demand begins to erode corporate earnings and a pernicious downward cycle begins.

How Will Other Countries Respond?

This movie will play out quite differently depending on how other countries respond.  In particular, China does not have the capacity to devalue its currency. Will they respond by constraining the supply of rare earths like they did in 2010?  If so, Japanese manufacturing could be ground to a halt erasing the stimulative effects of monetary policy.

What about Europe? Will Mario Draghi finally convince the German's to allow massive quantitative easing? Or will half-measures drag the European economy into a deep recession which could spill over to the United States? 

Unfortunately, the answer is unknowable. However, what is known is that currency wars have no winners.  Competitive devaluations send deflationary shocks throughout the global economy like a hot potato. When the hot potato lands in the hands of US investors they may respond by selling stocks and our 5 year bull market could be over.

As I said on Friday, I don't know WHEN this will happen, but I do know that the current path ends with a deflationary spiral. My hope is that the path changes and that other countries respond differently than imagined.

Perhaps political and economic actors will heed the words of the W.O.P.R from the movie War Games when it said:

Didn't Einstein say something about repeating the same act and expecting different results???

The difference with the BoJ move is the element of surprise...and irresponsibility...And it is this irresponsibility that is the only hope it has of more cowbell working. Yes, you read that correctly -- at this stage of the game the only way for more easing to 'work' is for a central bank to act irresponsibly. 

Let BK explain...wait, there is no time...BK will sum up... For QE to erase ingrained deflationary expectations the BoJ must convince its minions that the Yen they hold in their pocket today will be worth significantly less tomorrow, thereby inducing aforementioned minion to spend the Yen today. This is less about economic theory and more about human behavior. For those inclined to learn more about this process, BK suggests you read the works of economist Richard Koo.  So what does this have to do with the ECB?

Well they meet next week and the BoJ just threw the gauntlet down. The ECB must announce full blown QE next week or the market will continue to price in a lost decade. Basically, the BoJ is Hansel and just removed its underwear without taking its pants off...will the ECB be Zoolander?