Blockchain will succeed, but how Bitcoin/Cryptos can Create an Economic Crisis [say BitPrime]- And Regulators Need to Act

An opportune time to discuss Cryptos - as Bitcoin valuations go past the roof [The cryptocurrency hit a 24-hour high of $15,340 per unit and 24-hour low of $12,662.86], so depicting promise [for some], volatility and risks [all at the same time].

I want to keep this post as short as possible, but explain some of the risks associated with Bitcoins/cryptos, and happy to answer questions or discuss [just PM me or comment].

To provoke thoughts and begin my arguments- the best equivalent I can think of for Cryptos/ICOs - is Sub-Prime Crisis and CDOs- Collateralized Debt Obligations, it wasn’t too long ago- they both have some similarities/underlying principles-

• Housing/real estate prices will 'always' go up = Bitcoin/Cryptos price will 'always' go up
• There are only limited #Bitcoins in this world = Real Estate on this Earth is Limited
• Both CDOs and Cryptos have no underlying economic activity
• Everyone is saying, it will go-up but very few talking about the risks
• Regulators are aware of this, know the risks, but do not quite have a stand on it [yet]
• Investment bankers and traders are most excited for obvious reasons and creating new financial products [well, this time some technologists have also joined the party]
• Retail Investors as always, are falling for quick gains. Buying bitcoins like CDOs or any Ponzi Scheme, without understanding the risks

Does all that sound familiar or similar?

I'm sure it does, but before we go to the risks, I must add, I believe in the value that blockchain technology architecture brings [but DApps/ledgers/blockchain is neither new technology nor a new concept, but just a set of hard-coded governance mechanisms that makes it novel].

And Blockchain offers several advantages over legacy, centralized architectures and security mechanism, which can help simplify systems, processes for certain use cases, but it's not going to change everything [see what makes it unique and applications in my previous post here]

So, I'm bullish on blockchain, however, Bitcoin/Cryptos in its' current form are like any Ponzi scheme or at best CDOs/Lottery. It can make some people/investors really rich in the short-run, but a majority will lose money in the medium to long-term. Mostly retail investors who are buying the idea [or bitcoins and other cryptos], only because 1000's of others are buying too and thus the price rise. And yet there is little or no regulatory framework for investor protection, check massive movements, intra-day falls, or even corporate governance regulations for sellers/exchanges [like for other securities].

So, outlined below are some of the risks, and why Governments/Regulators need to act urgently:

1) First- Bitcoin mining is not equivalent to gold?  Gold is a standard for economic value not just because it is limited resource, which is always the first argument for bitcoin [there are many other natural resources, far scarce than gold].

So, what makes gold unique as a standard is not just its' scarcity- but its time-tested acceptance as a commodity of value, as an object of desire. It has been in use for storing and exchanging economic value for 1000's of years of human history.

And we know, Economics works on demand and supply- and there has always been real demand for Gold, 1000 years back and even today. Especially in cultures China, India, and Central banks which drive demand. And off-late Central Banks have also been on gold buying spree, after the financial crisis. Even the growing prosperity in India, China, is adding to the demand, and this affinity for the yellow metal is not dying anytime soon. You can validate these trends easily by a simple google search.

So, don’t look for experts, ask yourself - will you accept bitcoin SHA key/holdings say in a thumb drive in exchange for your gold? Or your pension fund? Or how about mortgaging your home? If not why, not?

And, are those investing in bitcoin only because it offers good short-term gains? There is nothing wrong with short-term profit booking, just that, bitcoin is like gambling, so do not confuse it with gold.

2) Huge Risk of the Concentration of Value/Bitcoins with Few Miners/Pools: While bitcoin/cryptos speak about distribution of trust, what about the distribution of value? Today only a few countries and mining pools are mining highest number of bitcoins. For instance estimates suggest over 80% of bitcoin is being mined by pools in China alone followed by Iceland, Georgia, Japan, US and few other countries with smaller single digit percentages.

Which means, there is unparalleled concentration of economic value/bitcoins in the hands of few miners/pools, and not truly distributed which so-called experts tell you. And bitcoins are being bought, traded in exchanges for real money and even goods. So, some miners have the ability to exchange/buy more than others at their will.

Do I still have to spell out the risks associated with concentration of wealth/ and power for tradeable securities and the ability that such concentration provides its' owners to manipulate the value- by exercise of options [like selling, buying, etc].?

3) But then they tell you, you can't manipulate it, because its based on consensus and tamper proof.

But does Consensus guarantee Public Interest?  Does it stop miners/pools from selling a certain amount of Bitcoins in a day [or hours and buying back] that serves their interests?

Consensus, Distributed Trust is often the argument and yes I agree, transactions are validated utilizing these mechanisms by the network and until now tamper proof. SHA256 is the most secure key today [besides Quantum], everybody knew that already before Blockchain.

But is this validation mechanism in Blockchain a check for authenticating the ledger/entry of transactions, or larger public interest?

Are there mechanisms that can check malicious intent? I have heard many so-called experts talk about consensus and trust, without even understanding how that works and what it means. As a mining pool/or owner, if I want to cash out, will that transaction not be considered legitimate? And Is there a way to check the, "insider job" who just wants to make money [quite the reverse, there is incentive for mining and for validating transactions, meaning incentive to propagate]. 

While for shares/securities- there are many checks and balances such as laws to prevent insider trading, stop of trading if intra-day prices fall beyond thresholds, KYC norms etc. etc. [just to name a few to protect interests of investors]. Even laws governing accounting principles, succession, bankruptcy and KYC to ensure company's activities and directors are legitimate, and continue in perpetuity.

But what about bitcoins and cryptos? Are there regulations and transparency norms, corporate governance or even safeguards for continuity of businesses ? And can it be manipulated in the absence of these regulations? Easy to answer!

4) Cryptos do not have any underlying economic activity, and tokens are at best like Casino Tokens not Gold or Equity: Equity or debt of companies [securities], are based on real economic activity/value addition and returns are guaranteed by their revenues, success in market. While mining bitcoins is computers playing the trial and error game at guessing Alphanumeric codes. Miners are not producing goods and services with economic value. Well, holding lottery tickets and gambling also fetches returns for, but can they be treated as securities and bills for exchange?

Imagine if tomorrow Las Vegas or Macau City Governments decides to legalize tokens of casinos to be used anywhere in the city to buy goods, book hotels, etc. But assigns a cap on the total number of tokens [say 21 million bittokens] that can ever be generated. And then based on business each casino generates, they can mint these tokens and the value of tokens will be determined based on how much money is poured into the city and spent each day. And some incentive to create new tokens for Casino that generates most business each day. I leave it there.

5) Cryptoeconomics and Experts. There are none: There are no experts here. What is cryptoeconomics anyway? How much data, evidence we have on the subject, behaviors and how it is related to macroeconomics, true economic activity? Will more investments in bitcoins mean more economic activity in a country? For companies who are producing goods and services, or building infrastructure, they are adding to GDP, but is it true for Cryptos?

The best argument bitcoin fans/sellers will have for you is -- they hide behind the technology argument! because they know that very few people can understand technology [in most cases they themselves do not understand how it works, and its just hearsay. Trust me, I have pricked some real fans of bitcoin on this topic/blockchain, and my results are 98%- do not really understand the entire working].

So, the theory is- When you can't convince, Confuse!

More importantly, are there economic principles associated with Cryptos like a new Demand-Supply curve, Diminishing Marginal Utility or exceptions like Giffin goods, etc to explain the movements, exceptions? If not, there is no economics, please.

Any new phenomena, business activity can be turned into a discipline that people can study, write literature on. And one can certainly make predictions [Bitcoin will reach $50, 000 valuation by next year] based on their economic interests [there is no logic behind it, have you heard any, ever?].

Or even simpler- lets' call Cryptos a piece of art, where the economic value is determined by the beholders' eyes [or economic interests = wallet holdings]!!!

6) The Real Risk of National Wealth Erosion, Credit Risk: When retail investors in any country are buying cryptos- there is transfer of real value/money which is generated by real economic activity- goods and services produced - being used for buying digital currency. Now that economic value is being transferred outside borders, in millions and billions, controlled by few [mining pools] and stored as – not Gold, Not Currency Bills, Not Bonds, but unregulated Cryptos.

Credit risk- there are consumer surveys that also suggest that a significant portion of crypto/bitcoin purchases are funded by Debt Cards and Credit Cards and given the price volatility, this could cause immense credit default risks similar to say CDOs. So banks should be wary and look at this objectively. Also, crypto purchases with credit cards can be easily liquidated as opposed to goods and services, and then liquid cash can be used for other activities to trick the credit card companies.

Should it be a cause of concern for nations? Is there an erosion of real wealth for nothing real in exchange [and imagine if tomorrow bitcoins/cryptos crash?]. Will a Nation Lose Money overnight if Cryptos crash, and what will be its impact on economy, consumption, savings?

7) So, do we need Regulations?: The real argument which may sound philosophical is- If everyone in the world attains sainthood, and say signs the Giving Pledge, we certainly do not need any regulations for cryptos or laws for anything. But until that happens [and even if there is one Crook out there] - "we do need laws, regulations to protect interests of citizens, retail investors and to keep a check on malicious activities.

I'm not saying ban Bitcoins and Cryptos, but create a regulatory framework that addresses these risks and protects citizens, national, economic interests.

The unfortunate truth today is - Regulators across the world are failing in fulfilling their responsibility [like they have many times in the past].

Why? Thanks to the larger need for technology and digital for improving lives and competitiveness- nobody wants to play the spoiler in the innovation party.

Everyone wants to be perceived as an Innovation leader [this is true for regulators, governments, the big4, 5, 6 whatever firms which advise on corporate governance, tax and regulations]. But problems begin when people only cite the benefits of blockchain, because it's cool, and means new tech business for many [after all every company today is a technology company or trying to become one].

So, Regulators Wake-Up and Do your Job i.e. to protect public interest. Or, if bitcoin remains unchecked- an economic crisis is imminent [and it could be devastating for economy], as more retail investors, financial companies join the Bitcoin Rush [Such as Chicago Based CBOE launching Bitcoin Futures this Sunday].

And, I'm not trying to be a crypto expert either, but its all too clear/simple to ignore. At this rate of euphoria - Coinmarketcap.com recently estimated the total value of all bitcoins in circulation at US$190 billion, 1000% up this year [at ~12K valuation], but at $15K its much higher].

So, the bubble-bust scenarios and exposure is pretty simple to guess:

Aggressive – Bust within the next 1 year [and at even 500% growth from now, ~$1 trillion exposure]

Moderate- Bust, 1-2 years [about $2 trillion+ exposure]

Base case- Bust, 2-4 years [$3-4+ trillion+ exposure]

Are we prepared for the next economic shock of this magnitude?

And the Trigger points for this bust could be below scenarios-

1) Major Bitcoin holding pool/s decide to cash out, and subsequent selling

2) Wallet/exchange hacks and investors lose trust, start pulling-out [Cryptocurrency Mining Market NiceHash Hacked-~62 million Stolen]

3) Fraud, Citizen outcry and protests on streets and the resulting regulatory crackdown

One final advise to Retail Investors- if Bitcoins could only go-up, Jeff Bezos, Jack Ma, Bill Gates, Warren Buffet, et al, would have invested all their money into it, but they haven't, and that’s reality. Gambling can be a leisure activity, and gains can fund your next vacation, but cannot guarantee financial security! So, invest in blockchain and tech. startups, not bitcoins and if you have already, cash-out wisely. The Party will not last for ever!

Disclaimer: Views and opinions expressed here are my personal views