And the debate continues.
This morning, Goldman beat on the FICC number which is something of a relief but don’t let it be lost on you that the $1.45 billion in FI trading still represents a 26% drop from a year ago. That was due to “significantly lower” net revenue in commodities, interest-rate products and credit products.
As we noted last week when JPMorgan’s results showed a similarly steep decline in FICC sales & trading revenue, it might be time to start thinking about Bitcoin, or something else that actually moves.
Of course Goldman is indeed considering a move into the crytpo space although according to Lloyd Blankfein, nothing is finalized. Recall this:
Do note that just because the Goldmans of the word move into the space doesn’t necessarily mean they are “endorsing” Bitcoin (or any other make-believe space money variant) as “money” or as a store of “value.” Rather, it just means that with cross-asset vol. hopelessly suppressed, they’re looking for ways to generate revenue.
Also last week, we cited a new UBS note which concludes unequivocally that Bitcoin is not and never will be a currency. Here are two highly amusing excerpts:
The first and most important role of a currency is to act as a widely accepted medium of exchange. Currencies only have value when they can buy things that are useful. In this regard, government backed currencies carry a huge advantage. Governments set taxes, and tax is the largest single payment in almost any economy. In developed economies over a third of all economic activity that takes place in a year is paid to the government as tax. As such, people will always demand government-backed currencies because they are useful for paying taxes.
The second role of a currency is to act as a store of value. People need to believe that what their cash can buy today, their cash will buy tomorrow. In order to maintain the store of value, central banks take a lot of trouble to keep a currency’s value roughly stable (i.e. control inflation). This is done by making sure that the supply of currency generally matches the demand for a currency. If the balance is maintained the currency will broadly keep its store of value. An individual crypto-currency cannot achieve this balance, which explains their volatility. Crypto-currency supply cannot go down. A fall in demand for a specific crypto-currency will therefore cause that crypto-currency’s value to collapse as supply outstrips demand. For context, Bitcoin’s collapse in value in early September was worse than the collapse in the value of the German mark at the start of the Weimar hyperinflation.
Well on Tuesday, while the higher ups are busy trying to explain what’s behind the decline in trading revenue, Goldman’s analysts are out with a new note on precious metals as havens. One particularly interesting segment asks if “cryptocurrencies are the new gold.” Spoiler alert: “no.”
Here’s what Goldman has to say:
Are cryptocurrencies the “new gold”? We think not, gold wins out over cryptocurrencies in a majority of the key characteristics of money.
An understanding of the physical nature of Bitcoin allows us to revisit our previous analysis of the physical characteristics of precious metals, comparing and contrasting them with cryptocurrencies:
Durability: Both require expertise for correct long-term storage, but gold wins out over cryptocurrencies
There is no need to hold much physical material to own cryptocurrency – for Bitcoin, just 32 bytes (256 bits) for each private key and 65 bytes (520 bits) for each public key (wallet); even a technology as obsolete as the 3 ½ inch floppy disk could hold almost 15,000 public-private key pairs, and there is no upper limit to the value of bitcoins in each wallet. However, correct long-term storage and security is extremely challenging for several reasons:
Cryptocurrencies are vulnerable to hacking. It is critical to note that we do not mean directly via the protocols of the networks, but rather, indirectly, through either online eWallet or other services, the user’s own computer or smartphone, or (for more recent cryptocurrencies, such as Ethereum) through vulnerable “smart contracts”. In one of the earliest Bitcoin hacks, an online wallet, MyBitcoin.com, had around 51% of its bitcoins stolen (worth $49 million at the time). The largest Bitcoin hack to date was on the online currency exchange Mt. Gox, which saw repeated thefts from 2011 to its closure in early 2014, taking around $500 million worth of bitcoins. The largest Ethereum hack, which exploited vulnerability in a smart contract called the DAO (“Decentralized Autonomous Organization”) saw one-third of tokens stolen, worth around $50 million at the time.
Offline storage can help to mitigate these risks, but only to some extent, and ultimately this is somewhat like keeping gold in a safe at your home. The recommended way to handle security is to generate an offline “cold storage” wallet. However, having complete confidence in this process requires significant technical known-how. Furthermore, this is not a permanent solution as new, backwards incompatible versions of the Bitcoin client may be released in future, security algorithms might be broken, and “bit rot” (the physical deterioration of storage media, which flips bits and garbles data) could destroy wallet data. Multiple backups, either electronic or even paper copies, can be made, reducing this risk but increasing inconvenience and security vulnerabilities.
There are significant regulatory risks surrounding cryptocurrencies. Given the short history of the technology and its inherent abilities to skirt “Know Your Customer” (KYC) and “Anti Money Laundering” (AML) legislation, many regulators have expressed concerns over cryptocurrencies and the related field of Initial Coin Offerings (ICO). Regulators in China and South Korea have moved to ban cryptocurrency exchanges and ICOs over the past few months.
Cryptocurrencies are also subject to network / infrastructure risk during a crisis. Blockchain technology was designed with the underpinning axiom of an open, non-fragmented internet. While this is a plausible assumption to make, and it seems a very low-probability event that this would ever change – there is still an inherent risk to cryptocurrencies if the internet were ever to “split”. In contrast, gold has outperformed during wars and disasters – exactly the events which pose the greatest risks to communication networks. Gold can (and for most of its history has) formed local markets: with each market having slightly different prices, but through trade (and smuggling) no-arbitrage conditions eventually normalizing prices. In contrast, with an internet split in two, it would be possible for bitcoin holders to “double spend” the same bitcoin. Since the only defence against this to trust only the longest blockchain, any temporary split in the network would therefore have to become permanent, creating another “hard fork”
Portability: Cryptocurrencies clearly better than gold. Transferring gold can be expensive, given its weight, the need for a high level of security and, in some countries (such as India), high import taxes. In contrast, since there is no need to make a physical transfer with cryptocurrency – just a transfer of ownership in a distributed database (which is already held digitally by computers all over the world) – it is much faster and less expensive to move bitcoins. While owners of bitcoins still have a legal obligation to ensure that they are complying with the law when transferring funds, it is much harder to enforce these laws for cryptocurrency transfers, particularly if wallets are held anonymously.
Divisibility (and medium of exchange): Cryptocurrencies look better on paper, but neither is really a good option in practice.
Gold bars and coins are not usually produced below a weight of 5 grams (currently worth over $200 plus a hefty premium). This makes physical transactions in gold quite challenging. As such, gold transfers usually only occur for larger values, with transactions typically occurring in 400toz (11.3kg) or 1kg bars.
The smallest Bitcoin unit is 1 satoshi. With 100 million satoshis per bitcoin, the currency is close to infinitely divisibly. This makes cryptocurrencies seem a much better candidate from the perspective of divisibility. However, there are significant technical challenges facing Bitcoin “scaling”. As the block chain has become longer, the network has become slower and miners have started to demand hefty transaction fees on top of the seniorage revenue from creating new bitcoins (which has fallen dramatically). This has led to much higher transaction fees for users than in previous years. Exhibit 63 shows that the average transaction fee has been more than $2 since mid-2017, compared with less than a cent in previous years.
Intrinsic value: Gold is not subject to competition from alternatives, cryptocurrencies are.
There is a limited supply of gold and other precious metals in the Earth’s crust. Both the Earth’s core and asteroids in space likely contain many more precious metals, but technology is still far from being able to exploit these sources. For cryptocurrencies, rarity is built into the code. This would again appear to make cryptocurrencies the better choice over gold, as limited supply is a mathematical certainty.
However, as we argued in earlier sections, a key property of all precious metals is that they are elements. Elements are not invented, they are discovered, and we have already discovered all the elements neighbouring the precious metals.Therefore, there is no way that an “alternative” precious metal will ever emerge.
In contrast, in Bitcoin we have already seen an explosion in alternatives over the last few years: alt-coins (cryptocurrencies competing with Bitcoin, in many cases derived from its open-source codebase), ICOs (tokens which look similar to cryptocurrencies, but operate as “side chains” within a specific sector, application, or company’s network) and “hard forks” (a splitting of the original cryptocurrency network into two or more incompatible, competing networks). This ability to easily create alternatives, with high degrees of substitutability to the original, means that there is effectively no control over supply at a macroeconomic level and hence no intrinsic value due to rarity.
Unit of account: Gold is clearly better at holding its purchasing power, and has much lower daily volatility.
We have also noted previously that gold has an extremely long history of broadly maintaining its purchasing power. In contrast, in their extremely short history, cryptocurrencies have failed to maintain anything like price stability. Exhibit 64 shows that Bitcoin/USD volatility averaged almost 7 times that of gold in 2017.
The extreme volatility of the Bitcoin exchange rate means that merchants accepting Bitcoin (who do not, implicitly, want to become Bitcoin speculators themselves) should demand large volatility premia to hedge their FX risk. For example, a simple Black-Scholes model for a 3-day USD/BTC put option at historical average volatility results in a premium of around 2.3%. This means that, under normal circumstances, a seller who accepts Bitcoin for a transaction, then changes it into USD the next day and waits for clearance over the following 2 days, ought to be charging a 2.3% premium.
Combining this FX premium with the (>$2) transaction fee to reach settlement on the Bitcoin leg of the transaction clearly illustrates that Bitcoin as a unit of account and medium of exchange is nowhere near as favourable as it first appears.
Ironically, that latter bit suggests there’s money to be made for banks which is precisely why Goldman is interested and precisely why at least some of its peers (although really, Goldman has no “peers” per se) will probably jump on board before it’s all said and done.
Finally, the ultimate irony in that whole discussion is that at the end of the day, gold is just as valueless as Bitcoin. Neither shiny yellow metal nor make-believe space tokens are going to be worth a damn thing if we all find ourselves living out Cormac McCarthy’s The Road. And on that rather dour note, we’ll leave you with one last quote, this one from the UBS piece out last week:
Currencies in themselves have no natural value – gold, for instance, is naturally as worthless as paper, sea shells, or wooden sticks (all of which have been used as currencies). Currencies only have value when they can buy things that are useful.
Oh, one last thing. If you missed our piece on “valueless valuables,” here are the passages that are relevant to the discussion above…
People have a demonstrable tendency to lose track of common sense and nowhere is this more apparent than with gold and Bitcoin. I’m sorry, but gold has zero inherent value once you strip away humanity’s natural predisposition to love things that are pretty and shiny. You can’t eat it, you can’t burn it, you can’t do a damn thing with it other than caress it, stare at it or, if you’re Scrooge McDuck, swim backwards in it. Yes, there’s a finite supply of it, but there’s a finite supply of all kinds of things that no one would ever characterize as “an inflation hedge”. It has value precisely because you think it does and if you ever find yourself having to survive in an inhospitable environment, it will be completely useless. That’s common sense.
As for Bitcoin, it’s make-believe. Someone made it up. And people are making it up again all the time and calling it something different. One day, governments are going to ban it. And that will be the end of that. That’s also common sense.
There’s a reason why gold fanatics and Bitcoin cheerleaders tend to demonstrate an aversion to governments and central banks and I’ll tell you what that reason is. The reason is because it grates on those folks’ nerves that a centralized authority can print pieces of paper that have value simply because the government says they have value. It’s true that printing pieces of paper out of thin air is nonsense and that it should, in the end, lead to hyperinflation. It’s also true that when the Treasury prints I.O.U.s and sells them to the people across the street at the Fed (with one degree of separation), that the government is engaged in a massive, circular, self-referential ponzi scheme that should by all accounts be doomed to collapse on itself. The reason this nonsense “works” is precisely because the government says it’s going to work and that drives some people absolutely crazy.
The more money gets printed out of thin air without causing hyperinflation and the longer the ponzi scheme persists without triggering an epic collapse of the system, the crazier the gold fanatics and, more recently, the Bitcoin crowd gets. The government’s power to legitimize something profoundly illegitimate is an affront to a lot of people and so they cling to myths about the “inherent” value of a yellow metal or the “revolutionary” characteristics of a make-believe electronic payment system.
It’s true that eventually currencies fail. It’s true that empires eventually collapse. But in the meantime, railing against the system by regaling yourself and others with fairy tales about the magical properties of what, in the final analysis, are just twinkling paperweights and digital exchanges that will eventually be shuttered by government decree, is tantamount to tilting at windmills.
On top of that, it’s by no means clear that human beings will always be entranced by gold. It could very well be that when society plunges into the next dark age, people won’t be fascinated by gold anymore. Maybe people decide “yellow” isn’t their thing and instead choose a different colored scarce object as a store of value .