‘As Good As Gold?’: A Last Minute Reality Check Before Sunday’s Bitcoin Futures Launch

Winklevoss can point to a strong track record as a bitcoin investor.

That’s from a new Bloomberg piece on Cameron Winklevoss who, together with his twin Tyler, were variously described by the media this week as “Bitcoin billionaires.”

As we pointed out, that would be inaccurate because their stake together was worth more than a billion and you can’t take two people who are collectively worth some amount and attribute the label that goes with that amount to both of them. If that logic were sound, well then one person worth a dollar and another person worth $999,999 could together be described as both being “millionaires.”

Apparently, the twins’ combined stake is now worth something like $1.7 billion, so they’re getting closer to being actual “Bitcoin billionaires” and thanks at least in part to the recent run-up, they are indeed both “billionaires” if you include their other assets.

 

Anyway, the amusing thing about the quote excerpted here at the outset is that it doesn’t just apply to Cameron Winklevoss. It literally applies to anyone who has bought Bitcoin and hasn’t sold. Unless you bought at the Thursday GDAX highs or else bought at some other high and then panicked and sold for a loss, then you too have a “strong track record as a bitcoin investor.” It’s pretty easy to “have a strong track record” in an asset that only goes up. All you have to do is buy it and not ever sell.

Tomorrow, the Cboe launches Bitcoin futures. You’re reminded that the Winklevoss twins play a role in this as Gemini is a Winklevoss production. Recall the following from the Cboe’s specifications:

The Final Settlement Value of an expiring XBT futures contract shall be the official auction price for bitcoin in U.S. dollars determined at 4:00 p.m. Eastern Time on the Final Settlement Date by the Gemini Exchange (the “Gemini Exchange Auction”). If the Gemini Exchange Auction price is not within Gemini’s parameters for a Gemini Exchange Auction price, the Final Settlement Value is otherwise not available, or the normal settlement procedure cannot be utilized due to a trading disruption or other unusual circumstance, the process detailed in the Contingencies section below will be utilized.

The alternatives that OCC could consider using in this circumstance could include, among others:

  1. Using the Winklevoss Blended Bitcoin Index value at 4:00 p.m. Eastern time on the final settlement date.
  2. Using the bitcoin price on the Gemini Exchange continuous order book at 4:00 p.m. Eastern time on the Final Settlement Date.
  3. Using a volume weighted average price (“VWAP”) or time weighted average price (“TWAP”) of bitcoin trade prices on the Gemini Exchange on the Final Settlement Date.
  4. Using the following day Gemini Exchange Auction price as the Final Settlement Value.

The form of bitcoin on which the XBT futures and their Final Settlement Values will be based is the form of bitcoin in U.S. dollars traded on the Gemini Exchange. If the Gemini Exchange were to offer trading in multiple forms of bitcoin in U.S. dollars, CFE would designate the form of bitcoin traded on the Gemini Exchange on which XBT futures and their Final Settlement Values would be based for all then currently listed XBT futures contracts and subsequent XBT futures contract listings.

What could go wrong?

Well as the world prepares for tomorrow’s leap into the great unknown, it’s worth reminding everyone (for the umpteenth time), that the forecasts for this by enthusiasts like Tyler Winklevoss are outlandish. Consider this excerpt from the same Bloomberg piece linked above:

“We think that bitcoin is a gold disruptor,” Winklevoss said in a telephone interview on Friday, predicting it may yet appreciate by 10 to 20 times its current value. “We think it’s just the beginning. We are definitely holders.”

10 or 20 times its current value. Just think about that for a second. Winklevoss and people like him are putting themselves in a position where they will either be spectacularly right or if they are wrong, suffer a reputational blow so egregious that it’s difficult to see how they could possibly recover.

I don’t pretend to know for certain which of those two outcomes will ultimately play out, but I do know for certain which one is more likely. Winklevoss is basing his projections on the idea that Bitcoin is a gold substitute. But it’s just not for a multitude of reasons which are detailed below by Goldman.

We’ve run these before, but because the twins are out parroting the “gold disrupter” narrative again just hours ahead of the futures launch that is effectively sponsored by them, we thought this was a good time to run them again.

Via Goldman

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.

GSBTC1

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.

GCBTC2

Oh, and incidentally…

KM4

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3 thoughts on “‘As Good As Gold?’: A Last Minute Reality Check Before Sunday’s Bitcoin Futures Launch

  1. Probably the most bizarre loss of Bitcoins – was experienced recent by an associate that thought he could store a thumb drive with his BitCoin wallet on it (off-line storage) – along with a some gold coins – in a hidden excavated niche, under a loose tile, in a closet, under his staircase. All buried behind his old luggage sets, boxes of Christmas decorations, boxes of electric trains that he had as child, and behind the sports equipment that he never uses. He said he placed them all in a double water tight zip lock bag. His concrete house is elevated and well out of any potential flooding.

    That was a year ago. Recently with the rapid rise of BitCoin value he thought he would check his wallet consider cashing some or all of BitCoin in before any potential collapse. His math suggested that his BitCoin was now a major store of apparent wealth and a significant portion of his net worth. When he accessed his well hidden niche – he found that some mice has also determined his niche to be a safe place. Unfortunately, and for unknown reasons the mice gnawed through the plastic zip-lock bags, the case of his thumb drive and further gnawing scrambled the electronic connection of the drive – as well – they peed and defecated on pretty much everything he had stored in the niche as they built their nest around and with his valuables – over and extended period during the last year.

    He washed his gold cons off and they were as good as new. He found a new place to hide them, this time in steel security box. The BitCoin – not so much. They were totally lost. He had several techs look at the gnawed and corroded thumb drives internals, but they said there just isn’t enough intact to have anything to recover. He wouldn’t tell me how much, but based on some of past stock purchases – I know he doesn’t buy anything in very small lots. He’s a “Go big – or go home type of guy.”

    Like a lot of people he bought his early BitCoins as credit card purchases. Now he’s wondering what proof the IRS will require that his BitCoins are indeed “lost and irrecoverable.” His credit card records clearly show his purchase of the coins, the date and their value when he purchased them – a fraction of the current value. He he seems to have no provable loss, but he has created the suspicion of potential recorded gain. While most BitCoin transaction have zero anonymity, one way to possibly achieve anonymity – is in unrecorded face-to-face cash sales of Bitcoin. He has the badly gnawed and corroded thumb drive, but there is no way he can prove that his BitCoins/wallet were ever actually on it – or actually lost with the thumbdrives functionality. He says with a groan, “This year’s taxes are gonna be really interesting.” Because of the size of his potential gain, he is sure that the IRS will be watching his expenses and income records closer than they ever did – waiting to see if he secretly converted his “lost” BitCoin to cash. This means he has to document every expense and purchase in far more detail and securely than he once might have.

    The frailty of the grid, internet and the digital storage systems and devices that BitCoin exists and relies on – is a far less secure environment than the average person believes. Blockchain technology only protects the transaction process, but does not protect assets transferred before they enter the blockchain transaction – or after it. A lot of millenials take the internet for “granted” and or “granite” as some say – not being capable of imagining or believing how fast it can disappear. Well, at least millenials that don’t live in E. Texas, Florida, and or Puerto Rico.

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