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Should you buy (more) bitcoin?

Mar 07 2018 14:34
Petri Redelinghuys

The great bitcoin rally of the fourth quarter of 2017 is apparently over and is seemingly, and very rapidly, busy ending with a very loud “pop”. 

Many South Africans got swept up in the rally, but only a handful of people actually made any money from it.

Of course some people have made absolute fortunes with bitcoin. 

While it has fallen by almost 60% from its highs of around $20 000 in December 2017, it is still up well over 680% over a rolling 12-month period, trading around the $10 500 mark in early March. 

The inconvenient truth is that the vast majority of people who got involved in bitcoin in the latter part of last year have made no money at all, and in many cases, have actually lost money. 

The reason is simple – they simply got involved too late. Most of the volume that was traded, was traded during November and December when bitcoin was trading near all-time highs. 

Since then, the price of the cryptocurrency has fallen drastically. 

How the bubble burst

At the start of 2017, bitcoin was trading at around $1 000, more than double the approximately $450 it was worth at the end of 2015. 

I say approximately, because bitcoin trades on multiple bitcoin exchanges and sometimes there are different prices on different exchanges.

Bitcoin started picking up momentum during 2016 after it had been range-bound under the $450 mark for some time. 

In February 2017, the price of bitcoin had taken out the previous high of approximately $1 200 it made in 2013.

At this point the people who had bought back then and were patient enough to hang on were once again in the green on their investment, and started talking about bitcoin with some enthusiasm. 

News flow around bitcoin and people making money with it started picking up again, and a few brave people started to get involved by buying the currency. 

Their excitement and enthusiasm were contagious and the hype started. 

Six months into 2017, and bitcoin was trading at $2 500, two-and-a-half times the price it was trading at in the beginning of the year. 

By November it was trading at $8 000. Anyone who offered a word of warning about the risks of buying into parabolic moves was regarded as an idiot and a non-believer in a technology that is changing the world. 

By late November, people who had no idea what bitcoin even is were pouring money into it, expecting that the breakneck pace at which the price was going up would last forever.

In late December, bitcoin reaches a record high of around $20 000 and… comes crashing down. Tulip mania all over again. 

The people sucked into the frenzy are being carried out on stretchers. 

What is bitcoin?

To understand why prices plummeted, we first need to understand what bitcoin is and what drives its value. Bitcoin is essentially open-source software that generates unique tokens, or pieces of software code, that can be transferred between people by making use of digital wallets, without involving a bank. 

There are several exchanges around the world on which you can buy and sell bitcoins with regular fiat currencies like dollars. 

With fiat money, if Bob wants to send money to Lucy, he needs to use his bank (the trusted third party that stores his money and keeps a record of his earnings and spending) to forward the money to Lucy’s bank (her trusted third party). 

With bitcoin, Bob can send the currency directly to Lucy without having to go through a bank, because both of them can store, send and receive bitcoins in their own digital wallets. 

Each bitcoin is made up of 100m pieces, each uniquely identifiable and uniquely programmable to have a specific quality or purpose. 

Let’s say for example that a company wants to grant its employee a medical allowance. The company can transfer bitcoins to its employee and programme them to be spent only with authorised medical institutions and on nothing else. 

If the bitcoin is not spent on medical expenses within a particular period, it can be programmed to be returned to the company.

The implications are huge: bitcoins completely remove the need for oversight and monitoring, and there are literally thousands of potential applications for the cryptocurrency. 

Understanding the blockchain

The magic behind it all is the technology in which it is based, or the way in which transactions are recorded and verified. This is called blockchain technology, or simply: the blockchain. 

In fact, the blockchain is really just open-source software – software that is freely available to everyone. 

The actual code that makes up the software is easily accessible and open to anyone who wishes to see how it works – and anyone is free to edit it if they so wish. 

The blockchain design is so ingenious that counterfeiting it is, for all intents and purposes, impossible. Let me first explain how a bank (the trusted third party) keeps a record of your money. 

The bank has a ledger of all transactions of money that comes into and out of your account, where it came from and where it was sent to. 

It keeps this behind closed doors, so to speak, on its own server and we place our trust in banks that its ledgers (or record of transactions) are accurate and correct.

With the blockchain, this ledger of transactions is not kept private: it is public. Therefore, every transaction that has ever taken place is in the public domain for anyone to look at on an ever-growing number of servers (or nodes) in the global blockchain network. 

These nodes are owned by individual people or companies that maintain the network for a reward. 

Put simply, these nodes, or privately owned servers, process and verify transactions on the blockchain and in return for doing so, are rewarded with bitcoins. 

Transactions are verified by checking that the input of the transaction matches the output of the transaction – that the wallet that has sent the bitcoins has in fact received a corresponding number of bitcoins prior to sending it. 

To keep it all practical and to remove the need to check the entire history of every bitcoin transaction ever, every time a transaction is made, the transactions are grouped in sets of 2 020 to make up blocks. 

Once a transaction is grouped in a block, it is deemed confirmed and that block is added to the chain. 

Because there are millions of computers around the world working on solving these blocks (verifying transactions), once a block is solved, it is broadcast to the entire network of computers in the blockchain network. 

Those computers again check the validity of all the transactions in the block before accepting it into the chain. 

This means that nobody needs to place trust in anybody, because everyone is double-checking every transaction that has ever taken place, and is doing so publicly. 

It also means that transactions are irreversible and final. 

Blocks are then linked to one another and placed in a sequential order. All of this is done by incredibly complicated mathematical formulas, which are similar to puzzles, that the nodes need to figure out in order to solve. 

This requires an immense amount of computing power. 

Mining bitcoin

Once a node solves a block, new bitcoins are created and are your reward for the work done – called bitcoin mining. 

Therefore, people are incentivised to invest in the hardware (computers and servers) to dedicate it to processing bitcoin transactions. 

In order to limit the number of bitcoins that will ever be in circulation to 21m, the reward for solving a block is halved every four years until, in theory, by the year 2040 there should be around 21m bitcoins in circulation. 

The currency will probably never hit the 21m limit, however, as the reward for processing a block will become exponentially smaller over time. This means that the economic viability of processing transactions to be rewarded with bitcoins will deteriorate and people will stop mining. 

Mining is expensive because it requires an ever-increasing level of sophisticated and powerful computer hardware and, of course, electricity. 

If the software is open source and editable by anyone, why can’t someone just change the software, alter the publicly distributed ledger and steal all the bitcoins? 

Well, because there are so many computers on the network that every single person who owns a bitcoin miner (or node) will have to change their software too in order for the change to be accepted by the entire network. 

Furthermore, the software is designed to make it more difficult to solve blocks even though more and more computers are added to the network. 

Each block is designed to be solved in about 10 minutes, but as more computers are added, these times reduce as computing power increases. 

So, the algorithm built into the blockchain technology automatically adjusts itself to make it more difficult to solve a block in order to compensate for the additional computing power coming online. 

It means that as more miners join the network that processes transactions and solves blocks, the more difficult it becomes to do so – and that brings us back to why the bubble burst. 

The economics of mining

The bitcoin frenzy reached a fever pitch towards the latter half of 2017 with every aunt, uncle and their dog buying bitcoin and driving prices higher. 

This made mining bitcoin extremely profitable, because the reward for solving a block is paid in newly created bitcoins, those bitcoins could be sold for cash – and the value kept going up. 

As a result, a flood of new miners entered the network, which made it harder and harder to solve a block. As the difficulty increases, only the latest computers are able to solve blocks and earn bitcoins: the older and now out-of-date hardware can’t keep up. 

So those miners are now spending money on electricity that they are unable to recoup in bitcoin profits. 

Their mining operations are now unprofitable, so they turn off their miners and sell the bitcoins that they have accumulated. 

Economics 101, right? The demand for bitcoin surges, new miners come into the market rapidly and create tons of supply. Older, now out-of-date miners turn off their mining rigs and sell their bitcoins to recoup their costs. 

This means even more bitcoins enter the market. Suddenly we have more supply than demand and prices come down. 

Combine that with panic of those who had bought the currency in November and December, which was when, to date, the majority of all bitcoin transactions ever had taken place…and pop!

Predicting future prices

So what now? To answer this, I want to compare what happened in 2013 and 2014 with what had happened more recently. 

In 2013, the price of bitcoin went from approximately $12 at the beginning of the year, to reach a high of around $1 200 in December. 

A 10 000% increase in price – significantly bigger than the 2 000% increase we saw in 2017. 

We then saw a classic bubble develop and burst. Prices fell during 2014 and 2015, erasing 85% of the gains bitcoin had made (back to a low of around $180 in 2015). 

The price spent all of 2015 ranged between $180 and $300, before slowly starting to trend higher again in 2016. 

In 2017, the previous high of $1 200 was taken out and again we saw a parabolic move, this time up to $20 000. 

My prediction is that we’ll see an 80% to 90% correction in the price over a similar (one-year) period, followed by a range-bound price for a year.

In the third year, prices start trending upwards, to take out the high of $20 000 in the fourth year, followed by another parabolic move, potentially up to $200 000, if not higher. 

A bold forecast, but founded in the belief that patterns repeat themselves. 

In 2013, much like in 2017, bitcoin was all over the mainstream financial media as its incredible rally left people dumbfounded. 

So there was a lot of hype – a key ingredient to any bubble. 

Also, there is the ever-growing network of miners/nodes in the blockchain network. 

As more and more people invest in bitcoin mining hardware, the value that bitcoin must trade at in order for those miners to be economically viable, must increase. 

It sounds silly, but when you look at the graph, first made public in 2014, we can see that as the difficulty of mining bitcoin increases exponentially, so does its price. 

Although the creator of this chart has not updated it since 2014, somebody updated it in 2017 and the curve seems to fit. It is almost frighteningly accurate.

It predicted that, based on the mathematics behind how bitcoin is created by the mining process, a bitcoin should be worth $10 000 on 22 November 2017, and it hit $10 000 a week later. 

For a prediction made in 2014, based on mathematics, it is close enough for me to believe that the prediction is credible.

How to trade it 

This leads me to believe that the cycle of bubble and burst will repeat itself at least a few more times, following the blueprint of trade action between 2013 and 2016. 

Considering that every four years the reward for mining bitcoin halves and that the bubble-and-burst cycle is four years long, I don’t think it is a coincidence that there is such an incredibly high correlation. 

If this theory holds true, we might well see bitcoins trading at $1m by 2040. 

What to do?

Wait for $4 000/bitcoin and buy some. Obviously, don’t buy more than what you can absolutely 100% afford to lose, as there is no guarantee that this theory is correct. 

Treat bitcoin like a stock and take an allocation in your portfolio similar to what you would invest in a small-cap stock or high-risk investment. 

Finally, I don’t think that bitcoin itself is the future of money and transactions, but I do believe that the blockchain technology on which it is based has laid the foundation for how transactions and money will be accounted for in future. 

Many other cryptocurrencies have come into existence since bitcoin was created in 2009. 

But I don’t believe that any of the other available cryptocurrencies are going to become the new global currency either. 

I think that as time goes by and blockchain technology is further explored and improved upon, we’ll eventually see a country make the move to convert its currency to adopt the blockchain technology. 

Bitcoin is not a currency, because a currency has three major properties, of which bitcoin only has one. These three properties are: a store of value, a medium of exchange, and a unit of account. 

Thus far, bitcoin has not been a store of value because of its extreme volatility (11 times more volatile than the GBP/USD currency pair). 

It is a medium of exchange, because people are using it in the real world to pay for goods and services, but it is not a unit of account as people are still measuring their bitcoin profit in fiat currency, like the dollar. 

Until people start measuring value in terms of bitcoin, it cannot be considered a unit of account. 

Bitcoins can therefore not be classified as a currency, but rather as a digital asset. 

Therefore, I believe there is “speculative” value in bitcoin because it was the first iteration of the technology, but eventually it will be replaced by a major world currency adopting blockchain technology. 

Whether bitcoin will lose its “speculative” value over time, once the 21m bitcoins are in circulation, is yet to be seen. I think we’ll only discover that after 2040. 

Petri Redelinghuys is a trader and the founder of Herenya Capital Advisors.

This is a shortened version of the cover story that originally appeared in the 1 March edition of finweek. Buy and download the magazine here.