The value proposition of bitcoin is that it exceeds gold in every one of Austrian economist Carl Menger’s elements of liquidity, except one: stability.
The reasons for why bitcoin can never be stable, and therefore can have no monetary value, are subtle and far beyond the grasp of most economists, much less amateur speculators. Since it has no other claim to value except for replacing gold, it may eventually end up at zero.
However, in the meantime, speculative flows are pumping up bitcoin and other crypto assets. So is bitcoin a bubble, and if so, when will it pop? A bubble needs an increasing rate of speculative inﬂows to avoid collapse, which is why bitcoin billionaires like the Winklevoss twins (also called Winklevii) are inserting the plumbing of wholesale and retail money markets into bitcoin to keep the money flowing.
Their Gemini.com exchange, for example, is a licensed exchange custodian that solves the problem of custody for hedge funds and other institutions. It is plugged into the Chicago Board Options Exchange, so traders and institutional investors can use their existing infrastructure for trading bitcoin without ever having to take custody of a single coin.
These trades affect the underlying market because every long futures contract requires a short. If there are no investors willing to go short, then the dealer has to create a short contract. The dealer then must balance his risk by directly going long on the underlying commodity.
This would be easy for a dealer that already has a huge amount of bitcoin inventory on hand, like the Winklevii. They spent $11 million, from a $65 million settlement with Facebook over who founded the company, buying nearly 100,000 bitcoins at around $120 each in 2013, making them the first confirmed joint bitcoin billionaires at the current price of $16,500. Now they can use this inventory to fund their dealer network.
If this is their exit strategy, then it is extremely clever. It is not easy to sell large amounts of bitcoin. Coinbase, the largest U.S. bitcoin exchange, for example, allows unlimited deposits, but limits withdrawals. Right now, the ﬂows are inbound, so withdrawal limits should not matter much, yet they already have them. Imagine the scramble when everyone decides to get out.
The Winklevii, by organizing a primary dealer exchange, will have no trouble liquidating their estimated $1.65 billion’s worth of bitcoin. All they have to is take the short side of the futures contracts that institutions are buying.
There is a close historical parallel of a major owner of an inflated asset liquidating through derivatives. During France’s Mississippi Bubble from 1716 to 1719, Richard Cantillon bought shares in the Mississippi Company early in the bubble, shares that had run from 200 livres to more than 10,000.
He then bought out his cousin’s interest in the family bank and began issuing credit to speculators, taking their shares as collateral. The speculators used the credit to buy more shares, sending the price higher, which in turn enhanced the value of their collateral and enabled them to borrow more—a classic bubble.
Cantillon decided to cash out when the share price was nearing its apex and proceeded to sell not only his shares but also his customers’ collateral. When the share price collapsed, Cantillon bought back the now worthless shares to cover his short position and then moved to collect the full amount of the debts owed to him by the bank’s clients.
Cantillon became a multimillionaire (when that really meant something) and died under mysterious circumstances 15years later.
Like Cantillon, the Winklevii have positioned themselves as the most liquid player in the bubble, enabling them to liquidate their own position and go short when the time is right, if they have the wit.
But the time is not yet ripe. “We’ve seen mortgages being taken out to buy bitcoin. … People do credit cards, equity lines,” said Joseph Borg, the president of the North American Securities Administrators Association, on a Dec. 11, 2017, CNBC interview.
As long as the price of bitcoin increases more than the interest owed on these credit lines, it seems like a good trade, and credit will continue to pour into the bubble—especially when an ETF becomes available.
A bitcoin ETF will allow retail speculators to use the margin capacity of their stocks held in their brokerage accounts, capacity that will expand along with bitcoin prices.
A Different Bubble
Unlike every previous bubble in history, bitcoin prices do not generate a supply response. Real estate bubbles cause overcapacity in real estate; government bond bubbles bring government spending and huge supplies of new government bonds. But the quantity of bitcoin increases at a steadily slowing pace. And the higher its price runs, the more it seems to validate price targets of hundreds of thousands or even millions, enticing those who own bitcoin to take them off the market.
These dynamics could send bitcoin’s price significantly higher even from here, but the final price target is most likely zero, or maybe some curiosity value, such as $100 trillion Zimbabwean notes, which now sell as curiosities for $90 each.
Calling the top of a bubble is no easy task, especially in this case. Normally a bubble pops shortly after the cash ﬂows of the speculative investments go negative. In other words, high real estate prices bring forth overcapacity, then rents fall, operators cannot meet their interest payments and default, and banks collapse. Those on the inside of the market have a good view of when cash ﬂows start going negative, so they can get out.
In the present case, bitcoin does not generate any cash ﬂow, and there is no overcapacity to observe. Instead, the inﬂection point will come when those who are taking out mortgages and credit card and margin loans must sell to meet their interest payments, which will knock the price down, then generate margin calls and knock the price down further, and finally, topple the whole structure.
Banks will suffer, not because they are exposed to bitcoin directly but because the man who loses his mortgage advance to the Winklevii will be unable to make his mortgage payment. At present, the bubble by itself is surely too small to threaten the banking system. But, like subprime housing, the bitcoin bubble could perhaps already act to trigger the unwinding of other bubbles. This potential will grow along with the mania.
Many bubbles end with one last spike higher, such as in 1929 and 1999. The bitcoin phenomenon is likely the last ﬂourish of Bernanke’s bubble. When all the credit money in all the bubble markets in all the world finally panics into gold, the results ought to be spectacular.
Dan Oliver is the principal at gold mining fund Myrmikan Capital LLC.
Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.