Bitcoin Remains Resilient Despite Establishment Backlash

Just this week, JP Morgan Chase CEO Jamie Dimon came out strongly against Bitcoin.  Calling it a “fraud“, claiming that “it is worse than tulip mania”, and declaring that he will fire any employee who trades the cryptocurrency for being “stupid”. (While somewhat amusingly admitting that his daughter invests in Bitcoin.)

Also this week, several China-based Bitcoin exchanges including BTCC, ViaBTC, Yunbi, OKCoin and Huobi have been ordered to stop trading by the end of September. This news follows a decision by Chinese authorities earlier in the month to ban fundraising through Initial Coin Offerings (ICOs).

The price of Bitcoin dropped by around 32% during September, before rocketing 27% in a single day on Friday.

What’s going on here?

At least three things.

Firstly, Bitcoin can function without a trusted financial intermediary, which means it may take business away from established financial institutions like JP Morgan. Bitcoin is a cryptocurrency; that is, a digital currency which records transactions in the blockchain, a decentralised shared public ledger stored on computers connected to the Bitcoin network, and secured using cryptography. As a result, transactions can take place between any users on the network without needing to pass through a trusted financial intermediary. As it happens, JP Morgan Chase often plays the role of a financial intermediary, from which it earns substantial revenues [pdf]. This may help to explain why Jamie Dimon, the firm’s CEO, has been so critical of Bitcoin. It is a technology which could disrupt his bank’s business model, which makes it a potentially serious threat that needs to be squashed.

Secondly, Bitcoin allows anonymous transactions worldwide, which makes it difficult for governments to monitor and control. Jamie Dimon is skeptical that authorities will ever allow a currency to exist without state oversight, and this may explain China’s crackdown. China is likely concerned that people are using Bitcoin to shift money out of the country in violation of its capital controls.  China is also likely worried, and legitimately so, that Bitcoin and ICOs could be used for things like terrorism financing, money laundering, and organised crime. As cryptocurrencies like Bitcoin become more mainstream, we should expect increasing levels of government oversight and regulation. America’s SEC, Australia’s AustracJapan’s Financial Services Agency, and others have already started to do this. My feeling is that the crackdown in China may be a temporary measure, which could be followed by the People’s Bank of China issuing a brand new government backed cryptocurrency that the government is able to control.

Thirdly, unlike fiat currency, Bitcoin is designed to have a strictly limited supply. No more than 21 million Bitcoins are ever expected to be issued. Assuming people continue to have confidence in Bitcoin, this artificial scarcity will help to guarantee its value. This may explain why Bitcoin’s price increased by 27% on Friday, even though there has been a lot of negative news coming from China and Jamie Dimon.

In response to Jamie Dimon’s comments, John McAfee, CEO of MGT Capital Investments, responded by saying, “you called Bitcoin a fraud? … I’m a Bitcoin miner. We create Bitcoins. It costs over $1,000 per coin to create a Bitcoin. What does it cost to create a U.S. dollar? Which one is the fraud? Because it costs whatever the paper costs, but it costs me and other miners over $1,000 per coin. It’s called proof of work.”

Bitcoin’s artificial scarcity could encourage investors to buy Bitcoin as a hedge against inflation rather than buying dollar denominated assets like government bonds. If the market for Bitcoin becomes big enough, this could make it more costly for some governments to borrow. Traditional currencies usually experience inflation because central banks tend to print more money than is required to facilitate economic activity, leading to higher prices. Inflation allows governments to borrow money today, and repay debts in future with money that is worth a little bit less. If Bitcoin becomes a global reserve currency, some governments may face pressure to issue debt denominated in Bitcoin. As a result, they would no longer be able to print money to repay their debts. For a country like America, which controls the world’s reserve currency and runs consistent budget deficits, this would represent a significant change from the status quo.

Bitcoin remains resilient despite this week’s establishment backlash.  However, the biggest risk for Bitcoin in the short to medium term would appear to be regulatory risk. Will other governments follow China’s lead by banning Bitcoin exchanges and seeking to establish their own state backed cryptocurrencies?

My feeling is that in Western countries, the free market will prevail. However, even if this is the case, we should anticipate much more government scrutiny, supervision, and regulation going forwards.

Image: Pexels

Levered Monkeys

levered-monkeys

As Oxford’s poet-philosopher Ludovic Phalippou once put it, “we are all just levered monkeys!”

What did Phalippou mean by this comment?

Well, as I explained to my corporate finance students this week, the use of debt by companies is called “financial leverage”. That is, debt acts like a lever which can magnify the size of both gains and losses.

Imagine that you are the CEO of Apple Corporation and require a return on investment of 10%. There is a new venture you can undertake that will generate a return on assets of 2%, but you can currently borrow money at an interest rate of 0%, and so you can use debt to help you achieve your required return.

You decide to go ahead with the project, and the numbers look something like this:

Venture     – Debt           = Investment
$1 million – $800,000 = $200,000

EBIT        – Interest = Income
$20,000 – $0           = $20,000

ROI = Income/Investment = 10%

Bravo!

In this very simple example (which ignores things like taxes and capital gains), you have successfully used debt to increase your return on investment from 2% to 10%.

As I mentioned in an earlier post, central banks in some of the world’s major economies are keeping interest rates at record low levels. And in a few places (like Japan, Europe, and Switzerland) interest rates are negative.

Since debt can be used to magnify investment gains, central banks are no doubt hoping that businesses will take advantage of lower interest rates to increase investment and thereby stimulate the economy.

However, record low interest rates can’t last forever.

When will central banks return interest rates to more normal levels?

This past week there was talk about whether the Fed would raise interest rates in September. Jamie Dimon, CEO of JPMorgan Chase, argued that the Fed should raise rates sooner rather than later. However, Goldman Sachs reduced the chance of an interest rate hike in September from 40 percent to 25 percent; while at the same time increasing the odds of an increase in December from 30 percent to 40 percent.

Nobody knows exactly when central banks will start to increase interest rates again, but it seems that it could happen in the not too distant future.

As the CEO of Apple Corporation, you had managed to achieve your required rate of return of 10%, and you were feeling pretty pleased with yourself. However, imagine now that the central bank decides over the course of a few short years to increase interest rates back to a more normal level of, say, 4%.

What happens to your return on investment?

Venture     – Debt           = Investment
$1 million – $800,000 = $200,000

EBIT        – Interest  = Income
$20,000 – $32,000 = -$12,000

ROI = Income/Investment = -6%

Bazinga!

As a result of rising interest rates, the return on investment for your venture has fallen to minus-6%. This is below the return on assets of 2%, and even further below your required return of 10%.

What can we learn from this simple example?

Well, one of the goals of central banks, in keeping interest rates at record low levels, is to stimulate the economy. This should work because lower interest rates reduce the required rate of return, as we saw in our example. However, by encouraging business leaders to undertake projects that offer low returns, it may be that central banks are sowing the seeds of the next downturn.

They have to raise interest rates at some point, and when they do, businesses who have taken advantage of financial leverage to pursue projects with low returns will have their losses magnified.

The more debt a business has used, the more pain it will feel.

Silly monkeys!

(Image Source: Flickr)