How the crisis makes crypto a better investment (2/3) - icoinic
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Imre Molnar - Algorithmic Trader - Team Icoinic B.V.
Imre Molnár
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How the crisis makes crypto a better investment (2/3)

The major problems of the financial aid package and Bitcoin as digital gold to fix it

After the first shock of the corona crisis hit the economy, the Federal Reserve and the government acted quickly to give financial help to corporates and to people. The provided solution looks to be a temporary relief for many, but it does not look clear whether it will solve the issue that corporates, after a decade of prosperity, were so vulnerable when they missed revenues for a month.

Problems with the provided solution

It seems that the emergency package solves the burning short-term problem, but there are three obvious, pivotal problems that do not seem to be addressed:

  1. Corona is a supply shock

The problem is not that consumers do not want to consume, or they would save too much of their disposable income. The problem is that they are not allowed to travel during quarantine, eating out or in some countries even driving around. Therefore, only those businesses can provide their services and sell their products which are digital or fit to the quarantine lifestyle. Giving helicopter money to the population will not solve this, neither bailing out the corporations in trouble as keeping them afloat will just become an indefinite morphine therapy as long as the underlying condition persists.

  1. Capital misallocation, low interest rates

It is obvious that big emergency packages will be in place around the world. But who is going to pay for those? Wealth was never created by printing money 1. When expanding the money supply, value is extracted from those who hold the currency. Those holders pay for the costs of bailing out the companies on the CARES list. It is difficult to say whether those companies deserve to be saved and it is definitely not a question that should be decided in a week or two.

Whether a company is important for a society and should remain in business can be also decided on the markets. If investors believe that the company runs a business which will be profitable after the crisis then they will allocate their capital to them to help them to survive. In this way they put their skin in the game and vote for those companies which have the highest chance of survival. This leads to a healthy price discovery and in a fair way would choose the fittest companies to survive. However, as soon as the FED has the authority and the means to save some privileged companies, the investors start to bet on those companies which will be likely to be saved and will be able to keep their market shares, instead of the ones which run the best businesses. This leads to capital misallocation in the society.

Although regular economic shocks have the advantage of cleaning up the markets as they provide a checkpoint of corporate business viability, some think that this should be different this time as the companies did not cause the corona shock. To illustrate how difficult to compensate the corporates in a way which does not give unfair advantages to some, see the following arguments.

Some companies, like some airlines seem to deserve to get help as they make a good service for societies and had a healthy competition in the last decade which had a natural selection effect on them. Now they are hit with an unprecedented shock that they did not cause by any means. On the other hand, there are also companies who also suffer serious losses not based on their fault like restaurants or manufacturing companies. But these are too small or not the direct victims of the virus, thus they would not get help or as much help. Furthermore, there are companies who seem to not deserve to get any help as they either tried to get too big to fail and leveraged their company balance sheet to an extreme level or they avoided taxes, paying almost zero tax on their profits.2

The task to fairly distribute emergency funds between corporates seems to be an impossible one and definitely not one that could be accomplished in a timeline that corona demands to act upon. Moreover, financing companies directly would be a communist idea that would most likely lead to huge capital misallocations and would inevitably fail.

Therefore, the current solution does not cease malinvestments and pumping more money in a system where too much money was available seems to just further postpone the liquidation of unfeasible businesses.

  1. Wealth gap

When expanding the money supply, value is extracted from those who hold the currency. Purchasing power of savings is diminished, hence, this is a form of tax that never has to be collected and also does not consider social aspects or promote solidarity. The unfortunate empirical experience is, it hits the poor and the middle class harder than the rich since proportionally they have more of their savings in cash. The newly created money is pushed into the system via the financial markets where it is used to support asset prices which are disproportionally held by the rich.

Although it is clear that the wealth gap should be decreased, printing money and pouring it into the financial system will not make it better or maybe even worsen it as it did after 2008. Moreover, increasing inflation to extract value will not do the job to go after those who do not pay taxes and collect those taxes.

In total it looks that the currently proposed solutions do not provide a solution to the structural problems. In the best-case scenario, it will keep big corporations afloat until the virus is over at the cost of SMEs and individual currency holders. The economy will be operational as soon as the outbreak ends with the exact same structural problems which made it so vulnerable on the way up here.

In a more realistic scenario, Quantitative Easing will continue to a point where inflation kicks in and consumer prices around the world will go up considerably 3. At that point unemployment and inflation can be so high that the mandate of the FED might be questioned. Social discussion might emerge on whether it is fair to bail out big corporations and social and political tensions will make it rather difficult to solve the challenges.

The case for Bitcoin and crypto

Bitcoin was created as a response for the ’08 financial crisis and aimed to eliminate the possibility that a small group has the power to print money and decide which banks to bail out at the expense of others.

Graph 1: The genesis block of Bitcoin in raw hex version

If Bitcoin wants to mature as a currency then it has to prove its excellence in a crisis situation. Most of the time Bitcoin is cited when cryptocurrencies are presented as a possible new form of money. This is for the reasons that Bitcoin became the first successfully operating crypto currency, furthermore its market capitalization is around ten times more than the second biggest Ethereum and by far, the most known crypto. Thus, it is going to be described here also as the de facto cryptocurrency, while analyzing its differences to other cryptos will be left out for now.

After its invention, Bitcoin became the toy of hardcore IT fanatics, who enjoyed sending money over the internet without using any third party service4. Soon the online underworld also discovered the advantages of using an autonomous digital currency and Bitcoin made headlines through 2012-2013, being the only currency accepted on SilkRoad, the biggest online black market at that time. At the end of 2013, the price of a single bitcoin soared over $1000 which marked the top of the first speculative bubble in Bitcoin. After the bubble burst Bitcoin finished 2014 with $315 and got no more attention for a few years. In 2016, investors started to flow in again and in 2017, the second speculative bubble of Bitcoin emerged, when the price reached $20,000. Since then, Bitcoin went down to $3000 from where it recovered and is currently fluctuating around $7000. By now, the main fundamental features of Bitcoin are known by investors and many contrarian investors refer to it as digital gold. It is something that one might have in the portfolio for its great diversification effect and its growth potential.

Bitcoin has many features that makes it a superior asset for being money, but currently its store of value property might be interesting. It is the most stable currency of the world in the sense that its supply is highly deterministic. The emission rate is commonly known information and its trajectory is decided until eternity. Based on that, Bitcoin is one of the scarcest assets of the world5 and its scarcity is comparable to that of gold6. The price of a bitcoin is determined on the open market and no decision maker can influence its supply to change or regulate the open market.

On the other hand, the price of Bitcoin measured in fiat currencies is currently very volatile. The price volatility is not a result of the protocol or an inherent feature of Bitcoin, but purely a market phenomenon. As crypto markets are tiny compared to other financial markets, it is relatively easy to have a big price impact even with limited capital. Therefore, when the sentiment flips to bullish or bearish, the price might change with 20-50% even within a month. Many claim that crypto markets are manipulated, and that might be true in the way that some big crypto traders might secretly cooperate to coordinate their moves and start price trends that they can benefit from. This might be successful or not, but they are anyhow risking their own wealth and not speculating on the cost of others, unlike when one can print money without getting any consent from the currency holders.

In conclusion, Bitcoin is similar to gold in a sense that it is scarce and its price is derived from free markets. Nonetheless, it is dissimilar since it is digital and thus can be used over the internet and one can pay with it instantly7; it cannot be counterfeited so there is no effort wasted on checking its validity and its markets are currently much smaller thus giving it bigger investment potential.

Graph 2: Market cap of gold and BTC over time

Reasons, why Bitcoin will not disappear even though it is very small as financial asset right now, will be described in the next part of the blog series as well as the possible trends that could make it irrelevant regardless. The final episode of the blog series will also discuss why Bitcoin is a superior asset to be money and how its scarcity could help recovery from the crisis. If you wish to read the series in one go, navigate to our Medium page.

Footnotes

  1. If it was then no poverty would exist and probably Zimbabwe would be the richest country of the world
  2. For instance cruise ship companies
  3. As several countries are seriously indebted in US dollar, they need to print more of their own currency to buy dollar and serve their debt.
  4. The first purchase of physical goods by Bitcoin occurred on the 22 May 2010, when Laszlo Hanyecz bought two pizzas for 10,000 BTCs.
  5. The block reward will be halved in May 2020 which will make it even scarcer
  6. For more on scarcity, see the The Bitcoin Standard: The Decentralized Alternative to Central Banking by Saifedean Ammous
  7. It is commonly thought that the only way to pay Bitcoin is to send a transaction to its blockchain and wait until a block appears in around 5 to 30 minutes which includes the transaction, however it is not necessary to use the blockchain and the lightning network can be used which relies on the blockchain but transact instantly.
Luc Correia Cabrito