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Nov. 27, 2017, 5:02 a.m. EST

Bitcoin rally may continue — but is it driven more by high-school dropouts than fundamentals?

No investor or serious analyst has been able to provide a fundamentals-based valuation model for bitcoin

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By Constantin Gurdgiev

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This ranges from the cognitively biased “you don’t know anything about the bitcoin” to “bitcoin is scarce & limited in supply” to “bitcoin is a promise of liberating the masses from the oppression of the central bankers.”

The first sort of argument exhibits not just Jurassic ignorance of logic, but also a gargantuan dose of arrogance. Repeated sufficiently enough, it signifies the absurd degree of exuberance of investors’ expectations.

The second argument is patently false. Bitcoin has undergone splits, and engendered dozens of other cryptos, with unlimited supply of such into the future. Bitcoin itself is divisible ad infinitum and, with forks, its supply is potentially unlimited. Worse, bitcoin rests on man-made mathematical foundations. Which means it has no physical bound or constraint. Anything man-made (and even more so, anything mathematically derived) is, by definition, fungible and axiomatic. Just because to-date no one cracked the code to alter bitcoin mid-stream or drain blockchain-held information does not mean that in the future such a code cannot be written. So hold your horses: gold is physically limited in quantity (even though in the Universe, it is not as scarce as it is on Earth, which makes long term supply constraint on gold potentially non-binding). Bitcoin is limited by our capacity to alter the underlying code defining it. Anyone thinking of an algorithm as a ‘law’ needs to go back to Godel’s mathematics.

Finally, there is an argument of liberation. Bitcoin value is only sustained as long as it remains convertible into goods, services and other currencies. This means that bitcoin cannot remain a government-regulation-free asset, as long as its popularity as a medium of exchange and a vehicle for store of value grows. Which means that in the medium term (3 years or so?), bitcoin will either cease to be, or cease to be anonymous. All protection from the dictate of the central bankers will be gone. Benign tolerance of bitcoin by some regulators can quickly turn into outright prohibition on trading — as current and past examples of China, Vietnam, Nigeria, Colombia, Taiwan, Ecuador, Bangladesh, Kyrgyzstan and Bolivia, Russia, and Thailand suggest.

Evolution of cybersecurity measures and regulatory and supervisory tools, including their spread into the cryptocurrencies domain, will only increase effectiveness of such measures into the future. So, unless you are planning to live in a libertarian paradise, where legal norms of other states do not apply, good luck committing much of your wealth to bitcoin as a safe haven for oppressive or coercive actions of the nation states.

Worse, anyone claiming that bitcoin is a hedge against inflation fails to understand how modern markets work. Again, to increase in value, bitcoin requires higher rates of adoption. Higher rates of adoption bring about higher rates of asset instrumentation (see above for BitMIX). Higher rates of instrumentation and adoption, taken together, imply higher holdings of bitcoin by institutional and diversified portfolio investors. So far so good? Right, now the kicker: these holdings imply greater, not lower, positive correlations between bitcoin and other asset classes in shock-experiencing markets.

That’s right, dodos: Goldman holdings of bitcoin are correlated to liquidity supply in general markets, because if such liquidity starts evaporating, Goldman will sell bitcoin to plug holes in other instruments. Sell-off in the markets can trigger sell-off in bitcoin. Now, another kicker: bitcoin is currently less liquid than any major asset class (see extreme volatility of pricing across various bitcoin exchanges). Which means that smart folks at Goldman will be dumping bitcoin before they dump gold and other assets. Hipsters hugging their laptops will be the last to wake up to this momentum (behavioral evidence suggests, they might actually buy into falling bitcoin in hope of speculatively gaining on a bounce, which, incidentally, can explain why large drawdowns in bitcoin can turn so fast into upward trends).

The tricky bit about bitcoin is that its enthusiasts need to learn to live in the real world first. Until they do, bitcoin will continue its upward path, and this process can go one for quite a while, depending on the supply of cash in the markets for bitcoin. Once they are taught a sufficient lesson, however, the rest of us will be learning the long-term fundamentals valuations of bitcoin. I, for now, have no idea what these valuations might be.

So bitcoin, then. A bubble or not? If you ignore the arguments that attempt to justify its valuations, it looks like one, albeit with dynamics that are very hard to interpret. If you listen to them, it looks that way even more, with more confidence in the arguments’ bogus nature. Draw your own final conclusions.

Dr. Constantin Gurdgiev is professor of finance at Middlebury Institute of International Studies at Monterey and continues as adjunct assistant professor of finance at Trinity College, Dublin.

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