Is Bitcoin like a Tulip?*

If it sounds to good to be true,

or like it should be illegal,

it probably is,

or will be soon.

I call this Ann’s Axiom, although I’m not sure I can claim exclusivity to the sentiment. I did add the last line to cover the current business environment, where it often takes a while for laws to catch up with technology.

So, bitcoin. Many of us are face-palming with regret that we didn’t buy some of this nouveau currency years ago. A small gamble, out of intellectual interest, might be worth the downpayment on a lux condo in Toronto now.

Why did it start? Because it could. The concept of blockchain – a way of distributing information so it is always verifiable – spawned a bunch of new concepts, including a currency or two founded on the principle. Bitcoin, like all currencies, are surrogates for value1. People who think bitcoin has value (buyers) will trade their dollars, gold, stocks or whatever for it, while those that find more value in the dollars/gold etc will sell their bitcoin, honouring the fundamentals of supply and demand.

Bitcoin futures recently started trading on the NY stock exchange, meaning that people can speculate on whether they think bitcoin’s value is going to go up or down2. There are futures markets in all kinds of things, from pork bellies to natural gas to Japanese yen. So why not bitcoin? Originally, futures were established to make doing business easier, such as allowing a farmer to find a buyer for their grain harvest while it was still in the ground and make plans based on knowing the value of the crop. Future’s buyers are willing, because early purchase might lead to a deal on the grain. Then humans got clever and decided that futures trading was a way to make money by riding the waves of supply and demand. I question what fundamental need is served by bitcoin futures?

Yeah, but, that’s not how modern financial markets work, you say. I’m worried, and here’s as flaky an explanation as I got: Bitcoin futures, along with the wild gyrations in bitcoin value and incredible increase in value over the past few years leaves an unsettled feeling in my gut.

There’s more enthusiasm than logic with bitcoin. Do I smell tulips3? It also reminds me of 2008, and the almost collapse of world financial markets.

Much as been written about the causes and impacts of the mortgage crisis of the last decade, what stands out for me are a few principles:

  1. It may not have been clear to everyone what they were investing in. Securities (surrogates of value) were bundled together in such a way that made them sound safer than they were.
  2. Past performance is no indication of future performance. Mortgages – what’s a safer investment? They’re secured on real estate, which time has shown to be a stable, safe investment. Stable meaning that it retains value without fluctuation and is backed by a tangible asset. But that supply and demand thing happened. A whole bunch of people defaulted on their mortgages in a short period of time and when the mortgage-holders tried to recoup their investment by selling the underlying asset, the asset spiralled down in value because there were many houses on the market. And so, the mortgage backed securities plunged in value too.
  3. But that’s not all. A chain reaction started when the mortgage-backed securities unexpectedly lost their value. Price instability rattled through the financial markets because investors needed cash to cover their losses and tried to sell other securities like commodities and bonds and financial whatnots. The whatnots were especially complicated when they were futures because of the unpredictableness of the situation. Commentary I’ve heard was that it wasn’t generally understood how the various markets, stocks, mortgages, commodities, bonds, were tied together. Perhaps because they weren’t tied together by any simple logic, only that people and institutions with a lot of investments have a lot of investments. (Right, eh?)

Do we understand now how bitcoin could impact the world’s financial markets? The thing that we can’t know, and shouldn’t really, is how the value of bitcoin will effect individual holdings, and therefore the desire of individuals to sell other financial instruments. If the value of bitcoin crashes, what would bitcoin holders sell to compensate? If it’s the same whatnots, will there be echo crashes?

Presumably we have tighter controls in financial markets across the world now. But my gut is uneasy. Tulips might be a good hedge. I’ve heard the sale of flowers remains strong despite economic conditions because people need a little bit of hope.

*  This (and all posts on this site) are commentary and solely my opinion. They are meant to be thought provoking, not business or financial advice.

1Currency makes trade easy and social. If I want to buy cauliflower but make my living as a dental hygienist, the dollar makes this exchange easy. I get paid in dollars and hand the farmer dollars. So much easier than cleaning one of their teeth every time I want some vegetables.

2Futures basics: Futures are a contract to buy or sell something for a fixed price at a specified date in the future. If the current price of gas is $1/litre, and you think the cost of gas is going to go down, but your friend thinks it’s going to go up, they might agree to buy a thousand litres of gas from you at $1.10 two months from now, thinking the market value will be $1.20 and therefore saving ($1.20 x 1000) – ($1.10 x 1000) = $100. You on the other hand think it will be $0.90 two months from now and so are happy to make a deal with your friend, sure that you can sell them $900 of gas for $1100, and profiting $200. Multiply all that by more zeros, big business and lots of suits, and you have a futures market.

3Many business and psychology profs will tell the story about mania in tulip bulbs in the 1600’s. Tulips, yes the spring flowers, increased in price in the Netherlands to truly silly values, with people reportedly selling their homes to buy just a few bulbs, only to have the bulbs crash in value a little while later, leaving investors with nothing but a pretty flower as their net worth. For more details see here or here

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