Warren Buffett Is Wrong: The Bitcoin Proof

When I first took a serious look at bitcoin, I focused on its potential as a currency. It was hard not to notice the enthusiasm for bitcoin among a number of its proponents. But I balked nevertheless. As I stated in “Bitcoin: New Gold or Fool’s Gold?,” I felt that bitcoin would have a common enemy in governments around the world, implying that it would be outlawed, burdened with onerous regulation, taxed, or otherwise butchered beyond recognition by policy. And all of this is still possible, of course.

But something fascinating happened: My thesis proved accurate, but the outcome was different than I anticipated. Russia’s government banned bitcoin and, shortly thereafter, China’s government announced major restrictions. In essence, governments were turning against bitcoin. I expected, however, the price of bitcoin to crash toward zero. It didn’t. My fears manifested themselves, yet bitcoin backers remained steadfast believers.

Was the bitcoin quote weaker after these announcements? Yes. But it didn’t go to zero — or at least to cents on the bitcoin dollar as it did in the past, when wallets had been hacked. Its price in dollars declined, of course, but it was far more resilient than I expected. Had the bitcoin crowd totally ignored this news? Were bitcoin enthusiasts crazy? Were they blinded by their belief in the technology platform? Or by an overzealous faith in bitcoin as a tool of the people to defend against an overreaching government?

So, I hopped on a plane and went to the Inside Bitcoins expo in New York City to find out. What I observed was a startling contrast to what I had expected. I had of course anticipated people to be enthusiastic supporters of bitcoin, but I also expected them to be more or less unaware — or at least unappreciative — of the recent events in Russia and China.

What I found, however, were people who were openly discussing the issues and had fully come to grips with the risks and nevertheless persevered with their support for the platform, funding programs, technology development, etc. In fact, the wave of development and capital pouring into the space was staggering. So, these people were well informed on these major headwinds for bitcoin and yet were undeterred. Needless to say, this intrigued me.

I also expected the crowd to be primarily composed of libertarian types enthusiastic to thwart government. My thinking was that perhaps they were simply blinded by their emotional investment in bitcoin as a bulwark against government intrusion. Perhaps they wanted it to work so badly that they were overlooking the cold, hard truth?

But this wasn’t the case either. Although there were indeed a number of libertarians in the audience, it seemed the crowd consisted of people from all walks of life and all sides of the political spectrum. Whoa. Say that again!?! Yep, there were libertarians, Democrats, liberals, conservatives, and probably all shades in between. And virtually all were enthusiastic, well-informed supporters. But why?

Bitcoin has solved a fundamental problem. Normally, whenever there is a financial transaction taking place, there is distrust between the two parties that must be solved by a financial intermediary that is willing to take on the risk that at least one of the two parties isn’t going to follow through on its end of the bargain. In fact, gigantic financial networks have developed over many decades to resolve this very problem.

Thanks to bitcoin’s block-chain technology, however, no financial intermediary is necessary for two parties to engage in a financial transaction. This is revolutionary. The emergence of bitcoin as a transaction platform means that for the first time in human history, any two people anywhere in the world can instantaneously exchange money (or any form of property) without needing a third-party intermediary to perform a validation or security function. In essence, bitcoin removes links in the value chain, which means that the cost of doing many forms of business declines. This is why bitcoin has intrinsic value.

So, Is Value Necessary for the Bitcoin Proof?

Absolutely. Bitcoin’s value as a currency must come first from its value as a transaction platform. That’s what I missed the first time around. And that’s what will give it staying power.

So, how much value does it offer? Consider first the value of bitcoin to a merchant. Is the case for bitcoin compelling from a financial standpoint? The following table, which should be used with caution, illustrates business costs to the average merchant as a percentage of sales when conducting business with credit card customers.

The table demonstrates that there are cost advantages to merchants who use bitcoin over other transaction platforms. Still, it’s important to be circumspect in using this table. Data are derived from a wide range of sources, and in some cases, there were discrepancies among them. The column totals may very well be double counting significant cost line items. For instance, the percentage of sales rejected because of fraud undoubtedly includes sales that are rightfully declined as well as some that are wrongly rejected. We simply don’t know how that line item breaks down into those two categories. Maybe the amount that is wrongly rejected is a little or maybe it is a lot. Moreover, different sources report different levels for each category. Which one is right? Don’t know. Also, these values are bound to vary widely from business to business. Lastly, it is not at all clear whether using bitcoin will reduce accounting costs for merchants. My investigations have yielded some conflicting anecdotes but nothing conclusive one way or another.

Nevertheless, I suspect there is some value to merchants from an accounting standpoint because every bitcoin transaction is digitized in a way that fiat money can’t be. Sure, today’s merchants have cash registers and process real-time data on inventories and credit card transactions, but there is a substantial cost to any organization to verify and track cash flows. With bitcoin, verification and tracking is automatic. Finally, merchants will have a different mix of business from fiat cash, domestic card–present transactions, and domestic card-not-present transactions, and so I urge caution in relying on these numbers as gospel truth. Still, this table does illustrate that there is a concrete cost-savings opportunity for merchants. The only question is how much.

So, when one thinks about money, one must differentiate between currency and money. Currency is a unit of account produced by the government. Money is something of inherent value that exhibits certain properties — chief among them, intrinsic worth. In today’s digital economy, bitcoin has inherent worth because of its cost reduction capabilities on transactions.

Around the same time “Bitcoin: New Gold or Fool’s Gold?” was published, Warren Buffett came out against bitcoin, calling it a “mirage.” He suggested that bitcoin was no different from checks or money orders because they are all just ways to send money from Person A to Person B. He then suggested that checks and money orders themselves have no intrinsic value, so bitcoin itself must have no intrinsic value. Therefore, it can’t be money. He also suggested that lots of other cryptocurrencies could pop up and dilute away the value of bitcoin. Is Buffett wrong? Yes.

First, as Legg Mason’s Bill Miller, CFA, noted, checks and money orders are unlimited. If you run out of either, your bank will gladly print more. Moreover, anybody can open a bank account at any bank in the world and use its checks and money orders. There is truly an endless supply from countless sources. Bitcoin is quite different. Although there are many other cryptocurrencies, there is only one bitcoin platform. And bitcoin is ultimately limited to 21 million bitcoins. The scarcity of bitcoins stands in stark contrast to the infinite capacity of banks to create new checks and money orders. And bitcoin is far and away the leader in the cryptocurrency space. So, it appears Buffett is mistaken.

Another important question to answer: Why is Buffett wrong? Buffett is quite open about his limited expertise in technology. So, despite his vast knowledge and expertise in business, he may have an inadequate understanding of network effects in technology goods.

To the casual observer, there is no reason why any other competing cryptocurrency couldn’t come along and snatch the lead away from bitcoin. But to the analyst well versed in network externalities, it is clear that there would be tremendous switching costs necessary for the world to transition from one platform to another. Bitcoin, however imperfect it is, has a dramatic lead over other cryptocurrencies, and it is bitcoin’s lead to lose. The world, of course, would be willing to leave bitcoin if it fails to deliver on its promise, but thus far, this has not happened. If bitcoin does fail, surely another cryptocurrency (altcoin, dogecoin, etc.) will take its place. The trust problem has been solved, and the whole world now knows how to do that. This genie is out of the bottle, and it ain’t going back.

Bitcoin indeed has intrinsic value. We just have to think of intrinsic value in a new way. Bitcoin’s intrinsic value is contingent on its value in facilitating transactions in the global economy. Just as gold’s intrinsic value is derived from its ability to fulfill the properties of money, bitcoin can meet all the same properties and have lower storage and transaction costs. And once you embrace the fact that its intrinsic value is derived from its value as a transaction platform, we have the recipe for the bitcoin proof:

Bitcoin is a meme. And in order for it to work, people must trust it. And people trust it because the block chain is real. And because the block chain is real, bitcoin has value. And because bitcoin has value, bitcoin is money.

This is not to suggest that bitcoin’s success is a fait accompli. It’s not. This argument simply proves that bitcoin is money so long as it has some intrinsic value. That said, that intrinsic value can still be squandered. As I see it, the bitcoin community needs to ensure that bitcoin possesses the following characteristics to put it on solid ground:

• Safe from theft
• Safe from loss of private key
• Safe from destruction
• Safe from volatility
• Anonymous
• Simple
• Efficient transaction processing

The public’s perception of bitcoin can also be improved by more widely disseminating best practices. For instance, individuals who own bitcoin should not store their bitcoin in the cloud or at their broker. Likewise, if individuals lose their private keys, they lose their bitcoins. When these tales of woe are made public, it creates distrust in the system. And trust is at the heart of every financial system — from stock markets, to bond markets, to banking systems, to currencies. Everything. And anything that destroys trust for bitcoin now might derail the success of the bitcoin platform. In other words, other people’s bitcoin problems are your problems. People also aren’t used to losing money on their money. So, volatility needs to be controlled and the tools to do so must be accessible to the layperson. We know from behavioral finance that people hate losses two to three times more than they like similar-sized gains. What this tells you is that people would gladly give up the upside in bitcoin if you protect their downside. This requires the development of a broad, liquid derivatives market married to bitcoin products that pools bitcoins together and hedges each person’s bitcoin value. The volatility of bitcoin should reward the creator of such a product handsomely. In lay terms, bitcoin needs bitcoin price insurance. There have also been some breaches of anonymity, when bitcoin accounts have been linked to email accounts. Some people may not understand the extent to which their actions will or will not be anonymous.

Few people truly understand fiat money. They simply know that they can buy stuff with it. Likewise, your cousin, mother, or grandfather need not understand bitcoin in order for it to gain wide adoption. They simply need to understand its value to them. And therein lies the opportunity for bitcoin. Just make bitcoin-related products simple and accessible to the layperson.

Lastly, the speed of processing transactions on the platform is limited to seven transactions per second. For comparison, the Visa network can process about 47,000 per second. Given bitcoin’s vast potential, it may never be feasible to execute all the transactions that people wish to conduct. So, this problem must be solved before the platform reaches that size and scope. Thus bitcoin’s success is not a foregone conclusion. But its value is real and the problems before it can be solved. Bitcoin is money. But make no mistake: bitcoin still needs you!

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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