The Bitcoin Bubble: How did we get here?

This is by far the most fascinating socio-economic development of our time. Not only because of the cryptocurrency, decentralized banking aspect, but because we get to witness first hand the birthing of a monetary system from zero.  A monetary system founded on theory and idealism and then propelled towards mainstream acceptance is unlike anything we’ve seen before.

The raging bubble in Bitcoin value has been caused by several factors: the media (the spark), the US Department of Treasury (the wind) and, ironically, the financial institutions that have tried to stifle its proliferation (the fuel).  This is certainly a far cry and in sharp contrast to what idealists may have intended to transpire, but like all wildfires eventually the fuel source is consumed and the fire extinguishes itself.

To visualize this analogy, it’s important to understand the basic flow of conventional money into and out of Bitcoins. Bitcoins can only be obtained in one of three ways:

  1. They can be “mined”; note the nauseating analogy to precious metal mining. Bitcoin transactions are “mined” to produce the next block in the chain (a global transaction ledger of sorts). As a result of this process, mining fees are collected and new Bitcoins created. Both are credited to the miner for each block successfully accepted into the chain. Mining Bitcoins is quite literally a technological arms race to compute a statistically significant number of cryptographic signatures (hashes) faster than your peers. Due to the design of Bitcoin, and its use of cryptographic hashes for mining, an appropriate analogy would be an arms race to create a machine gun with absolutely no ability to aim, but that fires the greatest number of bullets per second. If you manage to hit something, you win.
  2. They can be purchased: by physically exchanging existing currency (USD, EUR, etc.) with another individual who wishes to sell Bitcoins, or via an electronic “exchange”. The largest exchanges being: MtGox, BTC China, BTC-e, Bitstamp, Bitcoin.de, Kraken, CampBX, VirtEx, Bitcurex and to some degree Coinbase.
  3. And of course by receiving Bitcoins from a generous donor in exchange for nothing at all: gifting.

Let’s Get Started

Ok, that makes sense (sort of), so how do I sell my Bitcoins in order to convert them back into “real” currency? Just like in method 2 mentioned above, you will need to exchange them and here’s where it starts to get messy. Imagine this little scenario: Johnny takes a bag of cash to a friend and buys 100 BTC (Bitcoins). The Bitcoin seller sends these 100 Bitcoins to one of Johnny’s many “addresses” (think anonymous post office boxes) that map to his Bitcoin “wallet”. At some point, Johnny got anxious while watching the value of BTC/USD (the value in US Dollars of 1 Bitcoin) rise. Johnny has his eye on a nice condo in Walker Tower, but the seller of that condo won’t accept his Bitcoins, he’s never even heard of it! So Johnny sends these 100 Bitcoins to his account at an exchange and sells them in exchange for USD (US Dollars). Now his account at the exchange has a massive USD balance and he needs to send it to his bank so he can access the funds to buy the condo. He fills out the request and goes to sleep dreaming of the fancy Crestron system he’ll have in his new condo. The next morning he checks his bank balance online and finds that it hasn’t changed. He quickly logs into his account at his favorite Bitcoin exchange and finds that his transfer is still in progress. As time ticks on, the transfer is stuck at his exchange for months now, what is going on?

Silk Road

The infamous Silk Road, an online black market goods and services marketplace, put the scare into US law enforcement. Not so much because of the trafficking itself, but because the tried and true “follow the money” approach was hardly effective. It was once thought that all you need are criminals with faith in their anonymity and a judge to sign your warrants. Well, that’s what the FBI thought too…until they realized that these criminals were compensating each other with Bitcoins.

That’s when the headache began. The FBI decided to unleash their Geek Squad and get to the bottom of this. Quantico’s top of the class techs struggled day after day trying to backtrack Bitcoin wallet addresses through layer upon layer of Tor addresses. They soon outgrew the maps, pins and string, but nonetheless they were getting nowhere; they decided to call the NSA. But the NSA was too busy firing their cryptologists for letting a barely literate hipster make off with years of secrets. No doubt they tried to wiretap Satoshi Nakamoto, but the guy (gal?) seemed to be a ghost.

The Geek Squad gave up, told their handlers this Bitcoin stuff was untraceable. And that’s when the clamp-down began.

The Clamp-Down

If you can’t dissect the Bitcoin network itself, then control the money flows into and out of it. And piece by piece the ability to transfer money into the Bitcoin system, and out of it, started to evaporate. Banks were blocking wire transfers to known Bitcoin entities and end users, money transfer services were closing accounts with Bitcoin businesses; the anti-Bitcoin sentiment snowballed seemingly out of nowhere. To be fair, I’m sure the anti-Bitcoin sentiment from the banks is divided between fear of losing revenue to the Bitcoin system (fair point) and fear of compliance violations (get your systems in order) as the the US Department of Treasury reminded all that FinCEN hasn’t yet gone the way of HealthCare.gov.

Your Pipes are Clogged

With the US Department of Treasury throwing around terms like AML and KYC (no they aren’t lubricants) and the media telling the public of Bitcoin’s dramatic rise, an imbalance between dollars in and dollars out started to grow. Not only was the public charged up and ready to buy, but it became markedly easier for one to convert USD to BTC than to convert from BTC to USD…and actually get their hands on that USD. There are some important technicalities with wire transfers and other money transfer modalities that further exacerbate the issue, but let’s move on. On top of this added pressure on the fledgling monetary system the background “mining difficulty” was steadily growing. The “mining difficulty” refers to the ever growing computational capacity growth required to build an effective crypto machine gun (with no ability to aim).

Meet the “Exchanges”

It’s tough to really call any of these outfits an exchange and not feel all that much dirtier inside. Imagine hiring a bunch of web 2.0 developers and telling them to build an exchange. One guy fires up Node.js while the another is discovering floating point rounding errors for the first time all while the guy being interviewed in the conference room is talking about REST. Whether you understood the references or not, the bottom line is that these “exchanges” are quite far from what Wall Street has come to expect from an exchange. But nonetheless they are operating, and some are actually quite impressive; all things considered.

Now this ladies and gentlemen is the most valuable lesson *ever* on supply and demand. On one end of the spectrum, I like to call this the tail-end, you have MtGox, in Japan. This is by all accounts the largest and busiest BitCoin exchange in the world. But they have a fatal flaw. The reason I call this the tail-end is because this particular “exchange” is unable to reliably wire your USD funds back to you after you’ve sold Bitcoins for USD! Strangely, a company by the name of CoinLabs tried to rectify this bank relationship issue for them, but MtGox apparently backed out of the deal. So now we are left with the busiest BitCoin exchange in the world most likely sitting on (hopefully not spending) an enormous pile of other peoples’ USD. This is creating a heavily skewed market at MtGox that is pushing the BTCUSD exchange rate over 10% above the market consensus.

Why don’t people just go to other exchanges? In fact, Bitcoin’s best merit may be the fact that it’s very easy to transfer Bitcoins around the world, so if I’m looking to sell some Bitcoins, wouldn’t I prefer to go to the exchange with the highest bid for them?

Trouble Getting Dollars Out

So if everyone wants to sell Bitcoins at MtGox, why is the bid so high? That’s a really good question. Remember Johnny? Well, Johnny went to MtGox, and he sold his BitCoins for USD. His transfer got stuck, he waited…and waited, but it never came. So with no other way to get his money out, he decided to buy back into Bitcoins so he could move his money to another exchange. This “churn” or “exit door bounce” is the equivalent of the emergency doors being locked during a fire. So naturally, he pays the offer at MtGox and this continues over and over causing an artificial imbalance of buyers at MtGox because the majority of to-be-sellers wind up netting themselves out, just like Johnny, in terms of buy/sell demand. To MtGox’s credit, they do appear to be trying to balance the scales.  For example, they recently launched Bitcoins.com to increase transparency.

Trouble Getting Dollars In

However, the problems aren’t limited to just MtGox. On the other end of the spectrum you have BTC-e, in Russia. They have the polar opposite, where their BTCUSD rate is skewed to below the market consensus. This is a case of the opposite: trouble getting dollars in. Since most of these firms don’t operate margin accounts for their clients, you must have dollars in your account in order to buy Bitcoins. Therefore a shortage of new dollars flowing in causes an artificial lack of demand. This is most likely caused by banks blacklisting wire transfers to this exchange, but there may be some less obvious factors.

And somewhere in the middle

Now back in the US, there are a couple of exchanges who are right in the middle. Instead of ending up with skewed markets, they rate-limit the amount of dollars in and out on a daily and monthly basis. And let’s not forget the Know Your Client, KYC, and Anti-Money Laundering, AML, regulations. These startups are learning the hard way that managing a mess of paper documents in order to become quasi-compliant in the eyes of the US Department of Treasury (and international regulators) requires more than a geek in a garage running a website.

What about China?

Strangely, in a country constantly criticized for its “lack” of democratic policies, China is the home to one of the largest Bitcoin exchanges, BTC China. And while they only have serious liquidity in BTCCNY, they are strong and apparently quite professional. In a country where the on-shore/off-shore currency exchange gap is closing it may appear to be too little too late, but China still boasts a large number of expats living abroad and it seems to be a match made in heaven.

Is this bubble about to burst?

I don’t think so. I think before we see a serious correction, we need two things to happen:

  1. First, the dollar flow situation needs to be addressed so that the various exchanges can reach an arbitrage provided equilibrium amongst each other. In order for this to happen, wire transfers and other means of money transfer into and out of the Bitcoin ecosystem must be reasonably frictionless.
  2. Second, the Bitcoin mining groups must reach “new coin exhaustion”. By this I don’t mean actually mining every last one of the 21 million predisposed coins, but rather reaching a point of inflection where the benefit of mining in order to capture the new coin reward diminishes to the point that it is no longer a motivating factor and mining becomes solely a service for transaction processing.

Once these two criteria are met, we will begin to find the true value of Bitcoins, be it higher, lower or perhaps perfectly priced where it is today.

Stay tuned for more on the future of Bitcoins.

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