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Howard Marks Kills Bitcoin – Winklevoss Bitcoin Trust ETF (Pending:COIN)

Howard Marks just wrote another memo and this one is almost entirely on Bitcoin (COIN). I’ve written a rebuttal to the Bitcoin specific part of a prior memo that touched on Bitcoin. In this most recent memo, Marks concludes Bitcoin is in a speculative bubble. He does so only after an impressive display of his open mindedness. Read that memo and ask yourself when was the last time you’ve seen someone take one view and subsequently write he has learned more:

As I said earlier, there has been particularly spirited response to my comments on digital currencies. It prompted me to sit down with people ranging from some of my Oaktree colleagues to Steven Bregman and Murray Stahl of Horizon Kinetics (my July memo incorporated some of Steven’s observations on ETFs), and I learned that I’ve been looking at Bitcoin the wrong way.

Marks could be right about Bitcoin being in a speculative bubble, but I wanted to address some of the questions he raises in this recent memo as well. The parts from Marks’ memo I want to address have been put in quotes and my response follows below:

What Bitcoin partisans have told me subsequently is that Bitcoin should be thought of as a currency – a medium of exchange – not an investment asset. Given that the evolution of Bitcoin is so topical, I think further discussion is in order. To start, I’m going to present the case for it as a currency. What are the characteristics of a currency

I could probably be qualified as a cryptocurrency partisan. I like to think myself as a partisan of great investments and happen to identify Bitcoin as one. I don’t think of Bitcoin as a currency per se. Not as an asset either. It could end up checking all the boxes on either definition. But I wouldn’t waste too much time on putting it into the right box now. There’s this natural human inclination to feel the need to classify stuff and put it in the right box, but this can lead to mistakes. Instead of analyzing which is the correct word to refer to Bitcoin, we can get stuck arguing currency or commodity.

Since the blockchain exists on each person’s individual computer, rather than in a central location, it can’t be hacked, and thus Bitcoin can’t be stolen, counterfeited, or secretly created in amounts exceeding the authorized total. Likewise, Bitcoin isn’t subject to the currency controls on portability that are often imposed by failing governments. (But I wonder whether the technological claims made for the blockchain might be its Achilles’ heel. While I certainly don’t have the ability to assess these claims for myself, I wonder how many of Bitcoin’s advocates do either.)

Marks raises a major issue here. I lack those skills as well, but here are my thoughts on the matter. Even if you had the appropriate skills, your judgement alone should not be trusted. Sometimes people refer to the market cap of a cryptocurrency as a bug bounty. The bounty a hacker could collect being higher as the market cap increases.

One of the strange characteristics of cryptocurrencies – at this specific point in time – is that it is more valuable merely because its total market cap rises. Not just because of network effects and because its capacity to absorb value increases but also with hackers highly incentivized to scour for a way in, it is proven to be more secure, day after day.

It is notoriously difficult to put out software getting everything right from the start. Building on the code or messing with the code should be done as a last resort. A cryptocurrency like Ethereum makes it much easier to connect applications to its blockchain, but this additional functionality also makes it more vulnerable.

Being willing to agree that Bitcoin may become an accepted medium of exchange is not the same as saying you should buy it now to make money. Think about the fact that the price of Bitcoin has risen more than 350% so far this year and 3,900% in the last three years. To the degree people argue that Bitcoin is a currency, then (A) why is it so volatile? and (B) is that desirable? You might want to consider whether a real currency can do that, or whether speculative buying is determining Bitcoin’s price. And whether what’s gone up can come down.

A) Bitcoin’s volatility is a common complaint people use to disqualify it as a currency. But if you 1) accept it could be currency – as Marks now does – 2) look at Bitcoin as a reservoir that could hold trillions of dollars in value, while having started holding zero and with a cryptographically determined maximum of about 21 million units. 3) Understand the infrastructure supporting its many functionalities is far from complete and nowhere near the level of the major fiat currencies. 4) Acknowledge the value of a cryptocurrency is based on a social construct and therefore somewhat binary in so far as its ultimate value. 5) Understand many market participants take their cue about the probability of it succeeding from the market price.

It makes sense it is highly volatile now, but it does not need to be as volatile in the long run.

B) High volatility is desirable in so far it is better if Bitcoin appreciates a whole lot more. If Ray Dalio wanted to diversify the all-weather portfolio with some Bitcoin, it would be challenging not to push up the price of Bitcoin. If a high rolling Japanese billionaire wanted to send some money over the blockchain towards the U.S., it could prove challenging to move $50 million on a short-term basis. If the price of Bitcoin keeps rising, its ability to facilitate large transactions increases. Conclusion: For now, volatility is desirable as long as it occurs around a sharp uptrend. Which is the case for now.

The immediate issue of Bitcoin as a currency still comes down to the question of whether today’s price is right. The price of a Bitcoin is around $4,600 today. Can one Bitcoin buy the same amount of goods as 4,600 dollar bills?

You can actually get at least a 15% discount on anything you buy on Amazon through Pulse.

Coinbase enables merchants to trade out of Bitcoin instantaneously which is another reason merchants don’t really need to put a markup or anything on Bitcoin.

First, I expect there to be many competing transaction systems. Will the banks and other financial institutions cede this territory to Bitcoin? Wouldn’t banks’ systems be more likely to gain acceptance from people other than perhaps millennials? What would happen to Bitcoin’s utility as a payment mechanism if Amazon announced its own? Would you rather transact in Bitcoin or Amazonians?

Another great question Marks asks here. Banks will have little choice in the matter. It’s far from a certainty Bitcoin will be the cryptocurrency to solve the payment problem. I’m fairly sure it will be a more or less decentralized blockchain.

There is very little chance a corporation can compete with the efficiency of a decentralized blockchain. If only because they would have an IRR target for the investment. Start outlining how a major bank, like Wells Fargo (WFC), would build such a system and put probabilities on its chance for successfully launching a Fargo coin. There is a decent possibility they will all have their respective branded coins at some point but likely powered by a major independent blockchain. I would rather transact in Bitcoin, but Amazon (AMZN) surely has a better prospect to getting an Amazing Coin off the ground because of the trust factor it has with its customers.

Second, if Bitcoin were to become the leading non-governmental payment system, what would cause it to appreciate? If you want to pay me in Bitcoin and I’ll accept it, what would cause its price to rise?Adherents would argue that the limited supply relative to the growing use will make the price rise. But that assumes there’s no price so high for Bitcoin that transferees won’t accept it in lieu of dollars. The “pro” side of the argument foresees limitless appreciation, but that doesn’t make sense.

I did struggle with the price rise for a long time. However, if you look at M2, there is a lot of “value” maintained within the dollar. Even though it’s really not the greatest store of value of all time. Just look at this FRED graph.

Theoretically, you don’t want to store much liquidity in dollars but much rather own productive assets. There are all sorts of reasons why people and companies keep some working capital.

In addition, there is a lot of opportunity for transaction or record systems to function on the Bitcoin blockchain. One example I’ve often used is Overstock’s t0 exchange which can settle stocks at t+0 instead of t+3 (or t+2). All sorts of record keeping systems are possible and these will require some Satoshis – the smallest denomination of Bitcoin – to function as well.

I actually agree that if Bitcoin would purely need to function as a payment system and everyone used it in conjunction with fiat and just instantly converted back, it could function quite well without the price needing to appreciate.

Given 1) in practice, there’s a lot of value stuck in M2 in the U.S., but also various other countries combined with Bitcoin’s global potential, 2) the blockchain could function as the infrastructure for cheap and ultra secure record keeping requiring working capital in addition to M2. 3) Global uptake of Bitcoin is still in the very early stages, it seems reasonable to expect additional incremental demand.

Think of any other currency: isn’t there a price at which you wouldn’t accept it? Would you sell your house for euros that are said to be worth two or three times as much as the dollar?

I’m not sure I understand what Marks is getting at here. Isn’t this what someone in Mexico does when he accepts dollars for his house. “You say these dollars are worth 20x more than my pesos? Ha ha, You think I’ll sell my house for the value you imagine your dollars to have? Yeah, ok I’ll take them.”

So what’s my real bottom line?

Advocates say if Bitcoin is accepted as described above, you’ll make more than 50 times your money. Thus success doesn’t have to be highly probable for buying Bitcoin to have a huge expected return. This is called “lottery-ticket thinking,” under which it seems smart to bet on an improbable outcome that offers a huge potential payoff. We saw it in full flower in the dot-com boom in 1999-2000, and I think we’re seeing it in action again today with regard to Bitcoin. Nothing is as seductive as the possibility of vast wealth.

I’ll readily admit this is an important bias to check against when buying Bitcoin. However, the existence of the lottery-ticket bias doesn’t mean it is always wrong to bet on long shots. Long shots can yield positive expected value. Identifying something as a long shot does not equate with having identified a bad investment. In addition, Nassim Taleb made the interesting distinction between the lottery – ticket – which has a set maximum payoff and open-ended payoffs. Even though the lottery-ticket bias has been documented, you could make a case the sample is short of the truly extraordinary jackpots falling.

However, there’s a more reasonable argument to make, long shots don’t fit in YOUR investment framework. Which would explain a Howard Marks staying away, even after accepting cryptocurrencies could be a potential positive expected value bet, while Murray Stahl embraces cryptocurrencies because it fits the Horizon Kinetics philosophic framework better. Oaktree (OAK) does not ever want its funds to end up among the worst performing funds. It doesn’t gun to be among the top performers either, but still ends up there regularly. They are generally looking for opportunities where it will be very, very hard to lose money. Horizon Kinetics has a philosophy where there is room to allocate small amount of capital towards investments that can end as a zero or be truly transformative over time.

Finally, Bitcoin isn’t alone. There are hundreds of digital currencies already – including eleven with market capitalizations over a billion dollars – and no limits on the creation of new ones. So even if digital currencies are here to stay, who knows which one will turn out to be the winner? Hundreds of e-commerce start-ups appreciated rapidly in the tech bubble based on the premise that “the Internet will change the world.” It did, but most of the companies ended up worthless.

Just like with stocks. That’s where fundamental analysis and thinking come in. The best we can do is to make educated guesses. The argument most of them will fail is true, and I think we’ll see them multiply to a staggering number, far beyond the number of publicly traded stocks. It is surely a difficult endeavor but not more difficult than putting together a strong portfolio. After all, there are something like 15,000 publicly traded stocks.

Conclusion

It makes sense to me to divert a sliver of assets towards cryptocurrencies as a speculation. In addition, it adds diversification that’s hard to replicate with any other asset. As per Buffett: there’s nothing wrong with not swinging at a pitch you don’t like and it’s within Marks’ style to wait for pitches where risk is perceived to be low. With Bitcoin, it’s by definition very hard to protect the downside. I’m swinging, knowing I could be out.

Disclosure: I am/we are long OAK, OSTK.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.


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