Bitcoin boom: asset, commodity, currency or collectible?
If you read the news from the cryptocurrency market, monitor the bitcoin exchange rate online and try to understand the cryptocurrency prospects, perhaps you’ve heard the statement of the legendary investor and billionaire Warren Buffett, which he made in the January interview to CNBC that he would not invest in cryptocurrencies: “I have enough problems with the things I thought I knew something about. Why I should open long or short positions in something I have no idea about”. Today, a Professor of Finance at the Stern School of Business at New York University Aswath Damodaran, an author of books about investments and corporate finances, will help us to understand the bitcoin concept, the difference between investing and trading and, perhaps, the reason why Warren Buffett made his statement. In this article:
- Asset, commodity, currency or collectible
- Investing or trading.
- What is the bitcoin?
- Actual state of things.
ASSET, COMMODITY, CURRENCY OR COLLECTIBLE
It is impossible to establish the value of all things, however, it is possible to establish the price of practically everything. In order to understand the difference between the value and price, let’s start with allocating every investment asset to one of the four categories:
- Cash generating asset.It is an asset, which generates cash flow or will do it in the future. The business you own is, no doubt, an asset, since it pretends to create cash flows in the result of economic activity. A possibility to identify the value of the asset cash flows unifies all assets. Assets with a high level of cash flow and low risks are more valued than assets with a low level of cash flows and high risks. Apart from that, the price of assets with respect to each other could be identified with the application of the common criteria of assessment. For example, you will need to compare ratios (price/profit, EV/EBITDA, market/balance cost, stocks and company cost/receipts) among similar companies in order to identify undervalued and overvalued stocks.
- Commodity. The value of a commodity is identified by its use as a raw material for satisfying the basic needs of a human being, for example, in energy, food or dwelling. Although the commodity value could be identified through analyzing demand and supply, each of these indicators has a long-term lag and period of realization. It makes the process of identification of the commodity value more complex than identification of the asset value. That is why the commodity prices are often identified with respect to their historical values.
- Currency.A currency is a means of exchange used for denominating cash flows and also is a reserve of the buying capacity unless you invest in it. Currencies do not generate cash flows and do not have value by themselves, however, their prices could be established with respect to other currencies. The currencies that have a wider circulation as a means of exchange preserve their buying capacity better on a long-term basis. In time, the price of such currencies will grow with respect to the currencies that have worse characteristics. From a short-term point of view, their price formation could be dominated by such forces as governments and national central banks which try to manipulate the national currency exchange rates. You can see a simple example below where there are exchange rates of seven currencies with respect to USD during the period from 1995 until 2017. You can see that CHF and CNY grew in price compared to USD during the analyzed period, while MXN, BRL, INR and GBP fell.
- Collectible.A collectible doesn’t usually generate cash flows and it is also a means of exchange, however, sometimes it has an esthetic value (like a painting or sculpture) or emotional attachment (a CD or a book with the author’s autograph). The collectible value cannot be identified not because collectibles are often called invaluable, but because they do not generate cash flows. However, their prices could be established due to the desire of people to possess them, due to their availability or uniqueness.
Gold is definitely not a cash generating asset, but is it a commodity? Gold is more like a currency than a commodity since its value has little to do with its practical functions but it has a savings function which existed for many centuries. Real estate is an asset even if it takes the form of personal dwelling, in the absence of which you would have had to pay a rent (cash flow). A private joint-stock capital and hedge funds are a form of investments into stocks, currencies, commodities or collectibles and do not belong to one specific asset type.
INVESTING OR TRADING
The idea is that you can identify both the value and price of the cash generated assets. It is much easier to identify the price of a commodity than its value. As regards currencies and collectibles, we can identify their prices only. You may ask: so what? Since this article is about the bitcoin and we hear about investing into this cryptocurrency every day during the past six months, it is necessary to recall about the differences between investing and trading.
To make an investment, you first need to identify the item value, compare it with its current price and buy it if you think that its price is lower than its value, or sell it in the opposite situation. It is more simple in trading. You forecast the further growth or fall of the price using the advanced instruments of the volume analysis of the ATAS platform and only after that you enter the market. Although you may be successful in both disciplines, nevertheless the skills and instruments, used in trading and investing, are different. The table below shows the differences between trading (identification of the price) and investing (identification of the value).
|Identification of the price||Identification of the value|
|Basic principles||The price is a real number which you can operate with. No one strives to learn the real value of an asset since it is of little practical value unlike the knowledge of its price.||Every asset has a fair or real value. You can establish this value, however, with a high degree of error. As a result, the asset price should correspond with its value.|
|How it works||You try to forecast in what direction the price would move during the next period of time and trade in anticipation of this movement. Your forecast should come true more often than come false and you need to exit from trades before the price movement changes.||You try to identify the asset value also in the event it is undervalued or overvalued, you buy it or sell it. You should identify its value correctly (in the majority of cases) and the market price should match this value.|
|Key factors||The price is identified by demand and supply, which, in their turn, depend on the mood of the market participants and momentum.||The value is identified by cash flows, growth and degree of risk.|
|Influence of information||Progressive information (the news, stories and rumors), which changes the mood of the market participants, who influence the price behaviour, even if this information in reality doesn’t influence the long-term value.||Only that information, which is able to change the cash flow movement, growth and degree of risk, significantly influences the value.|
|Used instruments||(1) Technical indicators, (2) Price charts and (3) Trading psychology.||(1) Analysis of financial ratios, (2) Assessment using the method of discounted cash flows and (3) Study of book-keeping reports.|
|Time horizon||It could be very short-term (minutes or hours), middle-term and long-term (weeks and months).||Long-term.|
|Key skills||Ability to analyze volume indicators of the market, assess the sentiment and momentum before the rest of the market participants.||Ability to identify ‘value’ of an asset in the event of absence of accurate information.|
|Key personality traits||(1) Discipline, (2) Patience and (3) Quick reaction.||(1) Belief in the ‘value’, (2) Belief in the market, (3) Patience and (4) Immunity to public opinion.|
|Biggest dangers||The market movement could be very strong and may destroy a week’s income in several hours in the event of a poor risk management.||The price could differ from the value even if the value was correctly identified.|
|Additional bonuses||Ability to move the price (in the event of availability of a huge capital).||Ability to find a catalyst which would be able to bring the price in correspondence with the value.|
|The most misplaced beliefs||A trader who thinks that he trades on the basis of the value.||An investor who believes that he can make the market change its mind.|
No doubt, you should do what you can do best of all, whether it is investing or trading, however, the use of instruments or skills, which are not intended for it, will result in a catastrophe.
WHAT IS BITCOIN?
The first step to a serious talk about the bitcoin is finding out whether it is an asset, commodity, currency or collectible. The bitcoin is not an asset since it is not able to generate cash flows for its holders who get profit only after selling it.
The bitcoin is neither a commodity (raw material) since it cannot be used for the production of something useful. However, if the bitcoin could have become a part of smart contracts (a smart contract is a computer algorithm designed for execution and support of commercial contracts in the blockchain technology), it would have taken the functions of a commodity. However, smart contracts are already a specific feature of another cryptocurrency – Ethereum – and, in fact, it is its only value.
So, we can consider the bitcoin either a currency or collectible, and each of these variants has supporters. As of now, the bitcoin is more like a currency, although not a very successful one since it has a limited application as a means of exchange and its current volatility is too high, which doesn’t allow it to become a common means of savings. We can distinguish three possible scenarios of the bitcoin future development:
- World digital currency.The most optimistic scenario in which the bitcoin gains wide recognition as a means of payment all over the world and becomes the world cryptocurrency. For this scenario to be realized, the bitcoin exchange rate with respect to other currencies should become stable; central banks and governments all over the world should recognize the bitcoin or, at least, shouldn’t actively interfere with its development; and the aura of secrecy, which is now connected with everything that has to do with cryptocurrencies, should disappear. After that the bitcoin will be able to compete with fiat currencies and its high price could be justified due to a limited amount of bitcoins, which is caused by the existing algorithm.
- Gold for the youth of 2000s.This scenario envisages that the bitcoin becomes a resort for those who do not believe central banks, governments and fiat money. In other words, it will take the historical role of gold for those who have doubts or don’t trust central authorities any more. It’s interesting that the bitcoin language is full of mining terminology. There is no information whether it was done intentionally or otherwise. In fact, the maximum number of bitcoins in 21 million cryptocoins, which will ever be mined, better correspond with this scenario. If this scenario is realized, the bitcoin will preserve its long-term influence like gold and will behave like gold – growing in price during crises and falling in price under quiet conditions.
- Tulip bulbs of the 21st century.This is the worst scenario in which the bitcoin resembles a meteorite. It rushes and attracts more and more money of those who see the bitcoin as a source of easy money. It will burn out after a bright flash since traders will find another goal for their investments (for example, another more perfect cryptocurrency). And regular investors will be left only with the bitter memories about how beautiful it could have been. In such a case the bitcoin could become a modern equivalent of tulip bulbs – a speculative asset the cost of which sharply raised in Holland in the 17th century and then sharply fell.
It’s not likely that someone can sincerely say what scenario will be realized in practice. If you trade the bitcoin, you should not worry about realization of one or another scenario, since, most probably, your time horizon is minutes, hours and days rather than weeks, months or years. If you are interested in a more long-term bitcoin trading, you should pay more attention to its progress as a currency (a means of exchange) and pay less attention to the intraday price fluctuations. We should also note that you can be quite sceptical with respect to bitcoin and other cryptocurrencies but full of optimism with respect to the future development of the blockchain technology and its potential.
ACTUAL STATE OF THINGS
Let’s draw some conclusions having united the ‘Asset, Commodity, Currency or Collectible’ section, where we conducted classification of investment assets, and ‘What Is Bitcoin?’ section, where we state that the bitcoin is a ‘young’ currency:
- Bitcoin is not an asset.Those who allocate a part of their investment portfolio to the bitcoin, should understand why they do it. This is not because they want to diversify the investment portfolio, holding all types of assets in it, but because they want to use their trading skills in the bitcoin market in order to reach the highest level of profitability. Do not think that this is an attack on cryptocurrencies since the fiat currencies (USD, EUR or GBP) also do not belong to assets for the same reasons.
- It is impossible to identify the bitcoin value – just its price.This statement follows from recognition of the fact that the bitcoin is a currency and not an asset or commodity. Anyone who speaks about the bitcoin value either expresses his own personal opinion or just tells stories.
- The bitcoin will be treated as a currency.The bitcoin price will depend, in a long-term prospect, on how good it will show itself as a currency. It’s price will be high if it becomes widely used as a means of exchange and becomes sufficiently stable to be considered as a means of savings. Its price will be lower if it becomes a digital analogue of gold and the currency of the middle ground to which investors will ‘run’ at the times of crises. More badly if the bitcoin becomes a temporary currency, which loses its buying capacity, until it is replaced with something new and is completely washed out.
- Do not invest into the bitcoin but trade it.You cannot identify the bitcoin value, that is why you do not have a critical element to be an investor. You can be a trader and make a fortune trading the bitcoin but only because you are a good trader.
- Components of a good trader. To trade the bitcoin successfully, you need to understand that its price movement has little to do with its basic principles (anonymity, decentralization, ease of use, etc.). The price movement depends on the market volume indicators, moods of its participants and momentum, and strong bitcoin market movements could occur on the basis of the news or rumours.
So, let’s draw a conclusion to this study and come back to Warren Buffett. As you already know, the legendary investor doesn’t plan to invest into the bitcoin but not because you might have thought at the beginning. He cannot make a decision as an investor without identifying the bitcoin value and, as we discussed above, it is impossible to identify the bitcoin value. However, it is all about investors, even such famous ones as Warren Buffett. In the event you are a good trader, the bitcoin could become a good way of making money for you.