Crypto-currency assets are fast approaching $1 trillion, says Michael Wilson. Anonymous, tax-untraceable and floating on a global bed of popular support. What on earth might happen next?
In the inimitable words of Del Trotter himself: “This time next year, Rodney, we’ll both be millionaires…..”
“Naah, honestly. Strictly kushty. You can play the system, Rodney or you can play outside it. Sort of. Just find your own sort of people who share your own youthful values, and who trust each other, and then who cares what the boring old f@rts in the central banks say? Who needs <audible sneer> “fundamental analysis” anyway? We’ve heard what them baby boomers have said, and it’s all about protecting their own fat backsides, isn’t it? What have they ever left behind for us common people, eh? Answer me that, then, Trigger?”
In a weird kind of way, the crypto-currency people have a point. For the first time since the Age of Aquarius in the 1960s (“Harmony and understanding, sympathy and trust abounding, no more falsehoods or derisions, golden living dreams of visions, mystic crystal revelation and the mind’s true liberation”… yeah, move along folks, there’s nothing here to see), the arrival of a wealth system based on something other than hard economic realities and cruel mathematical ratios is taking hold. And it’s making an embarrassing amount of money (sorry, Del, “wonga”) for the early believers. My Coindesk subscription tells me that $895 of bitcoin in January 2017 is worth $12,000 at the time of writing. Having been all the way up to $20,000 and then chaotically down again. Lovely jubbly – but a bit scary all the same.
Stronger than it looks
So should we, as industry professionals, be taking bitcoin and its crypto brethen seriously? Or is it all just a disaster waiting to happen? Should we, as advisers, be bracing ourselves for the inevitable plane crash and trying to anticipate where the wreckage is going to land? And just what do we say to our clients who are absolutely slavering for this dodgy new paradigm?
I have to warn you that the following news isn’t all easy to swallow. Bitcoin has now been accepted by a number of central banks, and its “blockchain” confirmation concept is being seriously studied by big institutions all around the world. More importantly, it’s recently been opened up to the searching scrutiny of the short-sellers’ markets. And you know what? It hasn’t collapsed.
Well, not yet anyway. There were a lot of people who said that bitcoin wouldn’t survive the opening of the Chicago futures contracts in December 2017 – because, they said, bitcoin had never needed to base its valuation on anything other than that the numbers of people who wanted to buy it; and as for fundamental value, it had none anyway, so what would happen when somebody shorted it?
The question was intriguing. How do you short something that doesn’t have a fundamental value in the first place? If the buyer’s pitch is based on a loosely optimistic idea of future liquidity and the seller’s pitch centres around an equally intuitive but downmarket view of same, where are the two to meet?
The blockchain concept
I’m going to be perfectly honest here. I’m a traditional liberal artsy type who only scraped maths O level at school because I didn’t follow the inevitable logic of what other people were calling logic. Even today, my head starts to spin when I hear people making nearly-circular arguments about why one system is better/more logical than the others. But here’s what I’ve picked up about this thing that other people are calling blockchain.
The first thing is that blockchain doesn’t concern itself with who’s making what transactions, but focuses instead on ensuring that the identity of a unit of transaction (such as a bitcoin) is openly and publicly confirmed. Whenever a bitcoin transaction goes ahead, the blockchain sends out a “distributed ledger” notification to all and sundry to say that it’s happened, and that the bits-of-bitcoins have changed hands. That, in turn, should be enough to ensure that nobody will be able to claim that the dog ate his bitcoin, or that somehow an imposter has got away with it while his back was turned. And therein lies the security. Who needs a gold bar in the cellar when you’ve got that kind of confirmation of your claim to title?
The important thing, though, surely, is that the blockchain process doesn’t record who’s bought or sold the bitcoin. Anonymity is the absolute name of the game – which is why, unfortunately, bitcoin is still the currency of choice for fraudsters, pornographers, kidnappers, illegal Chinese currency brokers, and a whole lot of other bad people who the proponents of the New Age of Aquarius are trying to forget about.
But can the system ever break that chain of anonymity? There’s rather a lot riding on it. We’ll look at this question in a moment.
What’s a bitcoin worth anyway?
That’s a serious question, and we’re not going to find any answers in the textbooks. As long as we can get our heads round the fact that bitcoin and the like have no intrinsic value at all, but exist only as an aspiration in the searching hearts of their admirers, then we’re on the starting point for assessing the value of this strange new mechanism.
“Mechanism” is perhaps the right word. Supposedly invented by somebody called Satoshi Nakamoto, who now appears never to have existed, the general idea of bitcoin is that it floats upon the public consciousness and derives its value from the level of demand at the time.
So [playing the young devil’s advocate here], how different is that from all the conventional currencies in the world? All right, you can plant a tulip bulb in the ground and get a flower from it, and you can wear a lump of gold around your neck, or maybe even make an electrical connector out of it. But tell me, could you same the same about a dollar, or a yen, or a euro? Aren’t they just what we call fiat currencies? (From the Latin word for “trust”) Aren’t they just a load of bull***t from a bunch of self-interested bankers who’ve set up the world to benefit their own system?”
You don’t have to agree with that sentiment to see where the logic’s coming from. Buying a bitcoin is a statement of solidarity with a millennial generation which feels that it’s been passed over by the wrinklies. And the possibility that there might be a different way of floating a currency on a bed of public confidence is bound to feel attractive, isn’t it?
How big is crypto?
But none of these concerns are going to mean much unless we can get a proper sense of how large the crypto currency market actually is. Before we can assess the risk from the advancing army, we need to know how much gunpowder they’ve got.
The answer is illuminating. According to Coinmarketcap, the total value of crypto currencies in early January was $760 billion at current exchange rates. Of which perhaps half consists of bitcoins – the others include Ethereum, Lifecoin, Swiftcoin, Bytecoin, Primecoin, Blackcoin, Auroracoin and nearly 1,400 more. (Do you see where this is heading? Look at the list on www.instacoins.com for a comprehensive list of them.)
How does that $760 billion stack up against the global environment? It’s equivalent to a bit less than 1% of the world’s stock market capitalisation. It amounts to around ten days’ worth of US Gross Domestic Product.
Small beer, then. And when compared with the $22 trillion cost of the 2008 crash, it would be hard not to conclude that a crypto collapse would be opening up buying opportunities as soon as the losses exceeded $1 trillion or so.
Except that the downforce from a bitcoin crash would vastly exceed the losses suffered by the unlucky speculators. Troubles are likely happen because some institutions will have over-exposed themselves and will face liquidity issues, which will have knock-on counterparty effects all over the place. Bitcoin in itself won’t be the cause of a financial avalanche, but it might well be the trigger for one if the preconditions are already in place elsewhere. And that’s the hard bit to calculate in advance.
Can cryptos be taxed?
Here’s an interesting conundrum, courtesy of a contributor to an internet forum which I frequent. The contributor’s son, it seemed, had been given a gift of 250 bitcoins by a friend, many years ago, as a thank you for a small bit of research that he’d done toward a project. And how, with bitcoin at $16,000, his gift was suddenly worth $4 million, and what was he to do about it?
Should he be liable for income tax on what HMRC might well decide to regard as earned income? Or would tax be levied only on the value of the bitcoins at the time of transfer (probably less than $10,000). Or would the taxman be entitled to lay a top-rate tax claim to the entire sterling capital gain since the gift had been made?
Or could he simply dismiss the whole matter as a gift, and not as earnings at all? And if he did none of those things, would the taxman ever find out that he’d ever received the bitcoins, in view of the aforementioned provisions about blockchain anonymity?
What price anonymity?
That’s not such an easy question to answer as it seems, apparently. The prized anonymity of bitcoin transactions has been taken pretty much for granted up till now – not least, by the hackers and scam artists who infect people’s computers and then demand ransom payments to disinfect them – invariably in bitcoin. But the Feds are now starting to close in on the crypto-currency exchanges themselves. And that’s where the bitcoin taxation issue starts to get interesting.
Last November, a court in San Francisco approved a demand by the American IRS tax agency that forces the Coinbase exchange to reveal traders’ identities whenever they trade (or simply receive) bitcoin to the value of $20,000 or more. According to the evidence considered by the court, some 14,350 Coinbase users had traded in such amounts between 2013 and 2015, but only 800-900 had declared gains to the US tax authorities.
Coinbase had opposed the IRS’s move on the grounds that its sweeping demand for information was a threat to privacy The court found that the IRS “has a legitimate interest in investigating” taxpayers who remain stumm about their dealings – and the court ruled, according to Bloomberg, that the company “must turn over basic identifying information, records of account activity and period statements for accounts with the equivalent of $20,000 in any one transaction type during any single year from 2013 to 2015”. However, the court held back from ordering the surrender of other identifying data such as public keys that might allow the inspection of all accounts, wallets and vaults.
Courts in other countries, especially in Asia, are being less subtle about the increasing pressures that they’re bringing to bear on the exchanges to make them open up their records. Hardly a week goes by without some exchange being closed, suspended or generally leaned on. So is the cryptocurrency business ready to grow up and go mainstream?
First in, first out?
We’ll look at that question in a minute. But first, let’s ask a rather obvious question that’s been puzzling the US tax people. If you ask people to declare their bitcoin gains for capital gains tax purposes, how are you going to stop them from preferring last- in, last-out, so as to minimise the gains on which tax has to be paid?
I mean, if you buy a building or a distinct block of shares, or even a gold bar, it’s easy to see when you bought that particular item and when you sold it. But when you’ve been adding to (and drawing from) a liquid pool of same-stuff crypto-coinage, the task of defining first in and first out becomes much more difficult. The word is that Congress is still scratching its head about how to stop taxpayers from kicking their bigger long-term capital gains down the road for as long as possible.
The market calls for regulation
And yet the market itself is gradually starting to see the logic of regulating itself a bit more transparently. If crypto-currencies are half-serious about taking the task of money-creation out of the hands of the world’s central banks (pause for effect…), and if they want to attract serious attention from businesses and bond markets, they need to ensure that the scarcity of their currencies (and therefore their value) remains tightly controlled.
And that, of course, can be a tall order if the global fleet of crypto-currency operators insists on hoisting the Jolly Roger. Nobody appreciates that more than the now-defunct Mt Gox, formerly the world’s biggest bitcoin exchange, which crashed in 2014 after it discovered that fraudsters had spent the last three years silently skimming off around 850,000 bitcoins to the (then) value of $450,000. A sum which would now be worth somewhere around $15 billion. Eek.
The Mt Gox fraudsters, as far as my feeble brain can decipher, had cracked the secret of persuading the trading system to give them a second go at a bitcoin transaction when their first attempt “failed” (ho ho). And by this simple strategy they had been buying one, getting one free for years while nobody noticed. Moreover, it hardly improved the market’s confidence when Mt. Gox subsequently ‘discovered’ a wad of 200,000 bitcoins that had been lying down the back of the digital sofa in a wallet where nobody had thought to look for it.
The point here is that when your money’s gone, it’s gone. Nobody will know who took it, and you certainly won’t get any depositor protection. A point that you may wish to make to your clients when they enthuse about the burgeoning digital cash machine.
Then there are the inside fraudsters at the exchanges themselves. Trading at one US exchange was suspended in December for what seemed to have been a classic pump ’n dump operation – ramping up their apparent turnover in readiness for offloading their shares in the exchange. Elsewhere, there have been fears that smaller crypto-currencies have also been snapped up by staffers so as to inflate their values and dump them on the unwary.
And all the while, of course, the Chinese government is still battling to shut down the hundreds of illegal exchanges which exist to export yuan wealth from the country without anyone noticing. If they ever succeed, the volume of global trading is certain to plummet. And with it will go a huge slice of the demand.
How to advise your clients?
And so to the crunch question. Is there anything good to be said about bitcoin? Well, for some people there probably is. As you’ll probably have heard, you can buy fractions of bitcoins quite easily (including from vending machines!), and they make nice birthday presents as long as you regard them as a speculation, not an investment. The transaction charges are eye-watering, though.
You can buy into bitcoin values with an exchange traded note such as the ones marketed by Hargreaves Lansdown – and another one that focuses on Etherium instead. Other funds are available, but I am reliably informed that some of these trade at premiums of up to 35% against assets. Why? Because it can take two days to complete a bitcoin transaction, and the price can move an awful lot during those 48 hours.
And finally. If I were a hard-working millennial with no hope of ever scraping together a deposit for a house of my own, I might very well be inclined to think that putting a couple of thousand pounds into bitcoin would be more likely to fulfil my dreams than investing them in Ernie. We can’t know whether we’re at the market’s peak and getting ready for a sell-off and a fatal capitulation. But viewed from a young person’s perspective, you can see the logic of the situation. The IFA’s task, I suppose, is to try and instil a sense of perspective and proportion.
I’ll tell you one thing, though. If bitcoin does crash, there are going to be a heck of a lot of very disgruntled young people who’ve convinced themselves that bitcoin is the only kind of lottery ticket with a guaranteed 100,000 percent payout. I expect they’ll find a way somehow to blame it all on the baby boomers.