CRYPTOCURRENCY NOT SO REVOLUTIONARY AFTER ALL
▶ Please understand – there is no innovation here, not in theory nor in application
Buying bitcoins as an investment means going long bitcoin deflation. That’s it. Let me explain.
Bitcoin is a cryptocurrency, a digital currency made hard to forge using cryptography, and also a payment platform such as those used by Visa, ATMs and if you’ve done wire transfers, the Swift system. The bitcoin technology platform is not new, it was first released in 2009. The cryptography is older, having first been developed in the early 1990’s. The payment systems are decades old.
So what do I know about this? As the former head of Treasury at Union National Bank, I of course needed to understand currencies and currency market.
Also the Swift system is managed out of the treasury’s back office. Furthermore, I was the director of the board of Visa International CEMEA Region. For the technology, in the mid-1990’s, Moti Yung, a former student of my graduate adviser, tried to lure me away from computational finance research into mainstream theoretical computer science by explaining to me the uses of distributed databases and how they can be used for secure payment systems.
Although I didn’t switch, it was interesting enough that we would chat about it once in a while. Today, distributed databases have acquired a fancier name: block chains.
I tell you all this so that you understand the following – there is no innovation here, not in theory nor in application. Even if there was, actually buying a bitcoin does not give one economic exposure to any technology, simply to the supply and demand forces acting on the bitcoin currency. So we can narrow our discussion simply to analysing the currency markets.
What makes a conventional currency price move? A simple but not so useful answer is the supply and demand of that currency. So let’s go one step further. There are in general two markets for a security, the primary market when the security is first offered, such as an IPO, and the secondary market, a trading market like Abu Dhabi’s ADX or London’s LSE.
For a currency, the primary market is usually via the central bank’s monetary policy which injects currency into the financial system, as the US’ Fed has been doing in huge amounts under a programme called quantitative easing, or it can withdraw it.
On the other hand bitcoins are only added following a certain protocol which limits the total number of bitcoins to 21 million. As of this month there are about 16 million bitcoins in circulation. So the long-term effect of changes in the primary supply is zero. This means we should look solely at the secondary market.
There is no consensus on the main determinants of currency price fluctuation so I’ll offer my personal view: 1. Current account deficit: This basically measures the value of trade between a country and its trading partners. If it is a deficit then the country is importing more than it is exporting, so it has to buy foreign currency and sell its own currency to pay for the trade deficit. This would lead to a decrease in the value of the local currency.
2. GDP differentials: An economy that is doing better than other economies will attract investment. This investment in turn will lead to an increase in demand for the local currency and therefore an increase in its value.
3. Interest rate differentials: All other things being equal, a country with a higher interest rate will attract investors, leading to an increase in the value of the local currency. Please note that this means one has to first adjust for other factors, such as those listed here.
4. Inflation differentials: An economy with higher relative inflation will see the value of its currency evaporate. On the other hand, negative inflation, known as deflation, increases the value of the currency relative to other currencies.
5. Public debt: Similar to company debt, if public debt becomes too high the interest payments on that debt choke off government spending, which is bad for the economy and leads to a decrease in the value of the local currency.
6. Speculators: They look at all the other factors, rationally and irrationally, such as economic forecast, political climate, public perception, how others might be trading, etc.
We can analyse from this that when looking at bitcoins only inflation and speculators matter in terms of affecting the price as all of the factors do not exist for bitcoins as they are not backed by an economy. You might think that interest rates do matter but as it is not at the national level as set by a central bank then it does not affect the bitcoin economy. Interest provided for bitcoin deposits is simply a return provided for lending to a particular borrower. This is not a currency return but a lending or credit return.
This means that if you buy bitcoins as an investment you are basically betting that either there is deflation or speculators will drive the price up. This is not an investment. This is not a trade. I’m not sure if it is even a gambling bet.
Trading misconceptions: stop loss orders
I recently talked about the liquidity trap that some investors were getting themselves into when investing in illiquid stocks. The issue is not an investment issue but a trading issue that can greatly affect the overall internal rate of return (IRR). In discussions about this trading trap some other misconceptions come up and I’d like to address one of them: the stop loss order (SLO). In its most basic form these are orders that you give to your broker to sell a security if it drops below a certain price.
The main misconception with SLOs is that when the price of a security drops it will touch every price on the way down. For example, if you bought shares which are now at Dh20 and you put in a stop loss at 19.8, this will not necessarily trigger a sale at 19.8. If your broker actually manages to sell at 19.6 you’ve still lost an extra 1 per cent of your position.
But there is no guarantee that your broker can sell at the lower price. I recall in mid-1998 that the UAE markets, then trading over the counter (OTC), had been enjoying a great rally when they suddenly collapsed. I saw an order for the most liquid shares at the time, Emaar Properties, executed at Dh160 a share. The crash started the next day and the buyer immediately tried to sell the position. It took several days before a new buyer was found, at a price of Dh40 a share. That is a 75 per cent loss. The whole market had crashed.
This brings us to the second misconception, that SLOs guarantee size. The first concept showed that even in a liquid market the price can “gap”.
The size issue, covered in the liquidity trap, is when the trader holds a sizeable position. I won’t repeat the details but basically if the size of the trading position is large relative to the daily value traded then it is difficult to execute a SLO at the stop price without adversely affecting the price even further. This is effectively what a portfolio insurance strategy can end up doing and is one of the reasons cited for the Black Monday market crash which led to the largest drop in history of the Dow Jones Industrial Average in percentage terms.
My rule of thumb is that a 1 per cent position is considered big with 5 per cent considered huge. Huge!
The third misconception has to do with the idea of a stop loss as a risk management system. We’ve already delved into the point that a SLO does not guarantee price or size.
But even if it did, SLOs are a tool and in no way represent a risk management system (RMS). For example, the size of each trade is an important element of each RMS. If we assume the existence of a perfect SLO, set at a 5 per cent loss, there is a difference if the position size equals 1 per cent or 20 per cent of the overall portfolio. If the former, we are looking to protect against a 0.05 per cent loss to the portfolio, for the latter it is 1 per cent. There are other more complex issues such as correlation and volatility.
Stops, and similar orders, are useful but their use is limited to a form of support tool when traders are not able to watch the markets, for example, when a personal trader goes on vacation. Or perhaps in case they aren’t paying attention. They are certainly not a RMS.
One-minute round-up
Dubai’s SWF ICD reported a 21.4 per cent decline in full-year net profit for 2016. Hats off to them for not trying to equivocate. On the other hand ADCB stated “... [ADCB’s] fundamentals and underlying performance remained healthy...” Net interest and Islamic revenue grew at 15 per cent quarter-on-quarter whilst the equivalent expenses grew at 30 per cent. I personally don’t consider that healthy. Maybe ADCB defines fundamentals differently.
Perhaps listed companies should be explicit about what they mean by fundamentals and how they are calculating them from the financials. It would be beneficial if the Securities and Commodities Authority insisted on clarification of such statements. Financial performance should not be glossed over using vague, undefined terms.
Similarly du announced in the beginning of its commentary that it “has made steady progress in the second quarter of 2017, with a 6.2 per cent increase in revenue and a slight improvement in net profit.” The problem is that du’s financial statements clearly state that its operating profit dropped by 2.3 per cent.
We don’t have to argue about what core income is here, du clearly defines and unfortunately the slight deterioration in operating profit is not discussed.
Let me close with great news for start-ups: Dubai will start issuing a one-year “licence light”, which is faster and easier to obtain than a normal licence. A simple benefit: you don’t need to lease offices. This is valid for only a year before there is the need to renew as a regular licence. A great step forward.
Buying a bitcoin does not give one economic exposure to any technology, simply to the supply and demand forces acting on the bitcoin currency