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Category: Economics

At $10,000 is bitcoin now a bona fide bubble?

As bitcoin passes the historic mark of $10,000, Mark Mahaffey, CFO of hedge fund Hinde Capital, details his latest insights for Glint, revealing...

29 November 2017

Mark Mahaffey

As bitcoin passes the historic mark of $10,000, Mark Mahaffey, CFO of hedge fund Hinde Capital, details his latest insights for Glint, revealing why he believes blockchain is crucial but bitcoin is officially a bubble 

Mike Novogratz, the legendary ex-Fortress macro trader, claims that: “Digital currencies are going to be the largest bubble of our lifetimes,” and his new fund is betting the ranch on bitcoin and ether by the sound of it. “If it moves, I want to trade it,” is often the macro trader’s mantra. The more it trades, the higher it goes and the more people want to get in. This is the classic sign of a bubble.

Driving up prices far greater than their real value, whether it is tulips, South American “fertile” land, railroad stocks or 2000 dot-com internet stocks, is nothing new. But if we have learnt anything from these “bubbles”, it is that they often go further than you can imagine in your wildest dreams. There are fortunes to be made and lost, both up and down. The very smart investors make money in the huge run-up in prices, and then profit again as 95% of “new” things plummet to zero. Others stubbornly miss out or get in too late and lose their shirts. But, money aside, bubbles that are led by “new inventions” often bring the benefits of this revolutionary technology, some of which will be taken for granted in years to come.

We believe that the seed for “digital” currencies and blockchain technology, was sown as a result of the 2008/9 Great Financial Crisis, which, for the most part, did not endanger the world like a world war. Arguably, very few people lost fortunes. Many people who could never afford to buy a house in the US in normal times were led in to the sub-prime debacle tragically. But banks took the losses for the most part, while Greece, Spain and Ireland saw some tremendous housing crashes, true boom to busts.

But, both faith in the system and trust in the middleman, often financial institutions, was lost. Most are aware of the central banks “belief” that the only way to save the system (banks) is to print money and lots of it, but all of the people can’t be fooled all of the time. If we lose faith in the ability of our governments, the central banks and the banks to provide us with a stable currency ­– not only the money that is being printed by the grizzillion but also the trust to hold our money and process our transactions carefully and cost effectively – then bitcoin, and its blockchain technology, are a potential temptation for all. Trust, which has for centuries been overseen by a middleman, could be replaced by the trust of future cryptography and a currency that, while being ‘virtual’ and ‘digital’, is limited in theory by the original supply limit in the bitcoin programme.

Bitcoin is the best known of the new cryptocurrencies (of which there are up to 2000 in existence, as of late-2017), having been established in 2008/9. The unknown inventor, allegedly named Satoshi Nakamoto, authored a paper, entitled Bitcoin: A Peer-to-Peer Electronic Cash System, before releasing an open source downloadable code. This was, in effect, a digital payment system with no central control or administrator.

bitcoin price

The price of bitcoin on 29.11.17, source:

It is worth scrolling down this website to see the hundreds of coin issuances and some of their interesting names!

Odd names of coins

Other cryptocurrencies have similar structures. They are created or “mined” by computing power, solving difficult algorithms, and they are “finite”. Almost 17 million bitcoins had been mined by October 2017, but the rate of mining is now decreasing fast. Bitcoin’s limit of issuance, written into the original programme, is 21 million coins, which at its current declining rate will be reached between 2110 and 2140. The below chart shows bitcoin mined over time and the one below that its controlled supply.

Mining demonstration

We presume that the creation of bitcoin through “mining” was to have relevance to the extraction of precious metals from the Earth’s core, representing a scarce and finite supply. This is in strict contrast to the seemingly unlimited ability of central banks to print fiat money. When Satoshi Nakamoto mined the first bitcoins in January 2009, he embedded the message “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks”, into the coinbase of the block. It would appear he thought the time had come for a new system, both in terms of peer-to-peer transactions and also in a scarce, unprintable, currency.

But just because something is scarce doesn’t mean it has value. Only my wife and I seem to give any value to my four-year old’s rare and scarce nursery paintings.

Value is often a function of the time taken to produce something. The early use of objects, like shells for “currencies”, where a diver might collect ten shells a day on average, would give us a starting point. One day’s diving salary = ten shells, and so on. I have always believed the starting point for any discussion on value, including money, is the worth of one man’s daily labour.

One of the scarcest metals in the Earth’s crust is gold, a result of asteroid bombardment millions of years ago. The current production cost of gold across the world, on average, is approximately $1100/ oz. This is not far off the actual price of gold at $1275/oz today, but throughout history the price of gold has typically traded far higher than the extraction cost.

abundance of minerals

Bitcoin’s production “cost of mining” can be measured in the cost of buying a computer and the electricity used up while mining bitcoin. In the early days of bitcoin, “mining” could be done on a laptop. The download of the bitcoin software was straightforward and mining was the process of verifying bitcoin payment transactions and putting them into a block and solving the algorithm. Think of the algorithm as a computerised Sudoku puzzle that can be solved, and where the difficulty can be increased over time by adding more columns and rows. The bitcoin miner receives reward money for “solving” the block and also a small fee (in bitcoin) on all the transactions.

countries mining bitcoin

The distribution of global bitcoin mining operations, source:

Today, mining bitcoin is big business. The cost of the computers, electricity and heat dispersion, as well as the rent of the warehouses, are all crucial to the profitability of the mining operation. Recently, the press have made many references to the vast electricity used in mining, leading to warehouses being moved to places where the electricity is cheap and with abundant natural cool air, like Mongolia. Clearly, some truth to value lies out there, but on what scale, and does a currency that requires ridiculous amounts of electricity to function, even before its widespread use, really seem a good plan?

Bitcoin energy consumption

Bitcoin energy consumption source:

Bitcoin miners in Mongolia

A rack of bitcoin miners at Bitmain’s facility in Ordos, Inner Mongolia

It has scarcity value, as only 21 million Bitcoins will ever be “mined”, in theory. It has a production value and is currently in demand by many who hope to make a fortune out of it. But is it a “currency”?

The well-known economists’ definition of a currency includes a unit of account, store of value and medium of exchange. I’m not sure we have got there yet. Does anyone receive their salary/day rate in bitcoin, apart from a bitcoin miner? Do you know of many people who regularly buy things using bitcoin?

For all the problems with our current fiat money, the theory was reasonable that a central authority would produce enough currency to keep up with population growth. Gold was always particularly good at demonstrating that because its yearly production was roughly an additional 1.5% of the world gold stock (as gold was not being ‘used’ up like oil), which was similar to the world population expansion. If central bankers created money at 2% to match the expansion of the population, who produced their fair share of goods, the prices of goods should be fairly constant. Unfortunately, we know the history of indebted monarchs, through to today’s money-printing central banks, where it has proved far too tempting to produce far more money than we need in order to try to inflate away the world’s debts.

Whether bitcoin is a true currency is debatable. If the demand increases as “the population” demands it, then the price will rise because it is scarce. The inflation rate of bitcoin is dropping fast.

bitcoin monetary inflation

bitcoin monetary inflation

When we look at the number of transactions that are being done worldwide in bitcoin currently, it seems odd that bitcoin has risen 7-fold this year, yet the transactions haven’t kept up.

Historic transactions

Historic bitcoin transactions, source:

Bitcoin transactions over the last 2 years

Bitcoin transactions over the last 2 years, source:

Part of the problem could be that the bitcoin network is not coping well with increasing volumes, with confirmation times taking far longer (which is the reason why it was decided to have a split from bitcoin to a new currency called “bitcoin cash” in August of this year, with larger block sizes from 1MB to 2MB). In 2014, the fees that were needed to confirm a transaction were pennies and getting a transaction confirmed in the next block was 10 minutes. In 2017, the average transaction fee has risen to $4 and the average confirmation time is over an hour.  Mastercard and Visa can process up to 3,000 transactions per second, so bitcoin has some way to catch up. Maybe bitcoin just isn’t scalable. Of course, these huge payment companies lose millions in fraud with their much less secure systems. Does there have to be a trade-off between transaction volume and security; surely we can close that gap?

Market price vs estimated transaction value

Market price vs estimated transaction value, source: Hinde Capital /

Others might argue that although transaction volumes are not increasing with the market price, the transactions’ USD value is growing in line with the bitcoin price and the estimated USD transaction values daily as a % of the Market Cap, and this is very stable.

Estimated USD transaction as % of market cap

Estimated USD transaction as % of market cap, source: Hinde Capital /

But maybe the lack of increase in transactions is due to “hoarding”, which is a well-known economic term for when people believe their money will buy more goods in the future. So, has bitcoin become a digital investment or a digital speculation, rather than the peer-to-peer transaction currency it was potentially meant to be?

After all, who needs a currency that can drop 50% and bounce 100% in the matter of days?

bitcoin volatility

bitcoin volatility, source:

bitcoin chart

Ether price, source:

Digital currencies like bitcoin are stored in digital wallets, which are either connected to the internet or unconnected in ‘cold storage’. The digital coins or units don’t actually sit in the wallet, even though the wallet records as such. All that’s in the wallet is a set of keys, public and private. These provide ownership proof to enable the user to ‘spend’ the bitcoins that are available to be spent in the network. The bitcoin software had solved the problem of double spending digital units with a double entry accounting system that meant all units had to be accounted for at all times somewhere in the network. In fiat money, the person who has the note in his hand is the only person who can spend the money and claim to be the owner. In digital currency land, the owner of the right set of public and private keys can claim ownership on the ‘owned’ bitcoin and can spend it.

An example of a bitcoin key, source: Wikipedia

An example of a bitcoin key, source: Wikipedia

We should look at the public key like a bank account number, which can be written on an invoice harmlessly, and the private key like a PIN. The private key (PIN) number of a Bitcoin account is obviously far longer than your typical four-digit bank PIN card; hence, it is far more secure from a hacking attack, especially from a multiple entry testing attack.

It’s the old story of big numbers – a million seconds is 11.6 days, but a billion seconds is 32 years. Most of us have had a three-digit padlock at some time and forgotten the combination. Whether we have tried to unlock it by testing out combinations or not, we are aware that the number of combinations is 1000 and we might get lucky long before that.

With digits 0-9, there are 10 choices, so the number of possibilities is just 10^3 (10 to the power of 3) = 10*10*10= 1000 as we include 000.

Depending on the choice and the number of choices, we can easily calculate the possibilities. If we use a four-letter alphabet code, we have 26^4 =456,976. But if we use lower and upper case, we can get 52^4= 7,311,616.

My bank called me last Christmas to tell me that a person with my debit card and PIN was trying to extract money from ATM machines in the Philippines. I was told that my card had been cloned and that a hacker’s system had managed to turn off the three PIN security functions, and so they were just digitally testing all 10,000 in a fraction of a second. Maybe we should move to alphabetical PINs?

Today, the average desktop computer PC, without any specialised hardware, can search approximately 100,000 keys per second.

By increasing the choices available and the number of choices in the sequence, we can make some very large possibilities indeed. Base64, a common system for binary encryption, uses 26 uppercase letters, 26 lowercase letters, 10 numerals and 2 more characters like “+” and “/” to transmit data. Bitcoin and many other cryptocurrencies use Base58, which is Base64 without some of the characters that are frequently mistaken, such as 0 (number zero), O (capital o), l (lower L), I (capital i) and the symbols “+” and “/”.

Despite the belief that computing power is increasing constantly, possibly doubling every 18 months, according to Moore’s Law (that whatever we do, the computer will catch up) it is still a time-consuming task to test every sequence possibility. Adding to the sequence will keep making it too far in the future, no matter how fast computing power gets.

code examples

How code hangs together, source: Mastering Bitcoin.

While the private keys’ length and sequence ensures security, there is always the theoretical possibility of the private key being hacked through the wallet or in a note file on the laptop (if it is kept there). Many people resort to “paper wallets”, i.e. writing it down on paper and then putting it in a safe place. Like PINs, the more you chose to hide it, the more you might succeed. If you forget or lose your bank PIN, you can request another one after proving your identity. Unfortunately, with bitcoin, if you lose your bitcoin private key, you lose all your ownership to those bitcoin. There is no one to ask. This is the downside of a distributed, decentralised ledger that is unregulated and unpoliced. Since 2009, Satoshi Nakamoto, whoever he maybe, has mined over a million bitcoins but there is no record of him having spent any. Could it be that he has lost his bitcoin private key?

There have been some well-known examples of bitcoin hacking, such as Mt Gox’s collapse in 2014, but as this has not happened on a regular basis, we must assume that the digital wallets are reasonably secure and many of the loopholes for computer fraud have been eradicated by the constant updates to bitcoin software. These updates in the form of BIPs (Bitcoin Improvement Proposals) have to be voted on and agreed before implementation. But we still read stories about an ethereum programmer potentially locking out holders of $280 million worth of ether currency – possibly permanently because of a coding bug!! Banks have had their problems, mis-sold us mortgages and PPI, and overcharged us for FX conversions, but they rarely say “we have deleted your money by mistake and its gone for ever”.

Historically, in the world of cryptography, from its origins in ancient Greece (crypo=secret, graphy=writing) to the WWII Enigma codes, distribution has been the main weakness and the key to deciphering the code. But in the mid-1970s, the problem was effectively solved. Many mathematicians had been working on the problem over the years, including those at our own GCHQ, but the patents and credit generally goes to discoveries by Diffie, Hellman, Merkle and a key exchange: the RSA namesake system designed by Rivest, Shamir and Adleman.

The ability to publish a public key, encrypt a message by using your own private key (and public key), which does not need to be transmitted, and send it “encrypted” so it could only be read by the intended recipient, was a defining moment, not just in the world of code breakers, but also for so much of what we take for granted today. Every single email message and every online purchase is theoretically secure because of this amazing development.

The mathematical world of number theory – with its infinite large prime numbers coupled with one-way functions – has given the world the ability of secure communication.

Despite regular high-profile press reports about data being hacked from TalkTalk to Tesco, our understanding from discussions with cyber experts is that data is generally very secure, unless you are lazy. Their analogy was that very few burglar alarm specialists have their house burgled. TalkTalk’s IT security was apparently so weak and outdated that no hacker worth his salt even bother to break it for fear of ridicule in the hacking world.

But as the value of bitcoin and digital wallets soar, so does the financial incentive for fraudulent hacking. Like expensive houses, the hackers will keep coming no matter how secure the new cryptography is. Allegedly, North Korean’s hackers are stealing millions in new cryptocurrencies, no doubt converting them back to real money immediately.

Linking Blockchain

Blockchain has become such a buzzword that when the UK company On-line PLC added the word “Blockchain” to its name, the share price rose 400% that day! But what is blockchain?

It is a continuously growing list of records called blocks that are linked and secured by cryptography, according to Wikipedia. In the world of computing, records are used to being deleted or altered with no regard for history. This was one of the flaws of the modern world until, it would appear, the invention of blockchain, which was made well known by its use in the Bitcoin Protocol.

The phrase, often used is ‘unalterable, decentralised within the public domain’.

Since 1862, the UK Land Registry has been recording all land and buildings ownership in the UK. Each day of transactions could be seen as the ‘block’, which is theoretically secured by the publishing/backing up of data of those records on a daily basis. Anyone wanting to change the title history of a particular land package or building would, therefore, have to go back and change every single record wherever it was held in the land, which was the same basic tenet for changing newspapers from previous decades. Imagine finding every single issue of the March 20th 1984 version of The Daily Mail.

These analogies stand us in good stead for understanding that the concept of today’s blockchain is no different – apart from the fact we are not recording daily, publishing them in print and distributing them. The blockchain that was established for the use in bitcoin, primarily to solve the “digital double spending” issue, has wide ranging benefits in the current world of computerised globalisation and trust by cryptography. As we record more and more records, from financial transactions to food traceability, computer records that are structurally resistant to modification of data become paramount. In the blockchain used by bitcoin, each block has a hash pointer link to the previous block, a timestamp and transaction data. The more the layers of blocks on top of each other, the harder and harder it is to alter, just like The Daily Mail’s historical issues; not completely impossible, given enough time and resources, but very improbable.

While it’s clear that we need records that can’t be altered, what is less clear is who has access to them, and how do we ensure transparency of data when it is required and privacy of data when demanded? For a fee, anyone can access the UK Land Registry database. Privacy in transactions registered is often done through offshore companies. Bitcoin’s “open” blockchain ledger only records account entries, with no knowledge of the account holder. In time, we will all have to decide how our medical and bank records are protected electronically in a decentralised world. In many parts of Scandinavia, tax returns are open and posted online. I’m not certain that is coming here anytime soon but blockchain technology, trust through cryptography, is here to stay.

– From The Times article about ‘Electroneum’, the latest Initial Coin Offering, which raised $40m before having to be closed “temporarily” due to hacking from Russia cyber-bots.

Initial coin offerings, source: The Economist

Initial coin offerings, source: The Economist

Initial Coin Offerings are the latest craze for raising money. You’ve heard of start-up IPOs (initial public offerings) and crowdfunding (rewards or equity). Well, if you thought they were ‘highly speculative’ investments, ICOs are IPOs to the power of 10.

Instead of offering equity, Initial Coin Offerings offer “digital coins” in the new cryptocurrency venture that will gain in value if the business is successful. Ethereum is the flag waver for a successful ICO that developed into a currency and investors have been rewarded handsomely so far. Unfortunately, I fear that most of them will lose all their investment money in spectacular fashion.

Many people have lost their investments in early stage IPOs where money is exchanged for an equity stake of a young business in a regulated, yet speculative, environment. These monies are invariably eaten up by the business long before cash flow appears and the company fails. In the very unregulated world of ICOs, the business is linked to the currency token itself. No wonder the Chinese regulators have closed this market down and world regulators are rushing to address the issue. As someone who is invariably bogged down with reams of regulatory compliance about the suitability of investments to retail and sophisticated customers, this makes a laughing stock of the whole she-bang.


Just as Uber drivers’ Satnav technology competes with the black cab trade in central London, cryptographic technology will continue to challenge the middleman. Instead of two unknown parties being brought together by a 3rd party who is trusted by both for a large commission, many will deal direct securely. The middleman will still exist, but his margins will be cut. Such is the march of time.

Blockchain technology is necessary in the new world to maintain computer records effectively, without risk of deletion or alteration, and will become commonplace in the future I’m sure.

Humans tend to indebt themselves, individually, collectively and at government levels. Being able to spend today rather than wait is a natural species trait, so we need to regularly eradicate the debt, and there’s no better way to do this than to overproduce a currency (money printing, QE, call it what you want) relative to the population expansion. Clearly, bitcoin’s limited supply will never make it a stable currency. In the week that I have been writing this article, an as yet unpublished bitcoin has traded from $5000 to almost $8000 and back to $6000 while its alter ego, bitcoin cash, has risen from $300 to $2000. It would make sense that only one of these at most can survive. Can bitcoin or any other cryptocurrency release more than the original units that were in the written into the protocol? Believers will argue not, but surely it seems much more theoretically possible than expecting a new asteroid bombardment to increase the gold supply. Maybe there will be one crypto winner in the future, free from government oversight, that is allowed to succeed by the world’s regulators who have so far been slow to respond. Or maybe the powers will finally clamp down and bitcoin will be remembered as a period of collective delusion.

But make no mistake about it, this is a bubble. Whether there is one or a few winners in years to come, most of them will fail and the ICO market will no doubt be the source of many ‘tulip-mania’ stories. But there is money to be made in a bubble and an understanding to be had, so we will monitor it closely.

Maybe, when the world is done with ICOs and 2000 cryptocurrencies, and the fiat money system has blown up in an inflationary firestorm, the combination of secure digital transactions and gold will be the one left standing.

I mention gold because it stands in contrast to the bubble world of cryptocurrency: it keeps value, it’s heavy and tangible, and although the price moves, it has been worth something for pretty much all of human history. If everybody in the world was able to hold and spend gold as money it could revolutionise its value in more ways than one. While cryptocurrencies remain new and untested, speculation is naturally rife. But gold has passed the test of time, and coupled with the digital age of payments it may be the answer to all our needs, now and in the future.

Mark Mahaffey is CFO of Hinde Capital and a regular author for Hinde Sight Letters

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