Bitcoin, A Game Theoretic Perspective

Recently Charlie Bilello put together a nice collection of charts with the common theme of markets humbling the prognosticators. The one on bitcoin particularly has been making the rounds. However, I doubt that it will stop the top-calling. With the latest correction precipitated by China’s banning ICO and exchanges, there’s no shortage of “I told you so” going round, even from sources I respect. In this post, I discuss why I believe bitcoin prices will recover from this latest episode and go on to even greater heights. I’ll also address some of the common misconceptions.

The starting point is two facts: 1) Bitcoin is a survivor, from its obscure origin in 2009, it survived no less than five 70-90+% declines, the Mt. Gox hack, the Silver Road case, and most recently the BCC hard fork. It not only survived but flourished with price briefly exceeding $5000. 2) Bitcoin is now an international phenomenon with participation in every major economy. The map below came from a recent Cambridge study “Global Cryptocurrency Benchmarking Study”. It shows where key components of the cryptocurrency ecosystem are located.

Bitcoin and Government Crack Down

One of the greatest fears for a “would-be” bitcoin investor is the likelihood of government crack-down. I want to counter by taking a look at the most well-known example in game theory: the Prisoner’s dilemma. I’ll assume it’s somewhat a common knowledge. A full description can be found at the the Wikipedia Link. A quick synopsis of the conclusion is that although the best outcome collectively is for both prisoners not to talk, the rational decision for each is to talk irrespective of what the other prisoner does. An analogy to bitcoin and government crack down can be drawn:

  • A crime has been committed → the distributed ledger/blockchain is a true innovation that will have profound disruptions in finance and beyond. The bar is not high: it only needs to be believed to have a reasonable probability of coming true.
  • The best collective outcome is for both not to talk → the best collective outcome for all governments is to maintain the status quo by collectively crack down on bitcoin/all crypto.
  • The rational decision for each is to talk → the rational decision is for each country to foster bitcoin/crypto development within so as to get a leg-up/not fall behind in a future where the promises of the distributed ledger come true.
  • The worst outcome for each prisoner is when he does not talk but his partner does → the worst outcome for each country is to crack down on bitcoin/cryto only to find itself fallen behind. Here’s why the multi-player version of the Prisoner’s dilemma is stronger since the probability is higher that at least one other will talk/decide to develop blockchain technology.

So that’s the basic game theory consideration as far as whether governments will or can ban bitcoin/crypto altogether. My conclusion is no country at this point can afford to given the disruptive potential that the blockchain technology has already demonstrated. It’s telling that China’s ban was focusing on the exchange between fiat and crypto which had everything to do with capital controls. They actually made a point to distinguish the blockchain technology itself. Note also that cryptos are both the platform and the funding mechanism so can’t be separated from the development.

Bitcoin and Criminal Activity

It’s undeniable that historically bitcoin has been used by criminals to bypass financial controls, e.g. Silk Road and ransomware; however, there are serious misconceptions as well. I’ll offer some of my own thoughts.

  • All bitcoin transactions are part of the ledger and traceable. There are other coins or services on top of the bitcoin network that make transactions anonymous but bitcoin is open and fully transparent by design. The anonymity comes from the fact that addresses can be obtained easily and without any reporting mechanism.
  • I fully expect that US based exchanges and wallets to be required eventually to identify real persons behind the accounts ala the FINRA “know your customer” regulation. There will be efforts to register individual accounts and addresses. Coinbase will issue 1099’s & that’s probably a prerequisite for its IPO.
  • I have the mental picture of a large “gray goo” that represents all the bitcoin addresses. As legitimate businesses and individual addresses are certified, they become probing needles into this gray goo. Of course the gray goo is growing in size too, so it’s not so easy to limit nefarious activities. But the flip side is that it’ll be trivial to verify the legitimacy of funds and transactions which can be made into a requirement.

The last bullet point is why some believe “Satoshi Nakamoto” to be the evil incarnate (or a CIA agent, which is the same thing) bent on subverting individual freedoms. Now contrast that with those who believe bitcoin is invented for criminals, the dissonance is almost comical. I offer no personal opinion on this matter but thinking individuals should be aware of all sides of this issue.

Miners and Hedge Funds

Of the members of the bitcoin/crypto ecosystem, the miners have probably made the largest capital investment. They are also likely the largest beneficiary of the advancement in prices. There are staircase-like advancement in most cryptos, usually one after another. I have always thought it was the miners engaging in pump-and-dump to unload the results of their mining operations. I have no evidence of course. I simply put myself in their shoes and ask “what would I do?”, with the assumption that everything I can think of, plus plenty more, other people can think of. Anyway, as long as miners are in it for the dough, and the going is good, there is no reason to stop. In that vain, we must watch out for the next halving for an inflection point.

As I write this we’re still in the middle of a decline from early September where the spike low below $3000 represents a correction of over 40% in BTC. From Charlie Bilello’s table that could be the extent of this correction using the other two in 2017 as a guide. We know hedge funds are getting into this game. The new entrants are probably looking to load up since there are no easy way to short. We know the miners can’t leave the correction running too long or too deep, lest it gets “cold” and people lose interest. We also know the potential hard fork on Nov 1 could be a catalyst. So let’s see how things will play out.

Is Bitcoin a Bubble?

Well, fuck yeah! What else can you call it?! Now before you go sell off all your bitcoins make sure you read my views on bubbles. A statement like that has no meaning outside of the context of price targets and time frames (but it absolutely won’t stop people from issuing them). My own view as always been there is still one more leg of this bubble with mass participation to come, especially as the two main concerns mentioned above gets addressed. While we’re at it, here are some other thoughts related to bitcoin that may or may not be commonly accepted:

  • All currencies are based on confidence (hat tip to Martin Armstrong). Bitcoin is the opposite of fiat. It costs way more to mine a bitcoin than to print a federal reserve note.
  • Bitcoin is limited in number by design. Those who say there are be other cryptos so the supply is unlimited should look up the words “network effect”.
  • Crypto is an asset class. Claims of being currency are at best half-truth, just like every bubble needs some element of truth to get started. Bubbles are not about truth or falsehoods but the magnitude of expectations.
  • Hedge funds are rushing into cryptos like it’s a modern day gold rush. Except the gold is not the cryptos themselves but the masses that will loose their shirts.
  • In cryptos we may well be witnessing the repricing of a trillion-dollar asset classes, eventually. Just as the promises about the internet pretty much all came true, but the road was littered with carcasses like Webvan and Pets.com, and so will most altcoins.
  • Bitcoin will not be ALLOWED to reach 1 million (short of hyper inflation), at that point the whole lot will be worth 16-21 trillion. That’s simply too big a fraction of the world economy and such wealth transfer cannot be allowed.
  • That said I believe a price of $10-50K is totally possible or even likely.
  • The mass phase of the bubble will be signaled by something like a bitcoin ETF and/or Coinbase IPO. I would expect the price to double in several months to a year.

One thing for sure, crypto is a once in a life time opportunity. At times I find it a greater fascination to observe my own emotional reaction to the price movements. This self-awareness is at the root of my conviction that the mass bubble phase still lies ahead. Timing, as always, is everything.