## Friday, February 23, 2018

### Bitcoin, scarce cryptocurrencies are stocks in (hopeless) companies

The most adequate analogy should define the rules of taxation

Various central banks and regulators are trying to ban, suppress, or regulate the cryptocurrencies in one way or another. Others are preparing their own cryptocurrencies and join the irrational but widespread hype about the blockchain technology. Yet another group of central banks does both. The Polish central bank has paid some amusing $25,000 to Polish YouTube star to write texts and record videos such as I Lost All My Money about the cryptocurrency "investments". Czechia is the home to the largest non-Chinese and oldest Bitcoin mining pool, SlushPool, and there is a detectable important community that does these things. But cryptocurrencies remain a fringe phenomenon and that's also reflected by the attitudes of the Czech National Bank. Our central bank – typically echoing the views of Mojmír Hampl, the most active member of the board in such matters – says that it's right not to harm them, not to help them, not to protect them, and not to guide them by holding their little hands because they're irrelevant for the system and the Czech participants ultimately know what they're doing and that they enjoy no protection. The percentage of the wealth in the cryptocurrencies is very small and the percentage of the money in the real economy that goes through cryptocurrencies is even tinier. So the skeleton of our monetary system is in no way threatened. I agree it's true in Czechia but due to the ability of these bubble phenomena to rise exponentially, this assumption may very well break down in countries affected by a mania – such as South Korea. A repeating question is "what kind of an asset the Bitcoin and its volatile siblings are?". Are they currencies? Are they stocks? Derivatives? Commodities? Some pundits have pointed out that the Bitcoin buyers are like stamp collectors or the collectors of rare coins. The value is supposed to arise from the small number of copies that are out there. There aren't many people who own it and that's why it's a great idea to be one of them and pay lots of money for the stamps. Paying almost$10,000 for a Bitcoin – because there are just 17 million of them and the number won't ever surpass 21 million – follows a similar logic.

Well, the Czech National Bank has actually joined this interpretation, too. Bitcoin hodlers are a new generation of relatives of the collectors of stamps and rare coins, not to mention some crazier things (basketball trading cards) that people have been feverishly collecting. But stamp collectors are considered hobbyists. The purchases and sales of such things often take place in very informal circumstances and I believe that when the stamp collectors make some profit from a "complete cycle" of purchases and sales, most of them aren't taxing their profit at all. Am I wrong?

On top of that, there can't be any "truly complete" database of the kind of rare stamps and coins that you may own or be obsessed with. For those reasons, I think that the analogy between the Bitcoin and the stamps is misleading and unusable e.g. for taxation of the Bitcoin profits.

The Bitcoin is surely not a currency because it's not a trustworthy storage of value that could be effectively used as payments and compensation. One could say it's a commodity because the amount of a commodity is "roughly constant" and the price may vary rather dramatically. But the similarities between the Bitcoin and commodities such as metals are very limited: a chaotic graph and "approximate scarcity" are the only independent things they have in common.

At the end, I think that the Bitcoin totally falls to the category of a stock.

The only problem is that the company that you own produces zero profit and pays zero dividends. But you hold many ordinary stocks that also don't pay dividends for years and they have a value. You hold them because there are real assets behind the stock plus a hope that in the future, they will generate dividends again.

It's analogous with the Bitcoin. When you own a Bitcoin, you own one stock among 17 million in a company that just produces zero dividends (in dollars) and the rules indicate that it will always be so. But you pay for the stocks, anyway, because you believe that by being a shareholder, you possess some amazing invisible virtual assets. And sometimes in the future, the Bitcoins could produce dividends made out of unicorns.

When miners produce 12.5 new Bitcoins every 10 minutes in average, they are issuing new stocks. The key fact is that the total number of stocks in circulation is completely known and, in the Bitcoin case, perfectly planned. So the shareholders may use this perfectly well-known information to figure out what their investment is worth and whether they should buy or sell, reduce or accumulate.

The "miracle" of the Bitcoin and its approximate clones is the public-domain method to remember who owns which stocks. That's nice but sane investors don't really care about the precise method that remembers your balance in a database of the shareholders. A sane investor cares what he owns, not what is the shape of the paper or computer on which it's recorded that he owns it. The ordinary methods to remember and update the owners work just fine – the risk that they don't work doesn't significantly affect the stock prices. The Bitcoin hodlers are confused and they think that these details affect the price of the Bitcoin and that's how many of them explain why they bought into it.

But rational people know that this is just some irrational and emotional gibberish that pushes these people to do what they do. It doesn't matter at all what precise method is used to remember the ledger – and decide about the number of stocks that you currently own. Lawmakers and regulators should acknowledge the people's occasional irrational behavior and their right to behave irrationally but they shouldn't behave irrationally themselves.

The Bitcoin miners play the role of the managers of a company that is issuing new stocks because the decision to issue new stocks has been previously made by the shareholders' meeting. In 2009, Satoshi Nakamoto was the only shareholder of the Bitcoin stocks and he made the decision to issue new stocks according to the plan. Every 10 minutes, 50 new Bitcoins (stocks) were supposed to be issued in average. The number got halved in 2012 and 2016 and it does so once in four years.

What happens when there are $$N$$ stocks and you issue $$\Delta N$$ new stocks? Well, the total company (and its dividend profit, if any) was divided to $$N$$ stocks before the event but $$N+\Delta N$$ after the event. So rationally speaking, the price of the stock decreases by the factor of $$N/(N+\Delta N) \lt 1$$ at the moment when $$\Delta N$$ new stocks are issued. Because each old shareholder has a fixed number of stocks and their price goes down, his net worth goes down, too. The company gets new cash (dollars) by selling the newly printed stocks. The cash becomes an asset of the company and the total value of the company increases by the cash from the sale of new stocks during this operation – but after the new stocks are issued, it's divided among a larger number of shareholders. You expect these two effects to exactly cancel when it comes to the impact on the old investors' wealth. When new stocks are issued and sold, the company becomes more cash-like or diluted in cash but the value of the old investors' holdings is the same.

The increase of the number of stocks has indistinguishable real-world consequences from the following operation: At the shareholders' meeting, it may be decided that instead of issuing new stocks, all shareholders will sell the same fraction of their investment in the company. The fraction of his current stocks that he sells is equal to $$\Delta N / N$$. In both versions of the event, the ratio owned by the old and new shareholder is $$\Delta N:N$$. To make the operations really indistinguishable, you could clump the new stocks in the first case (or make a split in the second procedure) by the factor of $$N / (N+\Delta N)$$.

The Bitcoin "company" hires public folks with the mining hardware (GPU and ASICs) as their managers who physically issue the new Bitcoins (stocks). But the decision to actually issue them at some rate has been made by the shareholders – by those who hold the Bitcoins. It's expected that the rules will remain the same. But the miners, even though they're seemingly hired to do just some technical task whose basic purpose has been decided by shareholders, may actually "steal" the Bitcoins by performing a 51% attack. The Bitcoin holders have agreed to consider such a modification of the ledger to be legitimate. Even if they didn't, I think that no courts in the world would treat a 51% attack as an actual crime (shooting a monster in a computer game isn't a crime in "most" countries, either, and the 51% attack is formally just another thing you can do in a computer game). So it's the shareholders' risk. A lesson clearly is that the public blockchain method to update the database of shareholders makes it less safe, and not safer, for the shareholders than the old-fashioned methods where a thief may be held accountable and the theft may be reversed with the help of police and courts.

On top of that, the miners pocket all the money from the newly minted Bitcoins (most of this money is wasted for electricities and hardware). It's just like secretaries in a company who remember who bought the newly issued stocks and who pocket all the money collected from the sale of the new stocks! Imagine how stupid the shareholders would have to be to pay the secretaries this much. For some reason (I won't use the term "staggering idiocy"), the Bitcoin "shareholders" think it's a good deal. So far, most of the time, their bubble has been inflating so quickly that they haven't noticed what kind of an incredible waste of money they're doing on a daily basis.

At any rate, I think that the profit from the purchases and sales of the Bitcoin and similar cryptocurrencies should follow the precise recipes for capital gains from stocks. Things are simpler in the Bitcoin case because you may assume that the dividends will always be zero. But there may be capital gains and losses and those may be said to work as a special case of stocks.

It's funny to compare the Bitcoin to some actual companies. Take Kofola Czechoslovakia. It's sold for some CZK 411 ($20) now a piece. It's the producer of the legendary "Czechoslovak answer to Coke and Pepsi". Well, Kofola is special, it tastes significantly different, and some people may even hate it. But due to the retro spirit and people's habits, a bottle currently costs more than the same bottle of Coke! During communism, some research institute was ordered to find a useful application for some waste products during the production of coffee and they invented Kofola. After the fall of communism, the brand was resuscitated as a capitalist company by a skillful immigrant from Greece. One reason why Kofola is a particularly good company to be compared to the Bitcoin is that the total number of Kofola stocks is about 23 million, very close to the number of Bitcoins. So let's compare the Kofola Czechoslovakia company and the Bitcoin "company". They have both around 20 million stocks. The number is guaranteed not to grow, and if it does grow, the growth is controllable and has some advantages for the old stockholders (the company gets extra cash). A difference: Kofola produced dividends CZK 13.5 before taxation in the most recent year. The Bitcoin has produced zero. Kofola's market capitalization is some 9 billion crowns – less than half a billion dollars. It produces drinks that are considered a "cool brand" by some people from my generation in Czechoslovakia and the brand is considered worthless by many others. It sounds just like the Bitcoin. But there's still a difference: the Bitcoin hasn't produced a single bottle yet. It doesn't have any magic juice that some people may find tasteful or legitimately addictive. The Bitcoin "company" also produces zero iPhones, zero hamburgers, zero gallons of petrol, and zero of anything else, too. Nevertheless, while these are similar companies – with the difference that Kofola produces much more than the Bitcoin – and they have about the same number of stocks, the price of the Bitcoin is$10,000, about 500 times higher than the price of one Kofola stock. How is it possible that a drink producer Bitcoin that produces nothing compared to the nontrivial production by Kofola ends up costing 500 times more?

It's all about the brand and the irrational obsession of a sufficient number of people by the brand. Kofola is a good enough brand in some corners – as I said, you can sell lots of bottles for a higher price than the actual Coke. But the Bitcoin is a much more addictive brand. Even though those people get less than one droplet of their Bitcoin Kool-Aid, namely zero, they are still willing to pay 500 times more for a stock. In fact, it seems that the Bitcoin hodlers consider the "complete emptiness" of the Bitcoin to be a virtue, nor a vice. If you added a Kofola stock to every Bitcoin, the price of the Bitcoin wouldn't go up by $20. It could go towards zero, close to$20, because many people would realize that what they have actually is a Kofola stock and nothing more.

(The family of the late Greek Czech business has been accumulating the stocks to overtake the whole company again but some leftover of the stocks may still be traded at the Prague Stock Exchange. The stocks' performance at the Prague Stock Exchange has been a disappointment.)

The reason why I think that countries should classify Bitcoin-like cryptocurrencies as stocks (with zero dividend) is that stocks are the only well-known existing assets whose (high enough) price depends on the precise knowledge of the number (of stocks) that are out there. This is a property not shared by the fiat currencies (which may be printed and there are good reasons for that) and not even by commodities (metals may be mined and the mining may actually speed up if you pay to the drilling companies) or stamps (some number of rare stamps was printed and may be known but the number of those that have survived is smaller and unknown). On top of that, the Bitcoin forks have a counterpart in the stock splits (including splits of companies), too. The accounting rules are or may be isomorphic, and I think that the taxation rules should be the same, too.

If the cryptocurrency capital gains were taxed just like the stocks, there would be no need to invent anything new. Hodlers just need to learn how capital gains from stocks are taxed in one nation or another. (Weeks ago, I wrote a cool code in Mathematica to calculate my capital gains from individual stocks that were unusually positive in 2017. The broker doesn't provide us with these results itself and I believe that 99% of the traders must be unable to make the calculations that I have done.)

Of course, I tend to think that these recommendations come too late. The year when these people made some significantly taxable income was 2017 and it seems rather likely to me that all the following years will bring losses – and maybe the year 2018 will be the last one when this activity will exist at all.