Winklevoss Twins Bitcoin Folly

January 8th, 2018 by

Cameron and Tyler Winklevoss are a pair of Harvard-educated Olympic rowers who gained notoriety by successfully suing Mark Zuckerberg, the founder and CEO of Facebook, for essentially stealing their intellectual property while the three attended college together. (A dramatized account of how this legal battle began was portrayed in the film The Social Network.)

Now they are better known for their massive investment in bitcoin.

The Winklevoss twins—who are identical twins and sometimes sarcastically called “the Winklevii” collectively—not only won a $45 million settlement in the Zuckerberg case, but also received a significant portion of their award in Facebook stock rather than cash. Those shares eventually grew to a $300 million fortune.

The twins are now venture capitalists, and they recently generated renewed media attention by becoming some of the first well-known “Bitcoin Billionaires.” A glowing profile of the Winklevoss twins in the New York Times confirmed that the brothers bought over 100,000 BTC years ago, when the price was about $10. They claim to have held onto their entire principal investment. That would make their position worth nearly $2 billion.

There are two glaring follies at the heart of the twins’ entrepreneurial success story, however. First, the Winklevosses are front-and-center in marketing and publicizing bitcoin in a manner that smacks of price manipulation. Second, their own security practices regarding their digital wallets reveals the vulnerability of the the current cryptocoin ecosystem.

Gemini

The Winklevosses run their own bitcoin exchange licensed in New York called Gemini. It holds bitcoin and other various cryptocurrencies on behalf of banks and traders, perhaps acting like a clearing house for other crypto-related transactions. (They supposedly own an additional $350 million portfolio of smaller digital currencies.)

This is one move the twins have clearly made to advance the legitimacy of bitcoin. In fact, the quoted bitcoin price on Gemini is the benchmark used for the newly introduced CBOE futures contracts for BTC.

The problem, however, is that the trading volume on Gemini is still very small compared to the entire landscape of unregulated cryptos. It seems odd that it’s already being used to price futures contracts. Moreover, prices often vary wildly from one exchange to another, a sign of an inefficient and underdeveloped market. According to Bloomberg‘s finance columnist Matt Levine, the bitcoin “spot price” must be indexed from five different cryptocurrency exchanges.

This is why the promotion efforts by the Winklevosses borders on manipulation. Levine explains:

“Bitcoin futures volume is — so far — a tiny fraction of bitcoin volume, but Gemini’s auction volume is — so far — a tiny fraction of that. If you’re long $10 million of futures, you can afford to buy $2 million of bitcoins at stupidly uneconomic prices in the Gemini auction to manipulate your futures prices higher: Every extra dollar you pay in the auction makes you five extra dollars on your futures settlement. And if the auction volume is only $1.3 million, a little manipulation can go a long way. I guess this works almost as well if you’re short the futures, though, so Gemini is probably right that its volumes will increase: Anyone who wants to manipulate the futures price in either direction will know where to go.”

Levine adds, “Perhaps [the longs and shorts will] balance each other out.” This seems like wishful thinking.

Maybe it shouldn’t be surprising that the Winklevoss twins may be engaged in manipulating the cryptocurrency market—or at least providing an avenue for others to do so. In some ways, the current bitcoin market operates a bit like a pyramid scheme: just 1,000 people own 40% of all available bitcoins!

Interestingly, much of the world’s bitcoin trading is done on margin. You can buy bitcoin with 15 times leverage on the initial deposit to your trading account on some exchanges. In other words, it lends itself to highly speculative behavior. Leveraged bitcoin ETFs may even be coming soon, which would worsen the problem. The presence of such mounting counterparty risk (i.e. lenders and exchanges stand to lose your money if BTC prices drop) is one reason that Patrick Watson of Mauldin Economics warns that bitcoin could pose a devastating systemic risk.

Security

Aside from the problems with Gemini, the lengths the Winklevoss twins must go to protect their bitcoins are rather strange. They rely upon an unsophisticated technology relative to the blockchain: ink and paper.

The twins printed out the private key (or password) to their bitcoin wallet in physical form, and then broke the key into four-character chunks. Then they put those portions of the key onto separate slips of paper and placed them in bank vaults spread across different locations around the country for safekeeping.

The irony is that this practice reveals the considerable vulnerability that exists with digital wallets and crypto exchanges. So many have been hacked already. A security breach last month of the South Korean exchange Youbit forced the firm to declare bankruptcy and shut down. Even if someone trading bitcoin avoids getting hacked, they are still vulnerable to losing the value of their account due to price volatility or fraud. In Ukraine, one bitcoin analyst from the U.K. was kidnapped after Christmas and only released after a $1 million ransom was paid in bitcoin.

The problem is not the blockchain technology itself but how it’s being applied and leveraged by the existing financial system and people like the Winklevosses. Like all good ideas, it’s dangerous to the state and banking monopolies over money. Several state governments are pushing back against the free use of cryptocurrencies. India has threatened to tax it heavily, China and Israel have banned bitcoin trading, and the grand mufti (Islamic religious leader) of Egypt has suggested that virtual currencies are forbidden in Islam.

Investors will continue to try and break down the idea of bitcoin as it becomes more widespread. Many will buy it even without understanding what it is. The rise of cryptocoins has many parallels to the dot-com frenzy of 1999-2000: e-commerce has reshaped the marketplace today, but not before Wall St got ahead of itself and caused a huge bubble of inflated prices to collapse. The same is probably true of digital currencies. Even if the concept underlying bitcoin (the blockchain) eventually revolutionizes the financial sector, there will be a lot of growing pains between now and then.

 

The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.