Is bitcoin in a bubble?

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Bitcoin's transactional value might just prevent the asset's bubble from bursting and going the way of Tulip mania.

Do the soaring asset prices confirm that bitcoin is in a bubble? | Pixabay

Bitcoin is everywhere — in the news, in conversations, in the money market, even in ATMs. The cryptocurrency has gained so much attention that even the layman has his sights set on it. In the past year, the price of one bitcoin has shot up from a little over $1,000 to almost $20,000 and is now at hovering around $15,000 (as on January 9, 2018). That’s close to a 15x increase or a 1500% return and a 20-fold return at the peak. On the other hand, the Sensex and Nifty have a return of around 30%. If we were to expand our comparison and look at individual companies, even they grow generally between 50-100%. The magnitude of bitcoin’s asset appreciation and return is significant — parallels are being drawn with historical events such as the Tulip mania.

 

 

At the time of writing, bitcoin currently has a market capitalisation of over $250 billion. If it were a country, it would be on the list of top 50 counties by nominal GDP. It is even larger than many corporations that have a global presence including GE, Disney, IBM and McDonalds.

The fundamental question here is: what is driving the price of this cryptocurrency? The second question that naturally follows is, is this a bubble?

What is driving the price up?

The first perhaps is the interest taken by large investors as they looked out for new assets to invest in, even as they gained a better understanding of the blockchain’s underlying technology as well as the cryptocurrency.

 

 

 

Also, bitcoin does not have a central regulating authority, which means there are no capital requirements or other regulatory restrictions that are otherwise present in other asset classes. This has happened in an incremental way. As people saw others being successful, they also ventured into this asset.

 

 

 

Then there is the increased faith or recognition of the system. Our entire monetary system since metallic currency has been based on the shared faith in the said item of legal tender, an item which has no intrinsic value in and of itself. Like the many other constructs we have created through consensus over time, it exists in our shared imagination. This has allowed international currencies to be used in domestic transaction. A very recent example of this is the use of the Indian Rupee in Kuwait up till the 1960s.

Similarly with bitcoin, if and only if everyone subscribes to the belief that it is an asset will money flow into its market. The spread of this shared belief has helped create a market. The user base has doubled from about 10.9 million users at the beginning of 2017 to about 21.5 million on January 1, 2018. This belief is further bolstered by the legitimisation of cryptocurrencies and bitcoin as an asset class — the U.S.’s largest options exchange CBOE, the world’s second largest stock exchange NASDAQ, and CME, one of the world’s leading derivative marketplaces have either launched or intend to launch bitcoin futures contracts. There has also been an increase in the adoption of bitcoin as a means of payment. Companies such as Microsoft, Overstock, Reddit, Subway, Bloomberg accept payment by way of bitcoin.

The net result has been an increase in the amount of money flowing into Bitcoin, which has shot the prices up. The growth in transaction volumes show an upward trend over a two-year period (2016-present) — the increase in number of users is a clear indication of interest. And since the growth in demand for bitcoin significantly outpaced the growth in its relatively low supply, the gap is reflected in the significant rise in its price.

 

The above approach has also been reflected in the way pricing has happened. Whenever the price has moved upwards, the previous price seems cheaper and gives way to more forward momentum. Pricing has happened in an incremental way with heavy optimistic leanings where the market is quick to react to good news. By the same token, when China banned its citizens from trading in cryptocurrencies, bitcoin prices fell. The network lost almost 15% of its trading volume as the Chinese exited the market. Whereas, when CME group and NASDAQ announced that they would be launching derivatives based on bitcoin, the markets rallied immediately. This is one of the drivers that has continued to push the prices up.

The extreme price fluctuations in the bitcoin market have resulted in many jokes and memes. It is this pricing behaviour which leads us to wonder if this is a bubble.

Is it a bubble?

 

 

As per Investopedia: “A speculative bubble is a spike in asset values within a particular industry, commodity, or asset class. A speculative bubble is usually caused by exaggerated expectations of future growth, price appreciation, or other events that could cause an increase in asset values. This drives trading volumes higher, and as more investors rally around the heightened expectation, buyers outnumber sellers, pushing prices beyond what an objective analysis of intrinsic value would suggest[...] until prices fall back down to normalised levels; this usually involves a period of steep decline in price during which most investors panic and sell out of their investments.”

Our current scenario matches all these characteristics. The question we are essentially asking is: are the current price levels sustainable? To answer this, we need to establish the intrinsic value of the item in question. Bubbles occur when an asset’s market value significantly outstrips the intrinsic value.

The most elementary way to approach price discovery in economics is through the forces of demand and supply. This is perhaps the first instance in recent history that an item is completely unregulated and open to free market forces to act in an unrestricted manner to create price discovery. Normally you have circuit-breakers and other such barriers like in stock markets and other asset classes. There is a free reign given to free market forces. This process is a very messy process as we can see with price fluctuations.

But there still a need to arrive at an intrinsic value of the asset. People have now started looking at different valuation methods to understand how to value a cryptocurrency. Chris Burniske and Jack Tatar launched a book last year titled Cryptoassets: The Innovative Investor's Guide to Bitcoin and Beyond. It outlines a method to understand the value of the asset using the Fisher equation (MV=PT) and the concept of utility value. From the total addressable market, they set a belief about the market penetration and transaction velocity. Based on the utility value arrived at combined with the total number of coins available, one can arrive at the value per coin. This is a very elegant way of pricing a cryptoasset.

 

 

As elegant as this model may be, we must recognise that the bulk of the participants in the market are ‘investors’ and not people who use the cryptocurrency to transact. Thus, this does point to signs of a bubble.

But the bubble argument isn’t complete. Prices have to fall back to ‘normalised’ levels as the bubble bursts. What makes Bitcoin different from Tulip mania or any other such artificial inflation is that here we are talking about a currency whose transaction value is being recognised and accepted. There is some intrinsic value in transaction, and an ecosystem is developing that accepts this as a mode of payment. If a large portion of the people holding bitcoin wake up one fine morning and suddenly decide to start regularly using bitcoins in transacting, the ‘expected’ bubble-burst will never come. There undoubtedly will be a correction.

Such is the nature of free market price discovery. But it may not be to the tune that people expect in a ‘bubble’ and the valuations from these models may actually be justified. Thus, bitcoin ending up being a bubble isn’t necessarily a logical conclusion of the argument. The future is inherently unknowable. This brings to memory Former US Secretary of Defence, Donald Rumsfeld’s quote: “There are known knowns — these are things we know that we know. There are known unknowns — that is to say, there are things that we know we don't know. But there are also unknown unknowns. There are things we don't know we don't know.”

(Unless mentioned otherwise, all figures and statistics pertain to January 1, 2018)

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