Bitcoin Boom: The Next Bubble?

Posted in Finance Articles, Total Reads: 1024 , Published on 15 December 2017
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First it was the tulips, then the dotcom, followed by the housing market. Now, the recent meteoric rise in Bitcoin prices have prompted wall street experts to think: Is Bitcoin boom the next bubble?

A brief background

Bitcoin is a cryptocurrency which came into being in 2009. Created by the yet unidentified Satoshi Nakomoto, it is based on the ideas put forth in a white paper created by him. The interesting fact is that Bitcoins have no physical existence. They merely exist as balances in a public ledger strewn worldwide over a cloud based system. It is open-source and not owned by any central authority.


Image: pixabay


The general exuberance surrounding Bitcoin

On its launch in 2009, the value of a Bitcoin was around 1/80000th of a dollar. This rate was essentially derived from the cost of electricity used by a computer to ‘mine’ (i.e. create) a Bitcoin. Fast forward to 2017, the price of 1 Bitcoin equals around 7000 US dollar. Moreover, the prices have risen acceleratingly. It took 1789 days for Bitcoin to go from a value of 0 to $US1000. Then around 1200 days to get from $US1000 to $US2000. But in just 13 days, it jumped from $US6000 to $US7000, its latest milestone. The price rise is almost twice as fast as that of internet stocks at the peak of dotcom bubble. The Chicago Mercantile Exchange (CME) plans to launch Bitcoin futures in Q4 2017. The largest US options exchange, Chicago Board Options Exchange(CBOE) plans to offer Bitcoin futures beginning 2018. The Japanese authorities allowed shops to accept payments in form of Bitcoins starting this year. The general investor sentiment regarding Bitcoin is largely exuberant.

 

Why this exuberance is irrational

Considering that the underlying definition of its value being electricity-dependent has remained unchanged, the recent price rise has been on purely speculative grounds. Although people speculate on commodities like gold, the underlying difference is that the gold mined is tangible and can be measured but the same cannot be said for the Bitcoin. The investments in Bitcoin are merely bets that the price will go up further. In accordance with the greater fool theory, people expect others will buy from them at higher prices. This prompts them to keep on buying Bitcoins. However, Bitcoins possess liquidity issues. If someday, all the investors simultaneously decide to monetize this wealth trapped in Bitcoins, the market would crash. All investors would want to sell first, sending the prices in a downward spiral.

Bitcoin is so volatile that its prices get affected by the slightest geopolitical disturbances. They recently fell by 30% following reports from China putting curbs on Bitcoin trading. Unlike traditional assets, there is no way to mathematically calculate a Bitcoin’s volatility. People keep investing without being fully aware of the risks. Another chink in the Bitcoin armour, are the issues of fraud surrounding it. In the past, there have been instances like Mt. Gox, where the founders declared bankruptcy and Bitcoins worth $450 million were lost in a blink of an eye, apparently stolen by hackers.

Bitcoins are loosely regulated. There is no end guarantor like a central bank unlike fiat currencies. If someone is ripped off in a Bitcoin transaction, there is no way for him to get that money back. Texas financier Trendon T. Shavers created a Bitcoin Investment Trust, only to con his clients in a Ponzi scheme of millions of dollars. Shavers would get new investors via online forums, then use their investments to pay his old clients. He then used these funds for his personal purposes.

Bitcoin is based on the distributed ledger technology, blockchain. All the end-users in the distributed blockchain run the same code. So, a single bug can paralyse the entire system. The Bitcoins are generated by a process called mining. If someone controls more than half of the computing power being used for mining, the blockchain system may become a victim of the 51% attack. The attacker can effectively write an alternative financial history and make that version the ‘original’ one. In effect, the same money can be reused. Such problems never arise in traditional currencies.

Also, blockchain technology is not really secure. The lure of anonymity attracts many more criminals. In 2011, online media company Gawker discovered Silk Road, an underground website that was used as an eBay for illegal drug trafficking. It becomes difficult to track the fraudsters and criminals in an unregulated system. This may be fatal for companies as all their financially sensitive information will be out in the public domain.

Despite these glaring flaws, there is a hype surrounding blockchain. VCs are investing huge amounts in blockchain technology as well. Recently, a British firm named On-line Plc saw a 394% surge in its share price by merely changing its name to On-line Blockchain Plc. The exuberance surrounding the crypto currency and its underlying technology is far removed from its reality. This is something the wall street bigwigs are sceptical of. Goldman Sachs’s CEO Lloyd Blankfein expressed his doubts on Bitcoin saying he is still uncomfortable with Bitcoin, referring it to ‘consensus’ money. JP Morgan CEO, Jamie Dimon referred to Bitcoin as a fraud and equated its rise to the tulip mania and BlackRock CEO referred to Bitcoin as an index of money laundering.


Conclusion:

Given the contrast between the actual situation of the Bitcoin and the investor sentiment surrounding it, the Bitcoin situation may look similar to an economic bubble. However, unlike the previous bubbles which were realized only in retrospection, in the case of Bitcoin, the market experts and Governments are forewarned. If Government could bring Bitcoin transactions in legal purview, the exploitations of its anonymity can be kept under check. It would also help deflate the prices to reasonable levels. Also, as of now, the total market value locked in Bitcoin is reasonably small when compared to the popular assets. This fact offers some solace. However, long term regulatory policies need to be developed to keep the possibility of a potential bubble at bay.

 

This article has been authored by Aakanksha Raj from IIM Calcutta

 

References:

• www.economist.com/blogs/buttonwood/2017/11/greater-fool-theory-0

• money.cnn.com/infographic/technology/what-is-Bitcoin/

• www.bloomberg.com/news/videos/2017-11-01/Bitcoin-what-s-coming-in-the-year-ahead-video

• f-g-c.com/bitcoin-may-not-make-sense-but-its-bubble-is-not-about-to-burst-just-yet/


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