Cryptomania: When Cryptocurrencies Hit Bubble Territory
With cryptocurrencies having lost $30 billion in market cap in just over two weeks, it’s not only the skeptics who are asking whether the bubble has finally burst.
It’s true that prices have risen parabolically since the beginning of the year, with the value of all cryptocurrencies rising from $17.6 billion on Jan. 1 to $115 billion in mid-June—but this fact alone doesn’t make the sector a bubble.
Big winners in the tech sector that survived the bursting of the year 2000 tech bubble logged returns of 100-fold, although it took them many more years, and their market caps were significantly larger to begin with. Apple, for example, went from a split-adjusted $1 in 2000 to a high of $100 in 2012 before a more prolonged correction.
Penny stocks, the equivalent of most cryptocoins (not including bitcoin and ethereum), can easily perform as well in as short a time.
To answer the question of whether crypto is a bubble, and whether it has burst, we can look to bubble economics. In this, we can see that while part of the market is not only a bubble, but even fraudulent, the bigger cryptocurrencies only share a few of the characteristics of genuine bubbles.
Is Bitcoin a Bubble?
Bitcoin, the biggest of the cryptocoins, is the bellwether of the sector, like Apple is to tech stocks.
Because of its size, age, and proven track record in financial transactions, it exhibits the fewest bubble characteristics.
“The value for money is subjective,” said blockchain and bitcoin researcher Saifedean Ammous. “People put value on it and people are willing to accept it. Millions of dollars of bitcoin are changing hands every day. You can find a liquid market around the world.”
Bitcoin actually has a use and provides a valuable service. With a market cap of $39 billion, and with some privacy features outside the banking system, it is relatively cheap compared to other forms of money. Gold is valued at $7 trillion to $10 trillion, while global fiat money ranges from $50 trillion to $100 trillion.
The fact that it has a use differentiates it from the 17th-century Dutch tulip mania, for example, in which people bought tulips as an asset that had no use other than for beauty and status. During the mania, tulips were also valued at much higher prices than other flowers, making them relatively more expensive. The speculative frenzy was widespread through society, with everybody who could afford to do so speculating in tulips, hoping to sell out at a higher price.
To some degree, this also applies to bitcoin. “[This is called] the greater fool theory: ‘I’ll pay $2,000 for bitcoin because I think there’s some sucker who will pay me $3,000.’ And that guy says, ‘Well, I’ll pay $3,000 for a bitcoin because of some sucker that will pay me $4,000,'” James Rickards, author of “The New Case for Gold,” told The Epoch Times, in a previous interview.
Although bitcoin has a fast-growing following and there are many who buy it simply hoping to sell it at a higher price, only a fraction of people around the globe own a bitcoin wallet or have transacted in the currency. An easy test is to ask your colleagues how many own bitcoin. Chances are, only 1 in 10 do.
This is again different from the NASDAQ bubble of the 1990s, when every person who could open an E-Trade account was speculating in tech stocks. How many of your colleagues were stockpiling shares in WorldCom and AOL Time Warner back then?
In terms of popular sentiment, outside the group of cryptofans, most of society is rather skeptical of bitcoin, including most media organizations. Yet there are some outliers whose euphoria has led them to predict bitcoin will hit $1,000,000, making it the world’s next reserve currency.
Another important element in all bubbles is speculating on margin and borrowing to invest. This practice is inherent in all true bubbles, but the best example of this is the stock market crash of 1929.
In a rising market, speculators can borrow money to buy stocks, pushing them even higher. Because the speculators’ assets have risen, they can borrow even more money to buy more stocks. This process works until it doesn’t and leads to a violent crash.
When stocks start falling, the collateral for the margin loans is worth less and less, triggering so-called margin calls and more sell orders, leading to lower prices and—you guessed it—more sell orders. The vicious cycle repeats itself until most of the margin debt is wiped out.
Margin buying has also been included on most bitcoin exchanges and is part of the reason for the violent price swings, though it’s impossible to tell how much margin is being used, because the exchanges don’t report that number.
Bitcoin is not a fraud because there is no deception involved, nor any promises of exceptional returns. Its only promise is the faithful execution of its protocol, which it has been doing for more than eight years now.
It is also not a Ponzi scheme, which promises returns it can’t deliver and uses the money paid in by later investors to provide economically impossible returns to older investors—until the scheme collapses.
Altcoins, the Real Bubble
However, while bitcoin is only semi-bubbly, other cryptocoins and tokens, or altcoins, don’t have that luxury.
“Most of them aren’t connected to value in any way. There is a service, but if the service makes money, then you don’t get any dividends. It’s like buying a Starbucks gift card and its value is going up,” said Daniel Krawisz, director of research at the think tank Satoshi Nakamoto Institute.
So while bitcoin may have a use as money, many of the altcoins don’t. Even ethereum, the second-biggest cryptoplatform, technically isn’t a currency, as its tokens are used to power its network of smart contracts.
However, despite massive corporate sponsorship and a great marketing campaign, ethereum has failed to produce a sizable commercial application. With its high price and its failure to deliver on its main use, ethereum meets some of the criteria of a bubble, though the feasibility of the protocol could change if it is adopted by a larger commercial application.
Ironically, major media companies and big corporations are more positive about ethereum than bitcoin, making it more of a candidate for a bubble.
One of the use cases that could prove the viability of ethereum could be international real estate transactions on its blockchain. San Franscisco-based startup Propy wants to deliver this service by December.
“Today, a buyer from China or the Middle East who wants to invest in U.S. real estate, once they choose the property, needs to sign papers offline. They need to go to the bank—all the steps are offline. With propy, the Chinese buyer comes and makes a decision to buy the house and then everything happens online. The outcome of the process is secured by a smart contract,” said Propy CEO Natalia Karayaneva.
The prototype will still work with the local bureaucracy to secure the title deed, but Karayaneva hopes that in the future, the propy blockchain will serve as the standard for real estate transactions, making localized record keeping unnecessary.
In order to develop the product, the company is selling $35 million worth of tokens in an initial coin offering (ICO) in July. The initial coin offerings are easier to do than selling securities through an IPO, because there are fewer regulations. Also, the company does not have to dilute its ownership, which is a convenient way to raise money.
All the buyer of the token gets is the right to participate in the propy blockchain, a right that is hard to value at this point in time because the end product doesn’t exist yet—another bubble indicator.
Ammous, the bitcoin researcher, thinks this type of high-risk funding should be left to professional venture capitalists. “If you have a good idea, you can get funded. The ICOs are saying you can participate by clicking a few buttons.”
And while the propy ICO has a real company with real people behind it, the sheer number of ICOs with much more shady characteristics fits another bubble indicator, similar to the IPO frenzy of the late 1990s. In July alone, there will be nine more ICOs, including propy.
“These ICO people can take a month to make a new copy of the bitcoin protocol and then they have a Pink Coin or whatever. For some reason, they need tens of millions of dollars to make these things. And then they have to keep more than half of it because they are the geniuses who came up with it,” said Krawisz.
While the team at Propy won’t get any of the tokens or money raised, except in the form of salaries, and it is just a risky investment proposition, there are other ICOs that appear to be outright scams, like eros.
In the eros ICO, from which the two founders so far have raised $204,000 out of the targeted $10 million, the tokens are supposed to be used on a decentralized and censorship-resistant marketplace for prostitution.
However, looking past the illegality of this proposition in many states, the two founders just copied their whitepaper, or token prospectus, from another offering and changed a few words. After this was found out, they deleted the whitepaper from the website.
Moreover, a team of two is insufficient to develop a unique software like this, especially when the chief programmer doesn’t have any activity listed on GitHub, an open source programming database.
“None of those are going to make any profits. But the creators will dump the tokens before everybody else,” said Ammous.
Insiders selling first—that’s another classic bubble indicator.