Bitcoin has risen 10x in value so far in 2017, the largest gain of all asset classes, prompting sceptics to declare it a classic speculative bubble that could burst, like the dotcom boom and the US sub-prime housing crash that triggered the global financial crisis. Stocks in the dotcom crash were worth $2.9tn before collapsing in 2000, whereas the market cap of bitcoin currently (as of 03.12.2017) stands at $185bn
, which could signal there is more room for the bubble to grow.
Many a financiers and corporate stars think there is a bubble and a huge opportunity. One of the biggest bitcoin bulls on Wall Street, Mike Novogratz
, thinks cryptocurrencies are in a massive bubble (but anticipates
Bitcoin reaching $40,000 by end of 2018). Ironically (or not), he’s launching a $500 million fund, Galaxy Digital Assets Fund
, to invest in them, signalling a growing acceptance of cryptocurrencies as legitimate investments. John McAfee
has doubled down on his confidence
in bitcoin by stating his belief it will be worth $1 million by the end of 2020.
Former Fed Chairman Alan Greenspan has said
that “you have to really stretch your imagination to infer what the intrinsic value of bitcoin is,” calling the cryptocurrency a “bubble.” Even financial heavyweights such as CME
, the world’s leading derivatives marketplace, is planning to tap into this gold rush by introducing bitcoin
derivatives, which will let hedge funds into the market before end of 2017.
Bitcoin mania has many parallels with Mississippi Bubble
Bitcoin’s boom has gone further than famous market manias of the past like the tulip craze or the South Sea Bubble
, and has lasted longer than the dancing epidemic
that struck 16th-century France, or recent dot.com bubble in 2000
. Like many others events such South Sea Bubble, ultimately, it was a scheme. No (real economy) trade would reasonably take place but the company’s stock kept rising on promotion and the hope of investors.
In my view, a more illustrative example, with many parallels for Bitcoin, is Mississippi Bubble
, which started in 1716. Not only was the Mississippi Bubble bigger than the South Sea Bubble, but it was more speculative and more successful. It completely wiped out the French government’s debt obligations at the expense of those who fell under the sway of John Law’s economic innovations.
Its origins track back to 1684 when Compagnie du Mississippi (Mississippi Company) was chartered. In August 1717, Scottish businessman/economist John Law
acquired a controlling interest in the then-derelict Mississippi Company and renamed it the Compagnie d’Occident. The company’s initial goal was to trade and do business with the French colonies in North America, which included most of the Mississippi River drainage basin, and the French colony of Louisiana. Law was granted a 25-year monopoly by the French government on trade with the West Indies and North America. In 1719, the company acquired many French trading companies and combined these into the Compagnie Perpetuelle des Indes (CPdI). In 1720, it acquired the Banque Royale, which had been founded by John Law himself as the Banque Generale (forerunner of France’s first central bank) in 1716.
Law then created speculative interest in CPdI. Reports were skillfully spread as to gold and silver mines discovered in these lands. Law exaggerated the wealth of Louisiana with an effective marketing scheme, which led to wild speculation on the shares of the company in 1719. Law had promised to Louis XV
that he would extinguish the public debt. To keep his word he required that shares in CPdI should be paid for one-fourth in coin and three-fourths in billets d’Etat (public securities), which rapidly rose in value on account of fake demand which was created for them. The speculation was further fed by the huge increase in the money supply (by printing more money to meet the growing demand) introduced by Law (as he was also Controller General of Finances, equivalent to Finance Minister, of France) in order to ‘stimulate’ the economy.
CPdI’s shares traded around 300 at the end of 1718, but rose rapidly in 1719, increasing to 1000 by July 1719 and broke 10,000 in November 1719, an increase of over 3,000% in less than one year. CPdI shares stayed at the 9000 level until May 1720 when they fell to around 5000. By the spring of 1720, more than 2 billion livres of banknotes had been issued, a near doubling of the money supply in less than a year. By then, Law’s system had exploded – the stock-market bubble burst, confidence in banknotes evaporated and the French currency collapsed. The company sought bankruptcy protection in 1721. It was reorganised and open for business in 1722. However, in late 1720, Law was forced into exile and died in 1729. At its height, the capitalisation of CPdI was greater than either the GDP of France or all French government debt.
Why did Law fail? He was over-ambitious and over-hasty (like this Bitcoin pioneer?). He believed that France suffered from a dearth of money and incumbent financial system (Bitcoin enthusiasts claim it will revolutionize economies and countries like India are ideal for it) and that an increase in its supply would boost economic activity (Bitcoin aims to implement a variant of Milton Friedman’s k-percent rule: proposal to fix the annual growth rate of the money supply to a fixed rate of growth). He believed that printing and distributing more money would lower interest rates, enrich traders, and offer more employment to people. His conceptual flaw was his belief that money and financial assets were freely interchangeable – and that he could set the price of stocks and bonds in terms of money.
Law’s aim was to replace gold and silver with a paper currency (just like how Bitcoiners want to democratise/replace fiat money and eliminate banks). This plan was forced upon the French public – Law decreed that all large financial transactions were to be conducted in banknotes. The holding of bullion was declared illegal – even jewelry was confiscated. He recommended setting up a national bank (Banque Generale in 1716), which could issue notes to buy up the government’s debt, and thus bring about a decline in the interest rate.
During both South Sea and Mississippi bubbles, speculation was rampant and all manner of initial stock offerings were being floated, including:
- For settling the island of Blanco and Sal Tartagus
- For the importation of Flanders Lace
- For trading in hair
- For breeding horses
Some of these made sense, but lot more were absurd.
Economic value and price fluctuations of Bitcoin
Bitcoin is similar to other currencies and commodities such as gold, oil, potatoes or even tulips in that its intrinsic value is difficult – if not impossible – to separate from its price.
A currency has three main functions: store of value; means of exchange; and unit of account. Bitcoin’s volatility, seen when it fell 20% within minutes on November 29th 2017 before rebounding, makes it both a nerve-racking store of value and a poor means of exchange. A currency is also a unit of account for debt. As an example, if you had financed your house with a Bitcoin mortgage, in 2017 your debt would have risen 10x. Your salary, paid in dollars, etc. would not have kept pace. Put another way, had Bitcoin been widely used, 2016 might have been massively deflationary.
But why has the price risen so fast? One justification for the existence of Bitcoin is that central banks, via quantitative easing (QE), are debasing fiat money and laying the path to hyperinflation. But this seems a very odd moment for that view to gain adherents. Inflation remains low and the Fed is pushing up interest rates and unwinding QE.
A more likely explanation is that as new and easier ways to trade in Bitcoin become available, more investors are willing to take the plunge. As the supply of Bitcoin is limited by design, that drives up the price.
There are governments standing behind currencies and reliable currency markets for exchange. And with commodities, investors have something to hold at the end of the transaction. Bitcoin is more speculative because it’s digital ephemera. That isn’t true for all investments. Stockholders are entitled to a share of a company’s assets, earnings and dividends, the value of which can be estimated independent of the stock’s price. The same can be said about a bond’s payments of principal and interest.
This distinction between price and value is what allowed many observers to warn that internet stocks were absurdly priced in the late 1990s, or that mortgage bonds weren’t as safe as investors assumed during the housing bubble. A similar warning about Bitcoin isn’t possible.
What about Initial Coin Offerings (ICOs)? An ICO (in almost all jurisdictions so far) is an unregulated means, bypassing traditional fund raising methods, of raising capital for a new venture. Afraid of missing out on the next big thing, people are willing to hand their money over no matter how thin the premise, very much like in case of South Sea or Mississippi Bubbles. They have close resemblance to penny stock trading, with pump-n-dump schemes, thin disclosures and hot money pouring in and out of stocks.
ICOs, while an alternative financing scheme for startups, aren’t so far sustainable for business. Despite the fact that more than 200 ICOs have raised more than $3 billion so far in 2017, only 1 in 10 tokens is use after the ICO. And a killer app for most popular public blockchain platform Ethereum, which sees increasing number of ICOs? First ecosystem (game to trade kittens) has been launched and almost crashed Ethereum network. This game alone consumes 15% of Ethereum traffic and even than it’s hard to play due to its slowness (thanks Markus for this info bite!).
So overall, Bitcoin (and other crypto currencies) exist only for the benefit of those that buy-n-hold and use them while creating an explicit economic program of counter-economics. In other words, Bitcoin is not as much about money but power.
How it all may end (or begin)
The South Sea Bubble ended when the English government enacted laws to stop the excessive offerings. Mississippi Bubble ended when French currency collapsed, French government bought back (and ultimately wrote off debt via QE) all CPdI’s shares and cast out instigators. The unregulated markets became regulated.
From legal perspective, most likely the same thing will happen to cryptocurrencies and ICOs. China temporarily banned cryptocurrency exchanges till regulations can be introduced. Singapore, Malaysia, and other governments have plans to introduce regulations by end of 2017 or early 2018. Disregard, ignorance, or flaunting of regulatory and other government-imposed rules be mortal for startups and big businesses alike.
From technology perspective, a number of factors, including hard forks, ledger and wallet hacking and its sheer limitations related to scaling, energy consumption, security might bring it down. Also many misconceptions about blockchain/Bitcoin such as claims of a blockchain being everlasting, indestructible, miners providing security, and anonymity being a universally good thing are either exaggerated, not always or patently not true at all.
From business perspective, startups and companies raising money via ICO can be subject to fraud – Goldman Sachs’ CEO claims Bitcoin is a suitable means for conducting fraud, and thus subject to money laundering, counter-terrorist and other relevant government legislation. From investors perspective, shorting seems to be the most sure-fire way of investing profitably in cryptocurrencies.
During the dot-com craze, Warren Buffett was asked why he didn’t invest in technology. He famously answered that he didn’t understand tech stocks. But what he meant was that no one understood them, and he was right. Why else would anyone buy the NASDAQ 100 Index when its P/E ratio was more than 500x – a laughably low earnings yield of 0.2% – which is where it traded at the height of the bubble in March 2000.
It’s a social or anthropological phenomenon that’s reminiscent of how different tribes and cultures view the concept of money, from whale’s teeth to abstract social debts. How many other markets have spawned conceptual art about the slaying of a “bearwhale“
Still, the overall excitement around Bitcoin shows that it has tapped into a speculative urge, one that isn’t looking to be reassured by dividends, business plans, cash flows, or use cases. Highlighting a big, round number like $10,000 only speaks to our emotional reaction to big, round numbers. But it doesn’t explain away the risk of this one day falling to the biggest, roundest number of all – zero.