Bitcoin’s bubble
Observers of the cryptocurrency market will find this story familiar. Bitcoin emerged following one of the longest econmic expansion in history, with easily accessible credit, and global interest rates at their lowest levels in 5000 years of civilization
The surge in price attracted speculators into the Bitcoin market, helped by intense media attention. There are cases of individuals paying for Bitcoin by using credit cards or by re mortgaging their homes The rationale for higher prices became more fantastical, with claims the price could rise to $100,000, despitemore sober warnings
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The possible triggers for a pause in Bitcoin price rises included concerns about increased government regulation of crypto-assets and the possibile introduction of central bank digital currencies, as well as the large theft of assets and collapse of exchanges that have dogged
Going down
In liquid markets such as stocks (where it is inexpensive to buy and sell assets in large values) the price decline can be steep. In illiquid markets, where assets cannot easily be sold for cash, the fall can be brutal. Examples include the mortgage-backed securities (MBS) and collateralised debt obligations (CDOs) that led to the Global Financial Crisis.
Bitcoin isparticularly illiquid. This is due to a large number of different Bitcoin exchanges competing; often substantial transaction costs, and constraint on the capacity of the Blockchain to record transactions.
A Bitcoin ‘mine’ in China. Miners are rewarded with new currency for solving the complex math problems required to validate and record Bitcoin transactions. It requires a massive amount of computer-processing power. Liu Xingzhe/Chinafile/EPA
The aftermath
The aftermath of a bursting bubble can be brutal. The stock market crash of 1929 was a prelude to the Great Depression of the 1930s. The collapse in Japanese asset values after 1989 heralded a decade of low growth and deflation. The dot-com crash of 2000-01 destroyed US$8 trillion of wealth.
The effect of a crash depends the size, ownership and importance of the asset involved. The effect of the tulip crash was limited because tulip speculations involved a relatively small number of people. But sharp declines in property values during 2007 led to the worst financial crisis since the Great Depression.
Bitcoin is more like tulips. The entire market valuation was about US$300 billion at the peak. To put this into context, the US stock and housing markets are currently valued more than US$30 trillion each (the equivalent Australian markets are valued at A$2 trillion and A$6.9 trillion respectively). Relatively few investors own the majority – it is estimated that 97%of all bitcoin are owned by just 4% of users. This suggests the effects on the wider economy of the Bitcoin crash should be contained.
Estimating Bitcoin’s intrinsic value
The true value of cryptocurrencies is widely debated. Bitcoin entrepreneurs suggest a much higher price is justified. Others, such as Eugene Fama (a Nobel Prize winner) and Warren Buffett believe it is close to worthless. The bank of international settlements has described it as “a combination of a bubble, a Ponzi scheme and an environmental disaster”.
Obtaining a realistic estimate of Bitcoin’s intrinsic value is tricky because it is not an asset that generates a periodic cash flow, such as interest or rental income.
For such an asset, value ultimately depends on what others are willing to pay for it. This often relates to scarcity.
This does not provide a positive story for Bitcoin. Though the total number of Bitcoins is limited, there are many competing, virtually indistinguishable cryptocurrencies (such as Ehtereum and Ripple).
Bitcoin also fails to meet criteria of money. Its the price movements are too volatile to be a unit of account. The transaction capacity of the Blockchain is too limited for it to be a medium of exchange. Nor does it appear to be a good store of value.
Since it produces no income, has limited scarcity value, and few people are willing to use Bitcoin as currency, it is even possible that Bitcoin has no intrinsic value.
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