Of Bulbs, Bubbles and Bitcoin

Lilium and Tulipa are of a family of plants known as Lilliodeae. They are predominantly bulbous herbaceous flowering plants found in temperate regions of the northern hemisphere. Typical to their genus these plants produce fragrant flowers in different colours which have graced generations of European gardens since the 16th Century. In early references, Lilium has been found in King Solomon’s Temples and has been associated with the divine purity of the Blessed Virgin Mary.

However, the claim to fame of Lilum’s sibling, Tulipa, is less about royalty and divinity but more about greed and gullibility because in early in the 17th century, the then rare flowers, imported by Dutch tradesmen from the East, quickly gained something of a status symbol and their bulbs were highly sought after. Demand grew and thanks to a restricted supply, the prices of the bulbs soared. Seeing the fortunes made by the early tradesmen, speculators in search of quick returns from the bulb trade piled in, and as the bulb price ballooned, investors liquidated what they considered low-yielding assets such as property, to purchase bulbs for resale into a seemingly perpetual bull market. After all, everyone loved the fashionable Tulips especially the variegated varieties which were even rarer than the plainly coloured ones. Thus, investors were comfortable their investments were secure as the bulb price would defy gravity forever. What could possibly go wrong?

Almost a century later in the eighteenth century “What could possibly go wrong?” was a question which could have been asked by many investors but ignored as they parted with capital in search for higher returns with the South Sea company whose share price rose eight-fold in as many months between January and August 1720. After all, King George I was a governor of the company. What could possibly go wrong?

Indeed, what could go wrong in 1840 when the railways were touted as a safe investment. The United Kingdom led the world in rail travel and the proven success of established lines transporting passengers and freight gave a sense that an investment in any of the many of the newly established railway companies was a sure investment where returns were guaranteed. Case in point, UK Parliament in 1845 had quadrupled the mileage of authorised established lines, increasing investor confidence that there would always be passengers, and freight to carry. The railway companies would always be profitable businesses, what could possibly go wrong?

Fast forward, past the California and Australia Gold Bubbles of the nineteenth century and the stock market bubbles of the late 1920s to the DotCom bubble at the close of the twentieth and beginning of the twenty-first century to the housing bubble bursting in 2007/8 the story is the same.

In the Dot Com bubble, investors brushed aside any doubt on their investments because the prevailing thought was traditional “bricks and mortar” businesses were dead. “Clicks and web” were the greatest. Anything with a .com name was investible no matter the price. Traditional indicators like PE ratios which gave indications of when investors could begin realising returns on their investment were a thing of the past. Tenuous business plans, high cash-burn rates and illogical valuations would be made right eventually, because this was the internet age and dot-com companies were at the front of the Technology Revolution that was on par to the Great Industrial Revolution; the vast demand for internet services and commerce would ensure their viability. Thus, with such high promise, what could possibly go wrong?

As recently as a decade ago, “securitisation” was the buzz word which meant risk to banks from lending had been diversified away and passed on as securities to willing investors who bought tranches of Collaterized Debt Obligations (CDO) according to their risk profile. The CDO investment vehicles meant the initial loans were moved off the bank’s books and they were free to make further loans most of which were going to the ballooning sub-prime mortgage market. Notwithstanding this loss of diversification in the CDOs, banks continued issuing CDOs and CDOs of CDOs (CDO-Squared) and the ratings companies continued rating them as investable for investors desperate for yield, during a time when prevailing interest rates were low. So long as Joe and Jane Bloggs made their regular payments or perhaps defaults kept to a minimum – then investor returns were guaranteed. It was perfect – those who otherwise would be unable to afford a home got one through sub-prime mortgages; Banks were able to generate loans continuously without keeping them (and the associated risk) on their books; Security Investors got the higher yields they sought and because of presumed diversification of CDOs and their trust in the ratings agencies (who also got their cut),  the investors slept easier. Everyone was happy. What could possibly go wrong?

A decade on from the world of MBS (Mortgage Backed Securities) and CDOs the world is faced yet with another technological novelty in the realm of cryptocurrencies which are being put on par (in terms of potential impact to lives and livelihood ) with the inception of the internet. Amongst the many cryptocurrencies in current existence, Bitcoin is the market leader, taking about half of all digital currency transactions.

Created in 2009 by a programmer (or programmers) pseudonymed Satochi Nakamoto, Bitcoin is decentralised digital currency – decentralised in the sense that there is no central control. Not controlled by a Central Bank or government. It is a Peer to Peer network – anyone can run a bitcoin node on the network. Similarly, the mining of Bitcoins decentralised, (although the capital-intensive nature of the infrastructure required for bitcoin mining makes a concentration of power in those who are resource capable.) Thirdly, upgrades to the bitcoin software is decentralised although it is tightly controlled by community of core of developers.

Nodes on the bitcoin network compete to solve hash puzzles to gain the right create new blocks. A block contains a series of transactions, a pointer to the previous block and a “nonce” which is a pseudo-random number which when hashed all together, provides a given output. If the hash function is secure – and at SHA-256 it is, then the computational puzzle can only be solved through successive tries until the right value is found. This process which takes a lot of computing power and is known as “Proof of Work”. To understand the size of the problem, there are 10 to the power 20 hashes per block, or a thousand trillion hashes. This is the block creation or “bitcoin mining” and because of the computational power required, profitable mining tends to be restricted to those who can deploy the arrays of ASICs required to solve the puzzles within the current average block generation time of 10 minutes.

Successful miners can expect returns from two main incentives. Firstly, a Block Creation Reward i.e. the creator of a block gets a coin creation transaction – in effect a payment which on the onset was 50 Bitcoins but has halved every four years to current 12.5 Bitcoins. Secondly, a Transaction Fee. But this is not the only route to making money from Bitcoins because the restricted supply and the growing demand has sustained exponential increments in its price. Thus, speculators have simply bought bitcoins for the reward of selling them at a higher price.

In the past year, speculators have been amply rewarded as data from Blockchain.info shows that while median transaction volumes between December 2016 and December 2017 have grown moderately (41%), the median bitcoin price which has ballooned 1400%. And in the week leading up to its listing on CBOE, the price accelerated by $2000 to $19,000.

Like the double price volatility trips on Sunday 10th Dec. which triggered trading halts on its CBOE debut, the amber, if not red lights are beginning to flash as regulators are getting twitchy. Already, China moved to tighten regulation in September 2017 which saw the closure of Bitcoin Exchanges. The warning lights and blaring sirens were on according to the Director of the Board of Alabama Securities Commission, Joseph Borg, who recounted that some investors were taking out mortgages to purchase bitcoins. For many analysts, such actions mean Bitcoin has gone past the bubble inception phase and is well advanced in the bubble sustenance phase, the prelude to a burst. This is confirmed by a recent survey of Wall Street Economists which showed 80% thought the bitcoin market was a bubble whose magnitude according to a study of 10 financial bubbles by Birinyi Associates, was one of the biggest of all time.

Thus, many in positions of responsibility in the finance world are queuing up to offer warnings for example, the Fed Chair Janet Yellen in a recent speech said, “Bitcoin is not a stable store of value and it doesn’t constitute legal tender. It is a highly speculative asset”. The SEC has issued a warning for investors to take “extreme caution” investing in cryptocurrencies or the associated ICOs. (Initial Coin Offerings). Massachusetts’ top securities regulator, cautioned investors against the speculative bubble which like others in history left the “average investor with a worthless product”. Andrew Bailey, CEO of UK’s Financial Conduct Authority (FCA) was blunt. “If you want to invest in Bitcoin, be prepared to lose all your money.” Almost as if they are all looking to have their word in before the next stage, i.e. the bursting of the bubble and the subsequent ugly aftermath.

But of course, on the flip side, there are others who say this is just the beginning and one early investor who predicted Bitcoin’s rise, now predicts that Bitcoin could reach $100,000 pointing to the current listing on CBOE and approvals to list on CME and the rumours of listing on Nasdaq as some of the drivers. The Winklevoss Twins, whose initial $11M investment has transformed them to Bitcoin Billionaires, remark that the cryptocurrency is heading for higher valuations and have called it a “multi-trillion-dollar asset”.

The long-term trend these Bitcoin Bulls believe is up – even though there may be some retracements along the way. If the null hypothesis that Bitcoin in finance terms was no different from social media, can be accepted, then the implications would be immense. Because, if the number of customers who wanted to purchase from say Amazon, eBay, Alibaba etc. defaulted to cryptocurrency, specifically Bitcoin, which by virtue of its Brand, position as first mover, and market share it currently enjoys, they probably would, then, the Winklevoss’ “trillion-dollar asset” valuation begins to look not so much pie-in-sky.

At this point, the doyens of financial transactions, VISA, MasterCard, American Express, MoneyGram, Western Union etc., could quite simply find themselves going the way of BlockBuster Videos in the face of Netflix. In other words, going the way of the dodo. Extinction. It is the thought of this disruption and the Fear Of Missing Out (FOMO) has contributed to the bitcoin demand from both ordinary and professional investors.

The article started by anecdotal chronicles of some famous bubbles from early finance history to date, asking what could go wrong when everyone seems to have been happy making money off the price increments in the bubble assets. But go wrong they did from tulips to dotcom stocks and houses, when investors lose ‘trust’ in the value of the assets and begin doubting their astronomical valuations. A former article on this blog “Gold or Bitcoin, It’s a matter of Trust.” looked at the use of the early use of bitcoin as money and cited ‘Trust’ as an essential component in the functioning of the currency.

So, what could undermine that trust and cause the digital currency to lose its digital green lustre?

Regulation like that seen in China? Currently Western regulators have stood on the side-lines. The FED Chair Janet Yellen saying regulating cryptocurrencies was not in the FED’s remit and a similar stance was taken by the ECB’s Mario Draghi. Unlike China where government regulation of bitcoin forced closure of exchanges, the West is embracing cryptocurrencies and allowing futures trading on CBOE, CME and potentially the Deutche Boerse in Germany. Thus, unlike China, the West is putting its trust in market forces and although early days, it seems to be working as short selling on the CBOE has already tripped the breakers on Wednesday 13th Dec, in which trading was suspended as the Bitcoin price plummeted 19%. More short-selling is expected when Bitcoin futures begin trading on the larger CME. Therefore, without the unchecked price appreciation as seen prior to the entrance of short-sellers, would the demand volume arising from speculators chasing after a ‘quick buck’ hold?

It is most certain that with increased use, the pseudonymous nature of Bitcoins (which is a major attraction) and other cryptocurrencies like it, would most certainly fall foul of governments’ Anti-Money Laundering, Anti-Tax Evasion, Anti-Crime, Anti-Narcotics and Anti-Terrorism initiatives. Regulation would not only peel off the anonymity cloak bitcoin users don but also increase costs for operatives which would be passed on to users. When that happens would the demand hold?

Machines on any network are vulnerable and malware programmed to subvert the “Distributed Consensus” protocols on which Bitcoin relies on is a possibility. This so-called 51% attack may lack practical feasibility, but it is certainly something that has been discussed as theoretically possible. In the current environment of “Fake News” perhaps only the rumour of an attack is enough to plant seeds of mistrust in the system. In such an eventuality real or faked, would the demand for Bitcoins hold?

On December 7th 2017, $70M of Bitcoins were stolen from NiceHash, a Russian bitcoin mining company. This is follows $65M stolen from Bitfinex in Hong Kong in 2016 and in 2015, $5M stolen from a Slovenian Bitcoin Exchange, Bitstamp. These were dwarfed by the almost $500M stolen from Mt. Gox in 2013 – resulting in the closure of Mt. Gox, the largest Bitcoin exchange at the time. Bitcoin has survived these setbacks, but would it survive being linked to another underground network like Silk Road which was shut down a couple of years ago? Would it survive if it was found to be a payment method North Koreans were using in sanctions busting? Would the demand really survive more of these multi-million dollars digital heists?

In the previous article written on Bitcoin, mention was made of the trust users of any currency have in the government or central bank, that they would not debase the currency through wanton printing and minting. Likewise, in Bitcoin where only 21 Million are in existence and of which 79.7% have been mined. But Satoshi Nakamoto is reputed to have one million bitcoins in addresses linked to him/her/them, that’s about 5% of all the Bitcoins in existence and if these were unloaded, it would have an impact on the price which could trigger a cascade of selling. Would the current demand for bitcoins be sustained in such an eventuality?

Perhaps one of the main risks facing Bitcoin is the “fad“ alluded to by Robert Schiller, which upon passing, would see Bitcoin take its place in the pantheon of innovations that users fall out of favour with, in deference to perhaps an improved and “sexier” rival – having learnt from the shortcomings of the former – such as transaction latency, fees and unreliability. There are many pretenders to the Bitcoin throne – 1100 cryptocurrencies as at September 2017. Ethereum, Bitcoin Cash and Litecoin are main competitors. It is therefore entirely possible Bitcoin could go the way of Myspace.com because, like Social Media, it shares the sentiment of crowds, which is fickle at best. At that point, when users decide Bitcoin is no longer ‘cool’, we can be sure that its current valuation would slide along with the demand.

Without demand, bitcoins would look very much like tulip bulbs in the hands of those who had purchased them at exorbitant prices only to find the market had disappeared. For the early investors they care little as their fortunes safely guarded by stop-loss triggers to get them out early in the event of a panic sell. One commentator on Reuters notes that while a crash in the Bitcoin price may have a limited effect on the wider financial markets, the trading of futures on the CBOE and CME make contagion likely where a large Hedge Fund, caught out on a wrong bet goes under – case in point the collapse of LTCM in 1998.

This article has looked at some of the past bubbles and the now dubbed “bitcoin mania”. It looked at what makes Bitcoins so desirable and if that demand would hold should some of the major risks facing the currency congeal. As with any asset, without the demand, bitcoin is worth little, and looking beyond speculators, a key driver of bitcoin value is the number of transactions supported daily. This number is still miniscule compared with the number of transactions taking place in the world both online and offline. For bitcoin or any other crypto-currency to justify the Winkelvoss’ “trillion-dollar asset” valuation it would need begin to play a significant part in global financial transactions. At this point too, the amount of regulation that would be brought to bear on it would be substantial. In that light, many of the altcoins would probably not survive and like the bursting of the DotCom bubble, go the way of pets.com and boo.com. But many too would probably survive. Cryptocurrencies are here to stay. A decade hence Bitcoin or perhaps any of its competitors would survive the risks listed herein and others known or unknown to grow like Amazon and Google to become a global force touching the daily lives of billions across the globe.

By Lloney Monono
Maidenhead.

Sources:

Bitcoin is already dwarfing some of the largest financial market bubbles of all time
https://www.cnbc.com/2017/11/30/bitcoin-dwarfing-some-of-the-largest-market-bubbles-of-all-time.html

80% of Wall Street Economists, Strategists believe Bitcoin is a bubble: Survey https://www.cnbc.com/2017/12/12/80-percent-of-wall-street-economists-strategists-believe-bitcoin-is-a-bubble-survey.html?recirc=taboolainternal

Fed Chief Yellen Says Bitcoin is a ‘highly speculative asset’ https://www.cnbc.com/2017/12/13/fed-chief-yellen-says-bitcoin-is-a-highly-speculative-asset.html

Trader who called bitcoin rally says cryptocurrency will surge above $100,000 in 2018 https://www.cnbc.com/2017/12/11/bitcoin-could-exceed-100000-dollars-by-2018-says-trader.html?recirc=taboolainternal

‘Bitcoin Jesus’ is ‘really, really concerned’ about the future of the digital currency
https://www.cnbc.com/2017/12/11/bitcoin-jesus-is-really-really-concerned-about-the-future-of-the-digital-currency.html?recirc=taboolainternal

Winklevoss twin predicts multitrillion-dollar value for bitcoin https://www.cnbc.com/2017/12/09/bitcoin-cameron-winklevoss-predicts-multitrillion-dollar-value-for-cryptocurrency.html

Hackers steal $70M in bitcoins as price briefly hits $19K https://nypost.com/2017/12/07/hackers-steal-70m-in-bitcoins-as-price-briefly-hits-19k/

Commentary: Futures may legitmize Bitcoin, but let it infect other markets https://uk.reuters.com/article/us-global-bitcoin-spillover/commentary-futures-may-legitimize-bitcoin-but-let-it-infect-other-markets-idUKKBN1E91LN

Bitcoin makes up more than half the $400 billion cryptocurrency market. Here’s the rest https://www.marketwatch.com/story/bitcoin-makes-up-more-than-half-the-total-cryptocurrency-market-heres-the-rest-2017-12-06

Nobel-winning economist Shiller calls bitcoin a fad https://www.cnbc.com/2017/10/16/nobel-winning-economist-shiller-calls-bitcoin-a-fad.html

Blockchain Demo:  https://anders.com/blockchain/block.html

Blockchain Chart and Data: https://blockchain.info/charts/market-pricefad.html

https://en.wikipedia.org/wiki/Satoshi_Nakamoto

https://coinmarketcap.com/all/views/all/

http://cryptomaps.org/

 

 

 

 

 

 

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