Will Bitcoin be the next financial bubble?

The price of Bitcoin, the digital currency that is created through a sophisticated process called “mining” and is not printed or regulated by central banks, has risen exponentially over the last weeks and months. At the start of 2017, a Bitcoin was worth less than $1,000. In October it was trading at $5,000, in November it surged above $11,000 and at the time of publishing this article it was rallying above $16,000 according to Coindesk. It is hard to think of an asset that has the ability to appreciate in value so rapidly. This raises a couple of spontaneous questions. What have been the drivers behind the increasing demand for Bitcoin? Moreover, are the current levels of price appreciation in this cryptocurrency sustainable or is Bitcoin a speculative bubble destined to burst sooner or later?

Various factors have fuelled the growing interest in Bitcoin. Part of the attraction for investors stems from two key traits that characterise this virtual currency: the restricted supply, which is capped to 21 million units, and the anonymity that it guarantees in the marketplace, which is particularly appealing to criminals. However, the main reason behind the soaring demand for – and hence escalating price of – Bitcoin is the belief that it will be possible to sell the currency to someone else at a higher price. This strategy is known as the ‘Greater Fool Theory’ and presents a high degree of risk since a slight dip in the price of the currency may prompt a dramatic sell-off among investors, causing the price of the currency to crash.

Bitcoin Graph The Economist

Source: The Economist

Bitcoin features some of the typical elements that anticipate a speculative bubble, including high volatility of the price of the asset, a significant amount of speculation without a proper understanding of the risks involved and, most importantly, no real rate of return on holding the asset. In fact, unlike for example shares, which yield dividends, or bonds, which pay coupons, Bitcoin has zero intrinsic value and generates no income. Its value resides exclusively in the expectation of further price appreciation. This makes it possible for the price of Bitcoin to reach any value as long as demand for it keeps growing.

Yesterday Bitcoin futures started trading on the Chicago Board Options Exchange (CBOE) and on December 18th they will debut on the Chicago Mercantile Exchange. The inception was strong, with the price of the futures growing by 10% in the first two hours and trading being called to a halt at least twice due to speedy price gains. The launch of futures contracts is likely to draw more institutional investors to the market, leading to greater demand and hence a further increase in the price of Bitcoin.

The market capitalisation of Bitcoin, calculated as the price multiplied by the number of Bitcoins in circulation, is currently over $270 billion, which is close to the market capitalisation of Wells Fargo, the third largest bank in the US. What is the limit for the price of Bitcoin? Theoretically none. Nevertheless, indications of a financial bubble are looming, and not only for the technical reasons discussed above. History, in fact, seems to suggest this as well. The recent launch of Bitcoin futures mirrors the introduction of futures for tulips in the Netherlands in 1636, which led to the famous ‘Tulip Mania’ crash in the following year. An omen for Bitcoin? Perhaps.

Carlo Rubini

N.B. This article reflects the author’s opinions only.


References:

https://www.economist.com/blogs/graphicdetail/2017/11/daily-chart-23

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

https://www.economist.com/blogs/buttonwood/2017/12/crypto-through-tulips

https://www.cnbc.com/2017/11/01/bitcoin-price-hits-6500-to-new-record-high-after-cme-futures-plan.html

https://www.bloomberg.com/news/articles/2017-12-09/bitcoin-looks-like-bubble-new-zealand-s-central-banker-warns

https://www.facebook.com/wired/videos/1564036050346302/

https://www.coindesk.com/price/

http://www.bbc.co.uk/news/business-42304657

https://www.cnbc.com/2017/12/11/cramer-bitcoin-futures-launch-a-big-victory-for-the-digital-currency.html

https://www.ft.com/content/fe08d06e-db40-11e7-a039-c64b1c09b482

https://www.cnbc.com/2017/11/02/bitcoin-futures-mirror-1637-tulip-bubble-crash-ubs.html

https://www.nytimes.com/2017/12/07/technology/bitcoin-price-rise.html

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