I discuss the upcoming halving of Bitcoin in May with Adrian Przelozny, CEO of local crypto exchange Independent Reserve.
Is the Bank of England right to say its trading volatility means Bitcoin cannot be a real currency?
Digital Finance Analytics (DFA) Blog
"Intelligent Insight"
I discuss the upcoming halving of Bitcoin in May with Adrian Przelozny, CEO of local crypto exchange Independent Reserve.
Is the Bank of England right to say its trading volatility means Bitcoin cannot be a real currency?
Another deeply philosophical discussion with Adam Stokes about how we see the world.
What defines “Money” and how does the likes of Bitcoin stack up?
Prepare for some mind-stretching conversations about how we look at the world (and why people often ignore new concepts and ideas).
I discuss all things Crypto with the co-founder of one of Australia’s Crypto Exchanges and discuss the results from their recent survey.
https://www.independentreserve.com/
Independent Reserve is a registered Australian company (ABN 46 164 257 069)
Note: DFA has no commercial relationship with the exchange and we were NOT paid to make this show.
I discuss Bitcoin, Libra and cryptocurrencies in general with Alex Saunders From Nuggets News.
I discuss the latest about Bitcoin, Libra and cryptocurrencies more generally with Alex Saunders from Nuggets News.
We answer one of the the most asked questions on the DFA channel – what is the future for Crypto?
We answer one of the the most asked questions on the DFA channel – what is the future for Crypto?
Nearly 170 years before the invention of Bitcoin, the journalist Charles Mackay noted the way whole communities could “fix their minds upon one object and go mad in its pursuit”. Millions of people, he wrote, “become simultaneously impressed with one delusion, and run after it, till their attention is caught by some new folly more captivating than the first”.
His book Extraordinary Popular Delusions and the Madness of Crowds, published in 1841, identifies a series of speculative bubbles – where people bought and sold objects for increasingly steep prices until suddenly they didn’t. The best-known example he cites is the tulip mania that gripped the Netherlands in the early 17th century. Tulip bulbs soared in value to sell for up to 25,000 florins each (close to A$45,000 in today’s money) before their price collapsed.
The Bitcoin bubble surpasses this and all other cases identified by Mackay. It is perhaps the most extreme bubble since the late 19th century. In four years its price surged almost 2,800%, reaching a peak of US$19,783 in December 2017. It has since fallen by 80%. A month ago it was trading at more than US$6,000; it is now down to US$3,500.
That’s still a fantastic gain for anyone who bought Bitcoin before May 2017, when it was worth less than US$2,000, or before May 2016, when it was worth less than $500.
But will it simply keep dropping? What makes Bitcoin worth anything?
To begin to answer this question, we need to understand what creates the values that drive speculative price bubbles, and then what causes prices to plunge.
The above chart shows the magnitude of the Bitcoin bubble compared with the price movement of Japanese property and dot-com bubble from four years prior to their peak until four years after.
We typically think about bubbles in financial assets such as stocks or bonds, but they can also occur with physical assets (such as property) or commodities (like tulip bulbs).
A bubble begins when the price people are willing to pay for something deviates significantly from its “intrinsic value”.
The intrinsic value of an asset is theoretical, based its “fundamental” value. Fundamental value includes: the ability to generate cash flow (e.g. interest or rental income); scarcity or rarity value (e.g. gold or diamonds); and potential use (e.g. silver and platinum are used in both jewellery and industrial operations).
A house may have fundamental value owing to the scarcity of land, its use as a home, or its ability to generate rental income. A tulip (or Bitcoin) has none of those things; even the presumed scarcity does not exist when you consider all of the alternative flowers (or cryptocurrencies) available.
A bubble tends to occur after a sustained period of economic growth, when investors’ get used to the price an asset always increasing and credit is easily accessible.
To these conditions something more must be added for a bubble to form. That is typically a major disruption or innovation, such as the development of a new technology. Think of railways in the 19th century, electricity in the early 20th century, and the internet at the end of the 20th century.
Initially most investors tend to be cautious and “rational” about a new technology. For instance, early investment in railways took advantage of limited competition and focusing on profitable routes only. It was gradual and commercially successful.
This creates higher growth and profitability, leading to positive feedbacks (from greater investment, higher dividend payouts, and increased consumer spending), which raises confidence further.
If conditions allow, this develops into a period the economic historian Charles Kindleberger described as “euphoric”: investors become fixated on the ability to make a profit by selling the asset to a “greater fool” at an even higher price.
That is, they are attracted not by “fundamental” motives – the benefits from potential cash-flows such as dividend or rental income – but by “speculative” motives – the pursuit of short-term capital gains.
Higher prices attract a greater number of speculators, pushing prices higher still. Uncertainty around the significance of the new technology allows extreme valuations to be rationalised, although the justifications seem weaker as prices rise further.
The virtuous cycle of ever-rising prices continues, often fuelled by credit, until there is an event that leads to a pause in price rises. Kindleberger suggests this can be a change in government policy or an unexplained failure of a firm.
When asset prices stop rising, investors who have borrowed to finance their purchases realise the cost of interest payments on their debt will not be offset by the capital gain to be made by holding onto the asset. So they cut their losses and start to sell the asset. Once the price starts falling, more investors decide to sell.
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 Bitcoin’s short history.
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 is particularly illiquid. This is due to a large number of different Bitcoin exchanges competing; often substantial transaction costs, and constraints on the capacity of the Blockchain to record transactions.
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.
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.
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 the criteria of a currency. 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.
For such an asset, value ultimately depends on what others are willing to pay for it. This often relates to scarcity.
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.
Author: Lee Smale, Associate Professor, Finance, University of Western Australia
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The sharp rise and subsequent fall in Bitcoin’s value places it among the greatest market bubbles in history. It has outpaced the 17th-century tulip mania, the South Sea bubble of 1720, and the more recent Japanese asset price and dot-com bubbles.
The rapid price rise garnered attention from an increasing number of academics and investment advisers. Some have suggested that Bitcoin improves portfolio performance and can even be used as a potential “safe haven” asset in place of gold.
Our work finds that much of this research is flawed and overlooks some important attributes that any investor should consider before allocating funds to such a speculative investment.
This is particularly relevant if investing in Bitcoin is rationalised as a prospective safe haven in times of market turmoil.
The first attribute investors consider is how to value Bitcoin. Typically, assets are valued based on the cash flows they produce. Bitcoin lacks this property.
This leads to ongoing debate as to the true value of Bitcoin and other cryptocurrencies. Some, such as the Winklevoss twins and other Bitcoin entrepreneurs, believe the price will soar far higher. Others, including Nobel prize winner Eugene Fama and esteemed investor Warren Buffett, believe the real value is closer to zero. Another Nobel winner, Robert Shiller, suggests the correct answer is “ambiguous”.
There is even wide variation in price across the various Bitcoin exchanges. This is common in fragmented markets and makes it difficult for an investor to find the best market price at any point in time – a process called price discovery.
Bitcoin prices also have a high level of variation (volatility) when compared to other possible investments including bonds, stocks and gold. Even tech stocks such as Twitter, which are considered relatively volatile, are found to have less price variation. This adds to the difficulty investors face when trying to value Bitcoin and any portfolios that contain it.
This is of particular concern given the large daily losses that Bitcoin has experienced in its relatively short life. The largest one-day decline experienced by the popular S&P500 index since 2011 is 4.2%. Bitcoin has had nearly 200 days that were worse (and over 60 days worse than the biggest decline in the gold price of 10.2%).
Put another way, Bitcoin has had 200 days worse than the worst day on the stock market. This hardly seems like an enticing investment for most.
Investors should also consider the ease with which they are able to buy and sell any assets in which they invest. One method used to measure this liquidity attribute is the bid-ask spread – the difference in the price at which one is able to buy and sell the asset.
More liquid assets have a narrow bid-ask spread. Bitcoin’s bid-ask spread varies from one exchange to another, but in general it is much larger than for other assets.
While bid-ask spreads provide one measure of implicit trading costs, investors also consider the explicit transaction fees they are charged when trading. Transaction fees for trading traditional investments are typically well known and have trended down over time.
While Bitcoin fees have recently declined, they have proven to be highly variable, ranging from over $30 to under $1. The time taken to process a transaction can also be greater than 78 minutes. This is much longer than for stocks or bonds and creates another layer of uncertainty for investors.
Bitcoin is harder to value, more volatile, less liquid, and costlier to transact than other assets in normal market conditions. Potential investors should be wary and carefully consider whether such highly speculative assets are appropriate additions to any portfolio.
Given safe havens are typically in demand during financial crisis, when markets are more volatile and less liquid, it is highly unlikely that Bitcoin is even worth considering as a safe-haven asset.
Author: Lee Smales Associate Professor, Finance, University of Western Australia