Digital Finance Analytics (DFA) Blog
"Intelligent Insight"
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
Tony Richards, Head of Payments Policy Department, RBA, spoke on Cryptocurrencies and Distributed Ledger Technology at Australian Business Economists Briefing in Sydney.
He described the basics of Crypto, with reference in particular to Bitcoin, compares it with money, and concludes that many of these shortcomings of cryptocurrencies stem from their design around trustless distributed ledgers and the costly proof-of-work verification method that is required in the absence of a trusted central entity. In contrast, in situations where there are trusted central entities in well-functioning payment systems, there may be little need for cryptocurrencies.
He then goes on to explore the implications for central banks.
The Bank has been watching developments in these areas for about five years. Currently, however, cryptocurrencies do not appear to raise any major concerns for the Bank given their very low usage in Australia. For example, it is hard to make a case that they raise any significant concerns for the Bank’s mandate to promote competition and efficiency and to control systemic risk in the payments system.
Nor do they currently raise any major issues for the Bank’s monetary policy and financial stability mandates. There are only very limited links from cryptocurrencies to the traditional financial sector. Indeed, many financial institutions have actively sought to avoid dealing with cryptocurrencies or cryptocurrency intermediaries. So, it is unlikely that there would be significant spillovers to the broader financial system if cryptocurrency holders were to suffer valuation losses or if a cryptocurrency system or intermediary was compromised.
But given all the interest in cryptocurrencies or private digital currencies, people have inevitably asked whether central banks should consider issuing digital versions of their existing currencies. I can give you an indication of the Bank’s preliminary thinking on this issue, as outlined in December by the Governor in a speech entitled ‘An eAUD?’.
Currently if households wish to hold money, they have two choices. They can hold physical cash, which is a liability of the Reserve Bank, or they can hold deposits in a bank (or credit union or building society), which is an electronic form of money and is a liability of a commercial bank that is covered (up to $250,000) by the Financial Claims Scheme. Both forms of money serve as a store of value and a means of payment (assuming the bank deposit is in a transaction account).
Most money is already ‘digital’ or electronic in form. Currency now accounts for only about 3½ per cent of what we call broad money. The remaining 96½ per cent is bank deposits, which we might call commercial bank digital money.
Furthermore, the use of cash by households in their transactions has been falling in recent years. This next graph shows there has been strong growth over an extended period in the use of cards and other forms of electronic payments. In contrast, the dots, which are from the Bank’s Consumer Payments Survey, show a significant fall in the use of cash. In 2007, cash accounted for nearly 70 per cent of the number of household transactions. Nine years later, this had fallen to 37 per cent.
Clearly, some households are moving away from cash and finding that electronic payments provided by banks better meet their needs. And this trend is likely to continue as the New Payments Platform (NPP), which launched recently, allows banks to offer better services to households – namely real-time electronic payments that give immediate value to the recipient, are easily addressed, are available 24/7 and carry lots more data than currently.
So the question is: ‘should the Reserve Bank introduce a new form of cash – an eAUD as the Governor called it – to give households an electronic payment instrument issued by the central bank for their everyday payments?’
Our current thinking is that there would not necessarily be all that much demand for an additional form of money in normal times, though this would presumably depend partly on design decisions such as the interest rate (if any) that would be paid on this money.
But to the extent that there was significant demand, particularly if this occurred at times of financial uncertainty with households switching out of the banking sector, there could be significant implications for the Bank’s financial stability mandate. There would also be implications for the structure of the financial sector – for example, it could result in reduced financial intermediation. We would need to think through these implications carefully.
So for the time being at least, consideration of a possible new electronic form of money provided by the Reserve Bank to households is not something that we are actively pursuing. Based on our interactions with our counterparts in other countries, it is also not front of mind for most other advanced economy central banks. An exception is Sweden, where the shift away from the use of cash is significantly more advanced than in Australia and elsewhere. Sweden’s Riksbank is studying the issues regarding the possible issuance of an e-krona and expects to report by late 2019.
However, as the Governor indicated in December, there might be a stronger case for considering a new form of central bank liability for use by businesses and financial institutions.
Here it is important to remember that the Reserve Bank already offers electronic balances to financial institutions in the form of Exchange Settlement Accounts (ESAs) at the Reserve Bank. These balances can be passed between financial institutions during the banking day, with the Bank keeping the official record (or the ledger) of account balances.[10] A key function of ESAs is that they provide banks with a risk-free liquid asset for settling payment obligations through the day, to prevent the build-up of large exposures that could threaten financial stability.
However, some stakeholders in the payments area – including some fintechs – have expressed the view that the introduction of another form of central bank balances could be quite transformative. They have suggested the issuance of a new form of digital money that would be accessible to businesses and could be passed around on a distributed ledger. They argue that the availability of another form of central bank settlement instrument could reduce risk and increase efficiency in business transactions. For example, it could allow the simultaneous exchange of money and other assets on blockchains. A central bank digital currency on a blockchain could potentially also enable ‘programmable money’, involving smart contracts and the simultaneous execution of complex, linked transactions.
Moving in this direction would involve two major changes to current arrangements: it would involve the introduction of a new form of settlement asset and it would presumably involve broader access to central bank money for non-bank institutions. Consideration of the first aspect will require an assessment of issues relating to the technology. Consideration of the second aspect would get into some of the issues that are relevant to thinking about giving households access to electronic central bank money, namely the implications for financial stability and the structure of the financial sector.
As we think more about a model along these lines we will be considering whether the benefits could be equally well facilitated by other means. For example, could there be commercial bank money on blockchains – say Bank X tokens, Bank Y tokens, and the like, rather than RBA digital settlement tokens? Indeed, some models have been sketched out whereby commercial banks would put aside ESA balances at the central bank or would put risk-free assets into special-purpose vehicles, and then issue credit-risk-free settlement tokens for use by their customers. We will also need to think about whether the possible use-cases that have been proposed really need central bank money on a blockchain, or if they might also be possible using other real-time payment rails – perhaps the NPP. At the moment, it does not appear that a strong case has emerged for us to provide this new form of central bank money, but we have an open mind.
Another day and another hack in the crypto world.
This time the hack caused a mighty fall in the price of Bitcoin and other cryptos over the weekend.
Reportedly, a South Korean crypto exchange was hacked, which called it a cyberintrusion.
No matter the name, investors in the space had the same knee jerk reaction that has plagued the space, and that was to sell.
Let’s get right to discussing it.
Who’s to blame this time?
A relatively small crypto exchange called Coinrail is being blamed for this decline. The Wall Street Journal reported that alt coins to the tune of 70% of its digital assets were stolen.
The sleuths moved their spoils to what is called a cold wallet, according to the Journal. These cold wallets are not connected to the internet. Observers think that as much as $40 million of alt coins were made off with by the culprit or culprits.
As the news went viral, investors moved out. The loot caused cryptos to plunge more than $14 million in a short amount of time on Sunday, according to the Journal.
Sell, sell, sell
On Friday of last week, Bitcoin’s price seemed to be moving higher, however the news of this so-called cyberintrusion caused panic. In fact, Bitcoin sold off to near the lows we saw at the beginning of the year. As usual, the event served to drag prices other cryptos in the space lower, too.
During Friday’s late hours, Bitcoin was trading around $7,600. At the time of writing Sunday evening, the price was hovering around $6,700.
It should be noted that Coinrail is a small exchange. So the idea that traders would sell on news that it was hacked is interesting to say the least.
This is just one more example that shows how investors should carefully consider the space. There are going to be many more hacks like this, but the space’s resilience is noteworthy.
