Bitcoin: "Is there really a bubble?"

This is the question that many people asked themselves at the end of 1999, in summer 2007, in autumn 2008 and in winter 2011. The same question people ask today, looking at the rapid surge of Bitcoin and other cryptocurrencies' prices.  


"Is there really a bubble?" 


This is the question that many people asked themselves at the end of 1999, in summer 2007, in autumn 2008 and in winter 2011. The same question people ask today, looking at the rapid surge of Bitcoin and other cryptocurrencies' prices.

The answer might be easier that it seems. First of all, we have to find out what is an economic bubble. Basically, this is an economic cycle characterized by rapid surge of asset price that substantially exceeds intrinsic value of that asset.

What does this definition imply? First, we have to observe an exponential growth of prices. Second, this growth should be based on factors other than fundamental. As a result, we have to get a market  development of which is mostly driven by irrational demand. 

One of the best ways to understand whether the price of Bitcoin rises unjustifiably fast is to compare it with historical precedents. Let's take a look at four different cases, where two of them were related to indices and the other two concerned commodities. 

Table 1.1: Temps of growth of the IXIC during the Dot-com bubble

Nevertheless, the above examples showed that the temps of growth by approximately fifty percent every six months were enough to cause huge loses on financial markets. But does that principle also apply for less famous examples?  

On March 7, 2011 another economic bubble reached its maximum level. This time we got an overheating of price of another popular commodity. Just in two years the price of cotton increased by 418.34%. A year before the bubble burst, the growth rate was not as high as before and amounted only to 162.97%, but it was still much higher than in the two previous cases. 

Table 1.2: Temps of growth of the SCHOMP during the Chinese stock bubble of 2007

The last example involves a downfall of the Chinese stock market that happened right after the Shanghai Composite Index set a record high on October 16, 2007. The burst of the bubble obliterated hundreds of billions of market value. But how fast did it inflate? Two years before the fateful day, the value of index was 438.69% lower and a year before - 244.93% lower. Hence, these numbers make this particular bubble the most outstanding in terms of temps of growth. 

What can we say looking at these statistics in general? From past we already know that each of the above examples appeared to be a traditional economic bubble, where price of the asset grew unreasonably fast. Simply put, this means that fifty percent inflation per each six months was enough to cause a substantial decline of financial markets. Accordingly, the impact became even more devastating, when these temps of growth increased to one hundred percent per every half a year. 

As we have determined certain limits, it is time to take a look at the Bitcoin. However, firstly there is a need to make a remark. The price of the above crypto currency has not reached its peak yet and no one knows when it will happen. In this sense, the subsequent comparison will happen between not entirely similar cases. 

Table 1.3: Temps of growth of Bitcoin in 2007

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The second approach is more practical, as it explains how the Bitcoin is actually viewed in the areas where it is used. Here, the situation is more complicated. As an innovative technology that appeared only couple a of years ago, it does not have a deep and comprehensive regulation. But even the regulation that exists varies significantly in different parts of the world.

For instance, in the Netherlands the Bitcoin is classified as a part of barter transactions, which means that it does not have a status of a financial product or service. The Swiss government, in contrast, tends to classify and regulate it as a foreign currency. The Central Bank of Russia, in turn, considers it as a digital asset rather than a currency.

In the United States, the situation is even more mixed, as the CFTC classifies it as a commodity, while the Treasury Department views it as a money service business. In addition to that, at the end of July the SEC published a report where it said that digital assets or tokens that are offered and sold by "virtual" organizations should be classified as securities and, thus, subjected to the federal securities laws. 

The clearest attitude towards crypto currencies showed Japan, which in the middle of spring adopted a law that named Bitcoin as a new official method of payment. For ordinary consumers this means that now they can pay for their purchases equally with Bitcoins and Yens. However, for now Japan is rather an exception, because in the rest of the world the attitude and understanding of Bitcoin is very different. If we do not equate crypto currencies to securities and commodities and do not base their valuation on the same parameters, may be it is also not entirely correct to compare their growth rates and on the basis of these numbers to make a conclusion about the existence of a bubble? 

From a chart it is difficult to derive an exact day, but, in general, the starting point can be put somewhere between the last week of March and the first week of April. From a technical perspective, this period coincides with a moment when the Bitcoin crossed the 55- and 100-day simple moving averages. From a fundamental perspective, this period matches with entry into force of the above Japanese law, which recognized Bitcoin as a new currency and legal payment method. Was a combination of these factors enough to give an initial impulse for the subsequent surge? The answer, most probably, is going to be positive, as just in one month the price of Bitcoin increased by 34.70% and then by another 78.88%. 

In the meantime, there is another question related to this fundamental event. How did markets evaluate the decision made by the Japanese government? On the one hand, this decision legalized digital currencies and, in this way, made them more accessible and easy to use. In other words, the state helped the Bitcoin to become even more widespread medium of exchange, which is its main function. As a result, the new law had to spur the demand, which, in turn, had to leave a positive impact on prices. On the other hand, the new legal status implied tougher rules in the area of capital requirements, transparency, cybersecurity, taxation, accounting and anti-money laundering. Simply put, the government complicated the life of cons and speculators. If they had represented the majority of crypto users, the price of the Bitcoin would have fallen. However, none of this happened.  

Graph 1.2: Price of the BTC/USD in 2017

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So, we might assume that the exponential growth in summer had a fairly legitimate ground in the middle of spring. After all, sophisticated investors could have perceived this event as a signal of a new stage in the development of Bitcoin. Namely, a phase, in which other states would follow Japan's example and give crypto currencies a defined legal status and, thus, gradually pulling them out of the grey economic zone. 

Impact from speculators

However, the above event is not enough to explain the subsequent surge that happened in summer. Apparently, at a certain point various speculators had massively joined the trade and artificially inflated prices. To put it differently, many ordinary people saw an opportunity to make easy money in this unknown emerging market. Their capital and aggressive demand became the one that transformed a reasonable growth into an economic bubble. For this theory to be true there is a need to make sure that the above period did not contain some important news that could justify such change in prices.

But there actually is. Statistics reveals that since April there had been an explosion in a number of the initial coin offerings (ICO). The latter represents a method of fund raising, where investors acquire tokens and pay for them with the digital currency. Basically, this is an operation similar to initial public offering (IPO). But in this case, fiat currencies and shares in a company are substituted by the crypto currencies and cryptocoins.

So, by the end of May, the amount of money that was attracted in such way grew from $80M to $230M. The record high was set in June, when the volume of investment spiked to $570M. In the meantime, there is a need to notice that the amount of money that was raised in April is practically equal to the sum that was attracted during the whole 2016. This means that three months in a row there was an enormously high demand for the Bitcoin.

Surprisingly, but the price did not grow in parallel with the number of initial coin offerings. To be more precise, this inconsistency started in June when the number of raised money reached the extremum, but the price of Bitcoin entered into a thirty-six-days correction. But, when in July and in August the boom of initial coin offerings slowed down, the price of the crypto currency, in turn, skyrocketed. 

Graph 1.3: Statistics on Initial Coin Offerings (ICO) in 2017

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The difference might be related to the fact that in the process of the initial coin offering tokens can be exchanged not only for the Bitcoins, but also for many other crypto currencies as well as the paper money. In addition, the first half of summer was characterized bya number of quite sharp appreciations of the buck after release of certain macroeconomic data, such as the Consumer Price Index and the Federal Funds Rate. However, the last observation is valid only if we measure the price of Bitcoin in Dollars. Nevertheless, the above deviation does not contradict with the previous assumption. It still seems that money of unqualified investors was the main reason behind the summer's surge. 

Is it possible to find a confirmation of that? In general, economic bubbles among other things are characterized by hysteria in the media. This means that practically every day you might find a number of articles discussing the future price of Bitcoin. You, as a reader, will also see a plenty of experts, arguing that there is a future behind this new type of asset. Finally, the Internet and social media will be full of advertisements, calling to join the trade in crypto currencies and referring to people that have already quit their main job, as it brought less income than the "new investment opportunity".

Approximately the same situation can be observed today in the virtual environment. Comments like "I believe in the next three years you will probably see $15,000 to $20,000 for Bitcoin" and "Bitcoin could hit $100,000 in 10 years" only motivate uneducated people in the sphere of finance to substitute consumption with speculative operations.

To illustrate this, let's consider an example, when an ordinary worker acquires goods in a retail store. As a result of this operation, his money gets transferred into a company's bank account. Later, the owner of the store can buy with this money a new refrigerator, which will store the goods better and longer. Consequently, the number of clients will increase due to higher quality and better service. Eventually, the owner of the store will have funds to raise his employees' salary. In the meantime, the amount of paid taxes will increase as well. As a result of this, the government will get an opportunity to transfer this money for social needs, thus improving the overall standard of living. This example shows that money that is spent on consumption, eventually, increases the overall prosperity of people, as they are used to produce real goods and services. 

Graph 1.4: Economic bubbles visualized (1- Dot-com bubble of 2000, 2- Chinese stock bubble of 2007, 3- Crude Oil bubble of 2008, 4- Cotton bubble of 2011)

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When a worker puts their money into a speculative environment, this initial action, indeed, spurs a demand. As prices grow, his neighbors and colleagues begin to step in, also willing to make easy money. Because of the increased number of participants the prices continue to rapidly grow and our worker can collect a return. The problem is that this profit was rather generated by transferring money in a circle than by a real economic activity. In the context of our example, the money transferred to the owner of a grocery store or the government are used to produce things that have greater value. But people who spend their money based on the above opinions are only concerned about a momentary profit.

Consequently, a firm belief that tomorrow the price will be even higher than today is the main factor that step by step inflates the price. With the Bitcoin situation it is also complicated by the fact very few people actually understand what it is, compared to the cotton or oil. Accordingly, the majority of crypto currency owners cannot properly evaluate not only its current value but also realize its potential. In practical terms, this means that the current market prices do adequately reflect the genuine value of the Bitcoin.

Conclusion

What have we found out for now? Firstly, crypto currency is a relatively new, complicated technology with a huge potential in the long run. Secondly, understanding of this potential varies very significantly around the world. Countries like Japan and multinational companies like Amazon have already expressed their support and found application for the digital currencies. Such actions as well as anticipation that other states will gradually create a detailed legal framework represent a basis for the growth of price of the Bitcoin. However, as more and more people began to realize its unique features, such as decentralization and anonymity, more speculators began to step in. Observing an emerging trend, the press started to very actively to discuss this topic and, thus, attracted even more speculative capital. And this time not only from the hedge funds and other sophisticated investors, but also from households. The evidence of this is the fact that at some point the Bitcoin and Etherium became the top words for Google searches.

To sum up, the growth that we saw in the end of spring had certain fundamental basis. But when easy money hunters started to massively join the trade, the bubble started to inflate.

Even though today we are continue to get various valuable news, such as arrest and accusation of money laundering of the head of the BTC-e crypto exchange, split of the Bitcoin and Bitcoin Cash or plans of the largest international banks to develop and use their own crypto currency, it remains very difficult to measure their impact on the price of Bitcoin. As a result, we have a recently emerged unregulated market with exponential growth. Is it an economic bubble? No one can say for sure until the bubble bursts. But these facts make it rather complicated not to draw a parallel between today and the US Housing bubble in 2007 and the Dot-com bubble in 2000.

As a final remark, there is a need to remember that economic bubbles do not burst unexpectedly. In many cases, they are triggered by fundamental events. As a reminder, the latest financial crisis had formally started after Lehman Brothers became insolvent on September 15, 2008.

How high is the probability that the decision made by the US Securities and Exchange Commission or the China Securities Regulatory Commission will cause panic in the markets?

Keep in mind that decentralized bitcoins represent a global challenge for the contemporary financial system that is based on the American Dollar.