Is bitcoin in a bubble?
All you ever wanted to know about nonlinear dynamics, risk pooling, rational and irrational human behavior, information cascades, and Bayesian updating. A FAQ.
So, is bitcoin in a speculative bubble?
Yes. This has first of all nothing to do with the underlying value of bitcoin as a technology, and all with the current motivation of buying bitcoin.
To understand this, let’s be more clear what the difference between “investing” and “speculating” is. Investing is providing upfront capital for a technology or a venture that might yield a return (the “ROI”) some time down the road. Warren Buffet is the most prominent proponent of “value investing”, which requires due diligence on the investment opportunity. Speculating on the other hand is trying to profit from fluctuations in the price of an asset. At the extreme end (“technical analysis”), it requires no understanding of the asset at all, it simply tries to extrapolate past performance into the future.
Bitcoin was an investment opportunity for the longest time, but there’s lots of anecdotal evidence that recent buying of bitcoin was mostly driven by speculation — the expectation that the recent dramatic rise will continue for at least some time, and that if there is a correction, the speculators will be able to jump ship in time.
That means it will crash down to earth pretty soon?
No. There are generally two things that can burst a speculative bubble: an internal shock or an external shock.
An internal shock is a revelation that undermines the trust in the asset. The raid on the Mt. Gox exchange that stopped the first major bitcoin bubble in 2014 was such an internal shock. An external shock is a downturn in the economy that makes many people search for liquidity at the same time. A rapid shift in expectations can then lead to a self-fulfilling downward spiral. We’ve seen similar things many times over.
Internal shocks are pretty hard to predict. The one thing we know is that rapid increase in price draws in lots of sketchy elements, so bad stuff might still happen. There are the first signs of a macroeconomic correction but we’re (hopefully) talking years, not months.
The third, somewhat more remote option is that someone will try to undermine bitcoin from the outside. Bitcoin is designed to prevent that thanks to its decentralized structure but we also know there are limits to this protection.
Common to all downward corrections is that the reason for selling must be widespread, so that no other investor group can make up for the drop-out of the liquidity-crunched investor group. Heterogeneity of adopters is a good antidote against such an event, and indications are that bitcoin adopters are becoming more heterogeneous.
So will it go down to zero?
Probably not. One of the key paradoxes of bitcoin is that the lower its price, the better it works in its intended purpose: as a transaction platform. So if there is a correction, the speculators will drop out and bitcoin can go back to what is was built for.
It could go down to zero if it loses its technological edge. There are now a bunch of alt-coins in the market, including a variety of bitcoin forks with slight changes in the technology. The ultimate decision which of these technology standards will survive rests more on their ability to create payment networks than on the speculative activity around them. But as of now bitcoin (BTC) still holds the Ricardian position in the market — it’s the first thing people think of when they hear “cryptocurrency”.
Is bitcoin a scam or a Ponzi scheme?
No. There’s a huge leap from a speculative asset with herding dynamics to a scam. Scams are primarily communication strategies, and there is no evidence that bitcoin was invented (almost ten years ago) with a fraudulent intent. Regardless, the cryptocurrency space is far from an orderly and regulated market, so one should proceed with caution at all times.
So but it’s virtual gold now, a store of value?
No. This is a much proposed argument that now that bitcoin has become all but unusable as a payment platform (a “medium of exchange”), its primary purpose is as a long-run “store of value”, a more convenient way to insure oneself against hard times than gold.
This is a complete garbage argument by people who have gleaned their economics knowledge from Wikipedia and are confused about very basic economic concepts. A store of value is a completely drab investment. It is not supposed to offer you exciting returns, but should make you feel comfortable that at any time in the future, if you need cash (liquidity) fast, your drab investment has retained most of its value. Since you cannot pick and choose at which time you’re in a cash crunch, an asset with low return and low volatility is a better store of value than a high return, high volatility asset like bitcoin.
I recommend unfollowing anyone who makes such a proposal, because they are selling you bullshit. I have no problems with people seeing a risk-adjusted value upside of bitcoin even in the long run, that’s a perfectly acceptable prediction to make based on the state of the technology and the market, but people shilling bitcoin as a “store of value” are confused about very fundamental things, and should be hit with the mute button.
So should I buy/sell/hold bitcoin?
First, my job is not to give investment advice. My job is to untangle the multiple undercurrents that might influence the long-term prospects of a new technology. Bitcoin is an exciting innovation with a huge upside if all things fall into line, but it is also technologically in a funk (it is no longer a functional electronic cash platform, and all proposed solutions to restore that function via technology upgrades are at best on the horizon).
With bitcoin, there are a whole lot of factors at work which influence price in the short and long run — just for starters: congestion, attention effect, the entry of a new type of investors (Geoffrey Moore’s “crossing the chasm”), news about technology improvements like lightning networks, and the negative correlation between bitcoin price and its core functionality. All these factors influence each other, which drives most of the volatility and non-linearity.
Investing in risky long-term technology proposals is the domain of venture capital (or risk capital more generally). Venture capital works because it is backstopped by institutional investors with long liquidity cycles and the ability to absorb high risk, high reward investments. Bitcoin is still fundamentally a risky technology proposal, except it is offered to people with far shorter endurance.
So instead of offering investment advice, I paraphrase stock market legend Andre Kostolany: “If you are rich, you should speculate. If you are poor, you must not speculate. But if you are penniless, you must speculate!”
Whether this means you should invest in bitcoin, is something you should decide for yourself — after careful research.
Disclaimer: As pointed out multiple times in the article and elsewhere, this is not investment or even legal advice.