The extraordinary rise in the value of Bitcoin in recent weeks has unleashed a frenzy of investment, leading to claims Bitcoin is in a financial bubble.
The extraordinary rise of the value of bitcoin in recent months has caught both cryptocurrency investors and the general public by great surprise. Starting at a value of around $1000 in January, the value has skyrocketed in recent weeks to over $15,000. Interest in cryptocurrencies are at an all-time high. The global market cap for all cryptocurrencies worldwide is over half a trillion dollars, an indication of the surging interest in the market.
Public perceptions of Bitcoin
For years, bitcoin and cryptocurrencies were perceived as either a curiosity or as a sinister alternative to regular currency. In its early years, bitcoin was notorious as a form of currency among drug dealers and various crime syndicates. The infamous Silk Road website, which trafficked all manner of illegal products was one of the few places which took Bitcoin as a legitimate form of payment. To this day, despite cryptocurrency being regulated more like regular currency and legitimate exchanges opening, cryptocurrencies still have this stigma attached to them. While some governments are hesitantly legitimising cryptocurrencies, others are still decrying them. Philip Rowe, the governor of the Australian Reserve Bank, dismissed cryptocurrency’s recent surge as a ‘speculative mania’. He also went on to say the currencies are an attractive proposition for criminals on the black market. “When thought of purely as a payment instrument, it seems more likely to be attractive to those who want to make transactions in the black or illegal economy, rather than everyday transactions,” Dr Lowe told the Australian Payment Summit in Sydney.
There is ample evidence to back up Dr Lowe’s assertions. Terrorists in particular, including the Islamic State, have increasingly used Bitcoin to circumvent falling revenues from oil as well as various efforts to stem the tide of traditional currencies funding IS activity. As regulations on cryptocurrencies are currently varied from strictly regulated to not regulated at all, organisations such as IS have taken advantage of this inconsistent approach from the global community. Some newer altcoins, which have sophisticated mechanisms for anonymity, are especially popular among terrorists. With increased investment in cryptocurrencies and their underlying technologies, terrorists and other criminal enterprises will inevitably utilise cryptocurrencies more frequently.
Bitcoin and alternate cryptocurrencies
The current valuation of cryptocurrencies, particularly Bitcoin, has all the hallmarks of a bubble. Despite its exorbitant valuation, most cryptocurrencies, including Bitcoin, are not widely usable as a legitimate currency. Its value at present, if it has any at all, is mostly as an asset. As such, the value of the Bitcoin currency is vastly overstated. Unlike traditional fiat currencies, there is nothing guaranteeing the value of bitcoin. The effects of this can be seen in the extreme volatility of Bitcoin’s value. If any fiat currency in the world increased its value tenfold in the space of a year, this would be seen as an extreme anomaly and an unsustainable situation. A massive correction in its value would inevitably follow. This is important to consider, especially as proponents of cryptocurrencies breathlessly extol the value of Bitcoin and its potential to reshape the economy.
“Despite its exorbitant valuation, most cryptocurrencies, including Bitcoin, are not widely usable as a legitimate currency”
Another huge issue facing cryptocurrencies long-term is that the technology that mines coins and powers transactions is not scalable. The amount of energy utilised for even a single transaction is significant. Estimates claim that a single Bitcoin transaction uses the same amount of energy as ten US households do in a day. The bitcoin network overall currently utilises more energy than many countries. If this were to keep scaling at current rates, much of the world’s energy would be devoted to the mining of bitcoin before long. This, clearly, is unsustainable unless the mining and transaction process becomes much more energy efficient, and quickly. Such advances are unlikely, which further favours the argument for an impending crash in the value of Bitcoin.
“Estimates claim that a single Bitcoin transaction uses the same amount of energy as ten US households do in a day”
A possible outcome is various ‘altcoins’, alternative cryptocurrencies, being adopted instead of Bitcoin. Some of these currencies, such as Ripple, have a practical identified purpose. Ripple, for instance, is a foreign exchange utilised for instant transactions between banks. Ripple in particular has sharply increased in value recently as South Korea and Japan announced that banks in their countries would trial the currency for blockchain transactions. Another altcoin with a specific purpose, or a ‘utility’ coin is Ethereum. This coin is the second most traded digital currency after Bitcoin and is the most widely used utility coin. Ethereum contains a platform which replaces regular legal contracts with digitalised ones, as well as a variety of other uses. At this stage, however, even utility-based altcoins have niche uses, and the technology behind them is still flawed and in need of further development. If interest in bitcoin declines as a result of a price drop, the relative interest and utility of the associated altcoins is likely to decline also.
Bitcoin and investor psychology
Considering its relative lack of use, why is it, then, that the value keeps on increasing exponentially? It’s an important question to consider. Part of the question can be answered through the lens of psychology. An obvious and major aspect of this phenomenon is the media coverage it has received. As the currency passed through milestones such as $1,000, $2,000, $10,000 and so on, media coverage increased hugely. Arguably more importantly, the way bitcoin was reported on changed. At the beginning of the year, news stories about the currency would either dismiss the currency as an oddity or as a nefarious means to fund criminal activity. Despite the enormous increase in valuation, the fundamental way in which bitcoin and most other cryptocurrencies work has not changed significantly. Yet, the more positive press legitimised the currency in peoples eyes, fuelling its growth. As bitcoin became discussed in mainstream circles, the impetus to invest also increased.
The current mania surrounding bitcoin is a classic example of the phenomenon known as herd mentality. It is human nature to conform to what people around you are doing. This is no different when investing, whether it be in stocks or in bitcoin. This principle has been long-established by behavioural economics and has been the subject of intense study. Otherwise cautious or hesitant investors, for fear of missing out, make rash, ill-considered market entries they otherwise would not do. As masses of people invest, people perceive the risk to be smaller than it is, or rationalise going against market fundamentals and trends. This leads to an over-valuation of a commodity relative to its intrinsic value, creating a bubble effect.
Many analysts have cited the housing bubble of a decade ago, as well as the dot.com bubble a generation ago as parallels to the current situation with cryptocurrencies. While there are similarities, the current mania surrounding bitcoin is also different in some clear ways. Unlike housing or traditional stocks, the inherent value of cryptocurrencies is not easily ascertained, as it is not tied to a fiat currency or an asset. Speculating when, and if the bubble will burst, becomes harder as a result. However, due to its lack of scalability, unlikely meteoric rise and the media-led herd mentality behind the rising investment of bitcoin, all the signs point to a massive price correction, and soon.