Bitcoin, Ethereum and other “cryptocurrencies” made the news again this week for their rollercoaster market swings. Bitcoin passed the $11,000 mark in intraday trading before settling above $10,000 for the close, for the first time in its history. Two days later, it closed down 36 per cent. What is going on?
Bitcoin, Ethereum, Cryptocurrencies, Oh My!
Bitcoin and Ethereum are the two most popular cryptocurrencies. Cryptocurrency is described as “a form of digital money that is designed to be secure and, in many cases, anonymous.” In layman’s terms, it is a complex mathematical system of bookkeeping, an unalterable record of financial transactions. Its essence lies in the decentralized approach to the bookkeeping via peer-to-peer computing.
Once a transaction, or block, is confirmed, it is added to a chain of other transactions, and every user in the system is notified. This chain of transactions, or blocks, gives rise to calling the system a “blockchain” currency. For a more detailed description of what a cryptocurrency is, how it works, and how it is created, see this excellent guide in Blockgeeks.com.
Clever Investment, or Bubble?
Ethereum, the second most popular cryptocurrency, has risen 3,700 per cent since the start of the year, from a valuation of eight dollars to over $300 in just eleven months. In an opinion piece in Forbes in November, Ky Trang Ho writes that Ethereum may not be a bubble investment in spite of its meteoric rise. Ms. Ky is a writer who has covered the financial industry for the last ten years.
Unfortunately, the only evidence Ky adduces to support her claim that Ethereum is not a bubble is that its value does not approach that of the dot com stocks at the time their bubble burst. “As massive as the cryptocurrency market is at nearly $192 billion strong globally, it pales in comparison to the tech bubble, which erased $1.7 trillion in shareholder wealth.”
… these “currencies” have no underlying value; they are not backed by gold, do not represent wheat, pork bellies, petroleum….
So, to recap, these “currencies” are only entries in a massive database that is maintained by a peer-to-peer network. They have no underlying value, although they are traded like commodities. They are not backed by gold; they do not represent wheat, pork bellies, petroleum, or any of the other materials traded in worldwide markets. Their value depends solely on what buyers will pay for them and what sellers will accept.
Tulips Again
It is impossible to consider any financial investment that increases 3,700 per cent in value in a single year without remembering the Dutch tulip craze of the 1630s. When tulip bulbs were first imported into Holland from Turkey, they were very fashionable, quite rare, and valuable. A few years later a virus infested the tulips, which caused desirable genetic mutations producing dramatic variation in the colors and patterns.
Tulip Field in Holland, Monet 1886
Demand for tulips so outstripped supply that prices rose exponentially. Clever technologists of the day learned to manipulate the genetic variations to produce ever more unusual effects in the already exotic flowers. Prices rose so high that a single bulb could be sold for more than the price of a house, or of a country estate – and sold at a profit a day later.
The Last Fool in Line
The tulips appreciated in value so rapidly that they looked like a sound investment. No matter what a buyer paid for one, he knew that he could sell it at a profit within a week, or a month. In other words, no matter how foolish it seemed to pay a high price for what was, after all, only a flowering plant, there was always a greater fool ready to pay still more for it. Until there wasn’t.
One day you may find that you are the last fool in line.
This is called the “greater fool” practice of investing. You buy and sell, knowing that the demand is going up, and not caring about intrinsic value. Its only value lies in the willingness of someone more foolish than you to buy it at a higher price. The trouble with this approach is that one day you may find that you are the last fool in line.
The Dutch tulip craze broke in a matter of days. One day, someone decided the price was just too high, and suddenly everyone panicked, realizing that they had literally mortgaged their homes to buy a flower. Holland’s government tried to stabilize prices, but their offer of ten per cent of purchase price was quickly overwhelmed by losses. The entire Dutch economy suffered for several years before recovering.
The trouble with a bubble is that until it bursts, it’s a thing of great beauty, and it looks like it can go on forever. Is cryptocurrency a bubble? Hard to say – but it may be a good time to sell. Buy some tulips.
