Is the cryptocurrency “house of cards” poised to fall?
For those riding the rocket ship, a crash landing appears near-inevitable.
The following article was originally published in “What I Learned This Week” on September 7, 2017. To learn more about 13D’s investment research, please visit our website.
In an interview with Bloomberg in June, Peter Denious, head of global venture capital at Aberdeen Asset Management, offered a concise explanation of the current cryptocurrency bubble: “Prices right now aren’t being driven by network usage, they’re being driven by speculation that tokens are going to appreciate.” By any measure, the rise of cryptocurrencies has been staggering. As of the end of last week, bitcoin was up 400% in 2017, and 740% over the past twelve months. Ether, the second-biggest cryptocurrency by market cap, was up 4,600% in 2017 alone.
Such meteoric appreciation has proven polarizing — optimists claiming “the rocket ship” has barely left the ground; skeptics claiming irrational exuberance will leave investors with nothing when reality sets in: cryptocurrencies are “not real.” Both appear misguided, with Denious’ analysis far closer to the truth.
An efficient, safe, and cost-effective way to digitally transfer funds, cryptocurrencies have utilitarian value, and as usage has multiplied, demand for a limited supply has increased. Seeing this surge in demand, investors intensified speculation. However, that investment has veered into irrational exuberance — the fear of missing out driving speculation far beyond the fundamental short-and medium-term potential of today’s cryptocurrencies. For those riding the rocket ship, a crash landing appears near-inevitable.
In a seminal article written in 2014 for The New York Times, Marc Andreessen pinpointed why cryptocurrencies have real value:
“Bitcoin is the first Internet-wide payment system where transactions either happen with no fees or very low fees (down to fractions of pennies). Existing payment systems charge fees of about 2 to 3 percent — and that’s in the developed world. In lots of other places, there either are no modern payment systems or the rates are significantly higher…
Bitcoin is a digital bearer instrument. It is a way to exchange money or assets between parties with no pre-existing trust…Related, there are no chargebacks — this is the part that is literally like cash — if you have the money or the asset, you can pay with it; if you don’t, you can’t. This is brand new. This has never existed in digital form before.”
Optimism about this potential drove the first major bitcoin bubble. The value of a bitcoin peaked at $1,242 in November of 2013 before tumbling all the way to $175 by January of 2015. Irrational exuberance led too many to ignore that network-based businesses like bitcoin — the more merchants that accept it, the more buyers that use it, the more utilitarian value it has — take a long time to build and face hurdle after hurdle on the path to sustainable growth. Once this uncertain timeline became undeniable, investors fled.
However, over the past two years, bitcoin — along with a plethora of other cryptocurrencies — built a valuable network. According to a Cambridge University report, there were roughly 3 million active cryptocurrency users as of May — the total is no doubt significantly higher today. The number of merchants that accept cryptocurrencies has also multiplied — for one example, a reported 260,000 stores in Japan began accepting bitcoin just this summer. This rise in demand slowly drove up the value of cryptocurrency supply, which is naturally limited by the labor-intensive and costly effort to build out a blockchain. Seeing this appreciation driven by real-world utility, investor enthusiasm was reborn.
As former ARK analyst Chris Burniske has recognized, cryptocurrency appreciation follows a familiar pattern: the J-curve. Looking at both bitcoin cycles since 2013, this is clear:
As you’ll notice in the chart, Burniske has invented his own terminology to describe cryptocurrency cycles: CUV, which stands for “current utility value”, and DEUV, which stands for “discounted expected utility value”. Put more simply, DEUV refers to investor speculation and CUV refers to the real value derived from growing network usage. The J-curve progression goes: 1) CUV builds slowly as the network grows. 2) Investors catch on and begin accelerating DEUV. 3) More investor dollars flood in, DEUV spikes to the point of irrationality, and the currency comes tumbling down.
Of course, all promising equities attract speculation; however, cryptocurrencies appear especially prone to bullish and bearish extremes. Many factors contribute to this dynamic, but two seem key: widespread ignorance to the fact that the currency derives real value from fundamentals, not just sentiment; and cultish obsession with its potential to decentralize the financial system. In terms of the latter, Yale’s Robert Shiller recently spoke with Quartz about why cryptocurrency irrational exuberance has been fueled by technological destabilization:
“There’s a fundamental deep angst of our digitization and computers, that people wonder what their place is in this new world. What’s it going to be like in 10, 20, or 30 years, and will I have a job? Will I have anything? Bitcoin… gives a sense of empowerment: I understand what’s happening! I can speculate and I can be rich from understanding this! That…is a solution to the fundamental angst…Big things happen if someone invents the right story and promulgates it.”
So what could cause the current bubble to pop? First, irrational exuberance may crumble under its own weight. According to analysis by Mark T. Williams of Boston University, bitcoin volatility is seven times greater than gold, eight times greater than the S&P 500, and 18 times greater than the U.S. dollar. Downward spikes are inevitable and a severe one could frighten speculators away.
Second, the more valuable cryptocurrencies become, the more governments are threatening regulatory intervention. China took a first step this week, banning “initial coin offerings” (ICOs) as a fundraising method. Over the course of this year, more and more early-stage blockchain startups are creating their own digital “tokens”, which represent equity in the company. They then sell these tokens directly to investors, receiving cryptocurrencies as payment, thus circumventing the traditional venture capital system.
As the following chart shows, global ICO fundraising in 2017 has exceeded all angel and seed VC fundraising. This rapid escalation played a key role in boosting cryptocurrency CUV:
China’s stated reason for intervention was fraud — scam artists have more than once infiltrated the ICO process, both setting up fake companies and posing as representatives of real companies in order to intercept payments. However, China’s action tells a bigger story.
The financial system is built around gatekeepers. As the ICO boom suggests, cryptocurrencies threaten that control. This is no doubt another motivating reason China took action — to protect VC early-stage vetting power. It is also why twelve of the biggest financial institutions in the world have teamed up to create their own cryptocurrency. And it is why Russia has been experimenting with a state-owned cryptocurrency — a move Ben Bernanke has suggested other central banks should consider. Cryptocurrencies have real, utilitarian value in a digital world and unless gatekeepers intervene and own the future themselves, they will lose the economic control they’ve wielded throughout the history of the modern world.
To sum up, it appears cryptocurrencies are near the peak of their current J-curve. A dramatic fall to a bearish trough is likely. This will dampen regulatory scrutiny and cull the weakest from the herd, leaving many of today’s cryptocurrencies valueless. The strongest will survive — likely led by bitcoin and ether — and begin a new J-curve cycle, potentially climbing far above this cycle’s highs. Meanwhile, gatekeepers will begin solidifying a regulatory approach and building their own blockchains to support their own cryptocurrencies. Given their rule-making power, we find it hard to believe they won’t succeed, which could put the long-term future of today’s cryptocurrencies in question.
This article was originally published in “What I Learned This Week” on September 7, 2017. To subscribe to our weekly newsletter, visit 13D.com or find us on Twitter @WhatILearnedTW.
