Much has been written about the ‘bubble’, including some excellent thought pieces. Fred Wilson, a Union Square Venture VC, has recently warned against the speculative cryptocurrency bubble and advised to diversify assets “before it’s too late”. Wilson was speaking from personal experience, after having lost most of his wealth in the tech boom and bust of the late 1990s.
Is crypto a bubble? And if yes, are bubbles destructive? A bubble is said to exist when the price of the financial asset is decoupled from the underlying cash flows – past, present, and future. What is the evidence of such decoupling and do we have the tools to measure value properly? This is important to know because unless there is a clear answer to this question, the discussion of bubbles will remain… well, a babble.
On Past Bubbles
William Janeway, one of the key creators of modern venture capital, has written a particularly insightful account of ‘bubbles’. His book, Doing Capitalism is the Innovation Economy, is a must-read for technology investors, entrepreneurs and policy-makers. Janeway shows how bubbles have been ‘boringly repetitive’ throughout human history. They transcend political regimes and market structures and play an important role in driving innovation, growth in productivity and living standards. Financial bubbles emerge and explode whenever there are liquid markets in assets.
During the century preceding WWI, for example, there was not a decade without a bubble of some sort. Just focusing on London, the ‘little’ Railway Mania of 1835 was followed by the ‘great’ Railway Mania of 1845, culminating in the crisis of 1847 and the suspension of the Bank of England’s new charter. London contributed financially to the railway boom in the U.S. and suffered accordingly in the crash of 1857.
Bubbles in the prices of financial assets can be found everywhere. High-frequency trading which has come to dominate the volume of transactions in equity markets reflects strategies that by definition have no reference whatsoever to the value of the underlying asset.
Valuing a Cryptocurrency
How does one know if a cryptocurrency, of which there are about 1700, is valued correctly? There are different types of cryptocurrencies – utility tokens, currencies (media of exchange), commodities and securities – and it is possible that each of these classes should be valued separately. There are well-established methods for estimating the value of stocks, traditional currencies, as well as commodities such as gold and silver. Some of these methods have been applied to cryptocurrencies. Cryptocurrencies remain, however, a largely uncharted territory.
Chris Burniske and Jack Tatar, in their book Cryptoassets, suggest that conducting a fundamental analysis of crypto assets (which they classify into cryptocurrencies, crypto commodities and crypto tokens) is different from valuing stocks, as crypto assets are not companies. They argue that crypto assets should be valued more like commodities, the pricing of which is determined by supply and demand. So investors are well advised to examine the project’s white paper, valuation, community, developers, relation to other projects, and the token issuance model. As with any software, the value is derived from the community and the marketplace; the community, in turn, places value on utility (i.e., access to the digital resource) and financial speculation. Valuation involves many assumptions about the future, making fundamental analysis particularly problematic.
A study by Cong and colleagues shows how tokens derive value as an exchangeable asset with limited supply, as a function of the blockchain technology’s productivity. Tokens capitalise on the user base growth: users’ expectations of technological progress and popularity of a particular blockchain translate into a token’s price appreciation, which makes the token an attractive investment, inducing more users to hold tokens and join the ecosystem. This valuation model, focusing on user adoption, positive network effects and cryptocurrency as a method of payment, is consistent with most ICO (initial coin offering) white papers.
There are also views that cryptocurrencies do not have fundamental value, and so prices should be explained on the basis of liquidity and momentum. The appropriate formula is the liquidity price in the numerator (i.e., the total amount of dollars devoted to cryptocurrency), and the total number of units in the denominator (e.g., 21m, in the case of Bitcoin). Both the numerator and the denominator are associated with significant uncertainty, such as government restrictions diminishing capital available, or forks increasing token supply, while momentum is a further destabilising factor in the absence of value traders.
It becomes evident that lacking robust tools to value cryptocurrencies, and given a considerable diversity in their applications, it is hard to say whether their fundamental values are divorced from prices. In other words, one cannot claim with certainty that there is a crypto bubble.
There is, however, a different bubble – a bubble of ignorance about the true nature of technological innovation. This is not a new argument, and yet, judging by the media frenzy and an explosion of activity on social networks every time cryptocurrency prices rise or fall, the argument does not seem to sink in and is worth reiterating.
Bubbles and Innovation
Blockchain is a transformative innovation, like steam and electricity, having an economy-wide effect. Such innovations are associated with unquantifiable market uncertainty: it is impossible to foresee and estimate their outcomes, let alone calculate probabilities of these outcomes. Transformative innovations are characterised by a lack of market efficiency at the upstream end, leading to private companies and governments investing in R&D to an extent that is not justified by conventional cost-benefit analysis or ROI metrics. The same is true at the downstream end, where speculation is ripe, as investors are trying to exploit new opportunities opened up by innovation. In the end, innovation depends on sources of funding that are decoupled from concern for economic return.
Fred Wilson (USV) captures this logic succinctly: “(…) you need some of this mania to cause investors to open up their pocketbooks and finance the building of the railroads or the automobile or aerospace industry (…).”
Innovation bubbles involve trial and error and, by necessity, a lot of waste and inefficiencies, as market participants experiment with fundamental technologies leading to human progress. Bubbles are the vehicle for mobilising capital at a scale required to fund innovations in the face of fundamental uncertainty. They are to be expected, given the “nobody knows” quality of technological innovation.
It is no wonder, then, that people’s opinions of the significance of blockchain, and valuation of cryptocurrencies, tend to differ. While some believe that bitcoin is “one of the greatest bubbles in history”, others claim that to sell crypto now is like selling Apple shares back in 2001. As a result of this divergence, investors bid and offer prices on exchanges that correspond to these beliefs.
The only way to avoid crypto bubbles would be to kill blockchain innovation and close down exchanges and OTC markets.
The main takeaways are these:
- There needs to be a better understanding of cryptocurrencies, as well as rigorous methods and tools to value them before one gets caught up in the crypto ‘bubble’ debate;
- Bubbles and fundamental technological innovation are symbiotic; doing away with bubbles means killing innovation and human progress.
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