Investing in cryptocurrencies seems like senseless speculation at the best of times – yet, is there a case for this continued boom, or will the ostensible bubble burst soon?
Fall, Fame or FOMO
The well-documented horror stories about investments that have gone awry cause angst in every listener. Stories about leveraged investments that were a sure bet, that ultimately turned sour, leaving once savvy, successful investors standing in a soup kitchen line, or worse. Stunning, meteoric rises in fortune are also a common feature in news feeds – where hero investors and their renowned perspicacity is on display for all to see, with little mention of how hindsight provides 20/20 vision. The lesser documented stories are those, that are seemingly only told at family gatherings, in pubs and at restaurants – the stories about the one that got away. The once in a lifetime opportunity to get in at the bottom, that was passed up! These horror stories are avoidable – these hero stories are attainable.
Brass Balls & Crystal Balls
It is the intention of this article to explore the current threats and opportunities within the cryptocurrency space and to gauge whether it is near the top, the bottom, or somewhere in between. It is also the intention of this article to spark a debate regarding this nascent asset class that has stumped even the greatest financial minds in terms of valuation and timing of investment. It is not the intention to provide a crystal ball, silver bullet approach. It is not the intention to prescribe anything. It is not the intention to go deep, but rather to cover a lot of ground and to present well-lit avenues through which one can formulate an investment case.
Quick Cryptocurrency Catch Up
To better position an analysis on whether cryptocurrencies are in a bubble, it is important to cover the foundations of what cryptocurrencies are, what differentiates them and why they exist to begin with. Crypto-Genesis Cryptocurrencies are a decentralised, encrypted form of digital currency that are built on top of a blockchain. The first and most famous of them all is called Bitcoin (BTC) – which was developed by the mysterious Satoshi Nakamoto after the financial crisis in early 2009. It was developed to be a decentralised electronic peer-to-peer cash system that is cheaper, faster, safer and more transparent than anything else in existence -that doesn’t require a centralised third party to approve transactions.
Since the development of BTC, numerous alternative cryptocurrencies, called ‘altcoins’ are being added to the list in a Cambrian like explosion, with Darwinism at the heart of their survival. These numerous forms of cryptocurrency vary in a few ways, namely in their:
a.) ‘Mineability’ – The ease with which they can be mined. Some are easier and cheaper to mine than BTC (more on these in the next article.)
b.) Liquidity – The amount and frequency that they’re traded at, at any given point. Some cryptocurrencies are not even listed on major exchanges.
c.) Function – Ether (ETH), for example, isn’t considered a currency by ‘purists’ – as the underlying coin, ETH, is designed for use as a fee for operating the distributed applications (Dapps) and is not necessarily designed for trading and settlement in the way that BTC is.
d.) Acceptance – BTC is widely accepted for almost all types of transactions, whereas other cryptocurrencies are not. Some cryptocurrencies are only useful within their own tokenised network – more on that, and ICOs, below.
e.) Supply – A cryptos supply is sometimes infinite (ETH) or finite (BTC) – which plays a role in the valuation of these new age assets. Furthermore, the market supply of some cryptos is ‘held back’ through human intervention (see Ripple’s XRP being introduced systematically to avoid flooding) which further contributes to price uncertainties for some.
f.) Speed – The speed with which one can transact is oftentimes limited by the cryptographic processes underpinning the blockchain itself. Bitcoin’s transactions are only recorded every 10 minutes, whereas transactions are recorded every 14-15 seconds on the Ethereum blockchain.
g.) Transparency – A controversial aspect for many, is the fact that some cryptocurrencies are either transparent or opaque in terms of the identities behind the transactions. On the one hand opacity enables illegal activity. A large proportion of cryptocurrency transactions (especially within BTC) are rumoured to be for the sole purpose of illicit transactions such as money laundering, fraud and terrorist funding. On the other hand transparent transactions enable accountability to be built into a network, adding value through providing ‘trust efficiencies’.
The debate rages on as to where the intrinsic value for cryptos lies – what makes it valuable after all of the extrinsic layers are peeled away? An argument presented here, is that the intrinsic value lies within the functionality, the utility, that Blockchain and ultimately cryptos provide, within the new digital economy. Additionally, it is compounded by the effort required to mine more of it. Yes, gold may be useful in manufacturing and pretty when worn as jewelry. Yes, oil can be refined into plastics and other useful forms. Yes, the dollar may hold value through the Fed buying it back at a certain value (numerous arguments against this ‘backing’ exist.)
But, cryptos, through cryptographically enabled protocols, built on top of a Blockchain, that require miners to create supply, opens up a pandora’s box of opportunity for safer, more seamless, faster, cheaper, peer-to-peer transacting of valuable digital assets. In the digital economy, it is this inherent value that financial analysts seem to be overlooking, or misrepresenting. The next step could be to classify it as a separate asset class and to formulate a way to capture and quantify this inherent value.
Case for a Boom
What are the factors underlying the current boom in cryptos? What are the forces influencing this growth? Below is a list of some of the major forces contributing to a crypto boom:
1. Equities are a Poor Analogy – Equity valuations are, at the very heart of things, based on the underlying asset’s ability to produce future earnings – cryptocurrencies on the other hand, are not. Thus, as Josh Hannah points out, the value of a crypto, such as BTC, can grow at an exponential rate, much faster than most real-world businesses owing to the fact that it is untethered by building products or services.
2. Demand eats Supply for Breakfast – The majority of investors in BTC and other cryptocurrencies are said to be speculators driven by hype (see graph below, which highlights investment into BTC tracking Google searches for Bitcoin.) According to Marketwatch.com BTC is up 740% (YoY), ETH is up 4600% this year and Ripple’s XRP is up 3600% this year alone. Demand is clearly outpacing supply at a rapid rate. A more interesting calculation would be to denote the number of first-time investors, sophisticated investors, arbitrage traders, OTC traders and illicit investors. By understanding the who, one can deduce the why, where and when – and ultimately formulate a more accurate model for valuation. Whether exchanges (and other sources) will be able to eventually publish data like this is yet to be seen.
3. Flight to Safety – A strong argument for cryptocurrency growth is the fact that some cryptos are being traded as a flight to safety asset, similarly to gold. With a lower correlation to the market, higher returns on offer, faster transaction times and lower transaction costs, cryptos could offer an opportunity to reduce volatility whilst delivering premium returns.
4. Institutional investors – Cryptos currently have a tiny market-cap when compared to other asset classes, but institutional investors’ interest is building.
5. Recognition – Recognition of BTC as a legitimate currency by a nation, or even a large multinational, generally spells success for a cryptocurrency. It adds credibility and promotes demand.
Total Market Cap – 06/09/2017
Case for a Bubble
These are the factors that will drive down the value of a cryptocurrency. As with the Boom factors, some factors carry more weighting in terms of impact. They have been listed in no particular order of relevance as follows:
1. ICOs and Darwinism – Initial Coin Offerings (ICOs) are driving the crypto boom. In essence, they’re a form of crowdfunding using crypto tokens created by the company raising the funds using this mechanism. Some are built by competent teams, with genuinely valuable offerings. Most offer get-rich-quick schemes backed by a mere white paper and very little else to secure investor returns. They’re an incredibly risky investment, with little to no regulation existing within a space filled with snake oil. This high-risk bubble is sure to pop soon – when it does, it’ll spark a sell-off and many will be caught with their pants down. The Chinese have already instituted regulation in this space, banning them outright. Interestingly, Russia has opted to allow them, whilst trying to alleviate some of the pain points.
2. Greater Fool Theory – The belief that the asset will continue to rise and that one will always be able to sell at a higher price is inviting a lot of speculators, as previously mentioned. These speculators add to the volatility of the asset class and will most certainly contribute to the velocity in a downturn.
3. Valuation Ratio Analysis – The Mcap to Transaction Value (MTV) Ratio provides a PE ratio equivalent for BTC and can act as a guide for crypto valuations. The lower the ratio the more the value is grounded in its utility. The higher the value the more overvalued, when compared to its utility.
4. Regulation – The effect will depend on the level of regulation. Restricting transaction volume through heavier regulation will inevitably affect the value of a cryptocurrency negatively, in the short term. The risk of no regulation is that investors in unregulated exchanges and tokenized networks will have no initial legal recourse and there is an inherent lack of transparency – one of the major reasons for regulators to try to catch up clamp down. (High Probability Weighting)
5. Nascency – Cryptos are still the new kids on the block when compared to other asset classes. Their nascent nature means that there are still many kinks that need to be ironed out. These kinks can be volatile and are surrounded by enormous uncertainty.
7. Systematic & Systemic Shocks – Cryptos aren’t as correlated to traditional markets as other more established asset classes. This makes them an attractive hedge and (as previously mentioned) a form of flight to safety. The caveat, however, is that they don’t yet have a calculable intrinsic value, the market cap is too small and the market too volatile to provide an effective ‘safe zone’ for investors to park their cash during turbulent times.
There will undoubtedly be a drop off in crypto valuations. Some of them will also continue to rise to heights inconceivable at this point. There will be new entrants that supersede current leaders. The rise and fall stories that play out will be the same – the timing of which is dependant on the aforementioned forces and factors at play. In a world filled with uncertainty, it would be churlish to offer advice on where to invest your fiat currency, especially in the short term.
There is, however, enough anecdotal evidence to suggest that blockchain and cryptocurrencies are here to stay. It could prove too costly to sit this one out altogether. It could also prove too costly to mistime and miscalculate investment in this asset class, without taking the downside potential into consideration. Either way if one is interested in being a part of the group that tells a story of success – it would inevitably involve perfect timing, selection, and management of one’s investment in a well-traded cryptocurrency. Based on the following evidence and for the sake of gauging where are we are in the cycle – it is suggested that cryptocurrencies are nearing the top of an inevitable drop off, based on the ICO bubble bursting:
Phase 1 – Current
- ICO Growth – ICOs are expected to balloon further, as speculative investors chase exponential returns, foregoing rationality.
- Institutional Investment – Institutions will create ways to enter the hubbub.
- MTV Bubble Indicator – Cryptos, are on average, trading well above their MTV – this ratio will continue to rise as ICO speculation drives the bubble.
Phase 2 – Short to Medium Term
- ICO Burst – ICOs are out of control (literally, without regulation) and too many ‘bad apples’ will enter the fray. The bubble will burst when investors fail to receive promised returns and or when ICO company founders are found out for fraudulent behaviour.
- Regulation – The powers that be are already clamping down and will clamp down harder when the inevitable ICO bubble bursts.
*The timing of the above factors is based on a short to medium term (6 – 12 month) view.
With the above overview in mind, the timing and type of crypto investment is the subject of the next article in this two part Cryptocurrency series. It will cover the ins and outs of the top 6 cryptocurrencies, as well as the ways in which one can invest – including information about the best software, hardware, exchanges and wallets to do so.