What Bitcoin Can Do To Avoid Its Bubble Bursting


I have written before about whether we are in a Crypto bubble, we are, and I used the NASDAQ definition to highlight how clear it is:

NASDAQ definition: A market phenomenon characterized by surges in asset prices to levels significantly above the fundamental value of that asset. Bubbles are often hard to detect in real time because there is disagreement over the fundamental value of the asset.

I previously explained that bubbles are not necessarily a bad thing. A bubble, especially in technology, occurs when innovation creates a financial growth opportunity and that opportunity brings investment capital. A bubble forms, because organisations are in a race and investors, are putting their money behind those teams and projects they believe will become the leaders in this new market and thus deliver the best returns on their investment.

With the dot-com bubble, investors were putting money behind those companies which they believed would have the most growth potential. With Crypto it is the same, investors are putting money behind those coins which they believe have the most growth potential.

It is hard to argue against the advantages that Crypto offers against the fiat monetary system, and it is hard to argue against the benefits of the blockchain for application development. If Crypto goes mainstream, then early investors will be rewarded with significant returns, and if blockchain based service tokens are successful, they too will deliver high returns, and this is why we are in a bubble. Investors are speculating because the market is relatively small compared to how big it could be.

However money is defined, it is central to how we live and survive, it is the reason we go to school, university and get a job. Money, as sad as it may seem, defines our life. If we are investing, whether in stocks or Crypto, we are doing it to better our lives and the lives of our family.

People fear to call it a bubble because they are afraid of a crash, but the fact that it is a bubble drives the flow of capital in, accelerating innovation. If we accept it is a bubble it allows us to trade in a way in which we can target returns while protecting ourselves from if and when it bursts.

Whether it will burst and the extent the market drops will come down to the Crypto community: the leaders, the innovators, and the investors. It requires a coming together which seems far away while wars are being fought across multiple fronts:

  • Traditional banks and government v Crypto
  • Bitcoin v Bitcoin Cash

On Tuesday, CNBC reported from an interview with Ray Dalia, founder of Bridgewater Associates, the largest hedge fund by assets under management, with Ray highlighting that there is a bubble in the Bitcoin market, saying:

It's not an effective storehold of wealth because it has volatility to it, unlike gold. Bitcoin is a highly speculative market. Bitcoin is a bubble.

Ray's views were widely dismissed by the defensive arms of the Crypto community, especially so close after the FUD from Jamie Dimon, but he makes three good points about why Crypto is in a bubble:

  1. It cannot be a store of value because it has volatility to it
  2. You cannot spend it easily
  3. People are buying it to sell at a higher price

I agree with every point.

The risk of a bubble is that when it bursts, investors get burnt, both the small investors speculatively buying coins and the large investors providing the capital to the companies building the Crypto infrastructure. If the bubble bursts hard and we enter a significant bear market, then this sets back the Crypto ecosystem.

We should not just dismiss Ray as a naysayer because he also spoke positively of Crypto:

It's a shame, it could be a currency. It could work conceptually, but the amount of speculation that is going on and the lack of transactions [hurts it].

I agree with him again.

It could be a currency, it arguably is, but speculation is outpacing adoption which could lead to a crash, and that would be a shame.

The great thing about Bitcoin is that it could be a replacement for fiat and gold, it could be a better currency than fiat and a better store of value than gold. Fiat is a good currency because it is easy to spend but not such a great store of value because of exchange rates and eroding value through the endless issuing of new money causing inflation. Gold is an excellent store of value because it is universal and prices are stable, but it is a poor currency due to portability.

The key issues with Bitcoin (and Crypto) must be addressed, and Ray has identified the main ones though I add utility to his first point.

1a. It Cannot Be a Store of Value Without Utility

I argued this recently with someone on Twitter where I was claiming that Bitcoin cannot be a store of value like gold without utility. The person I was arguing said that gold does not have utility, typifying the naivety of those investing in Crypto. Let's look at gold regarding utility:

  • Jewellery
  • Electronics
  • Dentistry
  • Medical
  • Aerospace
  • Awards
  • Glassmaking
  • Gilding

Gold has utility, whether it is for decoration, a sign of wealth or for manufacturing and electronics. If you hold gold, you hold something which people either want to wear or use and thus there is a market to buy and sell gold. It is a physical product, a pure and rare element with inherent properties which generates demand commercial demand.

Bitcoin has no use beyond financial transactions, whether this is for the purchase of a cup of coffee or a significant cross-border trade into fiat, its only value is monetary. It cannot be worn or made into anything, thus, without utility, Bitcoin is just math.

For Bitcoin to keep growing, we need widespread retail adoption, which right now isn't there. While Coinbase and others are helping vendors accept Bitcoin, it is almost entirely limited to the online world apart and a few random businesses. Companies are working in the ecosystem to change this, but we need the pace of retail adoption to match the pace of price speculation. 

1b. It Cannot Be a Store of Value Because it has Volatility

Gold is an excellent store of value because:

  • Capped supply
  • Prices are relatively stable
  • It can be bought, held, retrieved and sold back with relative ease

Bitcoin is a better store of value than gold due to portability, but prices are currently too unstable for it to be a store of value. When the price spiked in 2013, it was not a good store of value because the price subsequently crashed, thus haemorrhaging value.

Longer term this may change. Price volatility is a symptom of the innovation which threatens the old ways of banking and governance. In time, as the market cap grows and the distribution of Bitcoin increases we will likely see volatility drop. While Bitcoin is volatile, it is the least volatile Crypto, as volatility tends to correlate to market cap. As Bitcoin grows in value, I would expect volatility to decrease. If it were a $6 trillion market like gold with millions or investors and users, individuals would be unable to move market prices so easily, and we would also have escaped the clutches of FUD.

2. You Cannot Spend it Easily

Ease of spend is sadly washed over by too many in the Crypto community. It is tied to utility, in that we need utility for it to be a store of value, but we are restricting utility while it is hard to spend.

There are two primary reasons Bitcoin is not easy to spend:

  • Transaction speed
  • Transaction cost

While both are being addressed, it should be central to the development of Bitcoin. A 90 minute confirmation time and £1 transaction fee for a cup of coffee make it a significantly less useful currency than fiat, as both cash and cards enable instant transactions with little or no consumer transaction fee.

While there are examples of where Bitcoin is being used to buy things, they tend to be within the ecosystem, such as with mining rigs and hardware wallets or big-ticket purchases such as houses, but with these transactions, speed and cost are negligible. For widespread adoption, we need a solution.

Some will argue that Bitcoin is not for a cup of coffee and doesn't need to support such transactions but it could. Other Cryptocurrencies have proved that you can have instant, low-cost transactions, so why not have it? If you do, Bitcoin can outperform fiat on every level. It can be used instead of cash and cards for a cup of coffee and a bank transfer for buying a house. Every purchase can be a fast, low-cost wallet to wallet transaction.

3. People are Buying it to Sell at a Higher Value

In a free openly traded market, this is what happens, whether it is stocks, foreign exchange or Crypto and this itself does not make Bitcoin a bubble, but it is what can cause a bubble to burst.

Buying Bitcoin to sell at a higher price is tied to volatility, utility, and ease of spending and this is where you can see how all these issues which Ray has raised are linked.

If you solve utility and ease of expenditure then you increase adoption, if you increase adoption you grow the market cap, if you grow the market cap, you reduce volatility, if you reduce volatility people will spend it rather than holding it to sell back into fiat at a higher value.

People are buying Bitcoin as a speculative investment, hoping that it will grow in value. Fiat has far better utility than Crypto right now, and if the price of Bitcoin inflates far quicker than it achieves utility, then investors will naturally trade out to fiat. 

The Good Thing About Bubbles

Bubbles are good at creating strength and destroying weakness. The dot-com bubble weeded out those companies with a flawed product or strategy. The dot-com bubble also highlighted which technologies worked and where infrastructure and consumer adoption was lacking behind innovation. Boo.com being a perfect example, in theory great, but the choice of technology was wrong, and consumers were not ready. Through trial and error, innovation and some brilliant people, we have some of the largest companies in the world: Amazon, Google, Facebook, etc. Moreover, where Boo.com failed we have ASOS, where it did not come down to technology innovation but user experience.

Crypto and blockchain are not going away. A bubble is a natural part of the economy, and when it crashes, a better market will appear, altering the way capital enters. Look at how difficult it is now to raise money for an Internet startup today compared to the late 90's. The same will happen when Crypto becomes a stable market.

The similarities between the rise of the Internet and the rise of Crypto are clear to see. You only need to compare the dot-com IPO hysteria to the current wave of ICOs. Taken from Investopedia:

In the year 1999, there were 457 IPOs, most of which were internet and technology related. Of those 457 IPOs, 117 doubled in price on the first day of trading. In 2001 the number of IPOs dwindled to 76, and none of them doubled on the first day of trading.

Read more: Market Crashes: The Dotcom Crash http://www.investopedia.com/features/crashes/crashes8.asp#ixzz4tEHQgQ5m

Now look at the number of ICOs, look at the prices of some of these coins without delivering an operational product. Do you think today an Internet startup could raise $200m on the back of a whitepaper and a flashy website? The risk we face now is similar to when the dot-com bubble burst, when Internet companies failed to deliver profits, ran out of money and could not source additional funding and went to the wall. The same could happen in Crypto when these service-based tokens deliver a product to the market. If consumer adoption does not economically justify the value of the coin, the price will fall, and then watch how quickly investors sell.

It is easy to dismiss the likes or Ray Dalia when it does not suit our narrative, but we must be realistic when investing. I, for one, hope that people wake up to the reality of the market we are in. Crypto can change the world, but we must face up and address its flaws.