Raphael Potter, Technology
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Is Bitcoin in a Bubble?

By: Raphael Potter

Bitcoin has taken the media by storm with seemingly new all time highs every couple of weeks, leading to the heated debate: is it a bubble or not?

The mainstream discussion surrounding the mysterious and enticing new form of currency, cryptocurrency, has largely been focused on Bitcoin, the first and most prominent of it’s kind. The fierce debate regarding the allegations of Bitcoin being in a bubble are debatably a result of a fundamental misunderstanding of Bitcoin; this confusion is exacerbated by the variety of opinions one may encounter on the matter. Most famously, Jamie Dimon, the CEO of JPMorgan Chase, has out right called Bitcoin a fraud, while Peter Thiel has said that many are underestimating the value of Bitcoin. One of the reasons that such high caliber investors have involved themselves in this discussion is due to the extreme fluctuations and growth of Bitcoin’s monetary value. In early January 2017, Bitcoin hit near record highs, trading at over 1000 U.S dollars per Bitcoin. Within the next 10 months, Bitcoin would trade at over 7 times that number. To further complicate things, as pointed out by George Soros, markets are self-referential, and the attention brought on by these investors, as well as news of the U.S and Chinese government’s increased involvement in the cryptocurrency market, further fuels the case of those who claim that Bitcoin is a bubble that is fueled by speculation. Ultimately, the question on everyone’s mind is just what on earth is going on with Bitcoin?

So What Exactly is Bitcoin?

Before attempting to make sense of Bitcoin’s behavior, we must first clarify what exactly Bitcoin is. As defined by Bitcoin.com, Bitcoin is a peer-to-peer electronic cash system. It is a consensus network that enables a new type of payment method and a completely digital form of money. It is the first decentralized peer-to-peer network that is powered by users. Much of the talk surrounding Bitcoin inevitably leads to a discussion of the Blockchain, the underlying technology that Bitcoin is built on. Blockchain is a distributed ledger, a collection of financial accounts, that permanently records all transactions, and is publicly visible for all to see. The genius behind this technology lies in the fact that it cuts out the middlemen, the banks, due to its self-regulating decentralized capability of recording and securing all transactions that have taken place. In exchange for the miners’ services of validating transactions, they are awarded new Bitcoin. An additional quality of Bitcoin that makes it so intriguing lies in its scarcity. Fiat currencies, those used by governments that are not backed by anything aside from their word, have the capacity to grow indefinitely, and are thereby inflationary currencies. On the other hand, one of the inherent characteristics of Bitcoin is that it is limited in its supply and will max out at 21 million Bitcoin. For that reason alone, some have speculated that Bitcoin’s value will continue to rise due to it being a deflationary currency. Lastly, and closely related to the previous characteristics, Bitcoin’s decentralization means that, unlike fiat currencies, no central authority can decide to increase the number of Bitcoin in circulation and fix the price in any way; the supply is limited and the price is dictated by buyers and sellers interacting in the market place.

A Currency or an Asset?

Bitcoin’s erratic behavior is one that can be interpreted in a multitude of ways, depending on how one categorizes Bitcoin. Thereby, a broad overview of the various financial entities that Bitcoin may be will help elucidate its tricky behavior. Is it an asset? A currency? A commodity? A collectible? Is Bitcoin truly worthless, or, is it the future of currencies, one that has the potential market capitalization of the U.S dollar? Lastly, the dark possibility constantly looming in the background, is Bitcoin in the midst of the most dangerous bubble in recent memory, akin in madness only to the famous Tulip crisis of the 17th century?

In order to properly frame this debate, the definitions of the terms being used must be clearly understood so as to understand what Bitcoin is. First, as defined by Investopedia, a bubble is an economic cycle characterized by a rapid escalation of asset prices followed by a contraction. It is created by a surge in asset prices unwarranted by the fundamentals of the asset and is driven by exuberant market behavior.

Next, and where many of the problems surrounding Bitcoin stem from, there are important differences between the two most commonly referenced categories when discussing Bitcoin; currencies and assets. Therefore, it is important to see how our classification will change our understanding of Bitcoin’s volatility. The definition of these two categories is somewhat flexible, and there does not seem to be a universally agreed upon set of propositions that this “item” must fit. Nonetheless, there are some generally agreed upon characteristics that are highly relevant when discussing Bitcoin.

In order for an item to be defined as a currency, first, it must be a widely accepted vehicle in the payment for goods and services. The essential function of a currency is to allow a transaction to transpire, therefore, it is imperative that this hypothetical currency be user friendly in its usage. It should be easily transferable, accessible, and accepted. Second, it has to be a stable store of value. If there are legitimate concerns as to whether the currency will have any value in the near future, people will be highly reluctant to transfer their wealth from a more stable storage to this currency. Third, it has to be effective as a unit for account; simply put, it must serve as a benchmark with which it can be compared against other assets. Additionally, it should function as a converter to goods and services. An extension of this, but less abstract, is that it must be cleanly divisible and countable; if you split it in half, each half is worth half of the original whole.

To give light to the “Bitcoin is a currency” position, it is worth providing the perspective of Aswath Damodaran, a professor at New York University’s Stern School of Business who has been called “Wall Street’s Dean of Valuation”. He has taken an interesting stance on the Bitcoin bubble question. He has argued that Bitcoin is best understood as a currency. He claims that the long term success of Bitcoin depends on whether or not it behaves as a “good currency”. Bitcoin does a fantastic job as a unit of account. It is fungible, divisible, countable, and more open than other currencies insofar as the public’s ability to monitor its movement. Additionally, it is currently impossible to be counterfeited. According to Professor Damodaran, the other two criteria of a “good” currency, however, have not been successfully met. Because of the lack of faith in the stability and longevity of Bitcoin (one of the characteristics of a currency), it is not widely accepted as a medium for exchange (the other of the three characteristics of a currency).

However, Professor Damodaran argues that sooner rather than later, one of the cryptocurrencies, most likely Bitcoin, will emerge from the pack as the de facto cryptocurrency. The takeaway of this analysis lies in the reframing of the “bubble” issue. Because Bitcoin is a currency, it cannot be overvalued, and the very definition of a bubble is that an asset is being overvalued. If Bitcoin is a currency, it should priced as a currency, and therefore must be measured as how it functions as a currency. Many of the issues with Bitcoin lie in the fact that many perceive of it as an asset as opposed to a currency, and this has led to immense volatility and lack of acceptance as a medium for exchanges. Insofar as how the future of Bitcoin will play out, Professor Damodaran has outlined three possible scenarios. First, it can become an accepted global digital currency in which it is widely accepted for transactions internationally. Second, it can be likened to a modern gold in which it is not truly a useful currency, yet, when individuals lose trust in governments and banks, they will transfer their wealth into Bitcoin as a way of avoiding regulated currencies. Third, and most gloomy, is that Bitcoin is analogous to the Tulip Bulbs of 17th century Holland, and that the speculation and misunderstanding of Bitcoin will eventually cause its price to spiral downwards until it is worthless.

Now, to address the other position on the topic, those that see Bitcoin as an asset. An asset is defined as an entity that generates, or is expected to generate, future cash flows. One unifying characteristic of assets is that their cash flows can be valued and priced. Assets can be valued insofar as their incoming cash flows and risks, while also being priced by means of proportionality to an accepted metric. Assets such as real estate and bonds can be priced against one another by comparing their PE ratio or IRRs. An example as to why Bitcoin can be more correctly viewed as an asset as opposed to a currency would be the scrutiny of Bitcoin’s current capability as a convenient mode of transactions. Because of the limit of Bitcoin transactions that can be completed in a day, it may take days for any given transaction to transpire. Currently, nearly 350,000 Bitcoin transactions are taking place daily – to put this in perspective, five years ago, Amazon was averaging 26.5 million transactions per day. Given the extreme volatility of Bitcoin and its inconvenience as a currency, some argue, Bitcoin is clearly a speculative asset that one buys in the hopes of reselling it a higher price – like gold.

Arguments For Bitcoin

Now that some of the trickier aspects of the conversation have been explicated, it is fitting to begin discussing both sides of the “Bitcoin bubble debate”. There is no lacking of highly intelligent people that seem to think that Bitcoin is not in a bubble, or that the conversation should be more nuanced than that. Some of those supporters include Peter Thiel, Abigail Johnson, Bill Gates, and John McAffee. First, supporters of Bitcoin argue that there is a massive global need for a currency like Bitcoin, serving as a useful replacement for gold. The fact that it is nearly impossible to counterfeit and can be distributed without cost and with time efficiency, as opposed to fiat currencies that require intermediaries like Western Union which are extremely slow and expensive, gives Bitcoin intrinsic value. Next, the immense distrust and animosity towards the global banking system is an obvious reason as to why people are increasingly adopting Bitcoin. Many see Bitcoin usage as a way of circumventing the distrusted and even fraudulent process that has long been the only viable method of engaging in finance. Most importantly, many see Bitcoin as a revolutionary force in the global banking system. The argument against Bitcoin based on the notion that Bitcoin is backed by nothing does not go very far when considering that interest rates are artificially low, and that fiat currencies are backed by nothing aside from the hearsay of large countries. Bitcoin’s value is positively reinforcing in that the more people to adopt Bitcoin, the more people will adopt Bitcoin. The Chicago Mercantile Exchange, CME, will begin trading Bitcoin derivatives in late 2017. Lastly, and least positive, Bitcoin’s largely untraceable nature makes it extremely enticing to criminals, the Silk Road being one of many examples. Bitcoin’s ability to render the traditional banking system completely obsolete and create a new dimension for global finance and transactions, and, if true, may serve as a justification for its ever climbing prices.

Arguments Against Bitcoin

On the other hand, there are many valid reasons to be skeptical of Bitcoin’s astronomic rise. For example, it seems plausible that many are buying Bitcoin on speculation, in that they believe that the value will increase indefinitely and that other people to buy Bitcoin from them at a higher price. While there is a case to be made regarding the inherent value of Bitcoin, that is an insufficient explanation as to why the price has skyrocketed in the last few months. If anything, the introduction of new cryptocurrencies that are competitors with Bitcoin should have pushed down the price of Bitcoin. Aside from the short term speculatory attacks on Bitcoin, it is worth discussing the troubling lack of education of some of those that have bought Bitcoin. Some people confuse blockchain with Bitcoin. Blockchain technology is not limited to just Bitcoin, and is in fact being widely adopted in other currencies as well as financial institutions. If many are investing in Bitcoin on the basis of its usage of blockchain, the price of Bitcoin is in for a damaging correction when other blockchain utilising currencies grow in popularity. Additionally, there is legitimate room for concern as to how governments will regulate Bitcoin in the future, one of the most important cases being in how China will relate to cryptocurrencies going forward. On a more practical note, the very claim that makes Bitcoin so popular – lack of involvement of government – may be one that is damning in the long run. There are conceivable technical issues as far as how Bitcoin will be taxed, and more importantly, what if there is a need to inflate or deflate the currency? While it is possible that Bitcoin may survive without any central authority, this is a momentous task that has never been attempted before. This lack of prior experience exposes Bitcoin users to immense risk, as we are attempting something completely unprecedented.

Looking Forward

Given the short and long term implications of Bitcoin’s astronomic rise in price, it is well worth considering what it is that is driving this rapid increase. Extremely intelligent people have taken diametrically opposing views on this topic, and the lack of clarity as to what Bitcoin even is further widens these diverging opinions. Nonetheless, to return to Professor Damodoran’s point for a moment, it is worth dwelling on how young Bitcoin is, and how fast things are moving. There are clearly logical and coherent positions to be taken from any given number of perspectives, and the endpoint for Bitcoin remains very hazy. Still, one of the most commonly agreed upon sentiments in the pro and anti bubble camps is that we are on the brink of revolutionizing the banking system, whether through Bitcoin or other blockchain technologies, a much needed correction to the presiding system that is riddled with flaws and has played an instrumental role in recessions of the past. Only the future can clarify who was right, but the mainstream adoption of Bitcoin as a valid currency/asset seems to be the tip of this new, chaotic, and bright future.

Works Cited

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