Table of Contents
As I’m writing this, CBOE Bitcoin futures contracts had just surpassed the $20,000 mark. In the last few months, Bitcoin has received unprecedented attention from the media and investors alike. Among all the topics to discuss, everyone is obsessively fixated on a single question: is Bitcoin in a bubble or not?
Alas, I don’t posses a functional crystal ball. I do believe that the crypto-currency market is in a bubble (with Bitcoin leading the pack) but I only believe so purely from a trader’s point of view. For all I know, Bitcoin is not in a bubble! But if you’ll indulge me with your patience, perhaps I can provide insight into how you can approach Bitcoin from an trader’s standpoint.
Introduction to the Crypto-Currency Technology & Function
First, we need to understand the uniqueness of Bitcoin. By itself, the technology behind Bitcoin is rather unremarkable. Bitcoin is simply a complex mathematical calculation. The algorithm is so complex that it requires tremendous computing power to solve. To achieve this, the “inventor” built the system whereby many users can contribute to the calculation with their own computers. Each piece is then verified against the algorithm and then “added” to the whole. An incorrect piece cannot be added to the whole as the calculation would be incorrect. The key takeaway here is that the technology and concept is not new. For those who may recall, a similar technique was popularised back in the 90’s under the SETI@Home program where users could contribute the computing power of their personal computers to sift through space noise captured by enormous satellites. The goal was to analyse the signals piece by piece to look for the signatures left behind by (potentially-existing) extra-terrestrial technology1Think of it as looking for the wake left behind by a boat. The wake is the “signature” that the technology (the boat) exists.. So Bitcoin is not particularly unique in terms of the technology.
Why then, is everyone raving about it if the technology isn’t particularly ground-breaking? There are several reasons. At the end of the day, I think it really boils down to one thing: it’s exciting and no one wants to miss out on making a quick thousand. What is important is that people should be excited even though it’s for all the wrong reasons.
The thing that makes Bitcoin nothing short of revolutionary is how it is used in practical application. Instead of using the tech to merely solve complex equations, Satoshi Nakamoto2Is that even his real name? Is that even a single person? turned it into a new form of currency. As a math exercise, it’s not unique but as a currency, it becomes an invaluable experiment. Because each piece of the calculation is unique and needs to “fit” into the algorithm, no single piece can be duplicated. In monetary terms, each “coin” can be instantly verified for authenticity and cannot be forged. At present, all fiat money3The traditional form of money we are familiar with that is backed by government. can be forged. Bitcoin (or crypto-currency) does not have this inherent weakness. In addition, the coins cannot be traced (because that would require a change to the piece, “coin”, which would make the piece a wrong “fit”). Lastly, each algorithm has a limited “supply” of coins because at some point, the math problem will eventually be solved. It cannot be artificially inflated or deflated by various government monetary reserves. You have to create a new coin to “solve” a new algorithm. You can’t just randomly “print” new coins. There is a real cost to mine for coins. If you are a libertarian, you should be drooling at the mouth. This is what makes crypto-currency amazing – not the technology but in its potential usage and real world application.
The Key Issues of Crypto-Currency
Unfortunately, crypto has a few problems of its own. The first and most obvious problem is the lack of adoption. Unlike fiat money, you cannot simply walk into any business and exchange Bitcoins for goods and services. Only some stores accept the coins and while there are a few brand names, they are few and far in between. Widespread adoption is key in order to legitimise crypto-currency. Currently, this is not the case. It will likely take at least a decade before we can really use crypto-currency in a meaningful and practical way.
The second problem is more nuanced. It is understandable that the general public did not pick up on this (and that includes the media and their ivory tower pundits) because it requires an understanding of trading financial instruments in the market such as equities in the stock market, currency pairs in the Forex markets, and futures contracts in the Futures market. To explain the issue, I will first ask you an important question: how does one go about profiting from crypto-currency? There are only four main ways to do so:
- Mine for coins and then sell it on a crypto-exchange.
- Trade the stock or index by buying and selling shares.
- Trade the currency pair such as BTC/USD.
- Trade futures contracts.
Do you notice a common factor among all four options? If you said that the only way to profit is to sell for U.S. Dollars, then you are absolutely correct! You cannot make money with Bitcoin unless you convert it into fiat money4Yes, I am aware that you can exchange a coin for goods and services but that’s not what’s happening for the vast majority of people. I also addressed this point earlier.. Simply put, Bitcoin, and by extension all crypto-currency, is backed by fiat money. As a result, this defeats one of the major purposes of crypto. Bitcoin is not seen as legitimate until it trades on its own market & exchange without having to use fiat money. In other words, it needs to reach the level where people trade one type of crypto with another type (e.g. Bitcoins for Ethereum coins). Until then, it is exposed to the weaknesses of fiat money. It is no wonder that crypto stocks (such as GBTC) have so little institutional interest! Rather, investment firms are opting instead to mine for different coins as opposed to trading the stock/index, currency pair, or its futures contracts! This is the key to answering the question of whether Bitcoin and the Crypto-Craze is in a bubble or not.
The history of the financial markets is a graveyard of burst bubbles. And although not every investor sees crypto-currency as a bubble, most take precautions by applying sound risk management. Sometimes, they hedge their trades. Other times, they approach the problem differently. But regardless, for crypto, the vast majority of institutional investors do not directly invest in crypto. Instead, they invest indirectly. Here are some examples of indirect investment of crypto:
- Invest in a parallel industry that has exposure to crypto-currency such as AMD, Intel, and Nvidia.
- Mine for coins.
- Invest in R&D of the technology or its “accessories”.
What the general public and the less experienced retail traders don’t realise is that the markets move primarily because institutional traders are in the markets. This is called making the market. Collectively, we as retail traders don’t “make the market”. On a parallel note, I understand the frustration people have when their stops are run through. But you need to understand that you were not the target – you are merely collateral damage. So when only a measly 2.25%5To provide you with some context, Microsoft has 75% institutional ownership, Apple has 61%, Tesla 57%, AMD 60%, and even failing Blackberry has 59%! of GBTC is owned by institutional investors and the average daily volume of the stock is usually less than 400,000 shares traded, it should serve as a warning sign that the experienced professionals aren’t investing. If the professionals who trade for a living aren’t willing to risk it, then what rhyme or reason compels the individual investor to invest?!
The second sign that we must notice requires an understanding of market dynamics – specifically, supply and demand. It comes as no surprise to anyone to hear about Bitcoin’s wild ride; its price changes are as fast as the changing direction of the wind. Why does Bitcoin’s price swing in such an extreme fashion? It does this because the majority of its shares (or its “supply”) is tied up. When this happens and demand is high, then the few remaining shares that are available become more valuable. As a result, you end up paying a premium. So if one share is at $10,000 pricing, a purchase of it will require the buyer to offer an amount whereby the seller is willing to part with the share. Market dynamics of the real world applies here in the financial markets; no seller wants to sell at a low price when there is a high demand and a shortage of supply. The inverse is also true – when price gets too high, no buyer is willing to buy unless the price goes down a bit. So the demand dries up a little bit and sellers are forced to reduce the price. This is how you get the massive price swings. This difference in the selling and buying prices is referred to as the bid/ask spread.
Take a look at the following chart of NYXBT (NYSE Bitcoin Index that tracks the price of a single Bitcoin in USD). I set the chart to a 6-month daily view. Notice how there are enormous gaps between each day’s activity? These gaps represent the bid/ask spread in action.
Thus far, we have the following factors in place:
- A technology subject to traditional market dynamics. That is, the product doesn’t do what it’s supposed to do and people will eventually realise this. Once they do, traditional market dynamics take over.
- Extremely low trust/interest by institutional traders despite a public craze.
- Low volume coupled with extremes in the bid/ask spread.
When you have these factors together in place, you have one of the classic templates for a bubble. And this is why I believe that crypto-currency is in a bubble. Caveat emptor.
Objections to the Analysis
You’re wrong – just look at the Internet. It’s still around.
Yes, it is. But a belief that the stocks, indices, futures contracts, and currency pair is in a bubble does not mean I do not think that the technology does not have a viable future (which I explained at the very beginning of this article). The Internet is still around but many of the stocks during the Dot Com era are no longer around. In addition, many people lost their money and never recovered it. The two issues are mutually exclusive.
Look at the price – you say it’s a bubble but its price has continued to climb steadily upwards. Therefore, you are wrong.
I could be wrong. I never said that it must be in a bubble. I said that I believe that it is a bubble based on some key factors. But I also disclaimed that it might not be in one. In addition, I did not place a value at which the bubble will pop (assuming that it is in a bubble). If Bitcoin is in a bubble, it can still very well reach a price of $1,000,000 USD before it pops. During the Tulip Craze of 1634-1637, a few tulips were worth as much as an entire estate! The remarkable thing is that it took 3 years before the bubble popped. So price does not determine whether it’s a bubble or not – rather, it is the behaviour of price that determines whether it’s a bubble or not.
AirBnB does not own real estate, Uber does not own cars, Facebook doesn’t create content, Alibaba does not have inventory. Yet, all these companies are profiting. Bitcoin does not have any “real money” in the bank. Therefore, it will profit like these companies.
This is an example of the logical fallacy of false equivalency. Each of these companies might not own real property but they do provide the service which they set out to provide. Crypto-currency has yet to reach that level of completion. Until it is in wide usage, Bitcoin has not yet provided what it intends to provide. The other thing is I have not analysed these other stocks. For all I know, they could all be in a bubble as well. Each stock has its own unique factors. This is Bitcoin’s factors – the factors don’t need to be identical to other stocks.
So should I invest in Bitcoin or not?
I have no idea. You need to decide on your risk appetite. For myself, crypto presents too high of a risk for my trading style. Hence, I will not be investing in crypto. But for some, the risk is acceptable. It all depends on you. I recommend you to read my primer to trading. In it, I state clearly that you need to develop your own style to fit your personality. Trading is an art – every artist is different and these differences are reflected in their trading style.
So what if it’s in a bubble? You can still make money.
You’re absolutely right – you can make money. The issue isn’t about making money but rather, it is about those who invest, hold on, and lose their retirement funds when the bubble pops.