Cryptocurrency Bubble Concerns

Recently, after a period of rapid growth, the cryptocurrency markets have endured a significant correction. The question on everyone’s mind is whether or not cryptocurrency is a bubble ready to burst. However, there is no simple answer to that question, there are strong arguments both for and against the bubble. Let’s start by defining what we mean by a bubble. The key to defining a bubble is to step back from the day to day fluctuations in the markets and identify the long-term value created by the product or service that we are considering.

The 100-year industrial boom that began around the middle of the 18th century created the means for a massive expansion of industrial output, a significant rise in population and an increase in living standards. Along the way, there were many cycles of fear and greed. Individual industries and companies were oversold, and fortunes gained and lost based on the psychology of the markets, but fundamentally the industrial revolution was real.

On the other hand, the Dutch Tulip Bulb Craze of the 1630’s was a bubble. Tulip Bulbs existed before and after the bubble, nothing really changed. The underlying intrinsic value of a tulip bulb was the same in 1630, 1635 and 1640, the only thing that changed was the market price. To identify a bubble, it is important to look at the real underlying value of the asset, rather than what the craziest buyer is willing to pay, as defined in greater fool’s theory.

It is important to understand that cryptocurrency is virtually certain to go through many growth and crash cycles, but that does not mean that the final state of the market will leave investors holding worthless assets. The cryptocurrency markets are inherently distributed. There are no limits. There is no regulation. Under these circumstances the cycles of fear and greed can lead to wild and rapid periods of growth and correction. This kind of growth is unhealthy and unsustainable. These bubble-like cycles are results of greed and overconfidence followed periods of fear and despair, characterized by selling and profit taking. However, if cryptocurrency leads to a more efficient economy, the markets should ultimately recover and continue to grow and stabilize as the broader economy slowly adopts the technology. If you believe cryptocurrency truly is the future and that the blockchain will change the world, then these short-term fluctuations should not be of any concern to you.

Let’s look at some recent history to get some ideas on how cryptocurrency might ultimately take its place in society and the greater economy.  The dotcom bubble of the late 90’s has several haunting similarities. The internet was new and initially only a few people really understood the technology, though many were excited about the potential. The dotcom bubble was characterized by a rapid rise in equity markets fueled by investments in Internet-based companies. The internet was clearly the future of technology and nobody wanted to be left out. Valuations quickly got out of hand as a result of extreme speculation, fad-based investing and an over-abundance of venture capital funding. Private investors and venture capitalists alike threw money indiscriminately at just about anything if they could find a half-decent reason. The bubble was driven by cheap money, easy capital, market overconfidence and sheer speculation.

There are very clear similarities to what we see in cryptocurrency today. Venture capital funding is too easily accomplished by simply distributing the early investment to average every day investors through initial coin offerings (ICO). This has led to an overabundance of financing which allows crypto startups to raise tens of millions of dollars in a matter of minutes - sometimes without even having a working product or so much as a well-defined value proposition. During the dot com boom, venture capitalists anxious to find the next big score freely invested in any company so long as it had a “.com” after its name, very similar to how anything blockchain-related gets funded today.

ICO funding and its easy access to massive amounts of capital is concerning, it definitely seems strikingly similar to that of the dotcom bubble. According to Investopedia, “Companies that had yet to generate revenue, profits and, in some cases, a finished product, went to market with initial public offerings that saw their stock prices triple and quadruple in one day, creating a feeding frenzy for investors.” Sound familiar? It should. Investors in ICO’s today actively express frustration if their investments don’t immediately turn a 3-4x profit. In my experience, after the launch of Decent and Waves, both made money for early investors. Decent actually made its earliest investors more than 10x and they genuinely got angry that it was only 10-fold. Any investor would take a 10x return, yet they feel scarred because other ICO’s that began at around the same time had earlier launches and yielded even larger returns. It is as if the common perception of cryptocurrency is that we simply put money in and get more out, but not only expecting to receive a little more, actually expecting to receive absurd amounts more. Obviously, this is not healthy and these extremely high expectations have caused irrational speculation, leading to prices that very loosely relate to value. There is no doubt that ICO investing shows many key indicators of a bubble but if you are excited about investing in new currencies, just be aware of the risks and do so with caution, as they will likely be first to feel the full effects of a bubble.

However haunting the similarities, it is important to consider the counterpoints to this argument – specifically the difference between cryptocurrency value creation and that of a traditional equity-based companies. There is a significant difference between the two, for example an equity-based company derives its value from revenue and profitability. Cryptocurrency derives its value from the utility it provides and how many people demand the currency in order to use the platform. This differentiating factor is very significant, cryptocurrency value creation has nothing to do with generating a profit, it is not a company nor does any entity own it. It is hard to compare the two as we don’t have a definitive metric for measuring cryptocurrency valuations yet. However back in the 90’s it wasn’t all that straight forward either; dotcom companies with no revenue, or even any plans of generating revenue in the near future, were getting valuations in the hundreds of millions. Obviously, these valuations were not realistic for equity-based companies which derive value from the potential to realize gains based on future performance. Cryptocurrency has similarities in that regard, the value is largely speculation-based regarding future use case potential. The only question is how much usage actually determines a fair valuation for a new coin, or any coin for that matter? We don’t have an answer for that yet and unfortunately for many of us we will have learn the hard way. Just like the dotcom boom, many cryptocurrencies that lack a real value proposition will likely disappear and be forgotten, but those that create real value over the long term will appreciate just as eBay and Amazon, continuing to deliver for both users and investors through many market fluctuations.