Cryptocurrency mania - do not become the last fool

Lately more and more close and distant friends are asking me if they should invest in Bitcoin or other cryptocurrencies. I assume they come to me knowing I have background as trader in both the currency, interest rate and equity markets, doing market-making for a major bank at the turn of the century, as well as I have been a digital entrepreneur for almost 20 years. The advise I give them, I would like to share with you:I believe cryptocurrencies and especially the blockchain technology behind it will be a major disruptor for many different industries. At the same time I believe the current mania we now see is a huge bubble that will crash. Let me explain why;

Whenever there is new technology that people believe will drive major disruptions, you find an early hype, which typically ends in a crash, before it slowly rebuilds into sound business. We experienced this at the turn of the century with the internet boom and bust. Now 17 years later the internet has totally disrupted most business models. However if you look back to the year 2000, most of the companies being part of this hype are no longer here today, or are significantly less valued. Of course there are winners like Google and Amazon, who unfortunately are the exceptions. 

Looking at the cryptocurrency markets there are now more than 1000 currencies available and with the boom more are popping up every week. Some of these might be a future winner, but most will die or go nowhere. Both the markets and technology are still very immature, and it might not be the largest ones that win this game, just look at where Yahoo is today.

Since these are currency markets, and not stock or bond market, where you own a share of a company or earn interest, we need to understand the fundamentals of what money is. Money or a currency is basically three things; a mean of transaction, a measure of value and a currency with its own intrinsic value. This is the same for cryptocurrencies. 

The cryptocurrency markets are currently not functioning well as means of transactions. Just looking at the transaction cost for Bitcoin, which is about $7. Yes, some new technologies and currencies like Iota claim to fix some of this, but this is still very early stage. 

Secondly cryptocurrencies are far from taking over from dollar or euros or other currencies as a measure of value. Trust is what defines the value of any currency. Normally currencies are backed and regulated by a country, with all its assets and its economy with the ability to bring in tax and other revenues. 

What we see is that the majority of transactions are driven by speculation. Looking at Bitcoin as an example, it is estimated that half a million new speculators join this market every day, fueling this frenzy. 

For cryptocurrencies there are typically no assets or government financial powers backing it. They only have a limitation on the number of coins available or to the cost of mining, a clever way to make us resemble rear minerals used as currencies throughout history. Implying the value is only driven by the trust and belief people put in it. Trust and belief that can change at an instant.

Any market driven by speculation will at one point reach the top, as there is a growing mismatch with the underlying economic values. Current market cap of Bitcoin alone is about 280 billion dollars. And while speculative bubbles typically last much longer than we expect, there are some indicators that we are getting closer to the top. Prices can still continue up more before they crash, but the higher they rise, the harder they fall.

We also need to understand how the value is set at the margin of the last transaction. For the value of Bitcoin to go from $15 000 to $16.000 there are not $1000 times the total amount of coins that is invested into the market. The price is set by one transaction defined by the price a seller and buyer are willing to trade at, making the market inherently self-inflatable. And the more it rises the richer people feel, and the more risk tolerant they get. At the same time you have new investors joining in on a fear of missing out of a great opportunity to make some easy cash.

Besides the increasing gap to the underlying values, the trader in me see several signs that we are at the later stage of a major speculative boom. A boom, which reminds me of when I was a market maker of options for unlisted internet stock at the turn of the century. 

First we see valuations driven by future optimism stemming from an underlying new technology most people does not understand the implications of. As the price go sky high we see analysts trying to explain why by saying that in this “new economy” old rules do no longer apply. 

Secondly getting more into trading psychology; the later stage a boom is, the higher volatility (fluctuation) and trading volume you typically see. Bitcoin has lately had up to 20 % daily price fluctuations, which is extremely high. And cryptocurrencies daily trading volume is now more than 50 % of NYSE daily trading volume.

Thirdly all this happens in a far from perfect, unregulated market with different price at different exchanges, further spurring speculations.

And the most important signal is when I see who enters this market. When my second cousin, whom I know has never every done any investments asks me if he should invest in Bitcoin to make some easy cash, I can tell we are getting close to the top. I am afraid most of the half million new speculators joining this market every day is like him.

Unfortunately there is no free lunch, and in a market driven by speculation someone will loose in the end. As always this ends up being that last fool. Just make sure that is not you!

Author: Aleksander Farstad – Partner Assetto Capital and CEO eZ Systems