Credit: Shutterstock photoBy Dan Leary, an executive at Bodhala, a New York City based technology startup. Prior to joining Bodhala, he was a regulatory lawyer at an international law firm where he worked on financial services and securities law matters.
“Is cryptocurrency a bubble?” has been asked so frequently that Google now autofills the question.
Indeed, the question itself has reached bubble status. Frequently, the question confuses whether crypto is (or will be) a bubble with whether the technology has long-term value. Both are true. Cryptocurrency is a revolutionary technology, and the excitement over revolutionary technology creates bubbles.
Revolutionary technologies result in over exuberant investors. In 1761, the Duke of Bridgewater completed construction of the Bridgewater Canal, a huge financial success which allowed him to efficiently transport coal from his mines to Manchester, England, rather than relying on horses. The venture was a huge financial success and reduced the cost of coal in Manchester by 50%.
This success brought frenzied investors who poured money into suspect canal projects, many of which were never built. Similarly, after the success of early railroads, an emerging British middle class poured money into dubious railroad ventures in the 1840s, leading to the “Railway Mania” bubble.
More recently, the release of the Mosaic web browser opened up the Internet, and investors poured money into anything with a “dot-com” in its name, leading to the dot-com bubble.
Professor Carlotta Perez of the London School of Economics has examined each technological revolution from the Industrial Revolution to the Internet boom. Her research indicates that anytime there is a transformative technology, money quickly flows into the space, creating a bubble. While many projects fail, this influx of capital is used to build infrastructure to support the new technology so that it can be deployed to consumers. As Perez explains:
Investment in the new industries is carried out by new entrepreneurs while the young financial tycoons create a whirlpool that sucks in huge amounts of the world’s wealth to reallocate it in more adventurous or reckless hands…a part of this goes to new industries, another to expand new infrastructure…but most of it is moved about in a frenzy of money-making money, which creates asset inflation and provides a gambling atmosphere within an ever-expanding bubble. Eventually, it has to collapse. But when it does…[n]ew industries have grown, a new infrastructure is in place; new millionaires have appeared; the new way of doing things with the new technology has become ‘common sense.’
Likewise, the early success (and spectacular returns) of cryptocurrencies like Bitcoin and Ethereum will continue to result in investors funding questionable projects. While some projects have amazing teams and tremendous potential, others have soared to billion-dollar valuations with little more than dressed up whitepapers and code cut-and-pasted from other projects. Those investing in these projects look eerily like the frenzied investors who threw money at 19th-century railroad projects that were impossible to construct.
The inevitable question, of course, is whether the cryptocurrency bubble has fully inflated. I don’t think so. For context, the entire cryptocurrency market is valued at about $400 billion (down from its peak of over $800 billion). During its peak, the dot-com bubble reached $2.9 trillion in value before crashing in 2000.
The cryptocurrency market, unlike the dot-com boom, is largely limited to retail investors, which limits the amount of capital that can flow into the market. Institutional investors still lack fully developed custody options for holding cryptocurrency safely, and other financial products such as Bitcoin ETFs have yet to receive regulatory approval.
As custody and regulatory solutions develop for institutional investors, I anticipate the cryptocurrency market inflating further. Indeed, the market for cryptocurrency may grow even larger as the market is global in scale, while the Internet boom was was largely limited to the United States.
There are, however, two unique aspects of the cryptocurrency boom that may serve to make it even more volatile than past bubbles.
The Social Media Echo Chamber
“investing is an activity of forecasting the yield of an asset over the life of the asset; speculation is the activity of forecasting the psychology of the market.”
--John Maynard Keynes
Many crypto investors are not buying assets for their future utility value; instead, they are speculators who are buying on the theory that someone else will pay more for the asset later. As Keynes identified, this is as much a prediction about the psychology of the crypto market as it is about the future utility of cryptocurrencies.
Modern media is likely to play a significant role in how investors view their cryptocurrency investments. To be fair, media has played a large part in past bubbles. During Railway Mania, increasingly popular newspapers in Britain were used to promote speculative railroad projects. And during the stock boom in the 1920s, wealthy speculators like Jay Gould controlled newspapers and used them to manipulate stocks prices.
Rather than have the media manipulate them, modern consumers manipulate themselves by filtering the news they see. Social media is unique in that it allows users to filter information that doesn’t fit their preferred narrative.
Indeed, studies have shown that social media can create an echo chamber, as users promote their favored narratives inside polarized communities. This is particularly dangerous in the midst of a crypto bubble, as over-exuberant investors may choose to filter out valid, negative information about a particular project or the market as a whole.
Similarly, studies have demonstrated that social media is associated with fear of missing out or “FOMO.” As social media users increasingly share their cryptocurrency successes (not losses, of course), their peers are likely to feel FOMO and jump into the market, further inflating the bubble.
Weakened Regulators
Lax regulation, too, is an important aspect of many financial bubbles. During Railway Mania, British Parliament pursued a laissez-faire approach to authorizing new railway companies. Anyone could submit a bill to Parliament to form a new railroad company, and demonstrating financial viability was not a requirement. And, of course, many Members of Parliament were heavily invested in railroad projects, so had little interest in slowing the approval of suspect projects.
Today, likewise, crypto projects have raised capital without regulatory oversight by using the initial coin offering or “ICO” model. Rather than sell equity, crypto projects accept contributions (usually in the form of Ethereum) in exchange for tokens that can be utilized on the projects future network.
Of course, the SEC has now signaled that such sales represent unregistered securities offerings, and crypto projects no longer solicit US investors for their ICOs.
But the story doesn’t end there. Cryptocurrency is by its very nature decentralized and transcends borders. Crypto networks operate distributed ledgers that are stored on “nodes” all over the world that verify transactions and reach consensus on the state of the ledger (i.e., who owns what). Ultimately, this means governments may find that they lack the power to regulate aspects of the market that have historically been subject to their power.
For example, the SEC can deem crypto tokens to be securities, and go after any projects that sell them to US investors via an ICO. And they can prohibit US-based crypto exchanges, such as Coinbase, from listing tokens they deem to be unregistered securities.
However, unlike stocks, trading cryptocurrency does not necessarily require the use of a centralized, third-party exchange for parties to conduct a trade. Instead, users can utilize a decentralized exchange (“DEX”) to trade tokens. A DEX allows users to trade tokens with each other without a third-party exchange sitting in between them and holding their funds. Instead, DEXs allow users to trade assets directly with each other via an automated process using a smart contract.
To the extent the SEC bans certain cryptocurrencies from exchanges like Coinbase, US investors may choose to purchase them on a decentralized exchange. The SEC’s practical ability to stop US investors from accessing a DEX to trade tokens is far from clear.
For better or worse, governments will find they lack their full power to limit activities in the crypto space.
Ultimately, crypto assets are likely to revolutionize many of the business and consumer technologies that we use on a daily basis. Yet, as investors begin to recognize this, their enthusiasm is likely to push values to unsustainable levels, resulting in a painful crash.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
