I’ve tried to stay out of the cryptocurrencies, such as bitcoin, fad for as long as I could, but when your employees, students, clients, family, friends and a guy I just met all ask about it. It seems like the right time to wade into the conversation. There is a myriad of reasons why cryptocurrencies such as bitcoin will fail, but there are two main ones that can’t be fixed and will ultimately be the downfall of all cryptocurrencies. Cryptocurrencies, such as bitcoin, has no real value at any price level.
Cryptocurrencies Such As Bitcoin Have No Intrinsic Value
When it boils down to it, intrinsic value can only be created when there is scarcity. As an example, Leonardo da Vinci’s Salvator Mundi recently sold for a staggering $US450 million ($591 million) because there is only one of them. The painting has intrinsic value because the supply is limited (in this case, to one). On the opposite end of the spectrum, air has almost no value to us and can be consumed for free because air from our perspective is an almost infinite supply.
Intrinsic Value Comes From Scarcity
Hence, intrinsic value has a very simple equation – total market value divided by quantity. As an example, if there were two copies of the Salvator Mundi, you can assume that the value of each one would be $US225 million, or half. Taking this to the extreme, if there were a trillion copies of the Salvator Mundi, the value of each one would be $450 million divided by 1 trillion, or $0.00045 each. Hence, anything that is not constrained by a scarce quantity will approach an intrinsic value of zero.
Cryptocurrencies essentially hold value via a hash or a long number. The problem with numbers is that it is infinite. If you gave me an infinite number, I can just add 1 to it and I would have a new unique number. It doesn’t matter if cryptocurrencies reach market caps of hundreds of trillions, it will still be worthless because numbers are infinite, and if you divide anything by infinity the intrinsic value will approach zero.
Cryptocurrencies Such As Bitcoin Create Artificial Scarcity
What cryptocurrencies have done is create scarcity by constraining the quantity of numbers available to create artificial scarcity. As an example, bitcoin has a constraint of 21 million numbers and no more can be mined.
However, the number of cryptocurrencies is not constrained. At last count, there are over 1400 cryptocurrencies that are available and hundreds of new cryptocurrencies and billions of artificially constrained numbers are created every day. If you take the total market cap of all cryptocurrencies and divide it by the quantity of artificially constrained numbers available, intrinsic value will approach zero.
What cryptocurrency creators are doing is basically what these entrepreneurs are doing with air.
Cryptocurrencies Such As Bitcoin Are Not Regulated
This one is simple. Governments can’t or won’t regulate cryptocurrencies because it is either too hard or impossible to trace. The alternative is to ban it. This has already happened with China and South Korea, two major hubs of cryptocurrencies. Regulation is good – it helps stop or slow funding for bad things such as terrorism, money laundering and nuclear annihilation. I don’t know about you, but I would prefer to live in a world run by governments than a world run by crime syndicates and fear of death.
The reality is, cryptocurrencies will fail because governments won’t let a private currency which can be used to destabilise a country to flourish. Whether this is something you like or not, it is the reality. If cryptocurrencies are to survive, it will become regulated and controlled. Once that happens, the major drawcard of cryptocurrencies, which is anonymity will be gone.
Why Cryptocurrency Such As Bitcoin Will Always Be Volatile
The volatility of a stock is linked to the establishment of fair value and a balance of investors versus speculators. When there is a high percentage of investors due to the establishment of a range of fair value, assets tend not to trend or move much. When there is a high percentage of speculators and fair value is unknown, assets tend to move quickly on high volatility.
An extreme example of this is treasury bonds, where valuations are well known and most traders are investors. On the other end of the spectrum, a speculative mining stock for example where fair value could be zero or multiples higher than current market price, the stock can move quickly on low volume due to speculation.
Since cryptocurrencies don’t have any intrinsic value, the asset will continue to be speculative and volatility will almost certainly never fall.
When The Cryptocurrency Bubble Will Burst
As an investor, trader, money and risk manager, we never ever deal in binaries or sure things if there is a time constraint. The fact of the matter is if you make a choice where there is more than one potential outcome, the probability of any number of scenarios happening or not happening is not zero, no matter how slim.
An example of this is whether our civilisation will make it another 100 years. A lot of things can happen between now and then – meteors, nuclear wars, major climate shifts and we could all be dead within the next 50. However, if we remove the time constraint, I know for a fact the planet will be gone at some point because our sun will run out of fuel – but the chance of that happening in my lifetime is nil. Hence, the issue with most probabilities and whether we can take advantage of it is not whether something will or won’t happen, but when.
In the next year or two, I have no strong view one way or the other. If you short cryptocurrencies you risk getting run over by an out of control bubble. If you buy, you risk being the guy holding the bag when the music stops. With bubbles, everyone except the fanatics knows the music will stop at some point so everyone spends all day looking at each other wondering who will sell first. This speculation causes the supply and demand imbalance to swing to extremes. Cryptocurrencies tend to switch from one extreme to the other – this is why the Bitcoin price is so volatile.
With markets, these extremes are called hyperdeflation and hyperinflation. Hyperdeflation happens when there is extreme greed, nobody wants to sell and everyone wants to buy because they expect it to be worth more. This creates a huge imbalance towards demand creating a bubble. Hyperinflation happens when there is extreme fear, everybody wants to sell and nobody wants to buy because they expect it to be worth less, causing a huge imbalance towards supply and creating a crash. Bitcoin went through a period of extreme greed and saw the Bitcoin price rise to over $20,000 USD.
How To Trade The Cryptocurrency Bubble Before It Bursts
When it comes to trading, especially in bubbles, the two most important factors is liquidity and counterparty risk. Liquidity is whether you can sell and counterparty risk is whether the party you sold it to will pay you or not.
Liquidity is quite simply how many people there are on the other side willing to take your trade. During times of extreme greed and fear, almost everyone is standing on the same side creating a lack of liquidity on the other side of the supply and demand equation. Your goods are only worth what someone is willing to pay for it. If nobody is willing to buy, then your goods are worth zero.
In regulated markets such as stock markets, a highly regulated and well-capitalised clearing house sits in the middle of all trades, transferring counterparty risk from the buyers and sellers to the clearinghouse itself. This creates trust within the market and allows normal markets to function properly. However, with cryptocurrencies, the counterparty risk lies with unregulated exchanges that are increasingly targeted by hackers and there is a graveyard of failed exchanges that have taken investors money with them.
Lacking these two factors, I find it extremely high risk to trade the bubble in its current state.
The Catalyst That Will Burst The Bubble
At some point, all these speculators holding huge amounts of capital gains will want to exit and this will create a crash. Regulation and loss of faith in cryptocurrencies such as Bitcoin will be the catalyst that causes all cryptocurrencies to return to the mean – its true value of zero.
With cryptocurrencies, we don’t know when they will or won’t fail. I would hazard a guess and say that it’s starting, but the world is complex and regulation even more so. We have already seen the start with China and South Korea banning cryptocurrencies. However, there are other countries that may embrace and let flourish under their own regulatory environment. Cryptocurrencies may continue to flourish for some time to come, but don’t expect it to revolutionise the world.
However, it does look like the music is coming to a stop. The Bitcoin price has fallen over 60% in 2018 and the number of failed and scam initial coin offerings (ICO) continue to climb.
If you feel that you can’t get away from the hype, then buy some to satisfy your curiosity. However, treat it the same way as you would when you go to the casino. It’s for entertainment purposes only. Don’t bet the farm, don’t expect to walk away with any money afterwards and have some fun.
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This is general advice only. MF & Co Asset Management has not considered your personal financial needs, objectives or current situation. This information is not an offer, solicitation, or a recommendation for any financial product unless expressly stated. You should seek professional investment advice before making any investment decision.