Wary of the cryptocurrency bubble

Welcome to 2018, a time to be wary of the developing bubble but watchful for the opportunity it will create. The markets and economy work as a form of pendulum of emotion.  They swing from a point of balance toward greed driven by over hyped expectations.  When the hype doesn’t measure up it drives us to despair and fear.  Only then do things begin to return to equilibrium where potential begins to match hype and real change begins.

We’ve seen it recently in the dot com boom and the sub prime crisis but it is a cycle that has repeated for generations.  Bubbles represent inflated short term expectations for underappreciated long term results.  In other words they create pain but also create opportunity.

Speculative bubbles are a certainty as people forget the last crisis, gain confidence in their ability to make money and gain comfort with increased risk taking.  Social Capital points us towards Hyman Minsky’s 1992 paper on bubbles and summarizes by suggesting they develop in three phases.  The first is when money is given to those who can pay it and the interest back with certainty.  The second, when given to those who can pay the interest with certainty, but not the original payment.  The third, when money is given to those with whom there is no certainty the interest or original payment can be paid back, but hype for the potential drives investment anyway.

We saw something similar occur with real estate locally prior to the sub prime crash.  It began with banks only lending to those who could readily save enough to cover 20% down payments.  As the housing market boomed and banks ran out of customers to loan to requirements were lowered to 5% savings.  Finally, banks started rolling out 0% and even “interest only” loans.  In 2007 many seemed to think the market could only go up.

When concerns regarding US interest rates rising and their impact on housing came to bear, the bubbled popped both locally and abroad.  The banks survived but those who speculatively gambled money they didn’t have on houses they couldn’t afford lost everything.

In 2010 I wrote a post crash review of pre crash thoughts and numerous other observations that at the time were rather prescient.  I finished my review of those times with a warning.

In good times it can be easy to get caught up in the party and forget all about the mess that’s left to be cleaned up when the party ends.

This brings us back to 2018 and the state of the markets.  Cryptocurrencies and Blockchain (or Distributed Ledger Technology) are the source of a great deal of hype.  The question is, is it a bubble?  Have we reached the point where people are giving money to those with whom there is no certainty the interest or original payment can be paid back?

We recently saw the local announcement of an “Initial Coin Offering” for wireless internet startup Horizon Communications.  The regulatory authority has come out saying this company has no license to operate.  The company at present has no assets and no equipment and is taking advantage of an unregulated means of fundraising to raise money for the project.

The problem with ICOs is that typically they provide no ownership and no say in the running of the company.  It is a glorified Kickstarter/Indiegogo/GoFundMe style scheme repackaged.  Purchasing a “utility token” effectively gets you nothing more than promises of discounts on future services and possibly weak IOUs.  If the company doesn’t deliver you get nothing and they owe you nothing.  You have no rights to any assets or collateral.  The majority of the risk lies with you, not the company.  If they fail, you lose.  Your potential to recoup any of your money is extremely limited.

Horizons Communications could prove to be a viable business.  That isn’t the point.  The point is that these sort of investment schemes are a sign of the third stage of a bubble and it is worth being very wary.  People are willing to give money to those with whom there is no certainty they will earn their money back and they own nothing other than promises.  This isn’t happening simply on a “venture capital” level with companies specifically geared towards high risk investments making such speculative games.  No, this style of investment is reaching the every day layman.

The approaching trouble is that cryptocurrency awareness has transitioned from the fringe to the mainstream.  The total market cap of cryptocurrencies listed on coinmarketcap.com (which likely doesn’t include many ICOs) stands at $800 billion dollars.  To put that into context, the dot com boom was suggested to have reached nearly $3 trillion dollars before it collapsed.

The rather shocking thing is that this bubble may still have room to grow.  We’re only now starting to see advanced financial concepts like futures, leverage and ETFs being applied.  Cryptocurrency ETFs are making cryptocurrencies and the risks of borrowing money to invest incredibly more accessible to the lay person.  When people start borrowing money they don’t have to invest in something they don’t understand it is a very bad omen.

$800 billion dollars invested is an incredible number.  What tangible value have cryptocurrncies generated thus far?  How have cryptocurrencies fundamentally reformed our banking system or made banking accessible to the presently unbanked?  It hasn’t yet and much of the investment is driven by the potential for disruption rather than disruption itself.  Worse, the sheer power requirements and environmental cost, which for Bitcoin is estimated at 240 kWh per transaction and amounts to power consumption at the equivalent of the country of Serbia is presently horrendous and completely unsustainable.

With all that said, despite the signs of a bubble, I remain a fan of the underlying concepts of Distributed Ledger Technology and even ICOs for their long term potential.  In the longer term timeframe when the hype subsides there is considerable opportunity.  The trick is ensuring we set the right foundation to take advantage of that opportunity and don’t get caught up in the hype.

The dot com boom was similar.  Much of the underlying global fibre optic cabling infrastructure that enabled the internet we benefit from today was created as a result of the euphoria of the dot com bubble.  Investment that likely wouldn’t have occurred if it hadn’t been for the bubble. Look at all of the innovations that have arisen as a result of the dot com bubble.  It’s incredible.  However investing in global cabling companies or over hyped companies that had little value based foundation was a waste.  Timing and infrastructure is incredibly important.

Bermuda is making strides to get involved and become a leader in this new industry.  It is a welcome move if we ensure we stick to areas of value creation that will provide long term returns while not getting too caught up in the hype of the party.  There will be considerable opportunities to use these new technologies to reinvent and disrupt many  industries.  However we need to be very wary of the bubble mentality that could wreck our house and leaves us with little more than a huge mess to clean up after the party is over.