To Invest Or Not To Invest: Beyond The Crypto Bubble

To Invest Or Not To Invest: Beyond The Crypto Bubble

In 2017, cryptocurrencies went mainstream. Over the course of a few short months, Bitcoin, Ethereum, many “altcoins” and the blockchain became household names—driving the collective market cap of all cryptocurrencies into the hundreds of billions of dollars and representing one of the greatest bull runs in history. The action attracted all kinds of investors, from venture capitalists and hedge funds to everyday investors like Rita Scott, a grandmother who bought into “Bitcoin Mania” with a portion of her retirement savings. Some people tried to buy Bitcoins with their credit cards, and others took out second mortgages to speculate on an asset they were convinced would never fall.

Then came the fall. Between the middle of January and early February of 2018, the price of cryptoassets started to plummet—and unlike the short-lived dips that barely registered during the great bull run, this drop persisted. Bitcoin declined from a high of nearly $20,000 per coin in December to a low of $7,000 in early February and most other cryptocurrencies followed suit. In less than a month, the entire asset class lost almost half of its peak value, or more than $300B.

Prices for many cryptocurrencies have recovered in the weeks and months since, but many investors are still in the red. Some of these investors may wonder: why did Bitcoin and other cryptocurrencies fall? What made them valuable in the first place? Are cryptocurrencies a bubble, or worse, a scam like the last days of Enron? Should we double down while prices are “cheap” or should we stay away?

For everyday investors who want to understand the role that cryptoassets should play in their investments, this dip marks a stellar opportunity to reevaluate the promise of Bitcoin, Ethereum and other cryptocurrencies with fresh eyes. To understand the outlook for cryptocurrencies beyond the “bubble,” we’ll take a step back and recall why these assets matter, identifying some of the traits that make Bitcoin and its kin different from other types of asset. We’ll use that knowledge to hazard a guess at why cryptocurrencies gained value in 2017, why they fell in the first months of 2017, and why they are now rising again—which may help you predict the circumstances that could help them rise again, meriting a role in your portfolio.

Why Cryptocurrencies Matter

Bitcoin was born in the twisted wreckage of our current financial system. In 2008, an epidemic of poor mortgage lending practices by big banks created a financial crisis that brought the global economy to a standstill. A bipartisan committee of American legislators later concluded that the worst worldwide recession since the 1930s was caused by financial institutions that borrowed too much and took too much risk, all while encouraging consumers to do the same. But most of these institutions or their leaders didn’t face consequences for their irresponsibility—in fact, they were bailed out by the government, and for good reason, because the entire financial system would have collapsed without them. The banks had grown so large that they now represented a central point of failure.

As an assault on the largest economy in the world, the financial crisis in the United States had an outsized impact on the rest of the globe, but it was far from unique. Over the past few decades, countries like Argentina, Mexico, Zimbabwe, Russia and Greece have faced recessions and economic turmoil caused by ineffective or corrupt leadership in the private and public sector institutions that collectively make up their financial systems. The victims of regressive and inept practices were individual citizens, who saw inflation and market downturns destroy their savings, with the money they had left often subject to severe controls.

Some people had enough. The 2008-2009 financial crisis made a void in the market apparent—a need for a currency, a store of value and medium of exchange, that resisted manipulation by governments and financial institutions by design.

The solution to this need was Bitcoin, an open-source protocol released in January 2009 by an anonymous person or group with the pseudonym Satoshi Nakamoto, shortly after Lehman Brothers went bankrupt. Unlike cash or checks, Bitcoin was peer-to-peer, meaning that no authorities such as banks or regulators controlled it. The code of Bitcoin specified a fixed supply of 21 million coins so it couldn’t inflate away. But the fundamental innovation of Bitcoin was creating a digital currency that couldn’t be copied and “spent” multiple times in the absence of a central authority to verify the authenticity of each transaction. Bitcoin does this by incentivizing third parties called miners to timestamp and record all transactions on a blockchain—a public ledger that is copied to many different computers around the world, making cheating nearly impossible.

Bitcoin was the first cryptoasset, but it is far from the last. There are now dozens of cryptocurrencies that build on the core concept of enabling decentralization through distributed code and built-in community incentives, adding a twist here and there—more anonymity, faster and cheaper transactions, and so on. Other cryptoassets represent the evolution of decentralization beyond currency. Founded in 2015, Ethereum allows anyone to write applications, like smart contracts, that can run themselves on a distributed worldwide computer. A new generation of startups has started to build decentralized versions of products from Dropbox to Reddit to Uber, creating ecosystems of entrepreneurs, users and investors that can transact and share value through crypto “tokens.”

Why Crypto Blew Up In 2017

Bitcoin and its peers tend to be slower, more expensive and harder to use than their centralized equivalents, like the US dollar or Uber. So why would anyone want them? Why are Bitcoin, Ethereum and other cryptoassets worth anything at all?

The rational explanation is that the value of cryptoassets is driven by a lack of trust in central institutions. Until Bitcoin, if you didn’t trust your bank or national currency to hold your life savings, you didn’t have many other options—maybe real assets like timber, real estate or precious metals. Now, for the first time, there was a way to store value and pay for goods and services without having to trust a particular bank or country. It’s easy to see that lack of trust build up in the years and months leading up to the crypto bull run of 2017. Political events like Brexit and the long-shot election of Donald Trump, economic catalysts like the failure of Puerto Rico’s bonds, fears of a recession in China, and hyperinflation in Venezuela, and a general atmosphere of institutional mistrust in the US and around the world certainly influenced the likelihood of investors to buy and hold cryptoassets.

These factors probably influenced the initial rise of Bitcoin and other cryptoassets in the early months of 2017. But the biggest driver of Bitcoin from the low thousands to a height of nearly $20K is hype, plain and simple. Pure cryptocurrencies like Bitcoin represent a “supply and demand” play. Unlike a unit of stock, which confers equity ownership in a company, or a bond, which may or may not be backed by the assets of a company, cryptocurrency isn’t backed by anything and is difficult to value in a traditional sense.

With low-interest rates, a public stock market that has seemed fully valued for some time, and lavish media attention heaped on the topic, investors around the world just couldn’t resist the allure of an asset that appeared to return 5-10% every single week, especially when wrapped in a narrative of delivering a technological solution to corruption and inequality.

The Bears Strike Back: From Hero To “Bubble”

If the driver of interest in crypto is “lack of trust,” why did the demand for cryptoassets, and therein their price, plummet back to earth last month? The short answer is that no one knows for sure. There are a few recent catalysts that have caused “fear, uncertainty and doubt” in crypto investors: worries about fraud in a stabilizing cryptocurrency called Tether that is supposed to be backed by dollars, fear of government regulation in big markets like China and South Korea, the threat of security issues and fraud faced by cryptocurrency exchanges, and pervasive fraud in smaller cryptoassets that bear more resemblance to penny stock “pump and dump” schemes than true innovation.

The largest crypto investors also have the power to manipulate markets all on their own. For example, more than 40% of outstanding bitcoins are controlled by an estimated 1,000 people. The lack of regulatory oversight makes it easy, in theory, for these “whales” to collude, buying and selling in unison to move the price of a cryptoasset so they can trade with insider information.

In a frothy, hype-driven market like crypto, a little doubt can go a long way. Once some or all of the factors above started nudging the price down, behavioral theories of market movements like reflexivity predicted that the fear of everyday investors would take over, creating a vicious spiral of falling prices and rising doubt that cause larger and larger sell-offs. In a nutshell: easy come, easy go.

Return of the Crypto: Post-Bubble Outlook

The thesis underlying cryptocurrencies hasn’t changed. Decentralized currencies and applications have the real potential to change how we create and share value, helping people gain independence from central institutions that can be inept or corrupt, and democratizing the wealth creation that stems from new businesses and technologies. For example, when a traditional startup succeeds, only its shareholders win, even though every member of the ecosystem helped create that value. But in a decentralized startup where users and operators alike are incentivized with tokens, everyone is rewarded for their contribution in making the network as a whole more valuable.

What the “popped bubble” last month represents is the realization of investors that an enormous gap exists between the promise of cryptoassets and their current reality. Bitcoin was designed to be a fast and cheap medium of exchange, but growing volume on the protocol has made transactions too slow and expensive to be feasible—though scaling solutions are in the works. Ethereum was designed to power decentralized applications, but the best example we have right now is a trading card game for virtual celebrities.

Given the fast and furious rise of crpytoassets, a cooling off period is probably a good thing—affording cryptocurrencies time to iterate and grow into their lofty expectations while giving regulators the opportunity to learn more and correct clear violations of good order like crypto “pump and dump” scams. The watershed moment for cryptoassets will be when people finally use them to actually make their lives easier, not just as a way to get rich quick.

The Bottom Line: Should I Invest In Cryptoassets?

Only you can answer that question and you should always do your own research. What we can do is offer a few rules of thumb to illustrate what we would do. The most important rule is only to risk what you can afford to lose. The crash at the start of 2018 was a painful demonstration that all cryptocurrencies, even well-known “large-cap” assets like Bitcoin, are extremely volatile, and we don’t recommend that anyone mortgage their home or use credit to purchase cryptoassets.

With over 1,300 cryptoassets currently in existence, the sheer variety of investment options in the crypto universe can be overwhelming. When considering whether to purchase a specific cryptoasset, it may be helpful to remind yourself why cryptocurrencies matter—think about whether decentralization would actually be helpful for the users or ecosystem of a certain product or service. Because it’s hard to tell which cryptoassets will end up like Amazon and which will be like, diversification is a sound strategy—especially with smaller cryptocurrencies, avoid putting all your eggs in one basket.

The final factor to consider is how cryptocurrencies fit your individual investment goals. A younger person has a higher risk tolerance than someone retiring next year, and all else equal can afford to allocate a greater portion of their assets to speculative, high-risk investments.

You should decide for yourself how much to allocate into cryptocurrencies—there’s tons to read, and we’ve linked some further reading below—but we’ll leave you on this note. Both centralization and decentralization have pros and cons, but until now, there’s never been a real alternative to trusted authorities that tell you what to do. Some systems and applications will probably be more suited to centralized governance, and some will be hybrid systems, but other centralized systems will be replaced by new decentralized options that are fairer, cheaper or better for their users.

There are thousands of smart, passionate people who believe decentralized systems can solve some of society’s big problems. If you’re already a true believer, pause and ask yourself a question: is decentralization really the right solution for the use case your cryptoasset claims to solve, or is it a cosmetic overlay that actually performs worse? On the other hand, if you don’t invest in cryptocurrencies, it’s worth taking a moment to put yourself in their shoes: if cryptocurrencies are just a bubble, why are people still hard at work improving them? What assumptions do they believe that you don’t—yet?

Further Reading

Beyond The Bitcoin Bubble

Why Decentralization Matters

How Bitcoin Works

How Does Ethereum Work Anyway?