Crypto is (partly) a Bubble

by Jacob McCartney on 2018-01-23

When it comes to cryptocurrency, I am a true believer. I believe in the use of decentralized payments, currency, and banking. I believe in the use of the blockchain to improve so many different areas of technology.

However, I remain pragmatic, and I see a huge craze surrounding Initial Coin Offerings (ICOs) and the vast majority of cryptocurrencies in the market, which are often propped up with "pump-and-dump" schemes as a way to "get rich quick." As Bitcoin grew to almost $20,000 last year, the question was asked many times: Is this a bubble? As an economist, these are questions I too must ask. I cannot simply place faith in something like this; I must be certain.

Nobel-Prize winning economist Robert Shiller wrote in his book Irrational Experience, "It seems like the dotcom bubble all over again, or the housing bubble all over again."

Those two bubbles are completely different. While the housing bubble created a financial crisis that affected the entire world, spurred inflation, and left millions out of homes and work, and dot-com boom left the world with internet infrastructure that gave way to Google, Apple, Amazon, eBay, and many, many others.

The way I see it, the crypto bubble is more similar to the dot-com bubble. Most of the market is filled with securities that have little-to-no substance behind them. These should not have value, but they do. At the top of the market are the ones that matter the most, but even they may be currently over-speculated. When the crash comes, the irrelevant coins will go the way of, while the best ones will go the way of Amazon.


Before writing this, I spent time looking through all the most recent ICOs. What I found was both amazing and disturbing. I saw companies of all different types raising money by creating and selling their own cryptocurrencies. Companies have raised hundreds of millions of dollars out of basically nothing. Buyers are rushing to invest in every ICO they can, hoping they can make money they missed out on with Bitcoin.

At first glance, the idea of the Initial Coin Offering seems like a great idea. Companies use it to raise capital for startup costs, and investors make money off the growth of the coin's value, which they can potentially sell or use as a currency at some point in the future.

I am not so optimistic about the model. The main issue is that the coins that these companies offer do not offer a long-term return. In the stock market, investors are betting on the success of the company and the dividends they can collect on that company's profits. With an ICO, yes, it only has value while the company is successful, but it offers no return unless held and sold, and this is a problem for many investors.

Furthermore, I must stress the importance of simplicity. Investors and people who work with this for a living do not have a problem, but for cryptocurrencies to be successful, they must be adopted by the general public. The public does not like complex, they like simple. Having dozens or even hundreds of different currencies to potentially pay with is a deal breaker for the average person. They want simple. Some of these ICO startups require payment with their native coin, and this will ultimately be their downfall.

Nick Ayton of Coin Telegraph asked, "Why are so many ICOs structured poorly with little or no chance of delivering anything for those who have invested?"

Ayton asks a good question. Many of these companies are poorly-planned, merely profiting off the hype of decentralized blockchain technology. A Hooters investor recently mentioned blockchain technology, and their stock price soared over 50% instantly, but that company is clearly not worth that much, and it did drop down slightly afterwards. The entire market is similar to this, and that is how a bubble works. People get excited, more money is put into it than it is worth, and it eventually corrects itself back to a normal value.

This is not to say that the ICO model is a terrible model. It has a lot of potential, and it is even something I would use (with a lot of planning and geared more towards your standard investor) in a company of my own. But, anyone thinking rationally about this entire market should know that this is not a sustainable model in the way it is presently being used. While some will end up successful (in the same way many companies survived the dot-com bubble), the vast majority will not, and billions will disappear.


Pump-and-Dump Schemes

I consider pump-and-dump to be a somewhat dangerous practice, especially for budding securities like the various altcoins being pushed. Essentially, it is a Ponzi Scheme. The practice is simple: Pick a cryptocurrency, buy a significant amount, and hype it up by bringing it up in the less knowledgable investor community. Hoping to make a lot of money, those investors begin to buy up that coin, which increases its value many times. Once the value gets high enough, the original investors sell their holdings, often making millions in profits, and the later investors lose money. The price chart looks something like this:


I consider this a poor model to follow, regardless of whether it makes money for some. I will admit to having bought into these at the right time and pulled out before the drop, making a decent profit. However, I will not promote such a practice. This practice results in an eventual over-speculation of the entire market (as I write this, the cryptocurrency market capitalization sits around $520 billion, down from over $800 billion around a month ago).

Interestingly enough, investors keep buying into these, even after they continue to lose money. This is a common aspect of bubbles - investors, desperately wanting to make money, refuse to admit something is a bubble until after it has crashed. I believe the same is the case here.


Vast Numbers of Altcoins

As I mentioned earlier, crypto must be accepted by the public for it to be successful, and the public simply does not like complex. Most people do not understand the ins and outs of securities trading and do not want to hold a variety of currencies. They want it to all be easy. This is why when cryptocurrency is finally adopted by the masses, a few coins will replace the many.

Dogecoin is an altcoin originally created as a joke, but it now sits at a market cap of around $745 million, down from over a billion several weeks ago. Coin Market Cap currently displays the data of 1,482 different coins and tokens, which includes RichCoin, The Vegan Initiative, Halloween Coin, President Trump, GAY Money, and many others. The vast majority of these are complete jokes and get-rich-quick schemes, and the fact that they have any value at all holds no basis in good economic practice.


Nevertheless, I believe in the future of cryptocurrency. I will put my support behind the coins I truly believe have potential, such as Bitcoin/Bitcoin Cash, Ripple's XRP, and Ethereum. These are cryptocurrencies that I believe are the best and should be focused on. I will not endorse any ICOs right now, but there are some I do see potential in.

Crypto as a whole is a bubble. I have no doubt about this in my mind. When the jokes and the over-speculation finally crashes, the media will give it more attention than they ever have, and it will be time for the serious players to take their place.