Sinister Signs

In the latest post I examined the fundamental side of BitCoin, and concluded what points are missing to create an economically viable currency. We saw that the bubble phenomenon generally means that an asset’s valuation substantially diverts from its underlying utility to the upside. Hence the rally reflects a speculative mood, where the only reason of the purchase is to sell it to a higher bidder, and cannot be explained by the improved fundamentals of the asset. A typical instance is the equalizing prices of tulip bulbs and properties in Amsterdam during the peak of the mania. Even though the utility of a flower is a highly subjective matter, it is hard to believe that an entire market can be indifferent between adoring the beauty of a plant and having a shelter in the buzzing economic hub of the 17th century Netherlands. However, as the personal value or utility is absolutely subjective, it is hard to precisely define what is the turning point in an asset’s life where we can start to call it bubble. For example, today’s lofty price of crypto-currencies would be justifed if one would believe that they can actually replace their traditional peers in the longer run. Yet, their limited presence in commerce, lack of regulation and supporting financial system makes it a bumpy ride towards their mainstream use and stable demand.

Although investors’ expectations vary, are often based on subjective judgements, and can be subject to cognitive bias, there are signs which can raise the alarm if the end is near. I won’t bore the reader with the well-known effects of housewives and psychological cases of pensioners. Furthermore, I will also avoid graph analysis, even though some of these tools are also good precursors of upcoming sudden volatility. Instead, let me focus on two technical factors of investing: the appearence of competitors and the use of derivatives. As we will see, there is no exact correlation, but these factors can highly contribute to the rise and fall of new asset classes.

The jealousy of the competition

As the basic economic principle holds, the higher the price, the more willing people become to supply the concerned good (or service). Regarding financial markets, the big central banks partly tried to leverage on this oversimplified assumption after the financial crisis and great recession when they pressured the yield-curve. The higher the bond prices become, the more willing corporations will be to sell them to the public and obtain funds.

The case of crypto-currencies is not any different. As soon as potential suppliers realise the business opportunity and purchasing power of the markets behind cryptos, they will try and jump on board the hype-train to issue their own revolutionary virtual coins. While the total value of ICOs (Initial Coin Offering) barely touched the 62 million USD limit in 2016, the last calendar year brought an astonishing increase to 2 200 million USD for first time issuers.

I already discussed the realtion between a currency’s usefulness and its market capitalization in my last article. In the case of financial markets, it is beneficial to view market capitalization in an alternative way. While an existing asset’s capitalization theoretically can be increased by just passing a single piece back and forth, using relatively low amounts of liquidity to raise the total value of the stock, initial offerings are different. The 2.2 billion USD mentioned above actually flew from one market participant to another, absorbing liquidity from the market. As we have seen, in the case of an initial offering the entire capitalisation has to be backed by funds, therefore the appearence of imitators facilitates the absorbtion of purchasing power in a soaring market.

Besides the simple phenomenon of new-comers on the market, another detail can also foreshadow the beginning of the end. The key here is the quality of the product. In traditional commerce it is an ancient trick in the book to raise prices by deteriorating the quality of the final good, and  leaving the nominal price unchanged. In the case of virtual currencies, the phenomenon occurs through fundraisings where the investors don’t get a piece of code, only a promise that they will get one upon the completion of the project. It is easy to see that selling a future good which is currently in production doesn’t only raise the price through present value calculations, but also by an added risk factor. On top of all this, this unregulated environment paired with a buying frenzy provides the perfect condition for scams.

Derivatives on the stage

Even though financial derivates are not the root of all evil, there were several instances where they were associated with market bubbles. They are indeed significant factors in forecasting the beginning of the final chapter when it comes to bubble stories. Similarly to the competitor aspect, the appearence of derivatives has a technical role in facilitating a frenzy and its collapse. These instruments make leveraged trades feasible for the masses, where investors only have to pay a fraction of the valuation during the transaction.

On the one hand, leveraged trading can give a boost to soaring asset prices. Since paying a couple of dollars more for a call option or forward contract can cause the underlying valuation to jump several hundred dollars in some cases, it is easy to see how a buying craze about this ‘cheap’ alternative can cause extremly volatile asset prices on the spot market. On the other hand, the downside risk of invetsing also gets amplified by the introduction of leveraged speculation. A couple of percentage points of correction on the primary market can wipe out the entire postion of leveraged holders, leading to margin calls and loss of wealth. These leveraged players might be tempted to cover their losses by selling their positions on Main Street, inducing a vicious circle between the derivative and spot markets.

The first test of the integrity of these instruments is when the contracts first come due and investors have to pay the remaining amount as forward contracts become spot ones.

Conclusively, there is no certain way to forecast market collapses or bubble bursts. However, accounting for technical factors and knowing the mechanism of different kinds of trades can help us to come up with an educated guess regarding the dawn of a mania.

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