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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Modern Tulipmania

Bitcoin’s value surpassed the 7 000 USD psychological limit during the first days of November. Most of the investors are cheering, however, it is not surprising given that there is a bubble inflating on its market, fuelled by wild speculation. Such euphoria is not unusual when an asset price reaches a new high each week. The tulip bulbs of the 21st century are not exceptions.

The Blockchain technology backing the digital currencies can actually be valuable. It is a decentrerlized, immediately available information system can save money, effort, and time compared to its linear peers. For instance, in case of an online marketplace, whether it is for physical goods or invesments, used or new, the use of a mediator during the transaction is almost universal. The role of these mediators vary between providing payment methods, IT infratructure, financial clearing, or acting as an agent for the parties; but it is almost always a common denominator. The spider web like, immediately available information is superior in its efficiency compared to the individually sent bits and pieces. Digital accounting might be the real innovation, not digital currencies. Wouldn’t be the first time in history that the application of a new accounting method and more efficient informational system, not the modern currencies improved the efficiency of commerce.

Regarding the financial application, the viability of the system is just as straightforward. Replacing multilayered interbank transactions with P2P technology, where each party can see the changes right away, can save days for clients. In case of investing and margin payments even hours can make a difference, but the saved time is also significant from cash-flow and working capital management perspectives. Unfortunately, the creators of the digital currencies are precisely aiming to break down the banking system by introducing P2P solutions, hence these benefits can not be harvested. Controversially Bitcoin and its peers try to create an alternative for cash payments, the exact type of transactions which are mostly between only two parties, leaving no leverage for the technology, and no effective need to ‘inform’ the entire network of the transaction other than its operative use. Consequently the technology becomes counterproductive, and economies of scale becomes diseconomies of scale. The more participant there are the more redundant information channels will be created. According to ING’s calculation, Bitcoin is one of the least efficient payment method when it comes to the costs of making a transaction (see charts).

So what creates the value of a Bitcoin? In order to understand the phenomenon, let us see what supports the value of traditional money. Primarily the value of money is created by basic economic (supply and) demand for currency. Purchasing goods and services requires an intermediate of exchange, creating demand for liquid assets. As a second step, add the debt markets and financial intermediaries to the equastion; the big picture remains mostly unchanged. Investors and speculators give credit in exchange for interest or principal appreciation, however, they need demand for liqudity on the other end to be able to lend money. Once again, the other end means demand for goods and services, where the debtors use proceeds to finance their physical investments or consumption. Of course we could say that loans could flow towards other financial assets, but once again real economy must stand at the end of the financing line, or we deal with mindless speculation, just like in the case of Bitcoin.

But how does the case of Bitcoin look like? The digital currency’s market capitalization (value of a coin x number of coins in circulation) is around 117 billion USD. To put it into context, the Fed’s balance sheet, providing liquidity for the global market of US dollars, is approximately 4 500 billion USD. In order to measure whether market cap is too high, let us think about the goods, services, assets, commodities and bonds USD liqudity can be exchanged for gloablly (creating demand for the greenback), and then compare it to the ubiquity of Bitcoins in commerce. Compared to these measures, there is no real demand behind Bitcoin, other than the trust that there will be a bigger fool than me, who will buy it at an even higher valuation. Since everyone plays according to this rule, once inflows dry up there will be no buying power and everyone will try to sell at the same time.

Advocators of the digital currency often cite low volatility and high turnover/financial liquidity (in terms of Bitcoin exchanges to other currencies) on its market. The second part might be true due to speculation and the asset’s ability to circumvent authorities in case of international settlements. Likewise, historically low volatility is rather the sign of a smooth, increasingly suspicious upswing in the rate, rather than a balanced market of supply and real demand. Lastly, a thought regarding an appreciating currency and its commercial viability. Since there is no banking sector which could counterbalance the appreciation (deflation) of the currency with low nominal yields, every percentage points of increased value counts as real interest. Nowdays, when real returns are scarce, it is not puzzling that speculators will jump onto an asset with such remarkable appreciation. The only issue is that why would you spend something if in the future its value will increase, and why would a vendor price anything in a unit which’s value changes by the minute.

Bitcoin, in its current form, is not viable. It is a free floating nothing, supported by speculation and some benevolance. A necessary collapse, which also seems to be inevitable, could kickstart digital currencies. After the price settles on a lower level, where market capitalization is in tandem with its real demand, the commercial use becomes more likely. However, the diseconomies of the technology even then remain unsolved… and immerse amounts of ‘wealth’ have to evaporate until that moment.