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When Will the Bitcoin Bubble Burst

Publication Date: 16 Dec 2017 - By Market Mogul By Market Mogul
Actionable
Differentiated

Thematic Cryptocurrencies Other Technology

Is bitcoin in a bubble? Currently, this is not the most important question for investors. The impressive price volatility suggests a speculative behaviour: current investors seem to be more concerned about speculative profit than about bitcoin’s intrinsic value or blockchain technology’s future.

In the theory of asset pricing, the value of an asset is its expected dividends or interest. Since bitcoin does not provide any dividends or interest and their price is positive, it is either in a bubble or an asset that provides a convenience yield. As pointed out by the economist and Senior Fellow at the University of Chicago John Cochrane, bitcoin phenomenon can be related to both: bitcoin has an intrinsic value but on top of that, a speculative demand in the form of a bubble exists.

The Convenience Yield

American economist Susan Athey said that “if people use bitcoins, they have a value”. Hence, future price appreciation is not the only reason why people hold it. For instance, physical cash gives no dividends and has a lower return than risk-free assets but people still hold it. This is because cash is needed to make transactions and, therefore, there is a “hidden return” called the convenience yield. Bitcoin has a higher convenience yield than cash it is easier to carry, it delivers transactions without physical interaction an is used internationally.

This implies that their financial “overvaluation” should also be higher. However, during the past months, many investors have been buying bitcoin only to benefit from its increasing price trend. This speculative demand has likely raised bitcoin’s price above the equilibrium. As in every rational bubble, a burst is to be expected at some point down the line. Now that bitcoin derivatives are being traded, the focus shifts from bitcoin’s intrinsic value to the timing of this potentially rational bubble.

The Bubble

The political and technical issues surrounding bitcoin have not influenced its speculative demand so far. In fact, the increase in transaction fees, the increasing presence of substitutes and negative opinion of globally trusted leaders have had no relevant impact on the price trend. At some point, the value of bitcoin will recover and this will happen even without the Chinese government’s ban.

So, when will the overvaluation end? Well, since the price is determined by optimists, the answer depends on the ratio between optimists’ risk-bearing capacity and the supply of bitcoins: the price will only collapse when the optimists’ risk-bearing capacity becomes lower than the supply. As a consequence, the current ratio between these two quantities becomes extremely important for the prediction of bitcoin’s future price.

Even though there are a large number of optimists, the current ratio is temporarily influenced by the low tradable supply. According to Bloomberg, 40% of bitcoins are currently held by approximately 1000 people, many of whom are founders or early adopters that do not trade bitcoin, which makes the tradeable supply to be only 60% of the effective supply. However, “the prospective introduction of bitcoin futures has the potential to elevate cryptocurrencies to an emerging asset class”, as said by Nikolas Panigirtzoglou, a global markets strategist at JPMorgan, because of the increased liquidity.

What the Future Holds

However, this does not help to determine precisely when the reduction in bitcoin’s price because will occur. The reason is that bitcoin’s demand is very difficult to estimate or predict because it is volatile and influenced by a myriad of factors, including the amount of money the Russian mafia wants to bring offshore in any given period.

Overall, it is reasonable to expect continued bitcoin volatility in the short run followed by a sharp decline in bitcoin’s price in the medium run. This does not necessarily imply that Bitcoin will not be used anymore in the future and that its price will collapse to zero. The most likely scenario is that bitcoin’s value will finally converge to its convenience yield value and still be widely used unless other cryptocurrencies demonstrate that they are more efficient and safer. As sovereign debts become more critical and the risk of inflation rises, cryptocurrencies like bitcoin can be seen as a bet against classical currencies and as a store of value.

 

The post When Will the Bitcoin Bubble Burst? appeared first on The Market Mogul.

 

 

 

 

 

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