Will the bitcoin bubble burst?
A pillar analysis of the market shows a promising future for cryptocurrency, despite the naysayers.
One of the biggest hurdles bitcoin has faced throughout 2017 has been poor journalism around the cryptocurrency, along with uneducated opinions from many so-called "experts" within the financial industry.
Jamie Dimon famously labelled the currency a "fraud" suitable for murders and drug dealers, while the chief economic advisor of Allianz said in September it should be worth half of what it was trading at back in September when it was edging US$5,000. I wrote about this in my last article when the price fell back to US$3,600.
Peter Switzer, a prominent and well respected financial commentator, was asked for his thoughts on the cryptocurrency around the same time in September. However in a more honest approach he advised he had chosen not to invest stating "I subscribe to the view that I don't invest in things that I don't understand", further quoting Charlie Aitken's reference to bitcoin being a "bubble".
The real negligence here has come into play, as there have been few signs that many of the most prominent financial commentators actually understand the cryptocurrency. Myopia has hit many individuals we have historically trusted to understand financial markets.
Despite the numerous comparisons, the cryptocurrency boom displays very few characteristics to Tulip Mania outside of a huge price spike. Many more similarities are found in comparison to the oil rush in the 1850's, which was actually the largest wealth transfer of this magnitude prior to the evolution of cryptocurrency. Those involved in it simply understood that the world was moving away from the horse and cart, and into a realm where oil would become an essential pillar of the economy. In the same way, currencies are changing and they are about to have a profound impact on everyday life.
It's time those around the financial industry, especially those giving financial advice and opinion, actually understood the currency, and what its technology really means for the future of currencies.
So whether you're an uninformed journalist informing others on the industry, a financial commentator struggling to understand the market, or just lost in the confusion of what bitcoin really means and why the price is skyrocketing, I've laid it out in simple terms below in what I call the "pillar analysis".
Let's take a granular look at the 6 core pillars of demand for bitcoin and cryptocurrencies - in order of evolution;
1. The shadow economy
Perhaps the most controversial pillar of demand is the shadow economy. We all remember Silk Road and the controversies surrounding its collapse. People operating within the shadow economy may use bitcoin due to its anonymity and its ability to be held on a private device and traded anywhere around the world instantly.
Interestingly while this "pillar" has been heavily criticised, I do believe the portion of bitcoin used for black market activities is in decline due to the rising of the other core pillars of demand by market volume. What we must remember is that USD (cash) shadow economic activity is estimated to be 5.4% of US GDP according to the Institute for Applied Economic Research.
The second large pillar of demand driving price is speculation: early adopters who have forecast the rise in demand within cryptocurrency markets, and continue to speculate on the currency. Over recent months many exchanges and CFD providers have reported huge volumes of new members forming accounts to trade and speculate on price. More recently we have seen rising demand within the self-managed superannuation funds (SMSF) sector as people look to invest in the currency.
Speculation is a major driver of price; in exactly the same way it has historically driven the price of physical commodities such as Gold. Unique addresses (think of it like a wallet), which are typically formed to hold the cryptocurrency have been growing steadily due to new speculators and small investors entering the market. Unique wallet addresses can be seen below graphed over time (data from blockchain.info):
3. Real-time, free, international transfers
If you have ever sent money overseas you've probably noticed your local bank favours fees over people's need, and its own convenience over faster speed.
Services like Bitwala, and many more, are gaining huge traction in terms of giving people the ability to send their money overseas in real time with minimal fee's and hindrance, and converting that back to cash in real time for instant access. Anyone can establish an account in less than one minute.
Bitpay now also offer a card in partnership with Visa, where you are able to spend your bitcoins at any retail store offering a credit card or debit card terminal, or at any ATM, worldwide. A relative in the Philippines for example could hold a card and withdraw funds directly from any ATM instantly, without the delay or approval of a bank.
Bitcoin and cryptocurrencies are a real alternative for people in developed countries like Australia, looking to send their money overseas, at a much cheaper rate and much faster than through a bank.
Second to that you may be aware of the difficulties in establishing a bank account in the developing world (and even the developed world to some degree). 39% of the world's population do not have a bank account, according to the World Bank financial inclusion database.
As a direct result of this we have seen the market for real-time international transfers boom and become the 3rd core pillar of demand.
4. Entry of retail funds and banks into blockchain
Recently we have seen several attempts to launch managed funds around bitcoin and open these to sophisticated and retail investors. Historically the Securities Exchange Commission has knocked back such applications and expressed concern around them. There is however some light at the end of this tunnel.
Only last week a small Paris-based asset manager, Tobam, launched Europe's first bitcoin mutual fund. Many more are predicted to follow. In September the Securities Exchange Commission advised Van Eck Associates Corp that it would not review further filings until "futures contracts on the digital currency start trading" – which ties into our next pillar of demand.
There have also been several articles around major banks looking to enter this space to operate and manage retail funds on behalf of their investors including BNP Paribus, while several other banking leaders have embraced blockchain technology including Societe General, Citibank, UBS, and Barclays. We have also seen Goldman Sachs close a US$50 million financing round for a bitcoin financial services start-up.
The entry of retail funds within this space will push demand higher, as they would be required to buy and hold bitcoins equal to investor funds. This will only push up price.
The continued understanding of blockchain technology within the banking sector will also bring further legitimacy and confidence to speculators, and investors.
Retail funds and fund offerings through banks and private equity firms, along with an increased adoption of blockchain technology within the banking sector will bring further legitimacy, demand, and confidence to speculators and investors. For this reason, the inclusion of retail funds and banks within the space is slowly forming a 4th pillar of demand.
5. Futures market
Recently it was announced by the Chicago Mercantile Exchange that it would be supporting a futures market for bitcoin, commencing 14 December.
Volatility is important, as no retailer wants to sell a product for $100, that they might make $20 on, in a currency that may fall or rise 20% as this essentially eliminates profit. In the same way, no farmer would ever be likely to forward sell his or her crops in 6 months for bitcoin given the risk of the market.
From December the Chicago Mercantile Exchange will launch the worlds first bitcoin exchange allowing access to lock in fixed prices on any date in the future, therefore eliminating this risk. This is a groundbreaking development for bitcoin and is a vital step in cementing bitcoin as a global currency.
The futures market is a key driver in the development of bitcoin, and should only lead to higher demand as participants are forced to purchase bitcoin to meet contractual demands
The final pillar of demand, and perhaps the largest in the long term, is retail acceptance. This is what essentially transforms a young currency into a world-leading dominating currency. The USD is so powerful because it is essentially accepted in any country worldwide, and most people are aware of its value. Some retailers in the developing world even prefer to receive USD in place of their own currency.
One of the biggest arguments I've heard against bitcoin is that it can't actually be spent, but this argument is becoming increasingly irrelevant and only continues to be propped up by those who do not understand the currency. Most currencies including bitcoin, Ethereum, and Litecoin can be spent - however currently only 3 out of the top 500 retailers in the US support bitcoin payments according to Morgan Stanley. I expect this to increase at a rapid rate.
Historically, as a retailer there are two core issues with receiving bitcoin as payment: its volatility and the ability to convert bitcoin into cash. We covered volatility and why that will be irrelevant within pillar 5.
For retailers looking to process transactions in bitcoin they are now able to adopt Bitpay, which offers a system to any retailer to accept bitcoin as a payment and have it transferred directly into the retailer's bank account as cash, instantly. Any retailer adopting Bitpay would not have to endure the typical settlement periods banks and credit card companies offer which are at times up to 8 days to receive funds from credit card and other transactions, and would not have to worry about banks reversing fraudulent transactions as bitcoin payments can not be reversed and the blockchain is completely transparent.
Bitpay has grown 328% over the past year, and continue to grow as more and more retailers choose to offer their customers the option to pay through bitcoin. Bitpay will likely have more and more competition. Bitcoin is going to hit retail in 2018, hard.
In summary it's best to think of the "pillars" as key supporting channels of demand, which are pushing the price of bitcoin up. One or more pillars may collapse, for example the regulators may change their mind on the futures exchange, or funds may be spontaneously banned from offering the currency to clients, but the industry will survive on the other four while the rest are being rebuilt. Bitcoin will forever have utility in Pillars 1,2,3 and 6. This is why when China banned bitcoin transactions in RMB only a few months ago, and the price dived, it was a perfect buying opportunity for those who understood the market.
Price is being driven by demand, while supply is fixed. There are currently around 16.7m bitcoins in circulation and there cannot be more than 21m. It is further estimated by Chainalysis, a digital forensics firm that studies the blockchain, that up to 4 million coins have been "lost" within the stages of early adoption meaning it is likely only around 13 million coins exist.
Any economics textbook will tell you price is a function of supply and demand. Think of total demand as a house, supported by 6 pillars, growing exponentially in adoption and volume. We have really only seen the first 2 pillars formed, and we are currently seeing the remaining 4 in their early stages. Extrapolating the forecasted demand for the growth of pillars 1 and 2, along with the development of Pillars 3, 4, 5 and 6, paints an attractive forecast for any cryptocurrency.
The real question we should be asking is not whether this is a bubble or not, but which cryptocurrency is likely to dominate and have the most uptake as we form long term investment decisions – and in this case it may be a little hard to obtain independent financial advice from those we've previously obtained it from.
Stephen Moss is a founder at investment firm and cryptocurrency brokerage Cryptoko. Follow him on LinkedIn.