Wednesday, December 13, 2017

Why Bitcoin is not a bubble... yet

Bitcoin has surged to a record breaking high of USD 17,000. Inevitably, lots of people called Bitcoin a bubble and will collapse soon. There's an interesting "Bitcoin Obituary" by 99bitcoins.com that lists (in chronological order) how many times Bitcoin has been declared dead or will die a slow and gruesome death, not unlike the Blemflarck crisis in Rick and Morty.


To talk about this issue, let's find out what a "bubble" is and some case studies:

BUBBLE

According to Investopedia, a bubble is:

"A bubble is an economic cycle characterized by rapid escalation of asset prices followed by a contraction. It is created by a surge in asset prices unwarranted by the fundamentals of the asset and driven by exuberant market behavior. When no more investors are willing to buy at the elevated price, a massive selloff occurs, causing the bubble to deflate."
Basically, a bubble is when an asset is so overvalued and it will burst when people want to cash out, it triggered an avalanche of asset selling that eventually the price plummets to almost zero.

CASE STUDY 1

The first bubble that have been recorded is the "Tulip Mania" back in the 16th century in Holland. What happened was:

The tulip bulb trade started inadvertently when a botanist brought tulip bulbs from Constantinople and planted them for his own scientific research. Neighbors then stole the bulbs and began selling them. The wealthy began to collect some of the rarer varieties as a luxury good. As their demand increased, the prices of bulbs surged with rare varieties commanding astronomical prices.
Bulbs were traded for anything with a store of value, including homes and acreage. At its peak, Tulipomania had whipped up so much of a frenzy that fortunes were made overnight. The creation of a futures exchange, where tulips were bought and sold through contracts with no actual delivery, fueled the speculative pricing.
The bubble burst when a seller arranged a big purchase with a buyer, but the buyer failed to show. The realization set in that price increases were unsustainable. This created a panic that spiraled throughout Europe, driving the worth of any tulip bulb down to a tiny fraction of its recent price. Dutch authorities stepped in to calm the panic by allowing contract holders to be freed from their contracts for 10% of the contract value. In the end, fortunes were lost by noblemen and laymen alike.

What can be learned from this event is:

1) Fundamental value. Each asset must have a real fundamental value. A tulip; whilst beautiful; have no real usage and even deteriorate over time.
2) FOMO: Fear Of Missing Out. People keep buying tulip as a "luxury goods" that have no real fundamental value.
3) Futures market and speculative pricing is a bitch. Be really careful and know what you're doing when investing in a future product. This includes oil, palm, rubber, real estate, etc.

CASE STUDY 2

The housing bubble that crippled some of the big banks in the United States in 2008. As written in thinkadvisor.com(key points bolded are from me):

The current financial crisis began when the American Dream of home ownership was planted in the hearts of millions, even those that didn't have the fiscal discipline or financial wherewithal to be homeowners.
To combat the economic aftermath of 9/11, the Federal Reserve lowered interest rates. Greenspan & Company badly miscalculated by keeping rates too low for too long.
Home prices rose anyway, reinforcing the American dream.
Artificially low interest rates created cheap mortgages which created a speculative boom in real estate.
Aggressive mortgage brokers capitalized by selling doomed subprime mortgages to unqualified borrowers. Despite a fundamental breakdown of lending standards and regulatory oversight, no one noticed. Banks and brokers collected billions.
Home prices continued to soar. From 2002 to 2007, the S&P/Case-Shiller Home Price Index of 20 metropolitan cities outpaced the stock market and jumped by 75 percent. Inflated real estate lured consumers, homebuilders and investors into a false sense of financial security.
Consumers continued to binge on real estate and home equity lines.
Instead of holding mortgages and collecting the interest on the yield from the loans, lenders pooled them into securitized burritos. The packaged loans were sold with the help of inflated ratings from Standard & Poor's and Moody's.
Wall Street's underwriters collected billions in fees and rating agencies got their cut. Earnings and profits rose, but executive compensation rose faster.
Investment banks like Bear Stearns and Lehman Brothers devolved into highly leveraged hedge fund-like entities. Both firms collapsed.
Mutual funds, hedge funds and other financial institutions that overdosed on risky mortgage securities that were once deemed safe began to falter.
Ailing mortgage borrowers set off a tsunami of defaults, which triggered a collapse in the value of mortgage-backed securities. Financial institutions were forced to write down more than $1 trillion from their balance sheets.
Other opaque financial instruments like auction rate securities and credit default swaps blew up.
Home foreclosures accelerated, which created a glut of residential real estate pushing home prices down further.
Financial giants like AIG, Freddie Mac, Fannie Mae, IndyMac, Lehman Brothers and Washington Mutual collapsed. Others followed.
The financial chaos even took its toll on "safe" investments. The $62 billion Reserve Primary Fund, one of the first money market mutual funds, was forced to liquidate.
Consumers panicked by withdrawing money from their banks and mutual funds.
FDIC increased its coverage of bank deposits to $250,000 per customer from $100,000 through 2009.
Home prices crumbled even further.
Financial stocks within the S&P 500 fell by 45 percent.
The meltdown demolished America's retirement plans by some $2 trillion.
Banks and financial institutions fought for survival by hoarding cash. They stopped lending to their clients and to each other.
Without cash flowing from banks, businesses couldn't carry on their daily operations, much less grow.
Liquidity in the financial system dried up.
Congress passed into law a $700 billion rescue package to help the U.S. financial industry.
The stock market fell and the future prospects of earnings and GDP growth dimmed.
Basically what happened was (economists help me out please):

1) Housing loan interest rates are kept low.
2) House prices rose.
3) People with no fiscal ability keep on buying houses with the intention of selling it at a better price in the future.
4) The loans were then packaged and sold to other banks.
5) When the house prices are too high, people stop buying houses and the borrowers starts to default.
6) Home foreclosures starts to drive residential home prices down.
7) Home owners are stuck with houses that are valued much less that what they had paid for.
8) Banks no longer have lending power, stopping businesses and dried up the liquidity of the financial system.

CASE STUDY 3

The Dotcom bubble that happened in early 21st century, fueled by the internet-based company. As written in Investopedia (bolded by me):

The 1990s was a period of rapid technological advancement in many areas, but it was the commercialization of the Internet that led to the greatest expansion of capital growth the country had ever seen. Although high-tech standard bearers, such as Intel, Cisco, and Oracle were driving the organic growth in the technology sector, it was the upstart dotcom companies that fueled the stock market surge that began in 1995.
The bubble that formed over the next five years was fed by cheap money, easy capital, market overconfidence and pure speculation. Venture capitalists anxious to find the next big score freely invested in any company with a “.com” after its name. Valuations were based on earnings and profits that would not occur for several years if the business model actually worked, and investors were all too willing to overlook traditional fundamentals. Companies that had yet to generate revenue, profits and, in some cases, a finished product, went to market with initial public offerings that saw their stock prices triple and quadruple in one day, creating a feeding frenzy for investors.
The NASDAQ index peaked on March 10, 2000, at 5048, nearly double over the prior year. Right at the market’s peak, several of the leading high-tech companies, such as Dell and Cisco placed huge sell orders on their stocks, sparking panic selling among investors. Within a few weeks, the stock market lost 10% of its value. As investment capital began to dry up, so did the life blood of cash-strapped dotcom companies. Dotcom companies that had reached market capitalization in the hundreds of millions of dollars became worthless within a matter of months. By the end of 2001, a majority of publicly traded dotcom companies folded, and trillions of dollars of investment capital evaporated.
Those are extreme examples of bubbles that affected millions of people. All are caused by buying craze that are not backed with proper fundamentals, and ended with people losing money without any asset to hold on to.

WHY BITCOIN IS NOT A BUBBLE

*disclaimer: this is just my opinion based on my own research. Things may go south tomorrow, or go the moon...

Even though Bitcoin has risen up to USD17k in the last few weeks, I still think it will rise in value in the future. Here's why:

1) Fundamental value.

Unlike tulip, artificially inflated house prices or bogus bubble companies, bitcoin is generated through it's blockchain, which is mined by physical machines which incur electricity and maintenance costs. Like gold, there will be a minimum value of bitcoin. A rough calculation indicates that:

     (the most efficient rig) Antminer S9 (14Th/s)    = RM10,000
     (electricity cost)  1.5kW/hr * 24hrs * 30days * RM0.507 (kW/hr Malaysia commercial rate)
                                                                                 = RM 550 per month
                              Internet and other maintenance = RM200 per month
                                         Reasonable ROI for rigs = 10 months,
                         Cost for rig running for 10 months = RM10,000 + RM550 (*10months) + RM200 (*10months)
                                                                                = RM17,500
So, per month of mining, the mining profit should not be less than RM1,750.

       (Current mining rate) 0.0022btc/day * 30days = 0.066btc/month
                                      Current bitcoin price, 1btc = RM70,000
                                                                  0.066btc = RM4,500 (still profitable)

Based on that calculation alone, regardless of the amount of bitcoins mined, as long as the profit exceeds RM1,750 per month, people will still mine bitcoins. Miners surely wouldn't sell bitcoins any less than that amount due to the cost of producing bitcoins. This is the fundamental value of bitcoins, the bottom price that miners will set. As the difficulty rises, less bitcoins can be mined per rig, but the production costs will stay the same. Hence, bitcoin price will only get higher in the future.

However, based on production cost, bitcoins should have a price of:
                                                                 0.066btc = RM1,750
                                                                        1btc = RM27,000

Why then, bitcoins are valued much more right now?

2) Supply and demand

Bitcoins have 21 million cap limit. Currently in circulation are around 16.7 million bitcoins. As more people are getting aware of the existence of bitcoins, more and more people are eager to get a hold of bitcoins, driving the price higher and higher. Do note that every time bitcoins reach new ridiculous price, there will always be a correction pricing that brings bitcoin value down a bit (and bitcoin death prophets to emerge).

3) Bitcoin evolution

Once upon a time, gold is processed into coins and traded for goods. As gold prices soar, they are no longer being used for daily trading, but used for asset keeping. This is because the price of gold is so high and keeping it as physical coins are very risky.
Bitcoin will eventually become virtual gold. As the transaction fees are getting higher and the price soared, it will eventually be used as asset keeping only. The value of other cryptocurrencies will be pegged to bitcoin. It will be no surprise if in the future, other coins (XMR, DASH, ZEC, ZEN, etc.) will be used for daily trading and bitcoins are kept safe in cold wallets and used for exchange/ high volume trading purposes only.

4) Blockchain technology

Blockchain technology is the future of digital asset. Regardless of bitcoin future, blockchain tech will be the standard of delivering and receiving digital goods. This alone will guarantee the future of bitcoin; the first commercial implementation of the blockchain technology. Without a doubt, there will be a disruptive technology superior to blockchain in the future, especially after quantum computing becomes commercially viable. But it is not this day.

CAUTION

A bit of caution though. Bitcoin futures market is opening. This may make bitcoin a true "bubble". Try and read this article. As bitcoin have virtually no upward price limit, thing may break loose next year as greedy whales play with bitcoin prices until the bubble bursts. Bitcoin prices can soar past 100 times it's cost value due to speculation alone and could collapse when people sell their bitcoin in a selling frenzy; not unlike the tulip bubble earlier.

Bitcoin is a decentralized currency. It exists and held value because of the users using it. No government is regulating the price and production. The price is still based on the users ability to buy and sell bitcoin freely.

I still trust my fellow human beings to make the right decision in bitcoin prices. That is; stop buying bitcoins when the price is too high.

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