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Abu Dhabi, UAESaturday 23 June 2018

Red alerts flashing as bitcoin bubble continues to expand

Cryptocurrency being bought by investors who have no idea what they are or how they work

FILE: A gold colored bitcoin token sits on display under a glass cloche inside the offices of La Maison du Bitcoin bank in Paris. Bitcoin is showing no signs of slowing down. Christophe Morin/Bloomberg
FILE: A gold colored bitcoin token sits on display under a glass cloche inside the offices of La Maison du Bitcoin bank in Paris. Bitcoin is showing no signs of slowing down. Christophe Morin/Bloomberg

If ever there was a bubble ready to burst, then surely it’s the price of bitcoin which on Monday hit a new high of almost US$10,000, an increase of more than 850 per cent since the start of year.

On January 1, it stood at $1,000 and even that looked toppy. Since then it has become probably the fastest-growing market in history, out-distancing the dom.com boom by a wide margin and leaving the 1970s Japanese market or Wall Street in the late 1920s for dead. Gold, it’s nearest equivalent in terms of virtual currency, never did this; nor did the sub-prime boom in the years leading up to the crash, or the bull market in railroad stocks in the mid-19th century.

The nearest recent equivalent I can think of is the Hang Seng index in 1973 which rose 10-fold, from 170 to 1,700, in less than a year. Then the bubble burst and it fell 90 per cent, leaving behind an awful lot of wreckage and endangering the stability of what was then still a British colony. Australian mining shares had a crazy run in the late-1960s (old hands will remember a stock called Poseidon) but within a few years there was the inevitable carnage and a terrible smell of burnt-fingers.

There are lots of other booms and busts, but just to put the bitcoin performance into perspective: based on an index of 100 in November 2016, dot.com stocks, as measured by the Nasdaq Composite Index, rose to 250 in the year leading up to the peak in March 2000, the height of what Alan Greenspan, then the chairman of the US Federal Reserve Bank, dismissed as “irrational exuberance”. Based on the same index, the bitcoin price is now nearly 1,500. That’s taking exuberance to a new degree of irrationality.

At the end of the day, the dot.com boom had a point to it. The use of computers and the internet were growing exponentially and needed a backbone structure to make the system work: software, data bases, search engines, server structures and so on. Huge sums raised in the markets went into building them, paving the way for growth of the Googles, Facebooks and Amazons that we have today. The same is true of the railways, aerospace and even mining stock booms, which left behind solid industries once markets returned to normal. What point has the bitcoin boom got? And what is “normal”?

On Monday the world’s largest online trading platform, IG Group, suspended trading of some of its bitcoin derivatives, citing “high security risk” created by roaring demand for the product. It put a strict limit on the amount of bitcoin it will hold at “ten of millions” of dollars, a fraction of the demand. Others will no doubt follow.

Unlike all other markets, the bitcoin market has no regulator, forming a virtual currency which no central bank or authority has any control over. It is, as the Financial Times remarked, the “Wild West of the financial world”, without even a sheriff in sight.

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Read more:

Bitcoin may be the 'Uber' of currencies, but don't ignore the risks

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This week the Chicago-based trading firm, Interactive Brokers, took the unprecedented step of taking out a newspaper advert demanding more regulatory oversight. It fears that bitcoin is so volatile it could create huge losses for traders, and undermine the health of the Chicago Mercantile Exchange, which plans to start listing bitcoin futures, the first exchange to do that. The dangers are obvious: a futures market enables investors to take positions, previously impossible in the bitcoin market where there is no short-selling, betting on the coin’s future value without actually holding it. Advocates for a futures, or derivatives, market argue that it is a desirable and necessary evolution of what is rapidly developing into a mainstream market. They have a point: futures usually make a market more stable in the long run and if bitcoin futures had existed a few years ago, the prices would probably not have swung so crazily in the past month.

The other side of that particular coin is that bubbles are built on derivative markets and a futures market provides the only missing component to complete it. If bitcoins weren’t a medium for gambling before, they are now.

The Japanese market of the 1980s is perhaps the most relevant historic precedent here. For two decades, Nikkei Index components seemed to exist on a planet of their own, subject to valuation rules which were quite different to everyone else’s. Then equity derivative contracts were launched, which quickly became part of the wider global market system, and suddenly Japan was like any other market. In 1990 it crashed - and has not recovered since.

Bitcoins are being bought by investors who have no idea what they are or how they work. It is the purest example of speculation since the South Sea Bubble almost 300 years ago. No one knows the true value of a bitcoin because there isn’t any - even the price of gold, which has been used as a store of value for thousands of years, is related to its production costs and to demand for jewellery.

In the digital age, it is inevitable there will be cryptocurrencies and in due course we will all use them even to buy our groceries in the supermarket.

But right now, when that currency becomes a gambling counter and out-performs all other markets by such a wide margin, the danger lights are flashing.