Sooner rather than later the old story will end the old way, adding another chapter to the chronicle of investment folliesby Paul Wallace / December 13, 2017 / Leave a comment
Over the past few years most people have either ignored bitcoin, dismissing it as a fad that would fade away, or they have predicted an imminent collapse in its value. But it is now impossible to ignore the “cryptocurrency,” so-called because cryptography is used to secure and verify transactions and to shield the identities of its owners. Bitcoin continues to defy the naysayers as it soars ever higher. This week brought the first trading in bitcoin futures, which started with a bang as prices initially surged by 25 per cent. At the end of last year each bitcoin was worth around $1,000. It surged last week from around $11,500 to a high of just over $17,000. After falling back it has since spiked even higher this week. Yet bitcoin shares so many similarities with past investing frenzies that it seems certain to share their fate as well. The bubble will eventually burst and those who have bought the cryptocurrency most recently will be the greater fools. For its evangelists, bitcoin is a piece of a digital future that will sweep paper currencies and bank deposits into the dustbin of history. Bitcoin, a decentralised digital currency, is the most striking application of the blockchain, a technology that is genuinely innovative by allowing people to collaborate through creating a shared digital ledger that does not require a third party or central authority (a full explainer on Blockchain can be found here). Big banks are already exploring its potential in operations such as settling trades. But cryptocurrency enthusiasts hope that it can be used to do away with those same banks—along with note-issuing central banks—by facilitating peer-to-peer transactions that bypass financial institutions altogether. Conceived at the height of the financial crisis in late 2008 when banks had come close to dispensing with themselves anyway, the cryptocurrency was launched in January 2009. Bitcoins are “mined” through a number-crunching process that gets progressively harder. The miners also earn less through regular “halving events” that have already reduced the reward for each new digital ingot from 50 bitcoins at the outset to 12.5. As in a gold mine the rich seams have already been exploited and it is getting harder to extract more. There are currently 16.7 million bitcoins and the limit is 21 million. Mining the extra ones now requires so much computing power that miners are increasingly operating in remote regions of China where energy is cheap. All this sounds as if bitcoin is a digital reinvention of gold as a currency grounded in scarcity. The form might be novel but the substance would be old. Bitcoin could become a universal rival to the national currencies issued by central banks. But how plausible is this? Money fulfils three purposes. It is a store of value, a means of exchange and a unit of account. Bitcoin fails on all three counts owing to its extreme volatility. If anyone had borrowed in bitcoin a year ago, they would now be bankrupt. Moreover, the opacity of the cryptocurrency also makes it attractive to criminals, giving it an unsavoury reputation. Strip away the jargon and the bitcoin phenomenon is an old story, too. At various times in financial history stretching back over several centuries speculative interest alights upon novel products or potential lucrative new ventures. Prices start to rise. That excites further interest and they rise still further. Now the game is on as more and more people pile in. Eventually the prices rise so high that some of the earlier buyers take their profits by selling. The process starts to reverse and gathers momentum in the opposite direction. This was what happened in Holland during the “tulip mania” of the mid-1630s. Despite a cottage industry of academics seeking to depict this as more legend than fact, there is no disputing that the prices of what were then exotic plants were bid up to ever more exotic levels—until they collapsed. Less than a century later, a similar mania developed in Britain in the South Sea Company bubble of 1720, as investors piled into an enterprise whose activities were much closer to home as it engaged in a murky government debt-for-equity swap. As so often in investment frenzies, fear of missing out as others profit drags more players in, fuelling the fire of greed. Isaac Newton, master of the mint as well as of the laws of motion, bet and won in the South Sea bubble, only to re-enter the market at the top and to lose much more. Blockchain remains a promising technology for a variety of uses. But despite its novelty bitcoin resembles past crazes that have taken on a life of their own. If bitcoin were a share its prospectus as a transformative currency would not pass muster at a stock exchange. Sooner rather than later the old story will end the old way, adding another chapter to the chronicle of investment follies.