The most contentious question must come first: are cryptocurrencies experiencing a bubble? Maybe, but not necessarily so. Defining Bitcoin as a bubble is problematic, despite it being very much in vogue to do so (especially by those not holding or unable to hold Bitcoin in their portfolios).  

The definition of a bubble requires some measurable, or at the very least conceptualisable, base intrinsic value from which the price shows abnormal deviation, even if this is retrospective. In the case of Bitcoin, the problem is ineffable, since many are unsure if Bitcoin has such an intrinsic value at all, if it is even deserving of such value, and if so, what this value might be. And yet others are convinced that it has all the properties of digital gold, and can function as a store of value superior to the shiny brittle metal to which we have for centuries entrusted enduring wealth attributes. What we do know is that for it to be a true store of value, it needs to function as a broadly accepted medium of exchange. For it to be more useful in this regard than currently available instruments, it only really needs to be less volatile.

Proponents of Bitcoin point to the fact that it acts clearly as a store of value and is already as fungible as many other forms of exchange (with steady efforts to make it even more fungible). They further point out that it may become a currency in time, but it is not, nor does it profess to be or even need to be one right now. Antagonists note that it cannot ever qualify as a currency, nor a commodity, and only exists in a decentralised network. The reality is that just because we have no precedent for such a type of ‘money’, in that it represents something other than a fiat currency or a tangible (as opposed to abstract) commodity, does not mean it has no use or value.

In fact, respected economists and financial professionals alike have warned of cryptocurrencies’ seemingly fictitious value, which only exists in the minds of those choosing to hold it, while not being backed by any physical asset or commodity. These same economists and professionals in the 1970s successfully convinced many sceptics that fiat currencies could take on exactly this role (valuing intrinsically valueless paper) as the global economy exited the gold-standard. Few today consider paper bearing the government’s emblem as valueless as it merely requires others to do the same. Cryptocurrencies are no different in this regard, and even boast the added benefit of being near frictionless in its movement and independent of the influence of central bankers and policy makers – two very attractive features in a global economy increasingly defined by distrust of public officials and institutions.

Bitcoin is an experiment. The creator(s) of Bitcoin literally put the hypothesis to the test that there was value to be unlocked in an idea, if it commanded sufficient appeal and propagated enough interest. In the age of Brexit and Trump – chasing populism, making the individual sovereign against unstable political or financial backdrops, and with the right incentives (regardless of how flawed) – it very well might work. And the price of Bitcoin is now set primarily by demand, and little else.

Valuing Bitcoin by its basement cost (the computer processing time and electricity costs required to admit hash-block solutions) could prove to be a source of concern to casual observers. Particularly as the current value of Bitcoin has overtaken the basement cost for mining it. This need not concern holders, though, for much like the fluctuating value of gold and the subsequent changes in profitability of mining activities, the added incentive to do so should (in theory) simply increase mining efforts and supply, and restore some parity over time. As the ultimate supply of Bitcoin is limited (in comparison to the limitless supply of fiat) and ease of mining declines exponentially with supply, the dilution potential should be of less concern than often stated by opponents. What remains is the intangible value and its interaction with the scarcity value – the two are multiplicative, and not additive, by design.

The fact that we have no useful models, either from an accounting or mathematics of finance point of view, to understand the phenomenon, is not a good enough reason to dismiss it. It thus remains incorrect to term this a bubble; yet at the same time equally incorrect to be contemptuous of suggestions that it is one. The media attention institutions worldwide are giving Bitcoin emboldens the crypto-verve. The launching of futures recently on Bitcoin on the largest futures exchange in the world (The Chicago Mercentile Exchange, or CME) as well as the CBOE (Chicago Board of Exchange), arguably further legitimises the phenomenon.

With Bitcoin, in all its’ imperfections, we evidence a perfect confluence of novel technology, scarcity and populism, and the genesis of a new asset class. The timing of its emergence following the global financial crisis is, in hindsight, also unnervingly opportune.

And the fact is that the most discerning capitalists the world over still lack a deep understanding of its full potential.

What is driving some of the (irrational) exuberance amongst investors in Bitcoin?

The promise of active investing (in the short- to medium-term) has been denuded by efficiencies brought about through global interconnectedness and algorithms that trade at high frequency across jurisdictions with low latency. We see the effects clearly in heightened return co-movement across asset classes the world-over. Cross-sectional volatility (the source of which many active fund managers derive their market-beating -or losing- performance traction) is consequently deflated. Professional investors, be they institutional, hedge funds or retail, are facing off against increasingly popular low-cost passive (and smart beta) alternatives.

The trading and valuation techniques that used to work well over the last 30 years – starting with atypical market intelligence, primitive technical trading rules (which work particularly well in a behaviourally driven/herding-market), to parametric statistical arbitrage and lastly machine learning – are to all intents and purposes concluded.

And then a new asset class appears, one where the alpha opportunities are ripe for the taking. The ability to make money in this space, as a private investor or a hedge fund, are ripe. Inexperienced non-investment folk are both spotting and executing obvious arbitrages across jurisdictions (trading manipulation, tax and regulatory transgressions aside). And more experienced investment folk, are simply dusting-off mothballed techniques to make short-term returns yet again. Interest of colossal proportions is thus created and fuelled in an alternative (virtual) environment.

While Bitcoin retains the first mover advantage in the cryptocurrency space and represents the gateway to the market, propped up by fierce social and political underpin – it does face some strong headwinds.  Bitcoin settlement speed and fees are increasingly a concern (spawning Bitcoin cash, a similar offering with a faster block size), and with each bifurcation, there will be dilution. The cryptocurrency environment is also bursting with second generation platforms such as Ethereum, and now third generation offerings such as Cardano and Ripple. These provide better platforms and settlement environments, improved governance and inter-operability, and comparably superior scaling.

Our bold predictions on Bitcoin going forward

1. First, we expect the ‘ostensive’ bubble (and associated cries for wolf) will likely be far larger than anything we’ve seen before in the history of capitalism. In fact, we are perhaps already witnessing it.
2. Second, the evolution that previously took 30 years to crystalise (information edge -> technical trading -> quantitative arbitrage -> denudation by machine learning with low latency) will take orders of magnitude shorter to reach its zenith and then fizzle. Bitcoin’s value will stabilise after correcting significantly (although it may still have a way to go before correcting – possibly stabilising at prices far higher than it is currently trading at). Many of the other cryptocurrencies and AltCoins will do the same.
3. Lastly, we need to concede that there is no clear investment case here now, or even in the long term, based on our current understanding of its use and usefulness. Perhaps that understanding will change. Perhaps the convergence to a fair-value of Bitcoin will precede that understanding. The lower risk to the investor is that the realisation only follows the fair-value convergence with respect to Bitcoin. The greater risk is that the new asset-class is ignored entirely.

Need we remind the reader of the initial apprehension of businesses and investment professionals to invest in computing technology a few decades ago, or in internet technology more recently, purely as a result of their then incapacity to fully appreciate its future use?

What is worth paying attention to in this new asset class?

Blockchain is the open-source code underpinning all the innovation in this space. It is essentially a digital storage of consensus truth in the form of a tamper proof, irreversible and encrypted ledger, that is neither stored in a centralised location nor managed by any single entity. This is key.

Any open-source software that leverages on the blockchain technology is called a Dapp, or a distributed application. Dapps are remapping the information technology landscape, and will likewise be completely transforming other sectors in the process too.

There will undoubtedly appear, over time, many variants of Dapps with different encryption (proof of work with Bitcoin, but proof of ownership and proof of stake are already in circulation in other Dapps), tokens (be they cryptocurrencies), smart contracts and consensus algorithms. We are arguably nowhere near converging to any accepted standard for any single use.

But where the investment case can more robustly be made is around the corporate movement towards Dapps. In our view then, the ‘currency’ in ‘Cryptocurrency’ is largely a red herring from an investment mindset. Understanding how Dapps will shape the industries of the present and the future, is the task at hand for investors and custodians of wealth. These applications will alter the landscape over the next few years in ways we can only start to comprehend. They will do this in all of finance (asset management, banking and insurance), healthcare, retail, logistics, entertainment, and any system reliant on voting/governance, to name the obvious ones. This will organically also spawn entirely new sectors.

Some idea of the next wave on Dapps can be found in the likes of FirstBlood, Ethlance, Swarm City, Coakt, Everex and Bitshares and even 4G Capital in Africa.

Additionally, we have seen the rise of many national cryptocurrency projects, showing just how seriously the formal economy is now starting to take the technology, bubble or not. The challenge for the investor now is understanding the possibilities and the growth potential here – how do we place a financial value on trust, trust networks, data provenance, access to bona fide information and the value and trajectory of co-operation between individuals, and between individuals and corporates?

Regardless of what we want or what we understand, the future is going to be a very different place. DM

Daniel Polakow is Associate Professor at the School of Actuarial Sciences, University of Cape Town, and Investment Strategist, Prescient Securities. Nico Katzke is Consultant Economist (SA asset-management Industry, Prescient Securities, SARB) and PhD student (University of Cape Town). Onno Huyser is a Sustainability and Technology Consultant, Oh! Consulting.

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