Bitcoin: Three Ways the Bubble Could Pop
Summary
- Bitcoin is called a bubble frequently
- As a Bitcoin enthusiast, I have decided to venture to the dark side and discuss the catalysts I see as potentially bursting the bubble
- We discuss the next possible Mt. Gox sized collapse, regulations on ICOs globally and the possibility of exchange shutdowns worldwide
- Sound interesting? Read on — there’s plenty for both bulls and bears alike
Bitcoin is a bubble, a tulip, a magic bean factory. That’s all you hear over and over again from various pundits on traditional media outlets or in the comment sections on any of the latest stories. Sometimes it goes a step further and is called a fraud or a Ponzi scheme. It’s for drug dealers and murderers. Who else remembers Silk Road and Alpha Bay?
Today we’ll venture to the other side of the story. What will cause the Bitcoin bubble to pop? Will it be another Mt. Gox? Will it be stricter regulations? Will it be affiliation with the dark web and markets? How about sovereign governments outlawing it as their economies are undermined? Today, we go to the dark side of the moon.
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Mt. Gox: Quick Recap (Skip if familiar)
Most of you know about the collapse of Mt. Gox in 2014. It was the largest cryptocurrency exchange in 2013, at one point handling over 70% of all Bitcoin volume. However, starting in March 2013, it began facing some major issues. FinCen released a statement that said bitcoin exchanges were money transmitters, therefore requiring them to register and comply with anti-money laundering (AML) laws. This, in part, caused the value of Bitcoin to plummet as concerns over regulations grew.
Mark Karpeles, the man in charge of Mt. Gox, told everyone not to worry as they were in full compliance with AML laws. However, it wouldn’t be until 2 months later that Mt. Gox registered with FinCen. In the meanwhile, Mt. Gox’s only payment processor, Dwolla, terminated their relationship with Mt. Gox due to a number of account seizures by FinCen. You could no longer withdraw your US dollars, which caused the price of Bitcoin on the exchange to skyrocket. People were buying bitcoin with their USD and then withdrawing from the exchange, causing a significant decline in volume throughout the rest of 2013.
The final nail in the coffin came with the hack that stole approximately $500m worth of bitcoin in 2014, driving people to protest outside the exchange’s headquarters in Tokyo. Ultimately, Mt. Gox had to declare bankruptcy which led to the longest bear market we’ve seen in Bitcoin yet. All in all, bitcoin declined from its $1,200 highs in December 2013 all the way down to below $200 in January 2015.
Catalyst One: The Next Mt. Gox
The purpose of this history lesson is to drive parallels to the world’s current largest bitcoin exchange, Bitfinex. Of the ~$5.3 billion in cryptocurrency trading volume over the past 24 hours (Sept. 13th), $616m of that volume came from Bitfinex, or approximately 12% of all trading volume. Like Mt. Gox, Bitfinex was hacked last year in August. However, the lost funds were significantly less at around $72m.
The hack affected random customers, many of which lost their entire account balances. As a result, Bitfinex made the controversial decision to reduce ALL customers’ accounts by 36% to pay for the hack and to help spread the losses between all customers instead of having a select few lose their entire balance. To make up for the 36% “haircut,” Bitfinex issued out BFX tokens. These acted as debt instruments that Bitfinex claimed they owed their customers and would redeem once they could afford to.
They subsequently allowed customers to trade these BFX tokens on the exchange so that customers could price them in their own accord based off the potential risk Bitfinex might never pay them back (akin to junk bonds). They traded around 40–60 cents on the dollar. In the end, Bitfinex redeemed all these outstanding tokens for $1 each, making good on their “debt.”
However, one astute observer named “BitCrypto’d” saw that as Bitfinex redeemed these BFX tokens, another company called Tether Holdings was issuing an equally large amount of a cryptocurrency called Tether. Tether is a cryptocurrency pegged to the US dollar at a 1:1 ratio, meaning that for each Tether issued, there is one US dollar in reserves backing it. The company will redeem any Tether for US dollars and vice versa. The primary purpose of Tether is to replace fiat currencies on exchanges due to the complications related to US banking and accepting fiat. Bitfinex has a majority stake in Tether Holdings.
This observer thought it was possible that perhaps as investors deposited US dollars to Tether Holdings for Tether, those US dollars, rather than being placed in reserves, were funneled through Bitfinex to pay off the BFX tokens. It’s a rather elaborate ruse that is only backed by circumstantial evidence. But it’s not as farfetched as it may initially sound.
Tether Holdings did not release audits for its reserves until a week ago, and the furthest those audits go back is March 31st. The majority of BFX tokens were conveniently paid off right after on April 3rd. In addition, both Bitfinex and Tether began facing significant banking issues once Wells Fargo decided to suspend international wire transfers to their Taiwanese banks. This also happened, conveniently, towards the end of March / beginning of April. Bitfinex began refusing fiat deposits and withdrawals, similar to what happened with Mt. Gox, leading to a premium for Bitcoin on the exchange over others.
In response to the events, Tether Holdings released a statement where they said any international wire transfers would be rejected and returned back to the sender. In addition, they stated that until they are able to resolve their money transfer channel concerns, they did not expect the volume of outstanding Tether to increase dramatically. However, this graph illustrates the exact opposite occurred:
In their last update, Tether Holdings justifies these increases being as a result of their institutional customers. Additional Tether are being issued to accommodate these customers’ demands, yet we know that few if any Tether are ever redeemed as you can see the supply has never gone down by any sizable amount. How believable is it that everyone is in a rush to deposit their fiat for Tether at a company facing banking issues, yet no one wants to redeem those tokens for US dollars?
Tether Holdings claims they will be releasing an audit in the “coming weeks or months” that will clear the air and audit their holdings all the way back to the beginning of 2017. It might be a legitimate operation; no one knows. But here’s what matters for Bitcoin investors: The collapse of Tether due to fraud will likely lead to the collapse of Bitfinex, which will cause ~10–15% of the daily volume in the cryptocurrency market to just vanish. That isn’t even including the significant amount of volume Tether has on other exchanges.
Unlike Mt. Gox, which was ruined by pure stupidity, this particular exchange would be ruined by fraud which is much more serious. Hence, the PR surrounding this event would likely be far worse than it was for Mt. Gox. The domino effect would almost certainly lead to a colossal loss in the value of Bitcoin and other cryptocurrencies. Therefore, it is critical to watch both Tether and Bitfinex closely.
Fortunately, of all the possible catalysts to lead to a pop, this one is the least likely. As I mentioned before, all the evidence is circumstantial. However, there are quite a few coincidences that are hard to justify as happenstance. In addition, there are a number of other factors about Bitfinex that I place in the “shady” column. These include:
- The freezes in Bitcoin trading last June
- The inconsistent claims between employees and Phil Potters as to how large the equity stake in Tether Holdings is (employees — 20%, Phil Potters — Majority stake)
- The anonymity of the team behind Bitfinex — CSO, Phil Potters, couldn’t even answer who is in charge
- $75k fine from US Commodity Futures Trading Commission (CFTC) last year for “offering illegal off-exchange financed retail commodity transactions in bitcoin … and failing to register as a Futures Commission Merchant (FCM)”
- Refusing all US customers towards the beginning of August
Overall, I would stay away from Bitfinex and Tether like the plague and encourage investors to keep up with these two entities in case we see another Mt. Gox level event.
Catalyst Two: Global Crackdown on ICOs
Recently we saw China impose a temporary ban on initial coin offerings (ICOs). These are akin to IPOs, except there are significantly fewer steps involved to get funded. Developers can often raise substantial capital off of a strong white paper alone, without the need to illustrate proof of concept.
As you can imagine, this leads to situations where the developers “take the money and run.” Or they receive such an abundance in funding that they don’t know how to adequately utilize it all. One report says that up to 10% of ICO funding goes straight into the hands of criminals. These criminals phish investors for their funds in most situations, but have also been known to hack or take advantage of exploits as well to steal funds.
This year, ICO funding outpaced early-stage VC funding which put it on the radar of not only institutional investors, but also governments around the world. Right now the regulatory picture is loose, but we are seeing more and more news that suggests that perhaps a crackdown might be in the cards soon. Below I summarize some of the key stances on ICOs globally.
Note: The most important information from this section is included in a graphic below — you can skip to this to get a quick overview if you don’t want details on each nation independently.
Switzerland
Known as the world’s oldest neutral country, Switzerland is also the epicenter for ICOs. Several of the highest grossing ICOs have been launched in the country due to its relaxed stance on cryptocurrencies. Here, cryptocurrencies are considered assets rather than securities. Note that this is one of the most important distinctions in regulations as many more rules are imposed on securities and more protections are put in place for investors.
Switzerland houses the prime hub for crypto, a small city named Zug just south of Zurich. Dubbed “Crypto Valley” after “Silicon Valley,” it hosts some of the biggest names in crypto including giants like Ethereum, Bitcoin Suisse, Shapeshift, and many more. Crypto companies operating here don’t need any special licenses as they do in, say, New York. Zug is a highly pro business location and the government seems keen to work with startups as much as possible.
Crypto Valley Association, a consortium of multiple large companies that fills a similar role as incubators do in Silicon Valley, recently issued a statement warning about the lack of “traditional support structures” in ICOs. I would encourage everyone to read this statement as it encapsulates all of the current issues with ICOs.
What’s interesting is that the representative of the world’s epicenter for ICOs is warning investors about the lack of security, documentation, and overall level of professionalism in token launches. While the overall goal of the statement is to increase awareness and illustrate good faith for working with the Swiss government, it is worth noting that even the world’s most welcoming hub for crypto acknowledges the current Wild West of ICOs.
Singapore
Although not as large a hub for cryptocurrencies as Switzerland, there have been some large ICOs based in the small, wealthy country. Cryptocurrencies are considered assets rather than securities here in most cases. As such, they are generally left unregulated.
However, the Monetary Authority of Singapore (MAS) made a statement at the beginning of August clarifying their position on ICOs. They state that tokens which demonstrate properties similar to securities (such as ownership stakes) “would be required to lodge and register a prospectus with MAS prior to the offer[ing] of such tokens.” Therefore, whether or not a token is a security must be decided on a case-by-case basis.
United Kingdom
Token issuers are operating on their own interpretation of the law. According to a report by fintech research firm Autonomous NEXT, the UK offers a regulatory sandbox for companies to test out new projects. The Financial Conduct Authority (FCA), which is in charge of regulations for cryptocurrencies in the UK, recently warned consumers in yet another statement that looks quite similar to the one issued by the Crypto Valley Association.
This statement, in addition to warning consumers, makes clear that the FCA does not regulate the majority of ICOs. As such, there is a possibility for crackdown in the future especially when you consider the language used in the statement. Yet again, there is emphasis on a “case-by-case” basis for deciding whether or not a token is a security.
United States
Perhaps the best known piece of regulation in the US is New York’s “BitLicense.” The creation of this license was sparked by the demise of Silk Road and then accelerated with the collapse of Mt. Gox. It was referred to as the “Great Bitcoin Exodus” as many firms discontinued operations in the “capital of the world.” However, this is not the most important piece of regulation in the US.
Recently, the SEC made some of the most important comments in history related to token issuances. In their response to the DAO incident, the SEC set out to state that some tokens fit the definition of a security while others don’t. The distinction of what is a security and what is not is determined by the age old Howey test. Again, the common theme here is that whether or not a token is a security is to be determined on a case-by-case basis. Up until this point, most cryptocurrencies have been treated as commodities.
Canada
The US neighbor has found that the majority of token sales are securities, and hence this is a less friendly environment. However, it never was a booming place for ICOs in the first place. Still, this is some of the clearest language yet we’ve seen from a country so it is worth noting.
South Korea
Yet another recent report released that states that the digital currency task force in South Korea will “punish initial coin offerings that raise funds in the form of stock issuance using digital currencies permitted in some countries, including Switzerland, for violating the capital market act.” The same report states that it is too soon to identify cryptocurrencies as currencies or financial products. However, it does appear that yet again, those which exhibit properties similar to a security will be punished if they are not appropriately filed as such.
Russia
The central bank of Russia also recently issued a warning (In Russian — paraphrase here) for consumers related to the dangers of ICOs. There are mixed signals coming from Russia that make it an uncertain environment overall, but in general it is not considered friendly.
China
As you all know, China recently banned ICOs. Several reports are coming out now saying that the ban will be temporary as licenses for the industry are drafted. Note that China has been in a state of constant flux with cryptocurrencies, so it would not be a huge surprise to see this be a pause rather than a permanent ban.
Hong Kong
Yet again, another statement made recently warning that most tokens are securities.
Country Overview (Skip to Here)
In order to make life a bit easier, I’ve created a timeline of the recent statements by all the different countries related to ICOs:
As you can see, the regulatory scene around ICOs is heating up quickly. We are seeing more and more nations give their opinion on whether or not tokens should be viewed as securities or assets. In general, the consensus seems to be that they are securities (for what it’s worth, that’s how I view them too). Why the sudden interest? The chart below illustrates why:
Overall, it seems like we’re headed to an ICO market that will face much more substantial regulation soon. ICOs of the future may require registry with the appropriate regulatory agency, a prospectus, and will likely become limited to accredited investors. Even Waves, a platform that prides itself on making the token launch process as easy as possible, recently released a blog calling for a global advisory committee that can evaluate token sales in order to help retail investors.
The major cryptocurrencies impacted by the health of the ICO market include Ethereum, NEO, Waves and many others. However, Ethereum is the most important of these due to its sheer size. At the time of writing this, Ethereum is currently valued at approximately 40% of Bitcoin’s market cap. If we see the payment channels for ICOs dry up due to regulatory agencies deeming them as securities, it could lead to a sharp decline in Ethereum that brings the market down with it.
Ironically, you can also argue that the exact opposite could happen too. Filecoin recently raised the most of any ICO in history, estimated at around $257m. The kicker is that the team decided to do it the “right” way and only invited accredited investors for the token sale. In addition, they also put significant effort into being SEC compliant through the proposal of the Simple Agreement for Future Tokens (SAFT), inspired by Y Combinator’s Simple Agreement for Future Equity (SAFE). The idea here is to comply with Regulation D, hence attempt to dodge some of the greater complications that come with the full-blown “security” definition. Time will tell which of these two sides will win. If you want to keep up with the latest news on ICOs, check here.
Catalyst Three: Closing of Fiat Gateways
Update: While writing this article, China gave notice on timing for closures and Huobi / Okcoin were given until October 31st, causing a rally in cryptocurrencies.
The final and most relevant catalyst that could lead to a drastic crash in Bitcoin is the removal of gateways between fiat currencies and cryptocurrencies. You’ve all seen the headlines related to BTC China shutting down. Some sources are claiming that this will extend to all Bitcoin exchanges in China. If you look at the reports by the WSJ, Bloomberg, and Caixin, they all use language that suggests all exchanges will be shut down in some capacity (read update at top of this section). And if you look at the declines in Bitcoin, you’ll notice that the declines in the three major Chinese exchanges (Okcoin, Huobi, & BTC China) are nearly identical despite only one of them making an announcement:
Therefore, the market is pricing in that all major cryptocurrency exchanges in China will be closed. Bitcoin declined over 20% on the news, so this is a clear example of how removing gateways to crypto from fiat currencies is one of the largest investing risks. China’s crackdown on exchanges may not kill the market by itself given only 13% of trading volumes are made using the Yuan, but it could be the beginning.
The real concern is whether or not this is the first step by sovereignties to shutdown cryptocurrencies as a whole. They may not be able to shutdown the cryptocurrencies themselves, but they can slaughter any chances of mass adoption if they remove the transfer channels between fiat and crypto. What would happen if the United States barred GDAX and Gemini from conducting exchange?
Many people champion this as the greatest risk to cryptocurrencies. However, China has always been the odd one out. Their borders are capitally controlled, they censor the internet through TCP packet monitoring, they’ve outlawed VPNs, and the list goes on and on. Is it reasonable to believe other countries will follow this extremist government? Still, since China seemed to lead the charge in the crackdown on ICOs, there is the possibility that China will also lead the charge on stricter regulations for exchanges.
While China is a significant portion of the market, they are nowhere near as influential as Japan and the US are. This is important because Japan has an exceptionally friendly environment towards cryptocurrencies, being one of the first major countries to welcome them with open arms. The two major US fiat-to-crypto exchanges, GDAX and Gemini, both have FDIC insurance and each have their own benefits that shield them from a crackdown. Coinbase, which owns GDAX, has recently raised $100m in a Series D funding round that values the company at $1.6 billion and adds legitimacy to the business. Gemini is backed by the Winklevoss brothers who have strong relationships with regulators and continue to help develop the space by working on getting a Bitcoin ETF (COIN) approved.
As such, I do not see the principal markets removing the gateways to cryptocurrencies from fiat. While I do expect regulations to tighten on exchanges, this is the natural evolution of cryptocurrencies and will increase their legitimacy. Do not look at China as an example of how other countries will behave. Ask yourself honestly if that has ever been a good idea. Bitcoin will need to be hit by more than just China for the “bubble” to pop, but it is worth noting that any headlines of increased regulations on exchanges in Japan or the US could lead to further downward spirals in price. As such, keep an eye out for statements by the FSA and SEC.
Grayscale Bitcoin Investment Trust: Buy or Short
Let’s shift directions for a moment here and discuss the Grayscale Bitcoin Investment Trust (GBTC). For those of you unfamiliar, this is the open-ended fund that invests in Bitcoin and each share represents 0.09242821 BTC. Because the fund can be purchased through more traditional means and can be used in an IRA, they trade at a significant premium over net asset value (NAV). At the time of writing, each share is worth $518.38 which values Bitcoin at $5,608.46 or roughly a 68% premium at the time of close on Sept 14th trading. This is much lower than the 101% premium the last time I wrote about GBTC.
Okay so, the premium has decelerated quite a bit. Should you buy it now? No, probably not. First of all, there are way too many headline risks surrounding Bitcoin at the moment. What happens when Huobi or Okcoin announce they will be closing their doors as well? I am writing this on Thursday and the current word is that they will be meeting with regulators today (Friday). It’ll be all over CNBC, WSJ, Seeking Alpha, Forbes, and any other publication you can possibly imagine. You can bet Andrew Left is drinking champagne right now. But what’s interesting about GBTC is that it gives you an opportunity to effectively leverage your position if Bitcoin bounces back, which I suspect it will. Continuing the tradition from my previous article where I discussed sell conditions, here I will be offering buy conditions:
1. Bitcoin’s Price hits $2,700 and premium is below 75%
2. Premium to NAV falls to 40% while Bitcoin is below $3,250
Unlike my previous article, where I provided conditions for both price directions, I do not recommend buying GBTC if Bitcoin accelerates in the next week or two. The only such scenario where I imagine Bitcoin will do so is if we don’t see news from Huobi / Okcoin or if the news is better than expected. I would give it at least a week or two to shake out headline risks from China before buying if Bitcoin goes to the upside. I’ll likely post an update to my thoughts if such an event occurs. I would never short GBTC barring an absurd premium (150% or higher). The reward does not even come close to outweighing the risks.
Wrapping It All Up
Did you survive until the end here? If so, congratulations! Our tour of the dark side of the moon is over and I can take you back to the bright side. Bitcoin is a strong long-term investment for anyone who understands what it offers and its perception by the greater markets currently. There are many institutional investors waiting on the sidelines for moments like this to pick it up cheaply. That dry powder will start getting deployed in bulk at around $2,700 if Bitcoin goes that low.
However, it is always crucial to be mindful of the risks associated with any investment. In this article, we covered the three that I perceive to be the greatest threat to Bitcoin’s long-term future. These three catalysts are:
1. The collapse of Bitfinex and Tether as a result of fraud.
2. Capital inflows drying up for ICOs as funding channels become constricted through regulations, leading to a significant market decline led by Ethereum.
3. Blocking of fiat gateways that enable cryptocurrency exchanges to operate, effectively cutting crypto off from the real world
I can’t provide much counterargument to the first catalyst. Even though it’s more akin to a conspiracy theory than anything else, I don’t see strong evidence to the contrary. As such, I am monitoring the Bitfinex & Tether situation closely. However, the other two catalysts have some strong counterarguments that we briefly discussed and which I will likely go into more detail on in the future:
1. Increased regulations could lead to a boom in ICO funding as it adds legitimacy and attracts wealthier investors who provide the bulk of funding anyway, as evidenced by Filecoin’s ICO raising record breaking levels of capital.
2. While China is the obvious headline here, Japan is still pro-cryptocurrency and has the highest volumes in the world. The US has added legitimacy to its exchanges through its association with the Winklevoss brothers, FDIC insurance, and sizable seed funding rounds by venture capitalists.
Still here? Thanks for reading! You can go home now. Really, you’re free to go. It’s over.
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