Are We in a Crypto-Bubble?

Cryptocurrencies fall into the same category as fiat currency and art; all three don’t hold any intrinsic value. In contrast, the value comes from what people are willing to pay. This means, the value is people’s willingness to pay. If people decide that ether is worth $1,000,000 tomorrow it would not be a bubble as long as people were willing to pay $1,000,000. A bubble is when an assets price greatly exceeds it’s intrinsic value. Bubbles happen when credit is artificially created. During the housing bubble mortgages were given to people with no ability to pay them back. This injected larges amounts of credit into the economy that could never be paid off. The mortgages that were said to be worth $x over 30 years when in reality they were worth much less.

A better question than “are we in a bubble?” is “does greater fool theory apply here?”. Greater fool theory is when a price is determined by an irrational belief in market participants. Example: I buy Bitcoin at $5,000 because I expect Becky to buy it at $5,050. Becky only wants to buy it at $3,000. I’m a fool. Essentially, greater fool theory is a fancy way of asking “is an asset overvalued?”

In order to determined whether cryptocurrency is currently overvalued, we have to think about all the forces in the market . It’s easy to just look at the fact that cryptocurrency market has grown from $25 billion to $100 billion market in 60 days and think we’re in a bubble. On top of that, in the last year, Bitcoin has gone up ~360%, and Ethereum gone up ~2000%. At first glance this may numbers may seem irrational, and it’s possible that the market is behaving irrationally. However, cryptocurrency usage/utility has also increased in the last year.

One of the most important metrics in traditional stock market analysis is the price to earnings ratio. The underlying value of a business is how much money it brings in, and therefore the price to earnings ratio is a great way to measure its utility relative to its price. When dealing with currencies the goal is to make transactions. Think of it this way: my dollar is worth something because I can go just about anywhere with it and purchase something. The ability to have that easy transaction is the dollars utility. A great metric for cryptocurrency is the valuation ratio. It measures the price divided by the number of transactions. This enables us to measure the relative utility of a cryptocurrency. If you look at Bitcoin’s valuation ratio, it has remained relatively steady since 2014. Ethereum’s valuation ratio is at about 4 times its normal average. 4 times the normal valuation ratio sounds overvalued, but there’s an argument to be made that the average utility of each ether transaction has increase recently, because of ICOs.

ERC20 token ICOs are becoming increasingly popular, and ERC20 tokens can almost always be purchased at the token sale with ether. This is a huge deal, because ether is now opening up a platform that allows companies to raise $35 million in less than 30 seconds or $150 million over a couple hours. The combination of ether and ICOS opens up venture capitalism to the average citizen. This is huge use case for Ethereum and could explain the higher valuation ratio.

There’s also an argument to be made that many of these ICOs create tokens that are overvalued. While, there are going to be ICOs that collapse in spectacular, (VC investments mean VC risks and VC loses). The majority of ICOs on Ethereum have had negative ROIs when compared to Ethereum. Many of these ICOs are raising money with Ethereum. Therefore, the tokens should be worth at least the value of the Ether that they raised.

What about supply and demand? Well from my anecdotal experience at TokenSummit several weeks ago I heard almost every speaker mention the existence of a bubble. Many if not most of the leaders in the space believe we’re in a bubble. If you don’t believe me just search cryptocurrency bubble on google and you’ll find countless articles. Skepticism from the experts in the industry should lower the demand.

Another theme of the conference was that every attendee had their own horror story about a friend or relative who couldn’t create a coinbase account. On top of that I doubt every potential user who wants to invest in cryptocurrency knows where or how to buy it. If you are a high net-worth individual who wants to buy a large quantities of cryptocurrency with fiat you have to get tier 4 clearance on kraken. Then you are going to have to learn how to properly store your own private keys. It’s not rocket science, but learning how to buy and store cryptocurrency does take some time. If you’re a massive institution $100 billion market probably isn’t even big enough yet. All these barriers are blocking potential users, which should lower the demand.

What if the supply is being irrationally held back? The top 1000 wallets hold over $5 billion in ether. Satoshi alone owns 1 million Bitcoin. Many ICOs are holding ether or Bitcoin to pay for future development/operational cost. This could be a problem if everyone decides to liquidate, but this seems highly unlikely to me. The 1% holding 90% the wealth is nothing new. Apple has a quarter of trillion dollars in cash and I don’t know anyone worried about them diluting the value of the dollar. For comparison a quarter of a trillion is about 1% of the worlds narrow money. Satoshi’s potential 1,000,000 Bitcoin is 2.4% of the entire cryptocurrency market. While Satoshi, in his market, is a bigger player than Apple; it is not by an order of magnitude. This leads me to conclude that supply is not at anymore risk than in any other market. Demand does seem to have several forces working against it together this should mean the current market price is actually undervalued.

While $100 billion market for all cryptocurrencies sounds like a lot, this is a brand new technology. Blockchain has more potential utility than any traditional fiat currency. For comparison, all the worlds fiat currency is valued at about $28 trillion. BTC is often compared to gold; all the worlds gold is worth $7 trillion. Cryptocurrency is still a small market. At this point blockchain technology has proven itself. Even if it blockchain is main use case is as a way to store value, similar to gold, that’s a multi-trillion dollar market.

One question I often as myself is, what would happen if gold was discovered tomorrow? It can’t just skyrocket to a $7 trillion market overnight. It takes time. I expect Ethereum and Bitcoin will see some very volatile swings for years to come, but blockchain is a truly useful technology that will/is causing true Silicon-Valley-5.2-Weissman-score-style disruption.