Is bitcoin a speculative bubble?

A Bic Camera store in Tokyo advertises that it accepts bitcoin

Wild gyrations in the price of bitcoin have some experts calling the market a bubble.

In the 17th century economic powerhouse of the Dutch Republic, a national obsession with tulips grew into a frenetic trade that became “tulip mania”.

The cost of a single bulb could equal the price of a grand home on one of Amsterdam’s most desirable canals.

The bubble reached its peak in 1636. By February 1637, it had burst, leaving in its wake the ruined fortunes of misguided speculators.

Now, almost four hundred years later, bitcoin is being called out as the latest economic bubble.

A cryptocurrency that uses blockchain technology to record transactions on a public ledger, Bitcoin was started in 2009.

Bitcoin: a gigantic speculative bubble

Bitcoin was developed in 2009 by Satoshi Nakamoto, who remains anonymous and may be an individual or a group of people. New bitcoins are created at a fixed rate by “miners” who receive bitcoins for processing transactions, effectively keeping the process operating with their IT skills. Once 21 million bitcoins have been created, new issue will stop and although that point has not been reached, the price is set by existing supply and demand and in recent times fuelled by speculation.

In May 2010, 10,000 bitcoins were used to buy two pizzas. At the start of 2017, one bitcoin was worth A$1354. By November 2017, it hit a record high of A$9710, which values that pizza order at A$97 million. In the same month, cryptocurrency market capitalisation surpassed US$200 billion.

The rapid ascent led JPMorgan Chase & Co CEO Jamie Dimon to deliver a speech in September 2017 calling bitcoin a fraud and dismissing it as “worse than tulip bulbs”. His comments caused the currency to briefly dip by 2 per cent.

Nouriel Roubini, one of the few economists who predicted the global financial crisis, called bitcoin “a gigantic speculative bubble”. 

Credit Suisse chief executive Tidjane Thiam told a news conference in November 2017: “From what we can identify, the only reason today to buy or sell bitcoin is to make money, which is the very definition of speculation and the very definition of a bubble.”

Are the bitcoin critics wrong?

Jason Potts, economics professor and director of the Blockchain Innovation Hub at Melbourne’s RMIT University, disputes the bubble tag. A bubble sees investors speculating on the price of a known commodity.

“It’s betting about what’s going to happen to the price in future purchases,” he says.

Bitcoin and other cryptocurrencies comprise a new economic infrastructure – a point he says is not widely understood.

Related: Blockchain – how does it work?

“People are getting confused because we’ve never seen anything like this. It’s very rare to see a technology that has such transformative potential across a huge range of areas,” he says.

Potts believes bitcoin’s price rises look more like the exploration of new technology, comparable to the period between the discovery of electricity by 18th-century physicists and the development of the electric motor in the 19th century.

“That would look like a bubble as well,” he observes. “This is much more like a discovery process, where you’ve got investors who are essentially betting on the idea that there’s a lot more of value to be discovered in this technology.”

How will bitcoin be used?

The uncertainty around bitcoin arises from the fact we don’t yet know its future uses.

“Every day we’re discovering more use cases,” says Potts. As new applications emerge from the start-up community, the bitcoin price rises. 

“That pricing-in phenomenon makes it appear from the outside as if this is a speculative bubble, but I really don’t think it is.” 

While bitcoin is currently the dominant cryptocurrency, that may not always be the case. Bitcoin is confined to payments, but rival cryptocurrency ether has a much broader range of potential applications.

Attached to the blockchain smart contract platform, ethereum, ether has experienced rapid growth on par with bitcoin, increasing from A$12 at the start of 2017 to a peak of A$574 in June 2017.

While Potts is reluctant to prognosticate on the future of bitcoin, he is optimistic about the potential of blockchain-based cryptocurrencies.

“Taken as a whole, the entire crypto-asset market looks enormously sustainable.”

Bitcoin volatility

One of the biggest limitations to bitcoin’s use in the mainstream economy is its volatility. In November 2017, four days after bitcoin reached a record peak just shy of A$10,000, it slumped 25 per cent to A$7330.

“Volatility is not a flaw in the system,” says Potts. “There is genuine uncertainty about the future value of these assets.”

What affects the price of bitcoin?

Researchers at Australia’s national science agency, the CSIRO, have identified four factors influencing the price of bitcoin: media coverage, political uncertainty, external regulation, and governance.

These factors are evident in recent fluctuations in bitcoin’s value. It rose on the UK Brexit vote, the election of US President Donald Trump, and on the September 2017 announcement that Japan’s Financial Services Agency (FSA) would endorse 11 cryptocurrency exchanges. 

That same month China announced a ban on bitcoin exchanges, triggering a 41 per cent price slump.

In November, a fall followed the cancellation of the SegWit2x fork, a software upgrade that would have introduced new rules to the network.

Potts argues that Chicago Mercantile Exchange’s announcement that it will begin trading bitcoin futures will help investors manage the risk of trading bitcoin, making it more accessible to individuals and businesses.

What investors need to know about ICOs

While the crypto-asset market is becoming more mainstream, investors should be wary of initial coin offerings (ICOs), a method of fundraising using the sale of blockchain tokens.

ICOs come with a high level of risk that has prompted the Australian Securities and Investments Commission (ASIC) to warn investors that the schemes are highly speculative, mostly unregulated and the chance of losing the investment is high.

Regulation applying to ICOs is unclear, with ASIC saying that in some cases they could be subject to general and consumer law, and in other cases might be regulated under the Corporations Act.

Potts is similarly cautious. “The space is still very risky for uninformed retail investors,” he says.

Read next: Bypassing banking with bitcoin

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