Introduction
We’re going to consider some of the cryptocurrencies now in the market, what has been happening to their valuations,
what the future may hold and how one might go about valuing them. We will also
consider how human behaviour and government action can rapidly increase or
destroy the value of cryptocurrencies.
Please note that this article does not constitute financial
advice. In fact, you may find it very difficult to discover financial advisors who
would recommend investing in cryptocurrencies. That is because of the nascent
nature of the industry, the huge valuations of many projects, a large number of
which do not have a working product, some of which will be scams, and the
likely failure of many of them. It’s certainly necessary to undertake your own
due diligence before investing and best not to invest more than you can afford
to lose.
Bitcoin and Other Blockchains
Let’s start with Bitcoin. Originally, with the creation of
Bitcoin, many people hoped that a new currency, not run by governments, the
supply of which could not be increased and debased without the knowledge and
consent of the Bitcoin community, had been created. Since then, with the
creation of new blockchain forks like Bitcoin Cash, and in particular because
of new blockchains like Ethereum, which allow applications (which create their
own cryptocurrencies) to be built on top of the existing blockchains, there has
been an explosion in the number of cryptocurrencies.
Blockchains like Bitcoin seemed to offer a potential
alternative to national currencies. In contrast, many of the most recently
created cryptocurrencies, built on the back of blockchains, could occupy only relatively
narrow market niches even if they succeed. They would never become generally
used currencies.
The Mania
The manner in which many people were throwing money at projects
that contains the word “blockchain” around December 2017 appeared similar to
what happened at the turn of the century during the “.com” (dot com) craze as internet
use became widespread. It seems amazing now, but at the turn of the century, just
adding .com to the name of a business, or suggesting it was undertaking
something related to the internet, could inflate company valuations
dramatically. Dot com companies were often launched on the back of Initial
Public Offerings (IPOs) instead of Initial Coin Offerings (ICOs). Of course,
some of those dot com companies did become huge successes. Using the word
blockchain can get many people’s blood running hot just like the words dot com
used to.
Technical and Monetary Difference Between the Dot Com Craze and
the Blockchain Boom
What are the differences between what is happening with
blockchain and the dot com craze? The dot com craze came and went as a part of
one boom and bust business cycle. Blockchain technologies have already had more
than one peak and collapse, although all within a period of only a few years,
and still within one business cycle lasting from the launch of Bitcoin in 2009
until now.
The dot com craze was based on the hope that huge numbers of
people would turn to the internet to get their goods and services, that there
would be large increases in productivity, and that new markets would be created.
In fact, while there were enormous gains as a result of the internet, many of
them took longer than expected to come to fruition. Hope exceeded reality in
the short term, as is often the case.
The key dot com concept was about moving transactions and
services online but using bank controlled existing national currencies (legacy
currencies) such as United States Dollars as the medium of exchange.
Banks are legally permitted to be able to create new currency
units of national currencies (eg United States dollars) out of thin air.
However, the fact that banks can do this, the amounts of currency that have
been created, and the impact of this on the population, are not well known.
Blockchain currencies are, in contrast, not controlled by
banks, and consequently the volume of them is known. It does not appear possible
currently to debase cryptocurrencies through the creation of additional
currency units, without everyone becoming aware of how many new units have been
created.
The Future of Bitcoin
What about the future of Bitcoin? Will it survive and
thrive? Perhaps. Major challenges with respect to blockchain projects like
Bitcoin currently include transaction speeds and mining costs. The Bitcoin community
is trying to adapt to meet these challenges. Even if it is not the very best
technology, perhaps Bitcoin can still remain as number 1, due to its greater
existing adoption, and as long as it is good enough relevant to the
competition. Perhaps Bitcoin could take up the mantle as the “Kalashnikov” of blockchains
because it is seen as more rugged, robust and reliable in the face of hacking
attempts. In contrast many other blockchains may be seen as more sophisticated,
but more likely to encounter operational and security problems.
It is possible that other blockchains may be used to
facilitate Bitcoin transaction speeds and to reduce Bitcoin transaction costs. EOS
developers are apparently investigating how to do so currently.
Cryptocurrency Valuations
Ultimately, the value of a cryptocurrency, depends, as for
any other currency, on confidence. Confidence that someone else will accept it
in exchange for goods and services. Confidence will, among other things, depend
on the currency not relying on obsolescent technology. In addition, each time a
new version of a blockchain like Bitcoin Cash is spun off, that arguably
inflates the total supply of currency units related to that type of blockchain.
Potentially that could undermine confidence in it.
It may be helpful when attempting to value a cryptocurrency to
consider:
1.
How much the entire target market being
considered is worth
2.
How many competing currencies there are among
which to divide the value in that market
3.
How much of that market value could potentially
be represented by the cryptocurrency in question ie what could be the market
share represented by that cryptocurrency
4.
Dividing that market share value by the number
of units of that cryptocurrency that are available, in order to get a value per
crypto coin/token/unit
It’s also important to consider whether there is anything
preventing thousands of additional cryptocurrencies successfully competing in
the same market space, including factors such as any first mover advantage. In
other words, to consider whether there are market entry barriers. If not, the
cryptocurrency in question could rapidly go to zero value, or fall hugely in
price.
There are other potential value indicators you will find
posted on many crypto analytical websites with respect to factors such as the
volume of transactions, cryptocurrency trading volumes, the level of activity
in the developer community. There are
concerns about manipulation of these statistics in terms of the potential
ability for persons or organisations to generate fake transactions, or wash
trading - buying and selling cryptocurrency purely to to increase the apparent
activity in the market and the price.
Human Behaviour and the Difficulty of Reacting to Crypto Price
Collapses
There has, as indicated, already been a number of steep
climbs and collapses in the value of blockchain valuations. Human behaviour dictates
that as the price of any asset climbs rapidly, lots of new people rush in and
invest just because of the price rises, thus causing a feedback loop and an
asset bubble. Then, of course, the bubble eventually pops, and lots of people
get financially burned. It’s not clear how many more blockchain bubbles and
crashes we may have.
We think that it’s also useful to remember not only that bubbles
can burst, but also that, unlike stock markets, the cryptocurrency markets
never sleep, and that prices can fall like a rock once they start falling. So,
if there is a massive crash while you sleep, you could wake up to find your crypto
holding decimated. Even if you are not asleep, prices can move so violently
that you may not have a chance to react if eg you are working on your regular
day job while prices are collapsing. Some people may attempt to use automated
systems for trading in order to help them attempt to reduce this kind of risk.
Potential Government Intervention
Currently, cryptocurrencies are a relatively small market
compared to the global financial system. However, if, over time, the majority
of people start trading in cryptocurrencies and not legacy currencies like USD
or sterling, governments may want to take control of the supply of
cryptocurrencies.
It may not be possible for a government to completely stop a
cryptocurrency from being used. However, if a cryptocurrency is made illegal it
would probably prevent the majority of trade in it. Consequently, government
intervention, especially if coordinated regionally or worldwide, could result
in the collapse of the value of a particular cryptocurrency.
Knock-On Effects From The Bond and Stock Markets
It’s best also to be aware that a number of commentators
have stated that the bond and stock markets in many countries including the USA
are now in very large bubbles and are ready for collapse as a result of massive
central bank currency creation which has been used to buy up financial
instruments (also known as quantitative easing). Cryptocurrencies have not gone
through a full business cycle and it is not clear what would happen to them in
this event. It may be that the best ones could still prosper over time, but
that the majority might also collapse due to a general loss of confidence in financial
markets.
Conclusion
The cryptocurrency market is arguably at a gold rush stage
with the number of blockchains, and the number of distributed applications
which sit on the back of them in particular, exploding in number. Projects
often have huge valuations based mainly on hope about price rises. Only an
extremely small fraction of the population has any stake in the crypto market
at this time however, and mass adoption of the technology seems to be on the
way. Consequently, there appears to be both very significant opportunities, and
very significant risks involved.
Attempts could be made at crypto valuations at this time,
all of which would be based on a set of assumptions and may include factors
such as the total actual or prospective market size, possible market share, and
the percentage of that market share that people are prepared to transact value
in using a specific cryptocurrency.
Because of the evolutionary arms race that is now in
progress, it seems possible that highly valued cryptocurrencies one month may
collapse in price quickly, or conversely, that unknown cryptocurrencies may
rocket in price out of nowhere in short timeframes. Consequently, long term
projections about the success of particular cryptos may be best avoided. Possible
indicators in the short term might be general market sentiment and what is
happening elsewhere in terms of what governments are doing with respect to the bond
markets for example, as that may affect currency flows in to, or out of, very
high risk assets like cryptocurrencies.
Market sentiment, and government financial policy, can
change extremely rapidly however, so look out if you choose to get involved in
the crypto space. If you do get involved, it’s best to be aware how rapidly
collapses can happen, to consider if you can react to them fast enough, and if
you are prepared (and financially able) to lose all your invested money, even
while hoping for success.
