The Bitcoin Bubble: The Rise and Fall of a Virtual Currency

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I feel this is a topic worth discussing at the moment, given that it’s about to make a whole lot of people very, very poor. It’s called Bitcoin, a decentralized digital cyptocurrency of which there is a limited number of coins, all subject to remarkable volatility.

That probably didn’t make any sense, did it?

Let me try again: Bitcoin is purely virtual money. It doesn’t have a physical form, it’s all just code. Like all other forms of money, it can be used to buy and sell things, and can be traded for real US dollars. It isn’t the first of it’s kind, but it’s far more successful than all the others.

Invented by Satoshi Nakamoto (not his real name, if it even is a he, assuming that it’s a single person and not a group of people acting under one name) in 2008/2009, Bitcoins were designed around the idea of a new form of money that uses cryptography (heavy encryption) to control its creation and transactions, rather than relying on central authorities. In other words, it’s a form of virtual money that cannot be controlled or tracked by governments.

When inventing this system, Nakamoto set it up so there can only ever 21 million Bitcoins in existence. They are created by an incredibly  slow computer processing known as ‘mining’. This can be done on any computer, but the hardware & software a computer uses determines how fast Bitcoins are produced (this has led to various individuals creating customized computers for the sole purpose of mining Bitcoins for profit).

If you wish to buy some of them, then you can choose a virtual wallet from one of the various providers. With a virtual wallet, you can start to receive and send coins, exchanging them for goods or real cash. If you aren’t a miner/computer genius, can buy Bitcoins on specialized online currency exchanges or online marketplaces such as eBay.

But before you decide to acquire some, however, you might want to wait a bit.

Since there isn’t a central bank or institution controlling Bitcoins, that means there is no authority that can set a definitive value for each individual Bitcoin relative to the US dollar. Furthermore, Bitcoins aren’t tied to any real asset (like gold or silver) that can give the currency value.

In other words, since Bitcoins are untethered to any real asset, their price is determined only by pure speculation on online exchanges around the world. It is an incredibly volatile currency, meaning that it’s price changes incredibly fast. Too fast, in fact, for some people to consider it a currency at all. In 2011, the price spiked up from $2 a coin to around $30 a coin, before dropping back down again to $2. Simply put: it’s a completely unreliable as a safe place to store money. The price changes too often and too radically to the point it can hardly be called a normal “currency”. In this sense, it’s more like an crazy investment in the stock market.

This is where recent events come into play. See, an interesting side-effect of the Cyprus crisis and the ongoing situation with North Korea is that people want a safe place to store their money in (especially the Cypriots, whose bank accounts are being raided in order to pay for their bank bailouts). Bitcoin advocates suggested the currency as an alternative to fiat currencies (government-controlled currencies) that can’t be devalued or confiscated by a government in serious need of cash.

Predictably, an excess amount of money began pouring into Bitcoins, creating an asset bubble. What’s an asset bubble you say? Basically, it’s when the price of asset rises so sharply and at such a sustained rate that it exceed valuations justified by fundamentals (the information that determines what something is actually worth), making a sudden collapse likely – at which point the bubble “bursts”. The 2008 financial crisis, to draw a comparison, was an example of a housing bubble: house prices kept on rising, more than house prices were actually justified, until the point that the bubble “popped” and prices came crashing down.

The chart below shows how the price of Bitcoins has risen over the past few months:

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That’s a spectacular rise, isn’t it? Unfortunately, it is a classic bubble: a sustained and sharp rise that exceeds what is justified, which is hard enough since the entire currency relies on pure speculation to begin with. Now, below is an image of what a bubble is usually like:

bubble-phases

If you compare the two charts, then you can the see the price of Bitcoins is somewhere around the “Delusion” and “New Paradigm” phase. However, the all time high price was at around $145 a coin. Recently, there was a dip, as seen in the image below:

index2

Though currently trading at around $132 a coin, I don’t expect this to hold up for long. Bitcoins are, I believe, currently in the “Bull trap” phase. I expect the price to collapse very soon, taking the value of Bitcoins back down to a dollar or so.

This might truly well be the end of Bitcoins as we know it. In a recent article in the Financial Times, professor Jim Angel at the McDonough School of Business at Georgetown University stated that he is skeptical of Bitcoin’s long-term viability:

Governments don’t like competition in the currency business and if it gets too big they will clamp down. Also, you are trusting algorithms to protect the system, and we all know that technology breaks or gets hacked. We are just one scandal away from Bitcoin collapsing entirely.

So what next? Well, it could go many ways. Personally, I believe the price will collapse and will slowly begin rising once again over a gradual period of time. Or Bitcoins itself could be brought down by governments, as previously mentioned, aren’t too keen the idea an alternate currency existing out of their purview.

One thing is for sure though: when this bubble collapses, a lot of people are going to lose money. On the other hand, I expect a lot of people to make money from this crash as well.

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12 responses to “The Bitcoin Bubble: The Rise and Fall of a Virtual Currency

  1. “Bitcoins are, I believe, currently in the “Bear trap” phase” I believe you mean Bull trap phase.

  2. 2nd to last paragraph: Sow what next? Well, it could many ways.

  3. Re: “…price of Bitcoins is somewhere around the “Delusion” and “New Paradigm” phase.”

    But your chart implies that before the mania must come the Institutional Investors, and Media Attention. Neither of these have transpired in any significant manner.

    I can see a correction in the short term, but my money is on that being prefatory even to your ‘Bear Trap’. Can you name a single institutional investor in the BTC space at the moment?

  4. While reading this, keep in mind that the author may have something to gain if people panic and sell their coins after reading this article.

    • Yes, because if I seriously intended to trick everyone into selling Bitcoins so I could short them, I would also freely advertise the fact that it can be done as well as linking to how it can be done.

  5. As a previous poster said, based on your analysis, it seems that bitcoin is in the “Bear Trap” phase. You noted a few venture capitalists and companies that have gotten involved or interested, and you said that the interest is “getting there.” That seems far more a description of the Bear Trap phase than the Bull Trap phase. If anything, based on your analysis, I should buy a ton of bitcoins and wait for the Mania phase to take place where the public (not a few rich investors and companies) takes great interest. Either way, it’s an interesting article, and I appreciate the open dialogue.

  6. Pingback: The Bitcoin Crash: Now you can buy in | Ghost Agenda

  7. USD is not backed by anything, how can you have a bull trap without a valuation?

    What is you valuation?

    • The USD is backed by the United States government and the trust people have in it. And THAT is backed by the full might of the US armed forces. I’m not even going to try to valuate how much all of THAT is worth.

      As for Bitcoins? Well, for a currency with no government or central backing, no real asset, driven entirely by speculation (this is where no governing authority hurts, as it can’t regulate the price)…. technically, the thing is worth 0.

      However, that’s the simple answer. In reality, I would guess that Bitcoins DO hold some value because of the (small) system supporting it, which people usually don’t account for.
      For example, Bitcoins are generated through “mining”, which is a process that requires powerful computers to crack hard math problems, which sometimes reward their owners with a new cache of Bitcoins. These specialized and powerful computers have some worth to them. A high-performance PC workstation called “Avalon” that generates 8 to 16 bitcoins a day costs $4,500. When Bitcoins were at around $200, a single one of these units was worth $16,500. And these are just the specialized units, not counting all the normal PCs used to mine Bitcoins.

      So considering all of this infrastructure, alongside the ideological and financial commitment of some diehard advocates of the currency, I would say Bitcoins are worth around… $20 to $30 each, maybe?

      But of course, the entire thing is driven by user speculation and mass manipulation. So attempts at valuating the currency are bound to fail.

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