The Bitcoin bubble in context

Over the course of recent months I have done a lot of work looking at Bitcoin and have watched its recent sharp ascent with a mixture of bemusement and concern. I do not intend here to go into a detailed description of how the currency operates and refer the interested reader to the website Bitcoin.org  for an overview. Instead I want to focus on the sharp surge in the price of Bitcoin which has seen its value against the dollar increase by a factor of almost six since the start of 2017.

The puzzling question is why its value should have risen so sharply this year – after all, it has been around for seven years and we have already been through one boom and bust episode. In 2013 Bitcoin’s value against the dollar surged by a factor of 83, only for it to fall back by 85% over the next 14 months. What is rather more of a concern today is that the market value of all Bitcoin in circulation stands at $99 billion versus $9 billion in late-2013, and one of the questions which has been posed to me in recent days is whether an implosion of the Bitcoin bubble represents a threat to financial stability in a way which it did not in 2013.

As to the first of these questions, I believe that the rally in Bitcoin this year represents a different sort of bubble to that of four years ago. In 2013 there was genuine interest in Bitcoin as an alternative currency. Much of this optimism was misplaced, however, as the disadvantages of digital cryptocurrencies became evident. For example, the huge variability in the price of Bitcoin means that it does not represent a stable store of value. Together with security issues – the collapse of the Mt. Gox Bitcoin exchange in 2014 being a case in point – investors began to rethink their Bitcoin strategy.

But the currency is underpinned by the blockchain – a distributed ledger which potentially has a huge range of applications outside the realms of the currency world. One of the fastest growing digital currencies this year is Ether which is created as a by-product of the Ethereum network – a blockchain technology with wider applications than that used for Bitcoin. But as investors have jumped on the blockchain bandwagon so they have forced up the value of the digital currencies which these systems churn out.

In many ways, the digital currency revolution is reminiscent of the dot-com bubble of the late 1990s: There are many new and interesting applications of the blockchain technology but they have yet to be fully realised. Accordingly, investors are paying for their potential rather than their realised value, and because it is almost impossible to put a price on potential value, they are overpaying. It is thus hard to avoid the conclusion that current Bitcoin valuations represent a bubble which is set to burst at some point. As a historical guide, I have compared data for the 14 months prior to the Bitcoin peak versus the late-1990s Nasdaq rally and the Tulipmania bubble of 1636-37. As is clear from the chart, the surge in Bitcoin outstrips the surge in equity valuations in 1999-2000 but would appear not to match up to events in the Netherlands almost 400 years ago. But given the poor quality of the data for tulip prices in the 1630s and the fact that we may not be comparing like with like (different types of tulip bulb sold for different prices), we should be careful in making comparisons. But the fact that the Bitcoin boom far outstrips the Nasdaq rally of the late-1990s demonstrates that this is a boom to be taken seriously.

On its own, the bursting of the Bitcoin bubble should not in theory impact most investors. Indeed, the market cap of all digital currencies represents only around 0.3% of global GDP. Moreover, China is increasingly the dominant player in the Bitcoin market, accounting for the vast majority of coins created. It is thus likely that much of the Bitcoin wealth is held by domestic Chinese investors who will bear the brunt of any price collapse (for a fascinating overview of the impact of the digital currency in the Middle Kingdom, this article from Quartz is worth a read).

However, there are residual concerns that a collapse in Bitcoin could be a canary in the coalmine for a more widespread asset price correction, following years of easy money which has pumped up equities and real estate prices. My guess is that this is unlikely and that the spillover effects will be limited, precisely because of the narrow base upon which Bitcoin ownership rests. But as IMF Managing Director Christine Lagard once said, “I'm of those who believe that excesses in all matters are not a good idea … whether it's excess in the financial market, whether it's excess of inequality, it has to be watched, it has to be measured, and it has to be anticipated in terms of consequences.” We should thus not be complacent if the Bitcoin bubble bursts. It might have a deeper meaning than we can currently ascertain.