Bitcoin: The search for fair value

 

In late-2017 I wrote a series of posts pointing out the extent to which Bitcoin was highly overvalued and that it was likely to fall back in 2018, which it duly did. But if we thought the digital currency was overvalued three years ago at a rate below 20,000 against the dollar, what should we make of a rate which this week spiked above 57,000?

The boom in context

We should not forget that this is not the first surge in the price of Bitcoin – indeed there have been five documented instances of a bubble prior to the latest one with each boom followed by a bust. Bitcoin started trading in April 2011 at parity to the dollar but by June it was trading at $32 – a gain of 3100% within just three months – although it subsequently collapsed back to $2 by November. In 2012 and 2013, there were three further boom and bust cycles with the final one resulting in Bitcoin breaking through $1000 for the first time. The inevitable collapse that followed meant that it did not break through the $1000 barrier again until early-2017. That year proved to be a watershed for the original cryptocurrency which started the year below $1000 but at one point broke through $19,000 to put the concept of digital currencies firmly into the public consciousness. Arguably the success of 2017 was one of the key factors prompting central banks to take the concept of digital currencies more seriously and their programmes in this regard have since come on by leaps and bounds.

The most recent Bitcoin surge really only got going last October and broke through its previous high just before Christmas. It today stands at 4.5 times the previous peak in December 2017. A number of explanations have been put forward for the surge. One argument that does not hold water is that it is being driven by the search for an inflation hedge on fears that the huge stimulus put in place to combat the Covid pandemic will ultimately spill over into prices. After all gold, which is a more traditional inflation hedge, is down 13% from its peak last summer.

A more plausible explanation is that Bitcoin is finding wider acceptance across the institutional investor universe. For example BNY Mellon recently announcing that it plans to hold Bitcoin and other cryptocurrencies on behalf of its clients, putting it on a par with traditional assets such as US Treasury bonds and equities. Earlier this month, Tesla announced that it has bought $1.5 billion worth of Bitcoin for “more flexibility to further diversify and maximize returns on our cash” and plans to accept payments in Bitcoin “subject to applicable laws and initially on a limited basis.” It is hard to avoid the feeling that there is a momentum effect behind Bitcoin with supply creating its own demand in a modern-day version of Say’s Law. This does not necessarily mean that it is a good investment. After all, in the seventeenth century there was a huge demand for tulips which pushed the price of bulbs to extraordinarily high levels before they crashed back to earth.

More cons than pros

That there is a role for digital currencies is undeniable but I continue to harbour major doubts about the suitability of Bitcoin to meet the claims that its proponents make for it. One claim is that since supply of the digital currency is limited to 21 million units (of which 18.6 million have already been “mined”) its relative scarcity means it has attractive properties as a store of value. But the huge price volatility recorded over recent years undermines claims that Bitcoin acts as a form of digital gold (it may do so in future but that time is not now). I also continue to harbour doubts about the security aspects of Bitcoin, which I have outlined in detail in previous posts. A monetary system residing on computer servers which do not enjoy the backing of a state guarantee is only one hack away from disaster, and as quantum computers become a more realistic prospect it is not inconceivable that they could eventually be used to gain control of the blockchain upon which the currency depends.

If Bitcoin cannot be trusted as a store of value, does it have a future as a medium of exchange? The arguments here are more favourable. But there is a trust issue: After all, it is associated with transactions of dubious provenance when parties wish to remain anonymous (e.g. on the dark web) which may limit its appeal. It is unlikely that most people would want to be paid in Bitcoin, preferring instead the comfort of currency units that they are familiar with. In the words of Janet Yellen, Bitcoin is also an “inefficient” way to conduct monetary transactions largely because “the amount of energy consumed in those transactions is staggering.” The amount of computing power required to “mine” Bitcoin implies that if it were a country it would be in the world’s top 30 electricity consumers, with the University of Cambridge Electricity Consumption Index suggesting that it now consumes more power than Argentina on an annual basis (chart 2).

On the basis of what goes up must come down, it is likely that the huge surge we have seen in Bitcoin prices over recent months will be reversed. Recent experience suggests that Bitcoin has followed a series of Gartner Hype Cycles in which the price surges as initial hype builds, followed by a collapse as disappointment sets in but then recovers slowly as investors climb the “slope of enlightenment” (chart 3). It is unlikely that the current cycle will prove to be any different.

What is fair value? 

Given the massive volatility in Bitcoin of late, it is worth asking whether it is possible to determine an equilibrium price which in turn might give us some steer on where the price goes from here. Based on US data, around 0.2% of total consumer expenditure is financed using Bitcoin[1]. On the basis that consumer spending accounts for an average of 62% of GDP on a global basis and that the IMF forecasts world GDP this year will hit $91 trillion, this implies global consumer spending of $56 trillion. Further assuming that 0.2% of this is accounted for by Bitcoin, this suggests that the total value of Bitcoin for transactions purposes is around $113 billion (note that the market cap of Bitcoin is around $927bn – around 8 times this figure).

Since Bitcoin was originally designed as a peer-to-peer online payment system (see the original Nakamoto paper) I would argue that the value for transaction purposes gives us a fair steer on the current equilibrium value. This turns out to be a figure in the region of $6100 (derived as the transactions market value ($113 billion) divided by the number of Bitcoin in existence (18.6 million)). This does not mean that Bitcoin will necessarily revert to this level. For one thing, the equilibrium value will rise as the level of nominal spending rises. It will also rise if the share of spending accounted for by Bitcoin increases. Current elevated levels can be viewed as an attempt by a forward-looking market to guess future fair value levels.

To give some scenarios of how fair value might evolve, I used estimates based on IMF forecasts to derive global consumer spending out to 2025 and assume that it grows at a rate of 5% per annum thereafter. The supply of Bitcoin is assumed to expand by just over 6% by 2050. If Bitcoin continues to account for only 0.2% of all transactions, the fair value rises steadily to reach around $24,000 by 2050 (chart 4) which is still only half current levels. If, however, we assume that the share of transactions financed by the digital currency increases to 0.5% of the total, the fair value rises to around $57,000 on a 30-year horizon.

This is an attempt to demonstrate that if demand for Bitcoin for transactions purposes increases whilst its supply is fixed in the long-run, the price should inevitably rise. This does not necessarily mean that it will. The whole cryptocurrency edifice may come crashing down if confidence is shaken for some reason (e.g. fraud or the security underpinning it is compromised by advances in computing). It may also be supplanted by central bank controlled cryptocurrencies. But much as I believe Bitcoin is overvalued, if you believe that it is here to stay maybe current elevated price levels may not look out of place in the longer term.

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[1] According to Forbes, $31.2 billion worth of retail products and services were purchased in the past year using cryptocurrencies in the US compared to total consumer spending of $14.2 trillion.

2018 in review

As we look back at 2018, many of the bigger trends which I anticipated a year ago did indeed pan out. There were a few unanticipated surprises, of course: It would not be quite the same if there were not. To summarise the year as succinctly as possible, global growth held up although fears of a slowdown began to materialise late in the year; markets had a rocky year and politics dominated the agenda. 

As I noted in early January, markets at the start of the year were entering late-cycle territory with many investors describing themselves as “reluctant bulls.” My recommendation at the start of the year was to reduce the degree of risk exposure, primarily because I expected volatility to pick up, but I still expected equity markets to end the year up 5-10%. I was right about the volatility but wrong about the trend in equities, although I was right to believe that equities could not continue to rally as they had done in previous years. The equity option volatility trend reflects a change in investor attitude towards risk and there was a sharp spike in February and a less elevated but still strong upward movement towards the end of the year. I have long believed that markets were under-pricing risk and 2018 was the year that a reassessment took place. Many of those who were reluctant bulls a year ago are now outright bears, and with hindsight I should have had the courage of my convictions to call for the market correction that I feared might happen.

The reasons for the investor reassessment are many and varied. My main concern a year ago was I believed equities to be overvalued: Based on the Shiller ten-year trailing P/E metric I still believe they are. Cracks in the tech universe were another factor: Tech stocks continued to fly high until late in the year but I did warn that “a market which is so dependent on tech stocks is clearly vulnerable to a shift in sentiment.” And so it proved when the FAANG stocks started to give up their gains around October. This is partly the result of product dependency fears, with concerns that demand for Apple products is slowing, and cyclical factors as growth concerns mount. I also noted that the Fed’s quantitative tightening policy, whereby it continued to reduce its balance sheet, at a time when interest rates were rising indicated that “more air is being taken out of the monetary balloon than at any time in the past decade.” There is no doubt that US monetary support for equity markets has been steadily withdrawn over the past 12 months.

But undoubtedly the biggest factor influencing markets was the outbreak of a trade war between the US and China – something which happened more suddenly than I anticipated because I thought that President Trump’s bark was worse than his bite. Although the G20 summit in December appeared to take some heat out of the US-China trade dispute, many of the issues which prompted the dispute in the first place remain unresolved. In what appears to have been a truce in trade hostilities, China made some trade concessions that prompted the US to hold off from raising tariffs on a wider range of goods. But China continues to skirt around the fact that the expropriation of copyright technology as a precondition for foreign firms to do business in the domestic Chinese market remains a live issue. To the extent that the trade ceasefire is conditional on eliminating this problem, we cannot say that trade concerns will not resurface in 2019.

Perhaps one of the biggest issues exposed by the trade war is that the rules-based architecture on which global prosperity has been based is threatened in a way we have not seen in many decades. The WTO exists as part of the institutional framework to prevent trade frictions from escalating, with 38 disputes brought before it this year alone. Unfortunately, the Trump administration is sceptical that the WTO will act in favour of the US and it continues to block appointments to the WTO’s Appellate Body which has been reduced from seven members to three. With the terms of two members set to expire in December 2019, this would reduce the Appellate Body below its necessary quorum unless new members are appointed and would mean that the WTO is no longer able to arbitrate in trade disputes. For the record, an analysis of WTO cases brought against China[1] indicate that “there are no cases where China has simply ignored rulings against it” – in contrast to the US which “has not complied with the WTO ruling in the cotton subsidies complaint brought by Brazil.” Bias? What bias?

But it is not only trade issues that have rattled markets. There is a growing trend towards economic nationalism evident throughout global politics which is leading to concerns that we have passed the high water mark of globalisation. Trump’s America First policy is a clear manifestation of this, as is Brexit. Indeed, perhaps one of the key trends to emerge in 2018 was the sense of drift in political leadership. I have talked at length about the political failures of Brexit, and I have serious reservations that politicians will see the light in the next three months which will avoid a hard Brexit having spent the past 30 months behaving irrationally. But French and German politicians are also facing increased pressure from an electorate which does not like what is on offer, whilst Italy’s populist policies have drawn the ire of the European Commission. This lack of leadership and inability to rise above local concerns to see the bigger picture is one of the biggest threats to the economy and markets as we look ahead to 2019.

In terms of some of my other 2018 predictions, I didn’t do altogether badly. Bitcoin prices collapsed, as I suspected they would; there was no war on the Korean peninsula and Donald Trump was not impeached. I was also right that Italy would not win the World Cup (though that was more to do with the fact they did not qualify for the finals). But when I did do the analysis in mid-year and tipped Germany to win, I did so only on the basis that the 18% probability assigned to their victory chances implied an 82% they would fail to win. Those are the sort of predictions I like – ones which can be both right and wrong at the same time. Happy New Year.

[1] Bacchus et al (2018) ‘Disciplining China’s Trade Practices at the WTO’, Policy Analysis 856, Cato Institute

Blockchain: A solution looking for a problem?

I have long argued that the blockchain – the system that underpins Bitcoin – is a real fintech innovation_,  whereas Bitcoin itself is a by-product. But not everyone agrees that blockchain is such a wonderful idea and that it is a flawed system. It is thus worth digging a little deeper into the workings of blockchain to assess some of the pros and cons.

There are two key elements associated with blockchain: How it works and why it works. The ‘how’ is a routine process of transaction verification designed to ensure that each transaction is valid. One way to do this is to add a timestamp to each transaction and adding it to a chain of time stamped transactions. This is validated by a complex proof-of-work algorithm that cannot be changed without redoing all previous steps in the proof-of-work chain. This makes use of an algorithm known as a ‘cryptographic hash function’ which converts a numerical input of arbitrary length into an output of fixed length. This process is resource intensive and has to be run numerous times before the hash function generates an output that is accepted by the rest of the blockchain community. One feature of the system is that it is difficult to work back from the output to the input, thus preventing miners from working out how to falsify previous blocks. This is similar to procedures used to encrypt website passwords which prevent hackers from being able to work out users’ passwords by viewing the encrypted data.

The ‘why’ of blockchain is also interesting. It effectively offers a solution to the long-standing game theory puzzle which has bamboozled generations of computer scientists – the Byzantine Generals problem. Cracking this problem offers an insight into how a decentralised ledger system can operate. To get a handle on it, consider a thought experiment in which a group of generals (>2) are assumed to be outside a city, each with an army, and all want to invade the city. It is known that if at least half attack at the same time, they will be successful. But if they do not co-ordinate their plans to ensure they can muster the requisite number for the assault, they will be unsuccessful. They must thus collude in planning their attack, but the generals face three problems: they must (a) know whether their messages get through in the first place; (b) receive an acknowledgment indicating that the plans have been accepted and (c) verify that the information passed between them is true.

Computer scientists have struggled for 40 years to derive a network solution which will overcome all three of these problems simultaneously but finally the blockchain appears to have managed it. Since the blockchain is arranged on a peer-to-peer basis, messages are transmitted to a user’s immediate peers and the information disseminates quickly through the system. Thus, unless the user’s connection is faulty, condition (a) is satisfied. Condition (b) is satisfied once all other users in the system validate the proposed change to the ledger.

But before users are prepared to validate these changes, they must be sure that condition (c) is satisfied. The trick to ensuring that people send true information across the network is to make the history of all transactions publicly available and the cost of providing false information prohibitively high. In the case of our Byzantine generals, in which they are each shuttling messages back and forth between themselves, a potential traitor must be able to falsify all messages – including those in which he had no hand in writing. If we impose a constraint on the time each general has to reply to the message sent from one of the others, it becomes ever more difficult to falsify the results of communication between third parties.

In the case of Bitcoin miners, the costs of doing the number crunching in order to falsify all historical transactions is so high that there is no apparent gain from doing so. In short, if we attach a cost to sending a message and ensure that only one person can send a message at a time, the authenticity of the blockchain is guaranteed.

So far, so good. Moreover, the blockchain offers the security advantage that information does not sit merely on one system, but is distributed across many, and may thus be less susceptible to denial-of-service attacks. But it may not be immune to hacking. For example, if sufficient computing power can be corralled to gain access to more than 50% of the systems linked to the network, the integrity of the chain will be compromised. This is not believed to be possible at present, but there may come a day when the power unleashed by quantum computers is such that it can overwhelm existing networks.

There is also a question of what sort of transactions are suitable for recording on a blockchain which is increasingly used to design smart contracts. The smaller blockchains upon which they rely might be easier to circumvent than the huge public networks which underpin Bitcoin, precisely because the smaller number of participants makes it easier for parties to collude (this blog post discusses such an example). If the complex and expensive  proof-of-work algorithms can be undermined in small networks, blockchain may not offer the security benefits for private sector transactions which are often claimed. Consequently, as the Bitcoin experience demonstrates, it may be more suitable for large-scale networks (e.g. maintaining driving licence or social security records). But the bigger the network, the higher the energy costs of maintaining it – a cost which is an inevitable consequence of providing the desired level of security.

I still happen to believe that blockchain has a future. It may not be the all singing, all dancing product which its proponents believe, but it does represent a major breakthrough in computing technology. It may prove to be a solution which has not yet found the right problem to solve.

The topsy turvy world of Bitcoin

The crazy world of Bitcoin entered new territory today following the introduction of a Bitcoin future on the Chicago Board Options Exchange (CBOE). Almost immediately, the one-month contract surged by 20% to a record high of $18,850 but by mid-afternoon the futures contract had stabilised at $17,800 with the spot price trading around $16,500. Depending on who you talk to, Bitcoin has either received an official stamp of approval which will push it higher, or recent trends confirm the madness that has taken hold which surely will hasten the crash.

The price has now increased by a factor of 20 during this year and the movements now really do mirror the price of Dutch tulip bulbs over the period 1636-37 (see chart). Like tulips, Bitcoin represents something totally new, hence the difficulty in setting an appropriate market price. Unlike tulips, Bitcoin has more than merely intrinsic value: Investors bought tulip bulbs (never the flowers) because they knew there was a demand for them amongst those wealthy people keen to adorn their gardens with rare flowers. In theory, Bitcoin is a medium of exchange so a rise in its price allows investors to buy an increased quantity of goods and services with it, although it now appears to be desired for its own sake as investors buy it in the expectation that its price will rise further. We should be in no doubt that this is a bubble: I have experienced a few in my time – though never one quite like this – and I have no doubt that this one will pop.

One question which was posed to me today was whether the establishment of a futures contract on a recognised exchange marks the point at which Bitcoin is about to go legit, which will allow it to attract institutional investors. I suspect the answer is almost certainly not. For one thing, regulators are concerned about the risks posed by money laundering. A basic definition of laundering is the process of allowing “dirty” money earned from proscribed activities to enter the legitimate economy via three main steps: placement, layering and integration. The placement stage represents the movement of cash from its source but the blockchain system underpinning Bitcoin does not allow us to identify the source, merely the fact that a transaction took place. Similarly, the layering process which is designed to make it difficult to detect illegal activity, is facilitated by the blockchain process. Accordingly, the integration stage, which is the conversion of cash earned through illicit means into a legitimate form, becomes so much easier.

Another aspect of the law which is increasingly taken seriously by financial institutions and regulators are the KYC (know your customer) regulations. The anonymity offered by Bitcoin transactions runs a coach and horses through the rules. Accordingly, no reputable institution worth their salt will want to incur the wrath of regulators by offering Bitcoin related products. Back in September Jamie Dimon, CEO of JP Morgan Chase, called Bitcoin a “fraud” and threatened to sack any of his staff who deal in it (its highest value at that point was $4880 which looked pretty elevated at the time). He subsequently said “the only value of Bitcoin is what the other guy'll pay for it.”

This strikes me as an astute assessment of market trends in recent months. This is how pyramid schemes work and in his column in the Daily Telegraph a couple of weeks ago, Jeremy Warner suggested that Bitcoin is “very probably already the biggest such racket in history.” He might want to have words with his sub-editor, though, who titled his column “Investing in Bitcoin is not idiocy but perfectly rational – it's called 'the greater fool' theory.” There is nothing rational about the greater fool theory.

That said, I have pointed out previously that I believe digital currencies have a future, for reasons I will come back to another time. But a Bitcoin collapse could set back the cause of digital currencies a long way. After the price of tulip bulbs hit their peak in February 1637, prices collapsed by anywhere from 80% to 95% over the next five years depending on the tulip variant we pick (there are significant variations in types of tulip, hence lots of price variation). A lot will thus depend on the extent of any market correction. What will help digital currencies in the long run is that they are underpinned by the blockchain which could yet turn out to be one of the most significant developments in the digital world.

But consider this: The total value of physical cash in circulation around the world is $31 trillion and the total number of Bitcoins it is possible to create is 21 million. If Bitcoin were to totally supplant cash, this would put the equilibrium price of Bitcoin somewhere close to $1.5 million per unit at current prices. The total value of all cryptocurrencies in circulation is currently around $450 bn – around 1.4% of the total value of cash. Suppose for the sake of argument that in the long run Bitcoin were to account for 5% of all cash transactions: This would still put the equilibrium unit price above $73,000. Presumably investors continue to believe this is where Bitcoin is headed – and good luck. Obviously, nobody has a feel for the equilibrium price of Bitcoin. But wherever it is, I still maintain the market price will go down long before it gets to that level and it may not survive a big crash as other digital currencies take its place.

Bitcoin: A currency whose time has not come

If anybody needed confirmation that Bitcoin is a bubble waiting to burst, consider this: It took seven years since it started trading for it to cross the $1000 threshold, which it did in January this year. Four months later, in May, the price surged through the $2000 level. By August, it broke the $4000 barrier and … well, you get the picture. It takes ever less time to go through each successive $1000 level. Just after 1am London time this morning, it broke the $10,000 threshold for the first time. Thirteen hours later, it reached an all-time high of $11,434 and less than six hours later it was way back down, at just above $9000.

If you draw a daily chart of Bitcoin moves, this is a trend which will not show up. But these are the sort of market movements that are hard to resist – everyone loves a good boom, and before too long it is a pretty safe bet that there will be a bust from which there is no coming back. Aside from the fact that any asset which rises at such a speed almost inevitably comes crashing down again, there are numerous ironies associated with Bitcoin which make it unsuitable to be the great alternative to central bank controlled cash that its proponents claim.

Consider the fact that its initial popularity was derived from those who believed the best form of protection against an imminent collapse in civilisation was to live in a remote cabin in the woods with plenty of tinned food and a well-stocked armoury. The theory ran that central bank cash would soon become worthless as societies collapsed and alternative forms of money would come into their own. There is just one snag. Bitcoin is an electronic token which exists only on a computer. In the event that civilisation were to collapse, who would be there to keep the lights on – or more pertinently, generate the electricity required to ensure that Bitcoin could continue to be traded?

To understand why all this is an issue, we need to go to the heart of what Bitcoin is. It was designed as a peer-to-peer electronic cash system to cut out the conventional banking system. In order to make this work, transactions between holders of Bitcoin are recorded on a digital ledger known as the blockchain. In a conventional banking system, the ledger is a record maintained by the banks. To bypass this step, a ledger technology was created in the form of an electronic file which records all transactions in sequence, so we can see how title to Bitcoin passes from one holder to the next. In the absence of a centralised record keeper, it is important to ensure that people are not cheating (i.e. claiming to own Bitcoin to which they are not entitled). This is done by timestamping each transaction and linking it to each previous timestamped transaction in the form of a chain. In this way, we can trace back all transactions – there are no secrets.

But transactions are only added to the chain after a complex proof-of-work algorithm has been solved. Due to the transparency of the system, falsifying the current transaction would require falsifying all previous transactions, and because the proof-of-work algorithm is computationally onerous, there is little incentive to cheat – it is simply too expensive in terms of time and transaction costs. So once you solve the cryptographic puzzle and all users agree the solution is valid, one iteration of the proof-of-work algorithm suffices to ensure the blockchain is valid. Bitcoin comes into the equation because those who maintain the blockchain, and do the complex calculations, are rewarded by payment of Bitcoin. An additional complication worth knowing is that the supply of Bitcoin is limited to 21 million, and almost 80% of all coins likely to come into existence have already been created. Moreover, miners get progressively lower rewards for each block they “mine.”

Having completed that diversion, it raises two issues. First, the electricity requirements to run the blockchain and mine Bitcoins are enormous. Because of their increasing scarcity, miners have to expend more energy to generate each additional Bitcoin – it is an energy-inefficient process. Currently, this activity consumes as much electricity as the Turkmenistan economy and estimates suggest that by 2020 it could consume as much as Denmark. Second, the real bonus of the system is that the blockchain is applicable to a wider range of activities than Bitcoin. The real reason why Bitcoin has surged this year is that investors have been bringing blockchain-related products to market via initial coin offerings. But the Ethereum network, which is an open-source, blockchain-based platform designed for a wider range of applications and in which the digital currency (Ether) is derived as a by-product of the verification process, has been one of the fastest growing currencies this year.

Policymakers have taken note of the recent bubble with the BoE’s Jon Cunliffe reassuring the public in a radio interview this morning that it is too small to hurt the wider economy. Indeed, the global market cap of all digital currencies currently stands at $283 billion – less than 0.5% of world GDP. But central bankers have taken note of digital currencies and have been thinking about central bank controlled cryptocurrencies for quite a while (I will deal with this another time). I do believe that there is a future for digital currencies – it’s just that I don’t believe Bitcoin is the vehicle to take them forward.

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.