Cryptocurrencies such as Bitcoin, Ethereum and Ripple are shaking up the financial scene today. There is discussion left, right and centre about their risk and their future place in the financial system. Many are excited about making quick and easy money transfers without involving banks, governments or card details, and investors are, of course, anticipating high returns. The decentralised theme makes it more attractive than regular forms of money. However, economic experts have warned that cryptocurrency is yet another bubble waiting to burst. Reminiscent of the late 90s dot-com bubble, investors are being encouraged not to work themselves into a quick money-making frenzy. Central Banks are concerned with the safety of cryptocurrency more than anything and may put the blockchain technology to use one day.
An economic or financial bubble is a situation where hyper-investment in an asset drives the price excessively above the asset’s intrinsic value. They tend to reach a peak and suddenly burst for various reasons, the main reason being higher interest rates because risky investments then become less attractive. When they burst, their prices drop as rapidly as they peaked.
Considering economic theory alone, cryptocurrency is certainly causing a bubble. The high volatility of their prices far outweighs their intrinsic values. Comparing the first and largest cryptocurrency, Bitcoin, with historical bubbles, it looks like its fate is already written in the stars. Crypto-sceptics would argue that historical evidence warns of an impending crash. However, those who love the idea of cryptocurrency becoming mainstream have hope that this bubble may be an exception.
A comparison of Bitcoin with other ‘bubbles’ (Source: Bitcoin)
An important thing to note is that most investors in Bitcoin and other cryptocurrencies are regular individuals, even novices in investment. Such investors are considered to make emotional decisions without much understanding of capital markets. This is likely to explain the volatility in prices as investments are made purely by speculation.
Big investment banks, though, have kept their clients’ money safely away from Bitcoin. It is too risky, volatile and, according to JP Morgan’s boss Jamie Dimon, ‘a fraud that will ultimately blow up’. Smart money investors have displayed sobriety by not jumping blindly onto a bandwagon that is headed into unknown territory.
Acting similarly, central banks have been observing from the side-lines. Mark Carney, Governor of the Bank of England, says that cryptocurrencies fail as money on all 3 canonical elements, while the European Central Bank has expressed its concern with their risk as well as the need for regulation. Perhaps the most drastic response is China’s ban of initial cryptocurrency coin offerings.
Despite the elitist scruple, cryptocurrencies seem to be creeping their way into our mainstream. Mark Carney believes authorities ‘should be careful not to stifle innovations which could in the future improve financial stability’. We aren’t eliminating a new fiat money rival, and there may be no explicit threat to the crypto-bubble just yet. Rather, regulation is the next step if cryptocurrencies are here to stay.