New money

Are cryptocurrencies a bubble waiting to burst?

23rd December 2017

“It’s a bubble!” scream financial regulators, cynics, and your partner’s Uncle Pete who works in a bank and has done alright for himself. As the Christmas sherries are poured and someone mentions that you’ve been dabbling in that Bitcoin thing, other relatives nod knowingly and someone mutters something about tulips.

But for all the experience of other generations who built their wealth via traditional investments like property, what’s going on in the cryptocurrency world is so unprecedented that comparisons to known economic cycles could be totally meaningless. And let’s remember too that “bubbles” as such are by definition unexpected outcomes. “Bubbles usually get identified in retrospect,” according to William Derringer, an MIT financial historian. “If we knew with absolute certainty that Bitcoin’s was a bubble, it would have already popped.” So if it’s not a bubble, what on earth is it all about?

A quick disclaimer before we move on: I am not a financial advisor, nor do I play one on the internet, this article does not constitute advice. In recent months I have learned a lot about the cryptocurrency world (which includes Bitcoin and many other blockchain-based currencies), but the first thing I learned is how much I do not know.  My very tiny portfolio, comprising a range of different coins, has more than doubled in the past 8 weeks – but that reflects the market rather than any expertise on my part. And the critical thing to understand is that no one – not even Uncle Pete – can say with certainty what will happen next.

That’s become very apparent, in fact, in the last couple of days, where the price of Bitcoin fell 30% on Friday morning – the biggest drop since 2013 – and then recovered.

It’s ‘just’ code

Part of what worries traditional investors is the fact that cryptocurrencies are decentralised, and not backed by any non-digital resource.  It exists as a computer algorithm, controlled by complex mathematical ciphers building an unalterable distributed ledger, verifying transactions through a process of solving staggeringly complex equations.

Do you need to understand the maths? Absolutely not. What you must understand though is that no-one owns the network, it’s a technology, which provides for a publicly-verifiable and intrinsically tamper-proof ledger.  This ledger is the blockchain, maintained by hundreds of thousands of “miners” worldwide.

The concept of mining for Bitcoins or other cryptos is pure analogy

The concept of mining for Bitcoins or other cryptos is pure analogy, a way of relating the idea of abstract code to tangible stores of wealth like gold – something which gains its value because of a combination of scarcity and cost of extraction.

And there’s an irony here because when Uncle Pete splutters, “but, it’s not backed by anything!”, he’s overlooking the fact that the Bank of England came off the gold standard in 1931, and traditional “fiat” currencies are not backed by anything either. They are social constructs, which let us agree that something we call a pound or a dollar is worth whatever society agrees it’s worth. And for society, read those in charge of economic policy, who can amend interest rates, inflation, and the actual numbers of currency units at any time. The UK and US governments survived the recent economic crisis by literally creating new money out of thin air via quantitative easing, and they’re considered stable economies… at least by anyone trying to deal in Rupees or Zimbabwe dollars.

So if cryptocurrencies are purely digital, how do you deal with them? First, you need to acquire some.

money

Purchasing Crypto

(That disclaimer again: nobody has any idea what is going to happen, with thousands of coins on the market today – some will undoubtedly vanish without trace, and it’s terrifying to hear about people borrowing to invest or putting their life savings in. NEVER invest what you cannot afford to lose, and do your own research)

To buy crypto with fiat currency (like Sterling or Euros), you need to create an account at an exchange. Coinbase is one of most accessible, currently offering four of the biggest coins, and an easy-to-use application, enabling you to send funds from your credit card or bank account. Once you’ve done the normal ID verifications, you can buy very quickly. Coinbase charges quite high transaction fees compared to some other exchanges, but it’s where I and many others got started. In recent days the addition of Bitcoin Cash to its offering has created some disruption and reports of delays in withdrawals, so as ever, due your own due diligence – there are many other exchanges you can try.

So that’s it, you now own your first bit of cryptocurrency, and you can watch it rise and fall against your baseline fiat on the exchange – literally minute by minute.

From Bitcoins to Alt-coins: so much choice!

Coinbase offers 4 currencies at the time of writing, Bitcoin, Litecoin, Bitcoin Cash and Ethereum. But according to coinmarketcap.com there are 1,372 cryptocurrencies to choose from at the time of writing. What are they? This is where your research comes in. Most are effectively crowdfunded start-ups by any other name, trying to solve real-world problems by building a blockchain-based solution. Financial guru James Altucher predicts a 90% failure rate, which I guess is in line with new businesses in general, and that 1,372 doubtless includes a number of outright scams as well.  

Back the right horse and you could genuinely see returns in the tens of thousands of percent

Back the right horse and you could genuinely see returns in the tens of thousands of percent, but for me most of these “alt coins” feel too risky, or I know I simply don’t have the time or professional background to investigate them thoroughly enough. Sometimes I take a punt when something looks promising, but most of my modest investment is tied up in Bitcoin and Ethereum, while I try to work out whom to trust.

Has anybody got a crypto-crystal ball?  The good news is that the bar to entry is low, and once you’ve moved some profits to a bigger exchange, you can often take a stake in something you have a hunch about, with very little upfront risk.

So why does it feel like the ‘Wild West’?

Because that’s exactly what it is. A largely unregulated new world, where some brave pioneers will clearly clean up – but where dangers from reckless cowboys, natural disasters and criminal gangs will wipe out many. No wonder it scares Uncle Pete, and it should scare you too.

But if you want to journey down the rabbit hole – with one hand in your pocket and your eyes wide open – it could be one hell of a ride in 2018.  The good news is, apart from your time and judgement, you can learn a great deal for free, as there are some great resources out there. This is one collection I return to frequently, covering every level from ‘explain to Uncle Pete’ to really advanced stuff.

Whether we end up losing our stake and drinking out of paper bags under a bridge or speccing out our new Teslas to be delivered to our private islands, it’s good to live in interesting times.

23rd December 2017