Is the Bitcoin Bubble for Real?

TheStreet.com

NEW YORK (MainStreet) —Just this January, one Bitcoin was worth less than $20. Then the price climbed up to more than 13 times. its own value, to hit a new peak around $266 on April 10. That foreshadowed the fall: last week, one unit of the encrypted virtual currency was worth as little as $68.50, down almost 75%. Today a single Bitcoin is worth about $137. All this yo-yoing boggles the mind, but even before the recent swoon, many people were questioning whether the online currency-cum-commodity was in the midst of a bubble. After the price collapse in last week, it’s worth asking: Was there a Bitcoin bubble before, and is it over now?

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Mere hours before the Bitcoin market crashed, Nicolas Christin, associate director of the Information Networking Institute at Carnegie Mellon University who has studied Bitcoin since 2011, said he was uncertain whether the dynamics indicated a bubble or whether Bitcoin was reaching its long-term value. “If I knew, I would be rich," he said. "But it definitely has all the typical characteristics of a bubble.” Based on Bitcoin’s exponential rise, Christin predicted that there would be devaluation at some point.

His prediction of a crash came true even sooner than he thought.

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Hindsight being what it is, there’s a consensus that Bitcoin was in bubble mode, says Reuben Grinberg, an associate in Davis Polk’s Financial Institutions Group, who has studied Bitcoins since he was at Yale Law School. “I think there is little question that the huge price run-up was due to bubble investing – people investing primarily because they see the price going up … and wanting to make a quick buck rather than really thinking and understanding the fundamentals of Bitcoin," he said. "If that’s the mentality of the people who cause demand to spike, which causes the price to increase astronomically, then any little thing will spook these same investors.”

One of the factors in the recent plunge was that Mt. Gox, the world’s largest Bitcoin exchange , suffered stronger-than-usual distributed denial of service (DDoS) attacks, as hackers apparently tried to manipulate the currency’s value by disrupting trade patterns . All the same, Grinberg doesn’t think that alone explains the selloff. “It’s possible that DDoS attacks contributed to the price fluctuations … but if they actually did happen and contribute to the price drop, [they] wouldn’t be a big deal if there weren’t so many bubble investors.”

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Grinberg points out that the bubble pattern has happened before: In the past, there was a “huge run-up from $1 to $30, with a quick collapse back to $2, and then, after a while, a steadying at $15.” Grinberg notes ominously that it will happen again.

He’s not alone: Back in 2010, Bitcoin’s lead developer Gavin Andresen predicted in a forum that there would be one to five Bitcoin bubbles in the following four years, driven by media attention.

Possibly augmenting the situation is the fact that there are a set number of Bitcoins, as the founders have promised never to issue more than that pre-set cap. John O’Meara, a certified financial planner and founder of Inner Harbor Advisors, notes how that’s different from a typical commodity like gold. “Gold can always be mined,” O’Meara says. “Any time there’s been a significant increase in the price of gold or other hard-to-find commodities, the more likely people are to find more, because they have a financial incentive.”

Likewise, Grinberg reminds us that “Bitcoins, like anything else, are subject to supply and demand.” Supply is fixed, because the rate of creation is known to everyone and set by an algorithm. He believes it's possible that the steady state price that accounts for the as-yet-unrealized demand is even higher than Bitcoin’s highest price so far, because not enough people know about it yet. Grinberg asserts there's something of a bubble mentality going on but says that alone doesn’t mean Bitcoin can’t legitimately gain in value again later—and merit it based on demand.

Although it’s hard to combat the main culprit, the bubble mentality, it could be possible to tamp down on a secondary culprit in the future: the incessant hacking of Bitcoin institutions. “Established market exchanges, like those for stocks or commodities, have regulators and self-regulatory organizations trying to figure out how to prevent such manipulation,” Grinberg says. “There is nothing like that in the Bitcoin world.” He thinks that Bitcoin’s reliance on key infrastructure like the Mt. Gox exchange “detracts from part of motivation behind it, which was to have a decentralized system that didn’t have a central entity that could be attacked, or could destroy the system through negligence or malfeasance.”

The solution? The Bitcoin infrastructure needs to grow up. “Almost every single Bitcoin exchange has gotten hacked and has had Bitcoins stolen," Grinberg says. "I suppose banks get physically broken into every once in a while, and probably have been hacked as well, but nothing like on the scale that has affected Bitcoin exchanges and e-wallet providers.”

What can we expect heading into the future? Grinberg strongly emphasizes that no one can know for sure whether the bubble is full over: “Go onto any forums, and you’ll hear people espousing all sorts of investo-charts-babble to say that this is the bottom or the middle or the top. But anyone who says they know what Bitcoin’s ‘true’ value is right now is lying. There are too many unknowns.”

Also see: Making Heads or Tails of Bitcoin

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