Thoughts on a Cryptobubble

Over the last 6 months roughly, the fiat prices of Cryptoassets have skyrocketed so much that more and more people have taken notice and the word bubble almost certainly follows the word Bitcoin in general conversation. It should therefore be an interesting time to look at this alleged bubble and try to understand where we stand.

Firstly, it is important to understand that there are generally three kind of crypto assets in my view:

a) Pureplay currencies that aim to be a medium of exchange or a store of value

b) Functional assets that aim to be the backbone of applications and provide the basis for new ways of transacting/jurisdiction/etc

c) Projects that want to use blockchain technology to decentralize services or offer some other novel product

In order to understand bubble dynamics, it is important to separate the view across these three asset types, so let's address each in turn:

a) Cryptocurrencies

The main cryptocurrency is obviously Bitcoin. There are numerous others in this space that I cannot even list (like Litecoin or Dash). They might all have some slight differences in technology such as using proof of stake vs proof of work or similar but they are ultimately nothing more than "me too" coins. Therefore, in my view, it makes sense to look only at Bitcoin as it is likely to set the general direction of all these currencies.

Bitcoin in essence functions as a type of digital gold. The only knock against it is that it is too volatile to be a a "safe haven" or adequate store of value, but otherwise it differs little from its physical brother. There is a limited supply, people will ultimately accept it as payment in many spaces even if that is a clumsy process at your local butcher shop and it only has value for as long as people believe in it. Whether you can touch it or not makes little difference. Sure - Gold can be worn around the neck and is shiny but Bitcoin can be transfered anonymously and taken everywhere you go by remembering a 24 word combination to your wallet. 

So is Bitcoin in a bubble? The short term answer is yes almost assuredly. This is because there are numerous short term challenges that could cause trouble, such as overblown optimism that the SEC will reneg on its decision to disallow a Bitcoin ETF earlier this year and first and foremost the block size limit currently discussed, which is at this point set so that even smaller transactions cost $5-6 to execute and take 2-3 hours. That is a major impediment as a means of payment / exchange and if the mining community cannot agree on a new and more efficient standard Bitcoin will tank or worse split in two chains. When anything like this happens and people all want to exit at the same time, the extremely low liquidity on most exchanges will squeeze the price downwards massively. Given the issues in the short term that need to be resolved and the liquidity situation I would say Bitcoin is most certainly in a bubble at this point and will see a 50%+ correction in 2017. Over the medium to longer term Bitcoin is likely to rise further as it gets accepted in more jurisdictions and let's not forget that for Bitcoin to be valued at the same value as all Gold in the world, one Bitcoin would trade at $350,000+. So therefore it is not unreasonable to expect bitcoin to trade around $10,000 at some point in the next few years (equal to 3% of gold value).

b) Functional assets

This is the most misunderstood category of the entire space. I am myself not massively tech savvy, but there are crypto assets out there that are, in a way, missused as a currency or an investment vehicle. The most prominent one is Ethereum, which is frequently mentioned as a "rival" to Bitcoin. That could not be further from the the truth in my view.

Ethereum is a blockchain like Bitcoin with the main difference being that it allows for smart contracts. Ie. while Bitcoin allows for A pays 10 btc to B, Ethereum allows for A pays 10 Eth to B if X happens. These smart contracts continue to be stored decentrally on the blockchain and validated by everyone on the network constantly, which means in a contract sense you will not need a lawyer to interpret them (as if X happens the payment will happen) and it prevents fraud to a large degree. Much more importantly though as most applications are nothing more than very complicated IF THEN combinations this kind of blockchain can be the backbone to decentralized applications that will in essence be unhackable and completely private. So if Bitcoin is digital Gold, Ethereum is actually much closer to a new backbone for the Internet. It is not therefore a currency. Yes, you need ether to run the apps on the network, so it has characteristics of a currency, but it is actually a viable application of the blockchain as a new technology. 

Now that we understand this, is ethereum in a bubble? On the face of it I would say clearly no. The market cap of Ethereum is $25bn. That is approximately the market cap of all Snapchat shares (which do not carry voting rights; owning all of ether would on the contrary carry quite a bit of voting right). So ask yourself: would you rather have a messaging app for 25bn (without calling any shots, ie just the economic right to it) or would you rather own the technology that is sneakily on the road to become the backbone of such apps and others. I think the choice here is pretty clear and Ethereum is therefore easily undervalued in perspective. Especially considering that it has institutional backing by now.

The clear threat to Ethereum is the same as for Snapchat, Microsoft or  Apple. If a better technology emerges it will be worth much less. In that sense the best indicator, in my view, is the one Steve Ballmer famously quoted "Developers, Developers, Developers". If at any stage the developing community switches to another technology, Ethereum is in trouble. Right now it is the technology developers are switching to not from and more than 100 corporates are developing on Ethereum. Watch the developer flow to see if you need to sell Ether. Of course there are the same risks to this as to Bitocoin in some ways - there could be another split of chains or a problem moving to proof of stake. However those should be hiccups as long as developers stay. A word on the side: "Ethereum Classic" is the result of an earlier split and currently NOT the space developers are flocking to.

c) Projects / Token

There are more than 500 so called token out there that people throw into the cryptocurrency bucket. A token is either a means of exchange as a separate "currency" on the Ethereum platform or even a separate blockchain alltogether. These tokens cannot really be grouped. Some of them are purely fantasy and offer their holders almost no future benefits, while others are clearly akin to equity (Lykke) or backed up with assets accumulating in a smart contract (Tokencard, Monacocard, Tether USD, others). 

This difference is vital in undestanding if they are overvalued and as stated just above it is hard to make a general statement. If one had to make that kind of a statement though, it is so obvious that this space is overvalued and in a huge bubble that it can hardly be put into words. 

If we look at market cap, the first "issue" is that the common notion in the crypto space seems to be to look at "circulating supply", which is in essence the free float if we compare it to stocks. But the market cap needs to include the total supply which in many of these cases is held by the issueing projects/companies. Some of these projects do not have a product and their tokens are worth in excess of $1bn. That is insane. Not because the idea may not actually be worth $1bn if compared to other start up valuations (though I massively doubt even that assertion), but because those start up valuations are for equity. Equity means actual ownership in the project. The tokens are basically thin air for now and a promise to be useable as a means for the service/product in the future. So they have some value, but certainly not equity. It is in many cases nothing more than a Crypto Kickstarter. I doubt any Kickstarter projects have generated $1bn in sales. In the token space this happens regularly. Even if we lose sight of the $1bn tokens - hardly any token is worth less than $30m in total. Insane. The total market cap of all these tokens is close to $150bn if you use total supply in issue and not just the circulating supply.

Couple this with the craze around so called "initial coin offerings" which are unregulated versions of "IPOs" for these non-equity, future-product-promise assets and the fact that people are bound to lose vast amounts of money on these at which point regulators will step in and you are in the middle of a tulip bubble.

To be clear: many of the projects behind these tokens are fantastic novel applications the world needs. But just like the Internet bubble overvalued letsbuyit.com they are completely misspriced. I believe tokens are a great new way to raise money for ideas and ICOs need to survive, but it will need regulation (even if that is decentralized regulation by consensus and not state-sponsored one), valuations will need to come down and the bubble needs to burst. Then you can probably pick up the new Amazons of this word for literally pennies.

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Overall, these differences described here are vital to understand when investing. Given most people do not have a vague idea of it, it is more than likely that all cryptoassets will tank in tandem when the bubble in the Tokenspace bursts or Bitcoin does not resolve its issues. Especially due to the tight liquidity on exchanges. Prices will fall much further than people expect. Just remember that when it bursts, it will be a fascinating opportunity to invest in Bitcoin, Ether and some very select Tokens for the longer term. Bitcoin is unlikely to be replaced as digital gold and as long as developers work on Ethereum it will always have a value that is probably larger than that of Snapchat et al. For individual tokens some will vanish and a few will strive. Selecting the right ones when the bubble bursts will be hard.