Time to Burst Bitcoin’s Bubble — An Exposition of Crypto’s Calamitous Climate
Let’s Poke Blockchain’s Bear
No truer statement rings true of economic bubbles than that of you know something’s wrong when everyone’s talking about it. And no statement is more fitting to the recent crypto craze, headlined by Bitcoin surpassing a market cap of 1 trillion USD. This surge in price, as well as the overall atmosphere, draws numerous parallels with that of the Dot-Com bubble, as well as the Great Crash of 1929. In this article, we’ll go over the bearish thesis for Bitcoin and why it, alongside other crypto assets, is in an immensely speculative asset bubble, using the constant light of history as our guide.
Firstly, what is an asset bubble? A bubble is defined as a situation in which the price for an asset is based upon unfounded and implausible forecasts and predictions; the asset price significantly exceeds its intrinsic value. Speculative demand, instead of fundamental metrics of the asset, is what fuels the staggering prices and growth. Due to this immense speculation, the bubble eventually, and inevitably, pops. Bubbles are a recurrent event in economics and finance due to our inherent cognitive biases and the psychology of herd mentality. There are 5 stages to a bubble, as identified by Hyman P. Minsky: Displacement; Boom; Euphoria; Profit-Taking; Panic.
Bitcoin represents a major paradigm shift in economics and the theory of value; it is also one of the first major applications of blockchain — a technology that has the potential to reshape industries from finance to healthcare. This is the displacement stage, with Bitcoin HODLers (individuals who ‘hold’ a crypto asset) enthralled by the groundbreaking technology. This narrative is eerily similar to that during the Dot-Com bubble. Fueled by the immense growth and widespread adoption of the internet, Internet-centered businesses and corporations saw massive valuations and immense growth. The internet was poised as the biggest thing, so how could any company fail? Between 1995 and its peak in March of 2000, the tech-heavy NASDAQ Composite index saw a rise of 400%. The growth was fueled by investors, encompassing both the retail and institutional kind, with immense confidence that these companies would turn in a profit — after all, how could they fail when they were the next big thing? An “irrational exuberance”, a term coined by then-Fed chairman Alan Greenspan, flooded the markets, causing investors to overlook fundamentals and blindly buy any company that had a website — not even a tangible product or positive balance sheet. In fact, just the addition of a .com to a ticker increased its share price. The rule on the street could almost be viewed as the companies that lost the most money were the best bets as they were investing in ‘growth’. This was the boom stage, and what a boom it was.
This irrational exuberance is present once again in Bitcoin. Individuals with no knowledge of Bitcoin and its underlying technological principles are stepping onto the BTC train. The volume of Bitcoin futures contracts — complex financial derivatives — has exploded since last Feb, and investors are chomping at the bit for ETFs and funds focused on crypto: BTCC.B.TO, the first-ever Bitcoin ETF that trades on the TSX, had a debut trading volume of 145 million USD. Anything and everything stamped with ₿ has investors piling on. According to data from PitchBook, there has been a boom in blockchain startups and financing, leading to oversaturation in a complex and continually evolving field, similar to what we saw in the Dot-Com Boom.
BTC achieved a price of over 10K USD in August 2020, and from August to November experienced steady growth in its value, with more and more users deciding to take a dive into the murky waters of crypto. This thus lead to a gaining in momentum, and between December 2020-January 2021, there was a massive boom in BTC’s price as well as the number of users. Additionally, there was a surge in widespread media coverage, with its Google search popularity score going from 18 to 31 from Nov. 1 to Dec 1st and from 31 to 61 from Dec 1st to Jan 1st. The fear of missing out (FOMO) is incredibly prevalent in the finance industry, and no one wanted to be left behind in this boom. Bitcoin is viewed as this once in a lifetime opportunity, posting some of the highest returns on investment of any asset. More and more investors are attracted into the fold, with the number of unique Bitcoin addresses going from 756.978K on Dec 1st to 940.647K on Jan 6th, 2021 (see below). The number of Blockchain wallets has also increased exponentially, with more and more people jumping onto the crypto hype.
When everyone from Wall Street execs to the clerk at the local grocery store is talking about it, it must be the next big thing; you’d be a fool not to invest. In fact, it’s quite the contrary; the dichotomy presented above is a telling sign of mania and the expansion of the bubble. As Nobel Prize Winning economist Robert Shiller put it, “you know something’s gone wrong when everyone’s talking about it”. Everyone has witnessed this magnanimous rise in price, with BTC offering some of the highest rates of return out of any security. You have amateurs and execs, self-proclaimed experts and influencers, all promoting crypto and its ecosystem. Yet, this hype appears largely artificial, with Bitcoin’s fundamentals not supporting its intrinsic value. What exactly are Bitcoin’s fundamentals, however?
Bitcoin was always intended to be a decentralized, peer-to-peer currency system. And ultimately, that’s what Bitcoin truly is: a currency, albeit one that is founded upon innovative and purely digital. As such, it makes sense to view it through a lens suited for the FOREX (foreign exchange) market. Currency, like all assets, is driven by the principles of supply and demand: quite simply, the greater the demand for an asset, the fewer people will be willing to sell it, and the more it will cost. We can create a fairly accurate picture of the supply and demand of Bitcoin using the number of confirmed daily BTC transactions and the number of unique addresses on the blockchain. A BTC address is a unique private key and is where BTC are ‘stored’ — you can send and receive BTC from this address; think of an address like an individual credit card containing all your BTC.
It hence stands to reason that, if the number of wallets is growing rapidly, and so are the addresses, then there is an increasing demand for the use of Bitcoin as a medium for transactions. I.e., the demand for Bitcoin as an alternative and viable currency is increasing, with more and more people wanting to transact in BTC. What we actually see is that the number of Bitcoin transactions has remained relatively stagnant, and has consistently hovered at around 310k since December 2019 and never looking close to meeting its peak of 425K in Dec 2017. There has been practically no increase in transactions per day, even though the price has continued to soar and there has never been greater access to the commodity. As such, there has been no increase in fundamental demand or usage, so what could possibly be driving such high valuations besides mania?
We can smooth out the data by taking a moving average, more clearly indicative of trends in complex time-series data. By plotting the 30-day MA from the graph above, the trend becomes glaringly clear: there has been no rise or significant change in confirmed BTC transactions per day during Bitcoin’s boom. Even as Bitcoin’s mainstream adoption has increased significantly (with Tesla, Microsoft, and even the Dallas Mavericks all accepting BTC as a method of payment), along with a reduction in political and economical barriers, the number of actual transactions on the blockchain have not increased at all. As such, we can conclude there has been no increase in demand for for Bitcoin as a currency, which is its primary purpose.
Further supporting the above thesis is the fact that the estimated transaction value in BTC has continually decreased (this is the total estimated value of BTC traded on a given day). So, the amount of Bitcoin being transferred on the blockchain has actually fallen, which once again begs the question of how its fundamental metrics support its astronomical valuation.
The final nail in the coffin is the fact that the number of unique Bitcoin addresses is actually down by ~200k from its last massive rally in 2017, and that after a peak of 940.6K addresses on Jan. 6th, it has fallen to 733.6K on Apr. 15th. If there truly is as much anticipated growth and mainstream acceptance of Bitcoin, how is it that addresses — the fundamental metric of users of the coin — have fallen from 2017 and have seen limited or even inverse growth? The trend in addresses is clearly demonstrated in its 30-Day MA graph.
The upshot is, the fundamental do not back Bitcoin’s massive price valuations. Furthermore, they are unlikely to improve as quite simply, Bitcoin is not and will not be a viable substitute for the USD or any fiat currency. Blockchain is a phenomenal technology, and I full support it and the principles underlying it. But it is not without drawbacks that are incredibly significant when it comes to money. The transaction times for BTC are massive, recently averaging ~30 min and can skyrocket to over ~1,000 min. These are not reasonable in a world of fast-pace financial transactions which need to be completed in seconds, not possible hours. Additionally, transaction fees have only risen drastically, with the average being about 30 USD per transaction. If your credit card company charged you that much, I’m sure they would go bankrupt fairly soon. Bitcoin is the first decentralized currency created atop blockchain, but the technology that provides Bitcoin with its monetary bravado is also its Achilles heel.
To provide even further evidence, we can analyze the put options on Bitcoin futures that trade on the Chicago Mercantile Exchange. Just as a quick overview, futures are derivative contracts (meaning their value is derived from the underlying asset) that represent a legal agreement to buy or sell an asset at a predetermined price at a specific time in the future. Purchasing a BTC future represents the obligation to purchase BTC at the price specified on the future on that date. For most BTC contracts, the underlying asset is 5 Bitcoins. Options are also derivative contracts except they represent the right, not the obligation, to purchase or sell the underlying asset at a specific price (known as the strike price) at any time before the expiration date (these are known as American options). Call options represent the right to buy and put options represent the right to sell. Hence, a call option on a Bitcoin future represents the right to exercise the futures contract, but the buyer has no obligation.
In general, put options denote a bearish sentiment on an asset, as the purchaser of the contract only makes money when the value of the underlying asset falls below the strike price and call options denote a bullish sentiment for the inverse reason. Thus, the purchase of a put option on a BTC futures contract indicates that the buyer expects the price of the BTC future — which is directly correlated to the price of Bitcoin — to fall. The damning fact is that futures are the expected prices for BTC (hence the term, future), so a put option upon a future indicates they expect the price of BTC to fall in the future.
Let’s look at the call/put option chains for Bitcoin for May 2021, taken from the CME Group and accurate as of 11:30 AM, April 19th:
The volume of a contract indicates the number of contracts traded. We can clearly see the the majority of volume for call options are for a strike price of 60k, which is what Bitcoin’s been hovering around for most of April and is a pretty safe bet. The second most are for 55k, which is around the current price of Bitcoin, and is an even safer bet. However things get really interesting on the put options side.
Notice how the vast majority of the volume are for a strike price of 55k and 50k, with a few in between those values. This indicates that there are a lot of people who believe Bitcoin will fall below 55k and even below 50k. Bitcoin’s put/call ratio is 1.17 for May; generally, any value above 1.02 indicates a bearish sentiment.
This, of course, is a much hazier metric due to the immense volatility on Bitcoin and its speculative nature, but it nonetheless provides support for the Bearish thesis outlined in this article and a general reading of the future sentiment of the asset.
We’ve established that Bitcoin’s fundamentals do not match its valuation, and investigated the overall sentiment surrounding it looking at options on Bitcoin futures; regardless of whether you believe in it as a currency or an investment vehicle, its valuation stems from the fundamentals. The current stage of the Bitcoin bubble is euphoria. Caution is thrown to the wind, and asset prices skyrocket, which is exactly what we’ve seen. Valuations reach all time highs and extreme levels that have very little rational justification. The Greater Fool Theory is clearly demonstrated with crypto: prices go up as investors are able to sell overpriced assets to a ‘greater fool’, regardless of whether the asset is overpriced. Look no further than Doge coin: when a cryptocurrency that started as a meme has a market cap of 50 billion USD — larger than both Ford Motors and Kraft — , there is something seriously flawed within the space. People are buying into it as they think there is no way to lose money.
This merry-go-round continues, of course, until there are no greater fools left on the ride. People are flocking to the crypto market, desperate to hop on the blockchain bandwagon. To provide a reference to history, at the peak of the Dot-Com bubble, the value of the NASDAQ composite was higher than the GDP of most nations. There is incredible inflation and seething oversaturation that continue to grow with very little rational or discretion.
People are fervently buying into anything remotely crypto, hence the rise of NFTs (Non-Fungible Tokens), where people are throwing money at anything and everything. There is no rational supporting the valuations, with investors looking to make profit off the hottest investment vehicle around. In fact, NFTs have plunged 70% from February highs, as the smart money sell them off before the bubble bursts. NFTs are intrinsically blockchain and the parallels that can be drawn between them and other crypto assets are clearer and more evident. If NFTs — which garnered immense support and saw astronomic growth — saw massive devaluations in only the span of months, what does this indicate for the greater crypto market?
The market hype around cryptocurrencies is immense, with no one looking at assessing Bitcoin or cryptocurrencies upon their fundamentals. During the Dot-Com Bubble, investors were purchasing stocks posting massive losses, throwing something as pedestrian as profit under the bridge. And analysts were supporting these companies. One might point to the rise in Bitcoin securities and investment banks and asset management firms expanding into the crypto space as a signal to its legitimacy, but remember that these companies exist to make money through any available options. During the Dot-Com bubble, many of these banks made billions of dollars off of IPOs. Additionally, recall that the 2008 financial crisis was brought on by investment banks and hedge funds trading subprime-loaded mortgage backed securities — derivative instruments created by them to profit off of home loans. If they can profit off Bitcoin’s irrational exuberance, they will.
The final stages of the bubble are profit-taking and panic, neither of which has happened yet. But there are clear indications of the market’s irrationality, and we’ve all seen the immense volatility of Bitcoin and the crypto space as a whole. Something as passing and insubstantial as a tweet from Elon Musk can send BTC and Doge skyrocketing, while pessimistic news can send it into a free fall. The most significant issue with Bitcoin is the massive amount of dumb money in it. People with very little crypto, and financial, knowledge and understanding are getting into the space just by following whatever an online self-proclaimed Bitcoin guru says. Bitcoin and crypto has become a part of everyone’s vocabulary and anything vaguely related to it garners rapid traction. Look no further than BitClout, what claims to decentralize social media, that has over $155 million in investments and over 160,000 users. There is very little known about the platform or its legitimacy, with the creator even being hit with a cease-and-desist. Yet, people are flocking to this service just because it has ‘Bit’ in its name and a bold mission statement. Sound familiar to ’99?
Blockchain and crypto, like the internet, has massive potential to reshape a myriad of industries. I am 100% for the principles underlying these technologies and the power of decentralization. However, there is massive misunderstanding and oversaturation within the space; this has culminated in the creation of a crypto asset bubble.
At the end of the day, Bitcoin is a highly speculative asset that is trading on investor euphoria and sentiment. The fundamentals of Bitcoin do not match its evaluation and the crypto space as a whole, including that of startups and NFTs, has many parallels to that of the Dot-Com boom. The sentiment itself is reminiscent, as due diligence is replaced with dogmatic notions.
The question then is, are you willing to be a martyr for crypto? When the music’s playing, everyone’s dancing, as irrationality becomes rational. But when the music stops, are you willing to be the one left without a seat?
Time to Burst Bitcoin’s Bubble — An Exposition of Crypto’s Calamitous Climate was originally published in DataDrivenInvestor on Medium, where people are continuing the conversation by highlighting and responding to this story.