Some of Warren Buffett’s most famous investing advice: don’t invest in anything you don’t understand.
My mom told me that in November 1999 she got out of tech stocks as much as she could, and sold half of her stock index funds because of their exposure to tech stocks. It seemed like we were in a bubble, although she was the only person she knew who seemed to think so. She recalls the Wall Street Journal saying that it was “more important to capture market share than to make profits,” and she will tell you “that is never true.” She didn’t see how these companies could sustain their business and didn’t understand how you could create value without profits. In March 2000, the stock market crashed specularly, and you can’t reference the Dot Com Crash without hearing the word “bubble.”
That brings us to the question everyone is asking today: “Are we in a cryptocurrency bubble?”
The majority of the people reading this probably haven’t invested in cryptocurrency yet, but know there are people making a lot of money off of it. Many also know, there is a lot of risk and volatility. Google “are cryptocurrencies in a bubble” and you will get a plethora of results. I attended a Meetup event at Byte Academy, a company that provides specialized education in Python, FinTech development, and data science, called “Where Do Cryptocurrencies Derive Value & Are We In a Bubble” with Matthew Gertler, cofounder of Digital Asset Research.
With the wild fluctuations in price and how high the price is rising, there is a lot of concern that cryptocurrencies are in a bubble, like the Dot Com Crash. Also, the high demand for talent that can mine Bitcoins and other cryptocurrencies has lead to a spike in the number of people enrolling in Byte Academy’s FinTech program, with a track for Blockchain.
Who are the people who showed up to this event? There was a bit of a mix, although most of the attendees seemed like they worked in or around finance. One person even worked in SEO and, similar to many people in the room, they were interested in learning more about cryptocurrencies overall and curious about the answer to the question: are they in a bubble?
Why did attendees want to know the answer to this question? One woman I spoke to works in technical sales for FactSet, a company that produces financial reports similar to Bloomberg. She commented on how cryptocurrencies such as Bitcoin are being talked about more and more, and companies are trying to understand more about them, yet companies like Bloomberg and FactSet don’t list any cryptocurrency prices.
One of the important aspects of Matthew’s presentation covered where cryptocurrencies derive their value. It’s important to establish what makes tokens like Bitcoins and Ether valuable if we want to understand whether or not they are overvalued. Cryptocurrencies are like fiat money, in that they are currencies that are not backed by a physical commodity, such as gold. That is where their similarities end. Fiat money is issued by a central bank and other banks act as a third party for people like me and you to pay each other.
Cryptocurrencies exist in the Blockchain (if you need a quick and simple explanation, this analogy explains it quicker, and better than I can at the moment). Also, the video below has become quite popular and was highly rated on Hacker News as being one of the best explanations of blockchain:
While there is (very technical) human involvement in creating a cryptocurrency, anyone can mine those tokens, and once you obtain a token, you can give/sell that token directly to anyone else, peer to peer, over the internet without the involvement of a third party such as Bank of America or Venmo. This is what people mean when they say it is “decentralized.” The value of the currency is somewhat based on people’s belief that the currency is worth something.
So, anyone can just make up a cryptocurrency and make a lot of money selling it? No. First, as I pointed out, people must believe it’s worth something, secondly, it must be legitimate. Here are a few points that reflect what Matthew pointed out, but I got a bit more detail from a Quora answer. A legitimate cryptocurrency:
- On the blockchain — It is pretty much a scam if the currency is not on the Blockchain.
- Has a business model — You can read more about the business model in the white paper the cryptocurrency releases. If it seems like bs, it is likely bs.
- Solves a big problem — This can also be found in the white paper. Again, if it doesn’t make cents it don’t make dollars, err…tokens.
- Has a target audience — We didn’t go too much into this one in the presentation.
Another thing that makes currencies like Bitcoin valuable is the fact they are limited. A central bank can continue to issue new money indefinitely, which would cause inflation. There is a limit to the number of Bitcoins that will ever exist, which in theory controls for inflation. This is partially why we see the price continue to increase. The way it was explained best parallels with NYC taxi medallions. There is a finite number of taxi medallions to operate a taxi within NYC. As a result, the price of owning an actual medallion has skyrocketed over time because of the economics of having something of value in high demand in very limited supply. While we all know Uber disrupted that industry, it is still very early days for Bitcoin and other cryptocurrencies. Early and wild, like the wild, wild West.
Bubble Bubble Boil and Trouble
A critical aspect to Matthew’s presentation was defining what is a bubble in the first place. Bubbles are usually marked by rapid escalation and fueled by speculation. We see new legitimate cryptocurrencies every day and many scam ones as well. We’ve also seen the 21st century version of a bank robbery with the hacking of DAO in June. A lot of the signs point to us being in a cryptocurrency bubble, but Matthew pointed out that doesn’t mean that each individual cryptocurrency is in a bubble. He pointed out that you could make an argument that Bitcoin isn’t in a bubble because when you look at factors such as:
- Market share compared to other currencies
- Number of developers compared to other currencies
- It’s popularity (one faith the currency has value)
- Being of finite quantity
Here Is Where Things Get Interesting
As I mentioned before, it is still very early in the world of cryptocurrency and we’re starting to hear see the beginning of regulation coming in. As we continue to see volatility in cryptocurrencies and with most experts in agreement that we are in a cryptocurrency bubble, regulation is becoming more important to governments and cryptocurrency communities. While this wasn’t a big part of Matthew’s presentation, he did a great job answering questions about regulation.
When you give a bank your money, there is someone regulating the banks to make sure they don’t rip you off. If they do, they can be fined, and in somewhat rare cases someone goes to jail. There are all sorts rules, regulations, laws, licenses, and more around banking. Matthew used to work at Venmo, where he learned about the laws in each state that Venmo has to comply with in order to operate within the US. With cryptocurrencies, local governments are starting to get involved. The State of New York requires businesses to obtain BitLicense in order to buy and sell tokens within New York.
Coin Center (one of the leading websites on cryptocurrency) recently created a State-by-State Regulatory Tracker for Digital Currency Policy — an interactive tool that helps you track “how current state money transmission law applies to digital currency activities, as well as the different state legislative and regulatory efforts aimed at digital currency.”
Remember how I mentioned DAO earlier in this article? Well, someone hacked DAO and made off with millions of dollars worth of tokens. Those who had tokens with DAO lost those tokens and will never receive them back. If someone robbed a bank, or committed fraud, there are regulations that penalize the bank for not protecting your assets. On a Federal level, we don’t have any of those regulations yet, which is why some state governments, like New York, have stepped in to try to self-regulate. The SEC did an investigation into the DAO hacking, and put everyone on notice that in the near future, cryptocurrencies would be under the same regulation as securities. What that means is no one was fined or jailed, but that could happen in the near future.
Inquiring Minds Want to Know
One of my questions to Matthew was how long before that regulation would kick in. Like any responsible lawyer or researcher, he wasn’t going to try to predict an exact number. However, when I asked him if it would be within the next 5–8 years, he replied yes. Or that it possibly could be coming even sooner. While the SEC managed to do research on the hacking that impacted DAO, given there is a high demand on people who understand and have experience working in cryptocurrency. I wonder if the government can get enough resources to regulate cryptocurrencies to the same level they regulate securities. Regardless, some cryptocurrency funds and individuals are doing their best to comply with the laws that govern securities now so when there is a crackdown they can show they tried to comply in good faith, given it wasn’t always clear what complying means.
Other attendees asked related questions around regulation, with regards to the news this week that China’s ICO ban. Similar to what many in the community are saying, Matthew thinks this isn’t a death nail for fintech in China. While the DAO example is about legitimate coins being stolen from a cryptocurrency fund, what China is trying to do with its ICO ban is slow down the frauds and scams for illegitimate cryptocurrencies. And there are a lot of scams out there. Think about when we were in the “great” TY Beanie Baby bubble of the 90s. People were spending hundreds and thousands of dollars on Beanie Babies. Inevitably, people started making fake Beanie Babies, including the much hyped Princess Diana Beanie Baby to take advantage of the trend. The same thing is occurring with cryptocurrencies. Bitcoin and Ethereum are reputed currencies, however, for those who are brand new to the world of Blockchain and cryptocurrency (and some who aren’t so new but maybe not so cautious), the market is ripe for frauds.
The Tax Man Cometh
Scams aren’t the only legal issue facing cryptocurrency. One of the audience members asked if taxes need to be paid on cryptocurrencies, and how are they taxed. It turns out they are taxed like property, however, many people opt not to report their tokens at all. In 2015, only 802 people filed a 8949 form with the IRS regarding their Coinbase profits. The IRS realizes most people aren’t reporting their tokens, but what was revealed next shocked me a little. The IRS asked Coinbase for their customer account data in an attempt to find everyone who hasn’t been paying their taxes on their tokens. Coinbase declined, lawyers got involved, and ultimately, Coinbase did not hand over the information to the IRS.
Several people had specific questions about buying tokens. The best advice was make sure to read the white paper to determine if their business plan makes sense and what problem they are solving. One person specifically asked if they should diversify the cryptocurrencies they buy in order to help hedge against risk. While none of these currencies are risk-free, your purchasing strategy should be based on your risk tolerance. While Matthew’s company Digital Asset Research does not promote any cryptocurrencies or participate in any ICOs, he did point out currencies that have been vetted in the fields of having a good business plan, solving the right problems, number of developers mining those coins, and peoples’ faith in the currency, Bitcoin and Ethereum can be less risky than some of the brand new cryptocurrencies coming to market now.
What Should I Takeaway From This?
In summary, while cryptocurrencies are likely in a bubble, that doesn’t mean every currency is in a bubble. Very importantly, do your research on any currency you intend on buying. The behaviors we are seeing now show why regulators are stepping in. I really enjoyed Matthew’s talk and the examples he gave when answering questions. As someone who is very new to Blockchain and cryptocurrencies, the amount I learned at this event was like drinking from a firehose. If this was an intense read for you, you’re not alone. I had to do research even after attending this event to understand some of these concepts enough to explain them to other people. There are some good resources for you to start learning more:
- Sign up for cryptocurrency newsletters
- Listen to Blockchain podcasts (my personal favorite)
- Read the white papers to understand where these currencies are deriving their value
- Medium articles (I ran into several useful articles that breakdown the concepts into something relatable)
- Digital Asset Research’s Digital Assets 101