The big new thing isn’t going to replace the boring old thing that’s been around forever. Ever.
Market bubbles are often based on “new paradigm” thinking – like a new concept or technology that’s considered revolutionary and with unlimited profit potential. But as prices keep rising, and paper fortunes are made, the mania takes on a life of its own. Business realities are forgotten, and getting rich on soaring prices is all that matters. Before long, the mania subsides, and prices fall – often dramatically.
The price surge of cryptocurrency bitcoin from US$215 last summer to a high of US$763 earlier this summer is an example of this kind of new paradigm thought. Bitcoin fans envision unlimited use of the digital currency, and unlimited profits for investors. They view it as the “gold of the digital era” – a safe haven for people to park their cash when the financial world is in turmoil.
(Bitcoin is digital money that is created and held electronically. At the core of bitcoin technology is a kind of super database called the “blockchain.” The blockchain is public and accessible to anyone, just like the internet. It allows anyone with internet access to make a financial transaction without the need for a middleman, like a bank.)
The latest bitcoin bubble may have popped
Previously we discussed how the third, mania phase of a market bubble eventually tips over into the fourth “blow-off” phase, where all the gains are swiftly erased and paper fortunes vanish. Bitcoin has fallen 24 percent from its June 16 high (we flagged the inevitability of a decline in bitcoin at around the same time). The blow-off appears to be underway, with much lower prices likely.
And one of the more recent catalysts was last week’s news that hackers stole about US$70 million worth of bitcoin from Bitfinex, a Hong-Kong based bitcoin exchange. Now a new, more realistic narrative may be driving bitcoin. Bitcoin is a speculative trading phenomenon. It’s not a legitimate alternative currency, and – besides its hacking problem – there are many obstacles to its widespread adoption.
The argument for higher bitcoin prices goes something like this: Similar to personal computers in the ‘70s and the Internet in the ‘90s, bitcoin is a disruptive technology that is just now going mainstream. Its use as a safe-haven currency will surge as global investors abandon paper currencies and seek alternatives. Because of bitcoin’s small market size, the tsunami of money chasing bitcoin will drive the digital currency’s price into the stratosphere.
It’s the “bitcoin as the gold of the digital era” narrative.
Bitcoin is not going mainstream any time soon
On the same day news of the US$70 million hack/heist surfaced, global investment bank Credit Suisse released a 135-page report on bitcoin, and its underlying blockchain technology. It noted 13 barriers to bitcoin becoming a mainstream currency and that it will remain a small player. In other words, bitcoin’s upside is not unlimited.
Credit Suisse also noted that the really disruptive thing about bitcoin is the underlying blockchain technology. It has legitimate promise – but in uses beyond bitcoin.
This doesn’t bode well for bitcoin’s price and its US$9.2 billion market value. The last time the bitcoin bubble burst, bitcoin fell from US$1137 in November of 2013, to US$310 a year later – a drop of 73 percent.
The biggest barriers to bitcoin going mainstream and becoming a “new paradigm” include:
- Extreme volatility. In U.S. dollar terms, bitcoin is 11 times more volatile than the British pound and 3 times more volatile than oil. Anything that volatile is not a reliable payment method or store of value.
It’s also way more volatile than gold – the classic “store of value” commodity. Gold prices are also volatile, but as shown on the chart below, gold’s price swings are like flat grasslands compared to bitcoin’s Himalayan peaks and valleys. This kind of bouncing around will discourage mainstream investors from getting involved with bitcoin.
- Regulation. Anything that becomes really popular and that involves money eventually attracts the interest of government regulators. So, as bitcoin gains more users, expect countries like the U.S. and China (where cryptocurrencies like bitcoin are used to illegally move money in and out of the country) to crack down on its use, or regulate it to death.
- Perceived security risk. The recent news of hackers stealing 119,756 bitcoins (US$70 million) in Hong Kong validates this concern. Anything connected to the internet is vulnerable to a cyber attack. And even though the hackers stole from traders’ accounts, and not the underlying blockchain, the general public will not understand the difference. All they will think is that bitcoins can be stolen by hackers.
If bitcoin is to rival Visa and MasterCard as a vehicle for financial transactions, or if it is to become a digital safe-haven currency like gold, it will have to build significant trust with users and investors. And it can take decades to build up that trust. Credit cards did not gain widespread acceptance overnight.
Gold has been used as a medium of exchange and a storehouse of value for thousands of years. Gold is tangible – it can be held in your hand, or hidden in your closet. Gold can’t be destroyed. Though a bit more is mined every year, the supply of gold is relatively finite, unlike paper money which can be continually printed. Humans have a long history of trust in gold.
In contrast, the trust factor for bitcoin is based on something else – technology. While tech enthusiasts may have faith in the arcane math of the blockchain, only a tiny minority of the world’s population could explain bitcoin technology in detail. It’s hard to have confidence in something you can’t understand or explain.
So the great new era of bitcoin probably isn’t happening. While the underlying blockchain will likely lead to revolutionary technologies, bitcoin won’t be disrupting Visa or Western Union anytime soon. And when global investors need a safe haven currency for their money in uncertain times, it will likely be the yellow metal they buy, not a digital version.
For more on the case for buying gold, click here for your free copy of our latest gold report.