This is how the bitcoin bubble will burst


Bitcoin is going to the Moon – again. Twelve years after its launch at the hands of pseudonymous coder Satoshi Nakamoto, the original cryptocurrency has been skyrocketing in price to unprecedented heights.

After starting 2020 at about $8,000 a unit, and slumping to just over $5,000 in March, the decentralised digital currency has been on a roll since mid-December. On December 16, exchanges priced bitcoin at $20,632, an all time high; since then, it has kept growing, amid new peaks and the occasional trough: at the time of writing, you can buy or sell one bitcoin for $41,000.

We’ve been here before. Back in 2017, bitcoin – and crypto at large – grabbed headlines as the fledgling sector ballooned into a distinctive bubble (or, for the more sophisticated, tulip) shape. Fuelling that rise was a frenzy surrounding a new cryptocurrency-based crowdfunding method called initial coin offering or ICO, in which self-styled startups funded their future projects and apps by peddling to the public “tokens” of cryptocurrency, which would supposedly provide services once the projects were built.

In fact, many of those startups never built any projects – and most of those tokens ended up being traded and speculated upon at swingeing prices on unregulated online marketplaces. Bitcoin, which – alongside fellow cryptocurrency Ethereum – was often used to purchase the tokens, became in very high demand. In late 2017, it established its then-record price of $19,783, before crashing down and staying there for a while. (Several ICO promoters would later be prosecuted by the US Securities and Exchange Commission, which opined tokens could be classified as unregistered securities.)

Are we in for a 2017 redux? Is this just a bigger bubble, barrelling towards a louder pop? Predictions are always hard, but the current situation is different from 2017. Where that crypto boom bore all the hallmarks of manias – a novel, little-understood technology, unrealistic promises of endless revenues, scores of small-time investors burning their savings – this rally has a much more muted tone. Even at $41,000.

“There’s a lot less heard-about-it-for-the-first-time mass retail rush to kind of be the first on the edge of something,” says Lex Sokolin, global fintech co-head of blockchain company Consensys. Just look at the Google search data, he says. In 2017 huge numbers of people were desperate to join the bitcoin gold rush. Now, not so much. While that is hardly scientific evidence, it evinces a real shift: this time it is not inexperienced retail investors – your neighbour, your aunt, your running buddy – who are buying bitcoin. More and more, it is the financial bigshots.

Bitcoin is going institutional. Corporates including cloud-based services MicroStrategy, and hallowed insurer MassMutual – besides funds such as former star-crossed Trump aide Anthony Scaramucci’s SkyBridge Capital – have all gone big on bitcoin. Between 2019 and 2020, crypto-focused hedge funds – which only invest in digital currencies, bitcoin the foremost among them – doubled their assets under management from $1bn to $2bn, according to an analysis by accounting company PwC and financial firm Elwood. The cryptocurrency that started its existence as an anti-establishment tool to avoid government detection and oil the cogs of dark markets is now being embraced by financiers.

This comes straight after major fintech companies like PayPal and Robinhood made it easier to purchase bitcoin, and on the heels of a breakneck regulation drive, chiefly in the US. In July 2020, the Office of the Comptroller of the Currency (OCC), an independent bureau of the US Treasury in charge of federal banking regulation, announced that all chartered banks could provide “custody services”, in other words keep their clients’ bitcoins safe in their storage devices; last week, the OCC also announced that banks would be allowed to partake in a blockchain network – the digital infrastructure where cryptocurrencies are exchanged – and even settle some payments in digital assets called stablecoins.

“If you actually abstract away from the substance of the regulation, what is a positive sign regardless, is that regulators are spending time and effort and brainpower on this,” Sokolin says. “Just that forward momentum, I think, to institutional investors, signals that this is here to stay.” Parallel to that, authorities are coming down hard on anonymous transactions – the kind bitcoin was supposed to abet – imposing or threatening to impose new know-your-customer rules on exchanges that sell users crypto for state-backed currency like dollars or pounds. Bitcoin and crypto are being domesticated and given a new sheen of legitimacy.

More interest from institutional investors means two things for bitcoin: the volumes bought are usually higher than when man-of-the-road investors trade; and those volumes are more prone to stay put – making the supply of circulating bitcoin scarcer, and therefore hiking the price. A report by Chainalysis, a blockchain analytics company that tracks cryptocurrency movements, suggests as much. In December 2020, purchases of bitcoins from exchanges for sums lower than $10,000 fell by 22 per cent, whereas buys for sums over $10,000 and over $1 million – more likely to have been carried out by large investors – grew by nine per cent and 32 per cent respectively. “Retail investors were either less involved in this rally, or at least have so far kept their bitcoin on exchanges, while large investors increased buying and taking their bitcoin into their own custody,” the Chainalysis report explains.

The report also suggests that bigger investors sucked out liquidity from the market, buying bitcoins from traders and keeping them under lock and key – “hodling” them, in crypto-lingo . When these larger investors sold their bitcoin, they usually charged higher prices. “New investors are having to offer prices that make it attractive for older investors to sell,” the report concludes.

This is only part of the story. Bitcoin’s price was bound to rise in 2020, by dint of a sheer technical fact: the so-called “halvening”. That is an automatic process by which the output of bitcoins produced by miners – individuals who run expensive computers to upkeep the currency network and get paid bitcoin rewards – every ten minutes was halved starting from May 11, 2020. One consequence of the attendant scarcity is a rise in price. “After every halving, the price usually increases,” explains Fiorenzo Manganiello, a venture capitalist and a professor of blockchain technologies at Geneva Business School. “That is a key event.”

And then there’s the pandemic. Bitcoin has long been proposed as a “safe haven” asset: one that is not issued by a central bank and it is therefore sheltered from the macroeconomic vagaries of the material world. That was always attractive to a certain crowd – libertarians, anarchists, goldbugs – but the triumph of chaos and despair also known as 2020 must have convinced many that it was worth giving it a try. “Let’s lump it all together: the confederates with guns in the Capitol, the propaganda machine out of the White House, the pandemic – that erodes confidence in the crown of the sovereign,” Sokolin says.

One consequence of the pandemic has been a lot of government spending, which made it a no-brainer, for many, to put at least some money in bitcoin. “Due to the macroeconomic situation – low to zero interest rates, excessive money-printing, stimulus programs and massive government interventions due to Covid-19 – the outlook for most economies looks quite unstable and more and more institutional investors are looking for alternative ways to diversify their portfolios,” says Marc P Bernegger, a cryptocurrency investor and board member of Swiss-based financial firm Crypto Finance AG. In some quarters, Bitcoin is now regarded as a genuine competitor of gold – to the extent that J.P. Morgan said this week that it could win over gold, and rise to a price of $146,000.

Is that really going to happen? Some factors could indeed push the price higher. The market is not mature yet, and as more investors join, the price might rise. “What is going on is increasing the pressure on other institutional investors to come in,” says Patrick Murck, an expert in digital finance and an affiliate with the Berkman Klein Center at Harvard University. “It feels like we’re early in that process.” The inauguration of a new administration in the US might also have an impact. Joe Biden is hardly putting bitcoin near the top of his list of priorities, but Murck says there is an expectation for the incoming president to “take a harder look” at technology and fintech, which might include crypto. “There might be more regulation coming,” says Murck. “But more regulation is not a bad thing – it could actually increase confidence in the market.”

Other relevant dynamics will be internal to the decentralised bitcoin community. Notably, miners are currently grappling with delays in the manufacturing of mining computers, which might drag on for months. Once those shortages are sorted out, the sudden inflow of new machines and new competitors will make the process less profitable for miners. According to Manganiello, the Geneva academic, miners will likely respond by holding rather than liquidating the bitcoin they create, in hopes of further boosting bitcoin’s price and increasing the value of their shrunken rewards.

That is not to say that there are no ways for the price to come crashing down. Several observers think that the ongoing rally is at least partly due to algorithmic cryptocurrency funds abiding by a trend-following strategy – and in so doing inflating the price to implausible levels. Some suspect foul play: Nouriel Roubini, a New York University professor and bitcoin-sceptic, has singled out Tether – a privately-issued cryptocurrency that is supposedly pegged to the dollar and can be used to buy bitcoin – as a manipulative force propping it up. (Philip Gradwell, a senior economist at Chainalysis argues that the data suggests the opposite. “In the current rally, less Tether flowed into exchanges relative to bitcoin than normal, suggesting the current market is driven by fiat [state-backed money] buyers, rather than Tether,” he says.)

More in general, a change in strategy from key institutional investors could certainly lead to corrections. J.P. Morgan suggests that if the mammoth Grayscale Bitcoin Trust, a crypto investment company that holds three per cent of bitcoin currently in existence, reduces the amount of bitcoin it buys every month (right now it is $1 billion) then the cryptocurrency’s price will inevitably change.

Finally, one might wonder whether a partial solution to the Covid-19 crisis – whenever that happens – would lead bitcoin-loving investors to move their funds elsewhere. For Sokolin, that is a distinct possibility. “Yes, you may have a price decrease if it appears that the apocalypse hedge is worth less, given that the apocalypse is less likely,” he says. But he also reckons that that decrease would not be significant, and that what is happening now is probably “a permanent shift”.

Gian Volpicelli is WIRED’s politics editor. He tweets from @Gmvolpi

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