A growing number of investors and financiers have begun to warn about the possibility that bitcoin has entered bubble territory. As a result, when the price of bitcoin fell abruptly on Wednesday, it would have been tempting to conclude that they were right.
Bitcoin opened the day at $9,908. It then spent the morning climbing higher before topping out at $11,377. However, over the next few hours, it plummeted, dropping to $9,290, an 18% fall. By the end of the day, the cryptocurrency had recovered to $10,230.
Data source: Coindesk.com.
Given the late recovery in bitcoin, it can't be said that the bubble burst today. After all, it eclipsed the $10,000 threshold for the first time ever. Yet, it would be a mistake to ignore what happened in intraday trading. What today showed is that bitcoin's price can drop just as quickly as it can surge.
The allure of bitcoin
Talk to anyone in the tech industry and they'll rave about the technology underlying bitcoin, which is not only important but valuable. I'm referring to blockchain, a so-called distributed ledger.
By leveraging blockchain, bitcoin users can cut out the middleman when making a payment. If you want to transfer bitcoin to me, you don't need a bank or payments processor to do it; you can just transfer it directly to me by way of blockchain, which will record the transaction.
Image source: Getty Images.
Take this explanation from Marc Andreessen, co-founder of venture capital fund Andreessen Horowitz:
Bitcoin gives us, for the first time, a way for one Internet user to transfer a unique piece of digital property to another Internet user, such that the transfer is guaranteed to be safe and secure, everyone knows that the transfer has taken place, and nobody can challenge the legitimacy of the transfer. The consequences of this breakthrough are hard to overstate.
What kinds of digital property might be transferred in this way? Think about digital signatures, digital contracts, digital keys (to physical locks, or to online lockers), digital ownership of physical assets such as cars and houses, digital stocks and bonds ... and digital money.
All these are exchanged through a distributed network of trust that does not require or rely upon a central intermediary like a bank or broker. And all in a way where only the owner of an asset can send it, only the intended recipient can receive it, the asset can only exist in one place at a time, and everyone can validate transactions and ownership of all assets anytime they want.
But is bitcoin a good investment?
Despite these benefits, it's important to appreciate that just because Silicon Valley is enamored with the technology underlying bitcoin doesn't mean that bitcoin itself is a prudent investment. This is especially true at bitcoin's price today, which has climbed more than tenfold since the beginning of the year.
Just looking at a chart of bitcoin makes it hard to deny that the cryptocurrency has entered bubble territory. Few assets that I'm aware of can climb so far so fast without an underlying catalyst that boosts the valuation of the underlying asset.
Data source: Coindesk.com. Chart by author.
The implication is that speculators are influencing the price of bitcoin right now, not bona fide users of the currency. And in a speculative market, what goes up can just as quickly fall back down.
One thing that could ring the death knell for bitcoin, in fact, is one of its major features. Namely, because there doesn't need to be an intermediary such as a bank or payments company in a bitcoin exchange, it offers a convenient avenue to launder money, which has become virtually impossible to do through a bank.
"Bitcoin is successful only because of its potential for circumvention, lack of oversight," said Joseph Stigliz, an economics professor at Columbia University and former winner of the Nobel Prize in economics. "So it seems to me it ought to be outlawed."
Warren Buffett has echoed similar concerns: "It doesn't make sense. This thing is not regulated. It's not under control. It's not under the supervision [of] any... United States Federal Reserve or any other central bank. I don't believe in this whole thing at all. I think it's going to implode."
Stiglitz agrees: "It's a bubble that's going to give a lot of people a lot of exciting times as it rides up and then goes down. ... If the government says 'the reason bitcoin is being used is circumvention,' they could close it down at any moment. And then it collapses."
So, in conclusion, no, the intraday drop in bitcoin's price on Wednesday does not mean that the bitcoin bubble has burst. But it does provide a prelude of what an actual collapse might look like.
