Introduction
We’re going to take a look at the variety of cryptocurrencies now in the market, what has been happening to their valuations, what the future may hold and how one might go about valuing them. We will also consider how human behaviour and government action can rapidly increase or destroy the value of cryptocurrencies.
Please note that this article does not include financial advice and we are not financial advisors. In fact, you may find it very difficult to discover financial advisors who would recommend investing in cryptocurrencies. That is because of the nascent nature of the industry, the huge valuations of many projects, a large number of which do not have a working product, some of which will be scams, and the likely failure of many of them. It’s certainly necessary to undertake your own due diligence before investing and best not to invest more than you can afford to lose.
Bitcoin, Blockchains and Distributed Applications
Let’s start with Bitcoin. Originally, with the creation of Bitcoin, many people hoped that a new currency, not run by governments, the supply of which could not be increased and debased without the knowledge and consent of the community, had been created. Since then, with the creation of new blockchain forks like Bitcoin Cash, and in particular because of new blockchains like Ethereum, and Neo, which allow applications (which create their own cryptocurrencies) to be built on top of the existing blockchains, there has been an explosion in the number of cryptocurrencies.
Blockchains like Bitcoin seemed to offer a potential alternative to national currencies. In contrast, many of the most recently created cryptocurrencies, built on the back of blockchains, could occupy only relatively narrow market niches even if they succeed. They would never become generally used currencies.
Some people refer to both blockchains and supported applications as Decentralised Applications (DApps), although others seem to refer to supported applications only as DApps.
The Mania
The current manner in which many people appear to be throwing money at projects that contains the word “blockchain” appears similar to what happened at the turn of the century during the “.com” (dot com) craze as internet use became widespread. It seems amazing now, but at the turn of the century, just adding .com to the name of a business, or suggesting it was undertaking something related to the internet, could inflate company valuations dramatically. Dot com companies were often launched on the back of Initial Public Offerings (IPOs) instead of Initial Coin Offerings (ICOs). Of course, some of those dot com companies did become huge successes. Using the word blockchain now is getting many people’s blood running hot just like the words dot com used to.
The Difference Between the Dot Com Craze and the Blockchain Era
What are the differences between what is happening with blockchain and the dot com craze? The dot com craze came and went as a part of one boom and bust business cycle. Blockchain technologies have already had more than one peak and collapse, although all within a period of only a few years, and still within one business cycle lasting from the launch of Bitcoin in 2009 until now.
The dot com craze was based on the hope that huge numbers of people would turn to the internet to get their goods and services, that there would be large increases in productivity, and that new markets would be created. In fact, while there were enormous gains as a result of the internet, many of them took longer than expected to come to fruition. Hope exceeded reality in the short term, as is often the case.
The key dot com concept was about moving transactions and services online, but using bank controlled existing national currencies (legacy currencies) such as dollars as the medium of exchange.
Banks are legally permitted to be able to create new legacy currency units out of thin air. However, the fact that banks can do this, the amounts of currency that have been created, and the impact of this on the population, are not known by the large majority of people. This is probably because the process is obscured by the terminology that is used, and the way in which it is recorded and reported (or perhaps not recorded and reported in some cases). Furthermore, another challenge with legacy currencies is that individuals and organisations other than banks can sometimes also create it out of thin air by copying printed money, and manage to use those copies to buy goods and services. Whenever anyone or any organisation other than a private or central bank creates currency out of thin air, it is considered to be counterfeit and illegal.
In contrast to the dot com concept, the blockchain idea is about enabling transactions and information exchange to take place with certainty about the validity and timing of those transactions and in currencies specific to the blockchain or application being used. Blockchain currencies are not controlled by banks, and consequently the volume of them is known. It does not appear possible currently to debase cryptocurrencies through the creation of additional currency units, without everyone immediately becoming aware of the fact. Blockchain technology has also created a new way of raising money for new business ventures via ICOs.
If the dot com era is any guide, the explosion of new businesses trying to carve out a portion of the blockchain market will ultimately result in a few spectacular successes of the Amazon and Google type, but with many new blockchain businesses vaporising, many existing businesses adapting to use the new technology, and many businesses that do not integrate blockchain within their businesses in the areas that make a real difference eventually being out-competed. Use of the word “blockchain” will, we expect, over time, be subsumed within regular business operations, and companies will go back to promoting what they are delivering, rather than how they deliver it.
The Future of Bitcoin
What about the future of Bitcoin? Will it survive and thrive? Perhaps. Major challenges with respect to blockchain projects like Bitcoin currently include transaction speeds and escalating mining costs. The Bitcoin community is trying to adapt to meet these challenges. Even if it is not the very best technology, perhaps Bitcoin can still remain as number 1, due to its greater existing adoption, and as long as it is good enough relevant to the competition. Perhaps Bitcoin could take up the mantle as the “Kalashnikov” of blockchains because it is seen as more rugged, robust and reliable in the face of hacking attempts. In contrast many other blockchains may be seen as more sophisticated, but more likely to encounter operational and security problems. It also seems possible however, that Bitcoin becomes obsolescent, and sinks beneath the waves as new and better forms of blockchain technology sweep over it.
Cryptocurrency Valuations
Ultimately, the value of a cryptocurrency, depends, as for any other currency, on confidence. Confidence that someone else will accept it in exchange for goods and services. Previously we have suggested that the mining price might be a price support level, however that still depends on confidence existing. Confidence will, among other things, depend on the currency not relying on obsolescent technology. In addition, each time a new version of a blockchain like Bitcoin Cash is spun off, that arguably inflates the total supply of currency units related to that type of blockchain. Potentially that could undermine confidence in it.
It may be helpful when attempting to value a cryptocurrency to consider:
- How much the entire target market being considered is worth
- How many competing currencies there are among which to divide the value in that market
- How much of that market value could potentially be represented by the cryptocurrency in question ie what could be the market share represented by that cryptocurrency
- Dividing that market share value by the number of units of that cryptocurrency that are available, in order to get a value per crypto coin/token/unit
It’s also important to consider whether there is anything preventing thousands of additional cryptocurrencies successfully competing in the same market space, including factors such as any first mover advantage. In other words, to consider whether there are market entry barriers. If not, the cryptocurrency in question could rapidly go to zero value, or fall hugely in price.
There are other potential value indicators you will find posted on many crypto analytical websites with respect to factors such as cryptocurrency trading volumes, the level of activity in the developer community, and the rate at which legacy currency units like dollars are being increased.
Some commentators warn about the use of trading volumes as an indicator of value on the basis that “whales” ie a few large volume owners of particular crypto coins, may sell coins back and forth between them to create the illusion of trading volumes and in order to draw in more investors and raise the price. The whales are then able to dump the coins, cause a crash in the market price, and subsequently buy back the coins later when everyone has been panicked in to selling. In the process harming smaller investors and enriching themselves.
Human Behaviour and the Difficulty of Reacting to Crypto Price Collapses
There has, as indicated, already been a number of steep climbs and collapses in the value of blockchain valuations. Human behaviour dictates that as the price of any asset climbs rapidly, lots of new people rush in and invest just because of the price rises, thus causing a feedback loop and an asset bubble. Then, of course, the bubble eventually pops, and lots of people get financially burned. It’s not clear how many more blockchain bubbles and crashes we may have.
We think that it’s useful to remember not only that bubbles can burst, but also that, unlike stock markets, the cryptocurrency markets never sleep, and that prices can fall like a rock once they start falling. So, if there is a massive crash while you sleep, you could wake up to find your crypto holding decimated. Even if you are not asleep, prices can move so violently that you may not have a chance to react if eg you are working on your regular day job while prices are collapsing. Some people may attempt to use automated systems for trading in order to help them attempt to reduce this kind of risk.
Potential Government Intervention
Currently, cryptocurrencies are a relatively small market compared to the global financial system. However, if, over time, the majority of people start trading in cryptocurrencies and not legacy currencies like USD or sterling, governments may want to take control of the supply of cryptocurrencies.
It may not be possible for a government to completely stop a cryptocurrency from being used. However, if a cryptocurrency is made illegal it would probably prevent the majority of trade in it. Consequently, government intervention, especially if coordinated regionally or worldwide, could result in the collapse of the value of a particular cryptocurrency.
Knock-On Effects From The Bond and Stock Markets
It’s best also to be aware that a number of commentators have stated that the bond and stock markets in many countries including the USA are now in very large bubbles and are ready for collapse as a result of massive central bank currency creation which has been used to buy up financial instruments (also known as quantitative easing). Cryptocurrencies have not gone through a full business cycle and it is not clear what would happen to them in this event. It may be that the best ones could still prosper over time, but that the majority might also collapse due to a general loss of confidence in financial markets.
Conclusions
The cryptocurrency market is arguably at a gold rush stage with the number of blockchains, and the number of distributed applications which sit on the back of them in particular, exploding in number. Projects often have huge valuations based mainly on hope about price rises. Only an extremely small fraction of the population has any stake in the crypto market at this time however, and mass adoption of the technology seems to be on the way. Consequently, there appears to be both very significant opportunities, and very significant risks involved.
Attempts could be made at crypto valuations at this time, all of which would be based on a set of assumptions which may include factors such as the total actual or prospective market size, possible market share, and the percentage of that market share that people are prepared to transact value in using a specific cryptocurrency.
Because of the evolutionary arms race that is now in progress, it seems possible that highly valued cryptocurrencies one month may collapse in price quickly, or conversely, that unknown cryptocurrencies may rocket in price out of nowhere in short timeframes. Consequently, long term projections about the success of particular cryptos may be best avoided. Possible indicators in the short term might be general market sentiment and what is happening elsewhere in terms of what governments are doing with respect to the bond markets for example, as that may affect currency flows in to, or out of, very high risk assets like cryptocurrencies.
Market sentiment, and government financial policy, can change extremely rapidly however, so look out if you choose to get involved in the crypto space. If you do get involved, it’s best to be aware how rapidly collapses can happen, to consider if you can react to them fast enough, and if you are prepared (and financially able) to lose all your invested money, even while hoping for success.