I am a crypto enthusiast and I believe blockchain is here to stay.
Yet, I believe there is a huge problem building up within cryptocurrency market and there will be an eventual Big Short opportunity looming around. I will try to explain briefly why I think as such in this post.
First, look at the coinmarketcap.com global chart. The chart that you need to look at is BTC dominance. Some things are evident in this chart.
- BTC dominance is falling.
- Altcoins with big names tend to rise fast and fall slowly, in terms of dominance(share of the total market cap.)
- Altcoins that are grouped together as 'Others' continue to gain dominance, as a group.
We have to ask and answer some questions along the road to explain why we'll have a bear market around.
Let's start with the obvious: why is BTC dominance falling? It's because we are having more and more altcoins that seem promising. Although BTC market cap increased a lot, other never-seen-before coins have risen even more.
Another not so obvious: why big-name altcoins rise fast and fall slowly? It's simple, really. They rise fast because of big promises and fall slowly because people aren't recognizing that's just a promise fast. If you are somewhat versed in financial economics, you'll know that to have an efficient price you must be able to short assets. Otherwise, there must be a bubble.
Let's explain why it's like that quickly for those who aren't familiar with the Efficient Market Hypothesis. You buy an asset when it is cheap relative to your valuation, and sell when it is expensive. Market price is efficient because all of our private valuations gets accounted for in that price. But when shorting is impossible, some of this private valuation doesn't get accounted for. If you believe that an asset is overpriced but you don't own that asset, then obviously you don't buy. You'll want to sell, but won't be able to. Your 'overpriced' opinion is systematically ignored by market price because short selling is impossible. What does that imply? A bubble, of course.
How does it relate to dominance time series of big-name altcoins? They aren't easy to short. Their price is too high. People bid up quickly to overpriced levels because there is no one to short. The price goes up until there's nobody left to buy - the worst fool has paid dearly for his stupidity at the peak. When there's nobody left to buy, the price stays at that level... That is until people start changing their mind and want to take profit. This is a slow process, as there are psychological biases like endowment effect and confirmation bias. This is why you see the rise-fast-fall-slow pattern in altcoins.
Let's tackle the third point now. Why do 'Others' continue to rise, to almost 25% of total market cap now? When you really think about the previous point, the answer is obvious. There are so many alts that pump with rosy promises and eventually let down investors - in other words, they rise fast and fall slowly. Because we aggregate, individual fluctuations cancel out, and we're left with relatively stable patterns. When the rate of the occurrence of new pumps falls, the speed of increase in the dominance of 'Others' is reduced, so we no longer see the rise-fast-fall-slow pattern in the aggregate. As for the higher lows, it's because we are getting more of new currencies and pumps.
So we got a glimpse of broad market conditions. Now we can start the juicy part.
Why do we have bear market ahead?
For starters, we are going to see more and more of 51% attacks. Why? It's a simple exercise of comparing cost and benefit. I took time to explain the Efficient Market Hypothesis and why it does not hold on the crypto market, and for a good reason. Altcoin prices stay too high for too long, relative to what they should be priced as in an efficient market, because it's impossible to short them. You stand to gain profit by stealing and selling them. What is the best way to do this? Launch an 51% attack. In an efficient market you won't do this because the cost of launching such an attack is going to be factored into the price and push the price of a currency down, making the attack unattractive from economic standpoint.
Why now, not before? Because we are in sideways/downside market. Holding cryptos aren't bringing those crazy returns anymore. We had bubbles from being unable to short before, true. But the expected return from simply holding crypto was much higher. At almost 1% per day - it was really something, a madman's craze in retrospect. Why would anyone have launched an attack and ruin the party back then? But now, the party is over.
All public and semi-public altcoins that can be traded and do not have a good short selling mechanism are ultimately going to suffer. That is, almost all altcoins, except maybe top 10~20. Think 95+ % drop in price for them. If you assume all altcoins that are listed on coinmarketcap.com are public/semi-public ones, that's roughly 15~20% of the total crypto market cap as of now. Remember all those talks about how only a few coins will survive? We'll get there.
There will be more automated exchanges between cryptocurrencies and they are going to cause problems too.
A simple mental exercise is in order here.
Think two PoW chains. Chain A has 1Th/s hash power and Chain B has 1Mh/s hashpower. Assume the cost of acquiring hashpower is the same for both chains. What is a good way to earn money if you can do, say, atomic swaps between them? Simple, launch 51% attack to B silently and start swapping it to A.
What just happened is, in a sense, an adaptation of the recent 51% attack towards Verge. How should Chain A know that Chain B has been compromised? It's really impossible because Chain A is never going to know which version of Chain B is legitimate. It takes human, manual intervention to determine which version is legitimate - and that takes time, an ample time for the attacker to gain profit not only from Chain B but also from Chain A.
In other words, 51% attacks on small altcoins are going to affect major coins.
And which major coins? BTC/ETH, of course. And that spells a big trouble because:
- BTC/ETH holders will be cheated by these thieves and their assets will get stolen. Thieves will then sell their crypto for fiat, probably using dark coins. Or worse, they would start shorting. After all it's easy to see that crypto prices will fall hard after such hacking incidents.
- BTC/ETH price movements affect the whole crypto market.
- ETH, when it introduces PoS, is going to have a problem with such thievery.
The first and second points are rather trivial to understand so let's focus on the third point.
Hackers can compromise small altcoins by launching 51% attack. With automated coin exchanges free of human intervention, it's possible to leverage these 51% attacks to gain ownership of ETH. When you have PoS (Casper) I understand that 34% is enough to cause trouble to the chain. ETH market cap is now about 17.5% of total crypto market cap, so an attacker needs to compromise ETH that's worth about 6% of total crypto market. The market cap of small altcoins(market cap less then NEM, the smallest crypto to have their own dominance time series on coinmarketcap.com) amounts to about 15% of the total crypto market. Easy to see that this is within the realm of possibles.
Well, I may be exaggerating and stretching imaginations. But what about other PoS/DPoS coins? EOS, ADA, Steem, (insert your favorite PoS/DPoS altcoin here)? They are much more vulnerable to this kind of attack.
I'm not saying a huge bear market is starting tomorrow. I know there are pieces and bits missing from my analysis, and I know that this scenario is going to take time even if I'm 100% right. But this can become a reality in the future. And if it does, it is going to hit us crypto investors hard.
*edit: corrected minor spelling errors and clarified some points.