Let's Talk about Cryptocurrency Risks
Disclosure: I hold cryptocurrencies.
I may be a little biased when it comes to cryptocurrencies, but whenever I talk to an audience about it, I try as much as possible to reiterate the risks. A friend even accused me of being so bearish about cryptocurrencies, yet I just couldn’t stop talking about how people are getting rich out of them. Now, we’ve gotten that disclosure out of the way, let’s get down to business.
If this is your first contact with any article that is cryptocurrencyrelated, I strongly suggest that you read the first article I wrote about the Bitcoin here. Now when you are done, also read this one. Now, we are all caught up, and we can talk about the risk of holding, or trading, cryptocurrencies.
At the time of writing the first article in September 2016, Bitcoin was selling for around $600, and the time of writing the second article in December 2016, the price was around $770. In just about a year, the currency is now selling at $15,500. There is no widespread and easily accessible asset that has done this well, except a couple of other cryptocurrencies. Therein lies the risk — an asset that can gain over 2,900% in just under a year can easily lose 99% of its value in just one week. Know this and know peace; then construct your portfolio accordingly.
Before we go on, I need to point something out real quick. There are a lot of schemes out there that promise some kind of Bitcoin payouts if you buy Bitcoins and invest in their schemes. Please note that these are pyramid schemes. The pyramids will collapse one day, and you will be left with the short end of the stick. These schemes are done using Bitcoins, but note that these schemes are not Bitcoins. Just the same way that the MMM pyramid scheme used Naira does not equate MMM with Naira.
The Bad News
Cryptocurrency prices are going to crash. This is something that will happen as long as the sun rises from the East. But the problem is I don’t know when and I don’t know how, and I also don’t know at what level this will happen.
There are two types of risky investments. The one in which there is a lot of small gains and one large loss, with a variable chance of occurrence, which can wipe out your entire portfolio and even run you into huge debt. Then there is the other one in which you make small losses, but one huge again, also with a variable chance of occurrence, which can make you wealthy. The latter is associated with gambling, but the former seems to be describing Bitcoin/cryptocurrencies at the moment. It doesn’t matter at what price you enter, it just looks as if it is almost impossible to lose. Those who bought when the price hit a previous all time high of $7,600, before dropping to $5,700 are probably now smiling because the price is now climbing towards $16,000. Those who bought at $19,000 before it dropped to $11,000 and held on are probably heaving some sigh of relief now as the currency seems to be recovering. The drop and then a quick recovery has been the hallmark of Bitcoin for several years now, but the question is how sustainable can this be?
I am now going to focus on the risks facing Bitcoin. Bitcoin is the largest and most established cryptocurrency, and for as long as this currency is alive, other cryptocurrencies (not all of them though) are going to do well. Bitcoin will have to crash first before the dominoes come falling down. Whether Bitcoin will remain as the largest cryptocurrency after everything comes down is something I cannot tell.
I have already mentioned the first risk that Bitcoin faces — pyramid schemes. This is not likely to bring down Bitcoins, because most Bitcoin holders know about pyramid schemes. It is only newbies, who really don’t understand what Bitcoin is, that are going to be caught in this storm. The damage to Bitcoin itself will be very minimal.
The second risk is from Government regulations. Governments may decide to shut down Bitcoin from within their borders, but this will require coordinated actions from all Governments. Now the problem here is that Australia, Switzerland, Russia, Japan, and Canada already have policies that favor Bitcoin. Even Vanuatu is now providing citizenship in exchange for Bitcoins. It will take a lot of effort to make all of them backtrack, and the chances of this happening is slim to none. I believe the risk from this is also minimal even if Jamie Dimon thinks otherwise.
The third risk is the lack of consensus in the Bitcoin community. This has led to a few forks with many more lined up for the future as a few factions break away. This weakness also happens to be the strength; there is a decentralization of the currency, which means just a few people cannot dictate how the asset should behave. This is how markets work — many people with diverging self-interests who finally settle for an equilibrium where everyone reaches compromise. The risk here is there is no one can predict what a breakaway faction can decide to do to the mother-ship. But the risk here is also minimal, because whatever they do will also negatively affect the coin they are promoting, and they will jettison the idea.
The fourth risk is the fact that the price has run up in a very short time, which has created a bubble. But how long will this bubble, that has burst so many times, last? Will investors/speculators just wake up and start selling because the price is ‘too high’? I don’t think so. Something will have to cause the price crash. And the truth is a bubble can only be deemed so with the benefit of hindsight. This is a real risk to Bitcoin and other cryptocurrencies as an asset class, but it does not change the underlying value. (Please don’t ask me about the fair value of Bitcoin, I don’t know. Just exactly the same way no one knows the true fair value of Gold. The value is whatever the market says it is.)
Less than three months ago, conversations around cryptocurrencies centered around what value the cryptocurrency was trying to deliver, and what gap it was trying to fill, but now conversations are now about how high can the price go? People who discovered Bitcoin, are now discovering hundreds of other cryptocurrencies and the question is, “Which one is going to gain 300% next?” The question is not, “Which one is going to change the way we do things and deliver value over the long term?” The fever is sky high, and the evidence is in the market. From about 70% of total market share just some months ago, Bitcoin now accounts for less than 45% of market share. People are spinning off new cryptocurrencies every day, and people are lapping them up because, “Wow! Bitcoin is doing well, but it is too slow, other cryptocurrencies are moving faster than Bitcoin!”
Coinbase now has more accounts than Charles Schwab. And Coinbase has been forced to include a couple of other cryptocurrencies because of huge demand for them. Most cryptocurrencies exchanges are bursting at the seam as huge cash flows into the market.
I joined a couple of Telegram groups, which talk about different cryptocurrencies and it is pure madness. You see people screaming “Hodl!”, “To the mooooon!” and so on. I have seen people banned from Telegram groups for asking questions about the underlying value the cryptocurrency. I have also seen people banned for asking why the 24 hour volume of a certain cryptocurrency is more than 50% of its market capitalization.
I watched Bitcoin buyers eat up a sell wall of $500,000 (half a million US dollars) at $19,500.00 in about 30 seconds. It was beautiful to watch, breathtaking and scary. (My heart goes out to those people who bought up the coins at $19,500.) I saw a fintech microcap company gain 2,400% after admitting its link to cryptocurrency.
We have a great technology in our hands but irrational exuberance has taken over. People are taking out mortgage and credit cards to buy Bitcoins and other cryptocurrencies. Well here is the problem: by taking out a loan to buy an asset, you either believe the asset will throw out cash at you, which cryptocurrency does not do, or continue to go up in value. Continuing to go up in value is contingent on new money flowing in. If people are borrowing to buy an asset, it means that they have finished using their disposable income. Now that people have finished using their disposable income, they will soon finish borrowing to fund purchases. When all that is done, where is the new money going to come from? Now, for people who borrowed money to buy the asset, what happens when cryptocurrencies can no longer go up, because no new money is coming in? Yes, they will have to start selling to meet up with debt repayment. At that point in time, all of us are going to be on our own.
I am doing a sign of the cross one more time for those who bought Bitcoins at $19,500, except they were lucky to use to use the bitcoins to buy alternative coins (altcoins). Now that altcoins have gone crazy, because people feel they will move faster than bitcoins, what happens when no new money comes in again?
Worst still is that cryptocurrencies are trading in unregulated markets. Prices can be manipulated downwards or upwards by those who have money. There is no control, no investor protection. Sooner or later, human greed will take over and all hell will be let loose.
I can confidently say we are at the inflection point, or very close to it. Markets always do the opposite of what people expect. This time last year, when Saxo Bank predicted that Bitcoin was going to hit $2,100 before the end of 2017, people laughed from Shanghai to San Francisco. That time Bitcoin was $700. Now everybody is saying 2018 is going to be massive for cryptocurrencies. No, my friends, 2018 is going to be the year of the gnashing of teeth.
The fifth and the last risk is the unknown unknown. Bitcoin is going to crash, and that time is not far. The cause of this crash, and how it will happen, is unknown, for now. We are all going to be blindsided — it may be insidious and it may be fast. Will it drop to zero? I don’t know, but it is highly unlikely. Even the people who will cause the crash will be surprised that they actually crashed Bitcoin. And when it finally happens, many will act like it had always been obvious all along, as all markets crashes are always obvious with benefit of hindsight. Many Bloomberg, Financial Times and New York Times article will go to town with how they predicted how Bitcoin was going to crash, and they will do everything to force their current narratives to that event. But I can bet everything I have to my last shirt, that the crash will not be anywhere near what anyone is currently predicting will be the cause.
How do I know this?
Bitcoin is a very young asset class. It takes very little to move the price up and down, hence its current volatility. Early this year, the ducks were all lined up for the death of Bitcoin, largely because of the inability of the promoters to reach a consensus with regards to the way forward. The network was clogged. Transaction fees were going through the roof. Ethereum was taking up market share, and people were beginning to predict that Ethereum market capital would soon overtake that of Bitcoin. Until one man, somewhere, came up with a solution. No one saw the solution coming, but lo and behold, the community was ready to activate SegWit. The market was still uncertain until Litecoin activated SegWit successfully. Bitcoin price doubled, not long after that. One man, working assiduously day and night, saved the day. One man cannot save oil price. One man cannot save stock market prices. One man cannot save the real estate markets. But one man saved Bitcoin. Bitcoin is still a very young asset class, and the headwinds are coming.
If you are still reading, and haven’t sold your cryptocurrencies yet, then let’s talk about the good news. Thank you for staying with me so far.
The Good News
Bitcoin has shown resilience in its short life, and it will weather the storm. After the crash, cryptocurrencies will evolve and become bigger and better than it currently is, but this is not going to happen in weeks or months like the market is currently behaving. We are already in a world where almost every single thing we do is in bytes. Zeros and Ones. Bitcoin is filling a gap — a digital asset that is outside the control of a few people (read: central banks). The market (read: the people) determine what the price of this asset should be, at every point in time.
Bitcoin has limited supply, except the whole community agrees to increase the supply, which is unlikely to happen. There was once a time a rise in Bitcoin price led to increase in purchase of goods and services in Bitcoin. Now, those who hold Bitcoins have started reducing its use, except when they want to trade for other cryptocurrencies, and most of them have plans of coming back into Bitcoins at one point in the future. Those who don’t believe in Bitcoins state problems such as slow transaction speed, fear of Government intervention, etc. All of a sudden we have two sets of people — those who are holding Bitcoins, because they are now seeing it as a store of value, and those who believe it does not have any kind of utility. But the rising price is now bringing in people who once thought it was some kind of Ponzi scheme, and they are now becoming ‘hodlers’. People are no longer buying Bitcoin because it is a new type of digital currency (Ethereum has filled that gap), they are buying it because it is now increasingly looking like a new type of asset, a store of value.
It is this ongoing switch in identity that will make Bitcoin survive the oncoming crash.
There is one more thing in play. Global asset prices are at historical highs, from bonds to treasury bills to real estate to equities to private equities. Startups are now raising money like they never raised in the past. Interest rates are at historical lows and even negative in some countries. Cash is becoming worthless, and billions of dollars are roaming the world looking for where to park. Bitcoin price increase should be viewed through this context, albeit with caution because people are using easy credits to fuel a possible bubble. There is really nowhere else to put money. Now, even regulated institutional investors want a skin in the game, hence the excitement about the Bitcoin futures market.
There has been a lot of logical argument against the use of Bitcoins and other cryptocurrencies, but in reality, the price is whatever the market deems it to be. And today, Bitcoin is $15,500. For as long as market is confident in the pricing of an asset, that is what the price is. While we can only predict a bubble with the benefit of hindsight, I am sure that the cryptocurrency market will probably lose 50–70% of it’s value in the coming months.
While my Twitter timeline may look like a cryptocurrency ticker, please use this post as my warning that we are playing a dangerous game with our money. I am aware of the risks, and I also want you to be aware.
Disclosure: I have sold about 40% of my cryptocurrency holdings, and I will still sell more.