In a famous paper of 1979 Oliver Blanchard and follow up paper in (1982) pointed out the concept of a rational bubble and I believe that it has direct applicability to Bitcoin. In a “Rational Bubble” something gets overvalued but because it gets overvalued then needs to rise at an increasing rate to compensate holders for an eventual collapse, so long as the currency increase at an increasing rate then rational investors are compensated for the increasing risk of an ever larger collapse each time the bubble gets bigger. This clearly means the overvalued asset has to increase at an increasing rate at each stage or follow an exponential path which is exactly what Bitcoin was doing until recently. Let us suppose that Bitcoin does have a fundamental value of let's say $500, when it gets to $1,000 then it is overvalued and maybe needs to increase at 10% a month. It then gets to $2000 but is now even more overvalued so needs to increase at say 20% per month to compensate for the risk of a larger collapse. At $3,000 it is even more overvalued and then needs to increase at say 30% per month and so on. So long as new highs are made some price corrections along the way are OK because investors are being rewarded for taking on ever increasing risks. However the failure to make new highs can be very serious as it maybe means the last buyers are in and people are then not being compensated for the ever larger risks they are assuming. The concept is captured in the diagram below:
Well if we look at the actual bitcoin price above we can see it actually followed an exponential path peaked at around $19,000 and has tried to make a new high but that stopped at $17,000 so this means that people are no longer being rewarded for the risk of a large collapse to whatever the “fundamental value” is. Also it may suggest that regret is now moving in as some bought at $19,000 and $17,000 but are now being punished. How far may bitcoin fall is an open question. Mining costs of around $5,000 – $6,000 might provide a floor but then again they might not as a bitcoin is fundamentally just a bit of computer code and can be easily replicated and there are plenty of alternatives around such as Ethereum, Ripple, Bitcoin cash and hundreds of others. Another thing that worries me is the bitcoin cannot act as medium of exchange as transactions are costing way too much to process $30 to buy a pizza NO THANKS. It still has some features such as a “store of Value” and the fact you can move money across borders and so long as others give it value then it has value a bit like stamps have value to a group of stamp collectors. My prognosis is not a happy one as many of the other coins from the spate of recent Initial Coin Offerings are essentially worthless. Investors are also assuming they can get their digital money transferred into real money but some of the Exchanges may not be willing to convert large amounts when the system is under pressure and will widen considerably the bid-offer spreads and limit conversions so liquidity risk and counterparty risk is very real in this market. People ignore all this so long as prices are rising but when prices are falling it is a different ball game.
