Are Cryptocurrencies Investment Bubbles?
Ever since Bitcoin climbed to almost $20,000 in 2017, the investment environment has changed. We have seen an overwhelming increase in volatility not only for the cryptocurrency sector but also for traditional equities and commodities. Within this article I will focus on explaining more about the different “bubbles” in the cryptocurrency market while laying the foundations for a potential analysis on how this affected traditional markets.
The Bitcoin Bubble
2017 was a very interesting year in terms of alternative markets gaining more momentum and attention from the media. When looking at Bitcoin, if we measure the price difference from January 1st 2017, all the way to the peak it achieved at approximately $20,000 on December 16th an increase of almost 2000% is visible. This is better shown in the image below.
An important question to be asked is whether this had any impact on other financial markets and the way people invest in new technology and traditional equities. During 2017, Bitcoin started gaining more momentum and spotlight from the media. In fact, it wasn’t until late 2017 that Bitcoin really burst to the upside as the continuous hype, leveraged by the media, skyrocketed it to what is known as a blow-off top. With the introduction of Futures Contracts and the overly exuberant market, the investment conditions for this asset changed because there was more incentive to start shorting or selling due to the low liquidity of the market.
As seen in the image above, the first big correction created a huge wick to the downside with almost 50% losses from its previous peak. Subsequently, at the end of 2018, Bitcoin saw a depreciation of almost 85% relative to its all-time high. This can be better seen in the image below.
Even though it is not uncommon for Bitcoin to see such drastic changes in valuation, it is clear that after this first bubble the investing environment changed for this industry and for others. If we consider the term “bubble” as an exuberant increase in valuation ending in a blow-off top formation and further depreciation, we can say that there have been multiple bubbles not only in the cryptocurrency environment but potentially in traditional equities. With this in mind and for the purpose of this article, I will refer to the above described price action as the “Bitcoin Bubble”.
The ICO Bubble
We can use the previously described “bubble” term to analyse other parts of the cryptocurrency industry. If we look at altcoins (or alternative coins), we can see that the dominance of Bitcoin valuation vs other coins hit record lows. This can be seen on the image below where the Bitcoin dominance went from almost 100% to a low of 36%. It is important to highlight that this data is not 100% accurate as there were thousands of altcoin projects underway during that time and not all of them were legitimate or big enough to be considered in this ticker.
The chart above best describes the price action of altcoins in comparison to Bitcoin. What we can see is that around the beginning of 2018, altcoins peaked in terms of their Bitcoin pairs. Although this was a result of the Bitcoin bubble, it is important to differentiate it as several projects increased from 10X valuation to almost 100X. In terms of percentage this corresponds to 1000% - 10000% which is way more than what Bitcoin obtained during the entire year.
Similar to Bitcoin, the altcoin market saw huge losses in valuation after its blow-off top. In terms of losses, the valuation of altcoins saw a decrease of almost 92% in comparison to Bitcoin’s almost 85%. The chart above better represents this percentage. It is important to consider that altcoins tend to be more volatile than Bitcoin in general and that a lot of projects either went bankrupt or executed exit scams as more regulatory constraints came into play due to the new Initial Coin Offering (ICO) model to fund projects.
On the bright side, thanks to the attraction ICOs and Bitcoin received, governments started to implement ICO regulation, which reduced the number of fraudulent projects and saved a lot of future investors.
The DeFi Bubble
DeFi or Decentralised Finance is a term that has surrounded the cryptocurrency industry in recent months. Although explaining DeFi and how it works is not within the scope of this article, in basic terms, DeFi refers to the use of smart contracts to automate enforceable agreements with the use of blockchain technology. Effectively there is no need for intermediaries like banks or lawyers as blockchain technology can be used to skip them and thus lowering commissions and real fees.
It is an undisputed fact that DeFi is a disruptive technology for the financial sector and even more so now that quantitative easing is at its peak due to the recent pandemic. However, a lot of the DeFi projects that are in the market are not yet ready for mass adoption. The image below shows how this particular sector gained a lot of attraction but displayed similar properties to the aforementioned bubbles. We can see a strong rise in valuation, followed by a blow-off top, resulting in a further decrease in price.
Although this might be one of the most mature and interesting sectors in the cryptocurrency industry, the price action is still fuelled by emotional decision making and Fear of Missing Out (FOMO). There is a strong potential for this sector to grow but it is necessary to be in touch with reality and analyse what is currently happening with these projects. A good example of this is Cardano. The project seems to have a very professional team and a lot of potential but its valuation increased almost 800% from its lowest low after the pandemic crisis despite it not having any real developers or projects in comparison to other chains like Ethereum. This does not mean that the project will not deliver in the future but there is a huge discrepancy between the use cases readily available and the valuation of the projects. It is worth noting that Cardano is not the only cryptocurrency project to see this cycle. Cardano has seen a decrease of almost 50% in its valuation as of the time of writing.
It is imperative for investors and traders to be more cautious when investing in cryptocurrencies as they follow a very volatile and unforgiving boom and bust cycle. Analysing the different bubbles within the cryptocurrency market lays the groundwork to potentially analyse how this also affected traditional markets, more specifically equities and commodities, which will be covered in future articles.
This article is from our October 2020 edition of Trader's Insight. Check out the full magazine here