A Crypto House of Cards
By: Daniel Benarroch
Tags: Bitcoin, Blockchain, Cryptocurrency, Bubble, Crypto

Dear Blockchain Enthusiasts,

First and foremost, I hope you all had a great beginning of the year and may the coming year be full of newsEds from Decoded Blockchain! Most of the coming newsEds will be shorter than this one, ocasionally I will write something more extensive as today.

If you are worried about the latest cryptocurrency drop, take a break and laugh:

Educational

Today I am going to address a topic that is in everybody’s mind: is the cryptocurrency phenomenon a bubble?

To start with, I want to explicitly differenciate between the price of a cryptocurrency and its value. For a given cryptocurrency, its value is intrinsic to the underlying project, company or product (how much value it can add to the community or the value of an exit) and its price is the market’s interpretation of the value of the asset, usually based on the expected performance or projections of the company (as well as other factors). However, as of now, the price of cryptocurrencies is driven by pure speculation, by people acting out of fear of missing out and short-term massive adoption.

In other words, think to yourself, if the value of a cryptocurrency was worth its market price, why would there be so much volatility? Any small event that draws attention in the industry has the potential of causing market disruption.

ICO Tokens

As you may know by now, Initial Coin Oferings (ICOs), or token generation events, are the new money-making phenomena, where companies create their own cryptocurrency and sell it in a “limited” way to investors. I say limited because some companies have raised more than $200 million during their ICO in the span of weeks.

An important aspect about ICOs is to understand what kind of asset the token actually represents: is it the company’s equity, a payment method, a utility token or none? An ICO with a token that has no utility has more probability to fail in the future since it has no intrinsic value.

If the purpose of the token sale is solely to raise capital for the project, that is not enough. Capital can and should be raised via equity and debt instruments, not by selling token assets. — Jason Goldberg

In my efforts to analyse the nature of the bubble we are going through, I will dedicate a specific section to talk about the Bitcoin phenomenon, which is taking everyone by surprise.

The Cryptocurrency Bubble

There is no doubt: the blockchain industry has grown exponentially during the past year. Not only in terms of the marketcap or price of cryptocurrencies, but also in terms of the number of people getting involved with the technology itself. Cryptocurrency exchanges are down because they cannot cope with the amount of new accounts and the massive volumes of transactions. More than $3.5 billion have been raised through ICOs in 2017 with at least 300 succesful ICOs.

This is what exponential growth looks like: the number of ICOs in the last four years.

However, exponential growth can sometimes lead to negative developments. On the one hand, people with low moral standards are trying (and sometimes succeeding) to scam the community by promoting fake projects or simply starting unrealistic ones. The bigger problem however, are the amount projects whose founders are not morally corrupt, yet do not see that there is no real use: always ask yourself, do I need a blockchain for this?

On the other hand, people are naively (and usually ignorantly) investing in those cryptocurrencies for fear of missing out, which given the extreme volatility of the prices, can be a mistake. People are even taking loans and mortgages in order to invest in cryptocurrencies, a terrible idea that can bring some to the ruin. So how does this affect our bubble exactly? If you have over-supply and over-demand of a given asset, you end up with an inflated price that does not represent the actual value of the asset. These are the main issues with today’s cryptocurrency market and why we say that we are going through a bubble, and it is becoming much harder even for educated buyers to invest in the right projects.

A perspective on the cryptocurrency bubble.

Let me try to elaborate further. Eventhough I was not very technologically able at the time of the dot-com bubble, I can certainly identify some similarities in behaviour for what is happening today with cryptocurrencies: the first applications or business models of a transformative technology are not the ultimate ones. Blockchain technology has the hidden potential of disrupting industries, but we are still very early to have overcome all of the technological limitations and the hype. Hence, just as with the inflated valuations of dot-com companies by the simple fact of having a website, we now see inflated valuations of ICOs by the simple fact of having an ICO. Even if some of these projects do hold certain intrinsic value because they have the capability to improve business processes in some industry, the price of its token is most likely inflated by the speculation effect.

Taking a different perspective, a bubble can be healthy for the further development of the technology and the industry. It can get more relevant parties involved, such as the SEC to regulate and stabilize the industry, or such as banks and consulting companies that will push for adoption (probably from a competitive drive for innovation). We saw in the last newsEd that the blockchain has severe scalability problems and some are hoping that we can pass the bubble and the hype so that more ressources can be added to solving the concrete problems limiting the technology (scalability, efficiency, privacy, etc.)

A peak of the post-crypto-bubble era.

The Bitcoin Bubble

Originally, Bitcoin was created as an electronic payment system, as Satoshi stated:

What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party. — Satoshi Nakamoto

Yet after 10 years since its inception, Greshem’s law seems to have applied, converting Bitcoin in a method for storing value instead of a currency used for payments and transfer of money. For obvious reasons, people believe that the price of Bitcoin does not represent its underlying value, but how high can Bitcoin’s price go? The real question is to what extent is the Bitcoin price inflated compared to its real value?

Since we cannot yet know what the real value of Bitcoin is, we should try to understand how its price can be (or is) inflated. I am not claiming that I can extensively identify every way that this happens, but there are some instances that the community should be aware of.

Bitcoin is a cryptocurrency without utility, since it is used only to store value and for speculative trading. So does it have any intrinsic value or it is the ultimate bubble? Indeed, Bitcoin was the first currency of the sort, and some of its value lies in the technological contributions it made to the community, opening the eyes of millions of people to a world full of untouched possibilities. However, there are already many blockchains and cryptocurrencies that surpass Bitcoin’s technological capabilities, in terms of scalability and privacy, and still its price is more than ten times higher than its follow up. In what follows I will argue that Bitcoin is partially a bubble, where its price can be manipulated (and may have been), contributing to the inflation and hence the bubble.

Let us imagine the following situation: a company creates a new cryptocurrency, XCY, that is pegged to the US dollar 1-to-1, where in theory, for each dollar someone gives to the company, one XCY is minted (or printed). The more dollars it has, the more XCY it prints. Now, let’s assume that this cryptocurrency is traded in an exchange in the form of USD/XCY and BTC/XCY pairs. When someone decides to buy bitcoin with XCY (let’s say instead of with USD), the price of BTC/XCY goes up. Some may recognize that a window for arbitrage is created. Given that XCY/USD is 1-to-1 but the demand for BTC from XCY is momentarily higher than that for BTC from USD, then one can buy BTC with USD and then sell at a higher price the BTC for XCY. This quickly increases the price of the USD/BTC price. Now imagine this company printing money without having US dollars to back it up. That is called a scam and a manipulation of the Bitcoin price.

There is a well known twitter user and Medium writer, Bitfinex’ed, who aims to expose meaningful scams and price manipulations. The main scam he has been exposing is that of the company Bitfinex, a cryptocurrency exchange that created its own cryptocurrency, called Tether, which was pegged to the dollar. He claims that Tethers were printed in extremely large amounts (as can be seen from Bitfinex’s actions), but were not backed by dollars in the first place. Of course, one cannot prove that this is true, but Bitfinex’s sketchy behaviour of hiding information and not revealing audits, allows for a strong hypothesis. There are several other manipulation methods, such as spoofing, wash trading and painting the tape. These are all illegal activities on regular financial markets, but the decentralization of Bitcoin and the unregulated exchanges allows for such actions. A big challenge for regulation bodies is to define laws that will enforce appropriate trading behaviour and to outsmart those scams who find loopholes in the law.

Another way to manipulate the Bitcoin price is the well known Ponzi Scheme. I have seen many people accuse Bitcoin of being a ponzi scheme, which leads me to believe that they analyze the technology from a purely economical or financial perspective in the traditional sense of the word. I will not argue in full length why they are wrong, but I will simply say that like any other currency (USD or EUR), ponzi schemes can be built on top if not properly regulated (e.g.: see Madoff).

A few days ago, a major cryptocurrency exchange and lending platform, Biconnect, was forced to shut down by regulators who accused it to be a ponzi scheme. For years it was run by anonymous entities and claimed that they had a smart bot trading and making large benefits. They had also created a cryptocurrency and it’s price decreased by 98% in two days.

Conclusion

The cryptocurrency market IS a bubble, but is not a scam or ponzi scheme. There is a lot to gain from blockchain applications, even from cryptocurrencies such as Bitcoin, but one must learn the technology before entering the world and of course be aware of the potential fraudulent activity that can influence the market. Keep in mind that the technology is so fresh that its real value cannot be known, so anything that is said is mostly speculation. Do not be like these people, please. Instead be like these, these or like Aviv Zohar, who are truly pushing the limits of knowledge in this field.

A note: thank you to my friend Ariel Nachumow for bringing to my attention the (potential) Tether scam.

What’s the Buzzz?

Some Use-Cases

First real non-fungible blockchain use-case, cryptokitties. Yes, fake fluffy animals like what the tamagotchi used to be.

A blockchain of blockchains? The cosmos network is looking into that.

Financial applications of blockchain.

Last newsEd’s Highlights

What are Consensus Algorithms

What is Segregated Witness

Bitcoin Mining and transaction fees

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Disclaimer: Curated by Daniel Benarroch Guenun, the Lead Cryptographer at QED-it. Follow me on twitter @BenarrochDaniel. The opinions expressed in this newsEd are solely mine, and do not represent those of QED-it. This newsEd is not a financial guide to invest in cryptocurrencies.