Understanding the Crypto-currency market: Boom or Bubble?

From January 1 to June 5 2017, the price of bitcoin grew from below $1000 to over $2,900, a 190 percent growth in less than 6months, and if the trend continues the price is expected to hit $5,000 before the end of the year.

Other crypto-currencies have also shown some growth, such as Ethereum which in the same time period grew from $8.40 to over $250 per Ether, a growth of about 3,000 percent, while Stellar Lumens grew from $0.0025 to $0.04, a growth rate of 1,600%.  All crypto-currencies appear to be currently enjoying an upward surge in price, and investors are predicting that the trends will continue. In the same period though, the price of gold inched up by a paltry 10%.

The question then arises; is this (crypto-currency price surge) a bubble or a boom? What factors are driving this astronomical growth in the price of crypto-currency? Are they likely to continue?

Economics 101 – Supply and Demand

The supply of bitcoin and other crypto currencies are limited. In the case of bitcoin the total number in circulation world-wide as at June 5, 2017 is only 16.3million, while the value of dollar notes in circulation is about $1.6 trillion, so for every bitcoin in circulation there is $100,000 in circulation, and that is just the US Dollar, which is just one of the over 180 country currencies in the world. Another way to think about the limited supply of bitcoin is that there are over 7.5 billion people in the world, and only 16.3 million bitcoins, meaning that if bitcoins are distributed only 2 out of every 1000 persons will receive a bitcoin.

In contrast, the demand for crypto-currency is growing significantly with a larger trend of investors seeking to hold it as an asset class both in the developed and emerging countries. Digital money was previously seen as strictly for nerds and dodgy people, that perception is changing, it’s now more mainstream; investors are beginning to hold it as a new asset class

Additional demand has also come from people seeking to hedge against recession and politico-economic instabilities. The recent politico-economic upheavals in Europe (Brexit), the United States, Venezuela, India etc, are driving people more towards keeping their assets in crypto-currency. 

As the supply is limited and the demand is rising, the price will keep trending upwards, a classic case of the law of demand and supply.

Increasing acceptance of Crypto-currency

It appears regulators perception of crypto-currency is changing gradually. Countries like Japan, China and Russia who were previously opposed to crypto-currency are beginning to moderate their views and be more accepting.  In April 2017, regulators in Japan introduced new rules that treated bitcoin less like an outlaw currency and more as a part of the banking system. That change led to a burst of trading activity in the country as investors rushed to swap yen for bitcoin.

In China, where the authorities have long had a love-hate relationship with bitcoin, it appears the country is growing more tolerant once again.

Russia, a staunch opponent of crypto-currencies, has reversed its position. The Russian deputy finance minister Alexey Moiseevrecently said that in an attempt to combat money laundering, the Russian authorities hope to legalize bitcoin and other crypto-currencies as a financial instrument in 2018.

Also, the Bangko Sentral ng Pilipinas (BSP), the central bank of the Republic of the Philippines, issued a guideline recognizing Bitcoin as a legal payment method. The bank will regulate exchanges where the bitcoins or virtual currencies are exchanged for real money — the intersection between the virtual world and real world

The map below shows the current level of acceptance of crypto-currency around the world.

In January 2017, the Central Bank of Nigeria (CBN) issued a circular to banks and other financial institutions prohibiting engagement in virtual currency transactions due to their inherent risks of intractability and anonymity. Where banks have virtual currency exchanges as clients, the circular advises the banks ensure adequate controls and compliance with know your customer (KYC) and anti-money laundering (AML) protocols.

Speculation and Media Hype

Another factor responsible for the rise in the price of crypto-currency is the flocking of speculators into the space. There is increased awareness about the opportunities in the crypto-currency world fuelling increased speculation. The roll call of speculators has increased from nerds to sophisticated institutional investors to your average Joe on the street who wants to make a quick buck from investing in this new world of crypto-currency.  As with all investments, there are risks and rewards, and more often than not, the bigger the potential reward, the bigger the risk.

Crypto-currencies are highly susceptible to news. There is also a lot of hype in media dedicated to crypto-currencies, which promotes increased investment in crypto-currencies.

Decreasing Trust in Financial Regulators

Unlike in the past where most investors had implicit trust in the financial systems and regulations, there has been an eroding of trust in these systems due to the several economic upheavals experienced in the last few decades.

In the United States, the 2008 financial crisis started as a subprime mortgage market crisis but later developed into a full-blown international banking crisis, severely eroding the confidence of several investors in the system, forcing them to scamper in search of alternative asset classes.

The US crisis was followed by the European debt crisis, in which several countries in the European Union could not pay their debt or bail out over-indebted banks under their national supervision without the assistance of third parties like other Eurozone countries, the European Central Bank (ECB), or the International Monetary Fund (IMF).

Other noticeable failures have been banking systems in Venezuela and Zimbabwe where inflation rate reached a peak of 79,600,000,000 percent per month in mid-November 2008.

These banking regulation failures have spurred investors to look for alternative asset classes not directly linked to the banking sector or under the purview of the banking regulators, crypto-currency being the most preferred of such assets.

In Conclusion

Generally, the factors driving the price surge of crypto-currency appear to be quite fundamental and are likely to continue for the foreseeable future. However, crypto-currency prices has been known to experience severe volatility as seen between December 2013 and May 2014, when bitcoin lost over 50% of its value, so things can change quickly.

While the outlook looks good and could potentially point to a boom, there is a need to remain cautious as with all new forms of investments, as this could be the start of a bubble.  The aim of this article is to educate potential investors on what drives the prices of crypto-currencies, it is not to encourage or dissuade you from investing.

TUNDE LADIPO