Bitcoin’s rollercoaster year casts a shadow on cryptocurrencies

Bitcoin and cryptocurrencies – a refresher          

Cryptocurrencies are a form of digital payment that utilises a de-centralised currency. They come in various forms, each with their own unique characteristics, but Bitcoin and Ethereum are amongst the most popular and widely known.

Because these assets are relatively new, they lack the track record of other investment assets and are typically difficult for investors to analyse and value. Much of the perceived value of cryptocurrencies relates to their potential future use, rather than their current commercial use.

Because of these reasons, and further issues around fraud, custody and security, cryptocurrencies typically exhibit high volatility versus traditional investment asset classes such as equities or bonds. In fact, over the previous 12 months, the volatility of Bitcoin has been 5.2x the volatility of the S&P 500 index, and 14.5x the volatility of UK government bonds.

A year of ups and downs for Bitcoin

Price moves of this magnitude in this period of time are extreme. In fact, as prices rose, many commentators warned of the signs of a bubble forming in cryptocurrency prices, and the perils of investing at such high asset prices. Some economists likened Bitcoin’s rise to that of the price of tulips during the period known as ‘tulip mania’ in the 17 century, when prices rose sharply before abruptly collapsing.

Others argued against a crypto bubble, referencing the nascent stages of development and application, the small size of the market relative to other investment assets and increasing interest from institutional investors.

Bitcoin’s Minsky moment

In investing, a bubble is typically characterised by a shift in investor behaviour that results in quickly rising asset prices and market euphoria that appears unwarranted when considering the fundamental data. This bubble then bursts as investors’ confidence is lost, and asset prices deflate often as quickly as they rose.

American economist Hyman Minsky is famed for his identification of the patterns of financial instability. Minsky identified five key stages of a typical credit cycle, and these can be used as a handy framework to understand bubble behaviour.

1. Displacement – when investors start to get excited about something, such as a new technology or product, or an abrupt change in economic policy.
2. Boom – prices begin to rise but gain real momentum as the fear of missing out haunts investors and more join the cause.
3. Euphoria – this is the peak of sentiment. Investors are now ignoring risk and only considering the potential gains.
4. Profit Taking – investors adept at spotting the signs of the bubble begin to cash in, ensuring they make a profit before the bubble begins to burst.
5. Panic – prices begin to fall just as quickly. Fear haunts investors and they look for their money back at any price, further deflating the price.

As the chart below shows, the price moves of Bitcoin over the last 12 months reflects the typical stages of a bubble – the acknowledgement of and excitement about a new technology, the rapid increase in price as investors fear missing out, the short sharp increase in price as euphoria takes over, the recognition of a bubble from some investors causing them to take profits, and the panic as prices deflate ever lower.

It’s also worth noting that bubbles are more likely to take place in assets with limited availability, as a constraint on investors ability to purchase or sell an asset will amplify the price moves associated with the bubble. This was true in the case of Bitcoin as it needs to be ‘mined’ in order to exist, meaning the limited quantity available amplified the upward price move.

No panacea in sight for cryptocurrencies

The rise (and fall) of cryptocurrencies has been a topic of much discussion within the investment industry. While steps towards the formalisation of market structures have taken place, such as the launch of Bitcoin derivatives by the Chicago Mercantile Exchange, there remain many significant headwinds for wider adoption by the investment community.

So, despite interest in the potential future applications for a decentralised currency, issues persisting with market infrastructure (including security, fraud and liquidity), the proliferation of different cryptocurrencies, and the hugely volatile market environment for major cryptocurrency assets are front and centre of investors’ minds when assessing the risk-reward dynamics.

Cryptocurrencies remain in their infancy. In the near-term, at least, we expect most investors will continue to discount the value of their potential applications against the level of uncertainty and risk the asset class shows.

Sources

1. Bloomberg, net returns in local currency as at 4/12/2018

Historical Bitcoin prices – Bloomberg

Risk warning

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past and future performance indicators are not a reliable indicator of future performance.