The bitcoin bubble- what is a bubble and how are they created?

We have had numerous asset bubbles in the past such as the tulip mania, the US housing bubble and the dot-com bubble. The latest bubble is the bitcoin bubble. All these asset classes rose in value due to irrational exuberance but the same characteristics were in place which drove up the prices. The price of bitcoin has fallen 80% from the peak in December 2017. All asset bubbles burst after a period of time. In this article we discuss the reasons for the bitcoin bubble, the reasons for the fall, and the implications with the price devaluation.

What is an asset bubble?

Asset bubbles occur when the asset is priced at a level which is well above the intrinsic value. This intrinsic value is the fundamental value of an asset. This value may be derived from the ability to generate cash flow or the rarity of the asset.

How was the bitcoin bubble created?

Economic Growth: When there is a prolonged period of economic growth then investors may be misled into thinking that asset prices will continue to go up.

Herd mentality: When prices go up people think the asset price will continue to go up and want to get exposure in that asset to profit from rising prices.

Easy Credit: With interest rates being very low, debt is cheaper for consumers to obtain and and banks are more willing to lend money. This gives people access to funds which they can put into assets which attributes to the rising prices.

What caused the bitcoin bubble to burst?

There is usually an event that occurs which causes the asset to fall. This could be a change in regulatory conditions or an event which causes sentiment of that asset to become negative.

When asset values start to fall, investors who have borrowed funds start to panic first and sell as they may be paying off loans on an asset with a decreasing capital value. This causes the asset price to fall further and other investors follow with more selling.

Bitcoin reached a peak of US$19,783 in Dec 2017 but now it is currently trading US$4,022.98 (as of 8th Jan 2019).  The bitcoin bubble was unsustainable as the market was overheating it was bound to burst. One of the causes of the bitcoin drop included regulatory worries when the South Korean government was planning on banning cryptocurrencies. The outright ban was revoked but the South Korean government would only allow real name bank accounts to be used for cryptocurrency trading to prevent illegal activity through Bitcoin. South Korea is the third largest market for cryptocurrency so any news would impact this asset class significantly. Asian trading volumes substantially declined after this news. However, there are other issues with bitcoin that investors are starting to realize. Bitcoin was created as a form of currency but the price movement oscillate too widely for it to be used as that.

Do asset bubbles cause recessions?

This depends on the asset itself. The bitcoin crash is unlikely to have serious ramification as the market capitalisation for bitcoin is too small. It is unlikely to affect the banking system or the global economy.

The 2008 recession in the US was caused by the housing bubble. People were buying houses they couldn’t afford with low interest rates and lax lending standards. When interest rates rose on these loans, home owners were unable to repay the interest repayments and this cause loan defaults which then affected the banking system as banks and hedge funds brought mortgage backed securities on the secondary market.

Lauren Hua is a private client adviser at Fairmont Equities.

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