Bitcoin continues to rise astronomically as the leading cryptocurrency gained more than 60% over the past month alone. This translates into an annualized return of around 720%. The market has not given up the crypto craze and continues to price the currencies arbitrarily.
Ethereum also registered a gain of 59% over the past month and outpaced bitcoin by quite a margin during the trailing 12 months. Ethereum’s market cap increased 60 times during the period while Bitcoin grew only 13 times.
Some investors are really optimistic about cryptocurrencies while others continue to be cautious. Michael Novogratz, a former macro hedge fund manager at Fortress Investment Group, thinks bitcoin will touch $40,000 by the end of 2018 while ethereum could increase three times from its current price.  Warren Buffett (Trades, Portfolio), on the other hand, is quite skeptical of the cryptocurrency. Citaldel’s Ken Griffin also fears the bubble may end in tears. He notes the bubble is akin to the Netherlands' tulip mania.
It is difficult to make sense of what is happening in the cryptocurrency space. Is the exponential rise due to the rock solid belief of the proponents that bitcoin will be an alternative to fiat currencies, or due to its property to be a store of value, replacing gold? Or is it just a reflection of the irrationality of human behavior? It seems the latter will prove to be true.
Alternative to fiat currencies?
Crypto advocates of “fiat replacement” are ignoring the power of regulation and the role of centralization in any society’s governing structure. Fiat is controlled by governments, so for bitcoin to be a replacement, governments will want to regulate it.
This is not the only reason people are reluctant to adopt cryptocurrencies as an alternative to fiat. Volatility, transaction costs and lack of user friendliness also make it difficult for cryptos to challenge fiat or other alternative payment methods. Consumers are used to payment solutions with no or low friction; credit cards are widely adopted for this reason.
Moreover, volatility is a real problem. Pricing goods based on bitcoin will be a challenge for merchants as price fluctuations are drastic.
Finally, there is no value for consumers to switch to crypto payments when there are other seamless, easy-to-use payment methods. As a result, the fiat replacement argument is not strong enough to justify the rise of cryptocurrencies.
A store of value?
Bitcoin is considered a store of value as it mimics characteristics of gold. Like gold, bitcoin does not generate any cash flows and does not have a significant utilitarian function like other commodities. Therefore, gauging the value of bitcoin is futile. Lke gold, it can only be priced, not valued.
How should it be priced? Even if bitcoin was a viable alternative to gold, that does not mean the cryptocurrency would replace it. Given the longstanding history of gold, it is hard to compete with. There is also regulation risks for bitcoin and other cryptocurrencies, which is not there for gold.
Moreover, there is no direct competitor for gold in commodities. You cannot just dig up new valuable elements. However, cryptocurrencies can be created. It is worth mentioning there are now more than 1,200 cryptocurrencies in circulation, according to coinmarketcap.com.
In short, risk of regulation and potential for competition is what differentiates bitcoin from gold. In a hypothetical scenario, however, where bitcoin replaces gold, it is quite undervalued by many standards.
The notional value of daily paper gold trading is around $125.3 billion per day. Bitcoin’s highest trading volume was around $1.6 billion on Nov. 12. On average, the trading volume for bitcoin was around $649 million over the past four months. Therefore, bitcoin is not even 1% of gold’s daily trading volume. Calling bitcoin a gold replacement is a long shot.
Is it just hype?
If the potential for bitcoin becoming an alternative to fiat or gold is not there, what is driving the price? First, proponents of bitcoin believe it will either replace fiat or gold in the long run. However, the rise of bitcoin feels like deja vu. Companies with dot-com branding saw their values skyrocket and then plummet to the floor in a series of events that are similar to the rise of bitcoin and other cryptocurrencies. Only a few companies emerged as winners from the dot-com era. There are a lot of similarities between the blockchain and dot-com crazes.
Cryptocurrencies may meet the same fate as the dot-com era. Behavioral science has been trying to explain the tendency of investors to buy high and sell low for quite some time. From a neoclassical rationality perspective, it should be the opposite. Regardless, the market has seen drastic price increases in the past, and the most recent example is cryptocurrencies.
Final thoughts
It is almost impossible to predict reversal in trends that encompass euphoric participation. But history has told us it almost always ends badly for the long-term shareholders. If you are not convinced cryptocurrencies can replace fiat or gold, then buy-and-hold investments in the space might not be a good idea.
Since there is no definite way to value bitcoin, investors have no choice but to price the currency arbitrarily. The problem is arbitrary pricing looks at preceding prices to form a new expectation. Put simply, the rally can continue given the positive investor sentiment. The end game, however, does not look good becasue adoption is not as likely as expected.
Disclosure: I have no positions in any securities mentioned and have no plans to initiate any positions within the next 72 hours.
