Cryptocurrency is either reshaping the financial world or it’s the biggest bubble in history. I’m on the bubble side of the debate. But whether you’re a true believer or a skeptic, it is always prudent to consider the risks in a new asset class and to temper boosterism with a critical eye.
To that end, let’s look at some of the most common claims made by those in the throes of Bitcoin euphoria—I use Bitcoin as a case in point because of its dominance. After all, something can always go wrong.
(First, a quick clarification: The investing bubble I refer to is in cryptocurrency, not blockchain technology. There is an emerging world of decentralized finance, or DeFi, founded on blockchain technology. Blockchain and DeFi can survive even if the current notion of cryptocurrency were to disappear.)
Bitcoin is an open-source idea—nothing can stop it! With the stroke of a pen, governments can—and have—prohibited its businesses and citizens from transacting in Bitcoin. Why would governments bother? For one thing, they are not eager to cede their monetary authority. If Bitcoin crowds out a country’s currency, it will be banned by that country. Governments might also object to the cryptocurrency’s huge energy consumption. The energy consumed in a year of Bitcoin “mining” is equivalent to the energy used annually by Argentina. Institutions—governments included—with an ESG bent will think twice about embracing such an energy hog.
Bitcoin’s value will only rise! The Bitcoin-owners mantra, HODL (hold on for dear life), is telling. By essentially locking up a large portion of Bitcoin, HODLers distort the market. What appears to be the current price, although technically correct, is a mirage when it comes to the total wealth that has been amassed. If most of the market is unwilling to sell, even a small buyer has to push the price up to find the other side. But try to sell a billion dollars of Bitcoin at that price and see what happens.
The apparent Bitcoin windfall is what Charles P. Kindleberger, in his classic book, “Manias, Panics, and Crashes: A History of Financial Crises,” calls the euphoria of paper wealth. It is apparent because if a sizable set of holders decide to cash out, they won’t find many willing to pay the current price—or maybe even a tenth of the current price. And as the price collapses, more and more people will feel the magic is gone, and fewer will be willing to take the other side. Add to this the high concentration of Bitcoin, both among the HODLers and the miners. That concentration, a bane of market stability, will multiply this effect.
Bitcoin will survive the implosion of fiat money! First, fiat money is doing fine. Yes, we have periods of inflation, recession, and budget deficits, but the specter of hyperinflation in the dollar or euro is a bit out there. Look at the scenarios being addressed by top banks and hedge funds. Failure of the developed world’s monetary system is not on the list. Now, on to the apparent benefits of encrypted peer-to-peer currency cutting out the bank—and central bank—as middleman. Without systemwide know-your-customer regulation and clearing agents, Bitcoin’s peer-to-peer framework means once you’ve made the transaction, it’s done. Any error made in the process, like sending a payment to the wrong person or adding a couple of zeros to a number by mistake, cannot be rectified. That’s a reason we don’t see bearer bonds anymore.
Bitcoin will prosper because it’s an anti-asset! Bitcoin currently behaves like a stock. It has a similar correlation to the broad equity market as an individual stock. Looking at it this way takes away some of Bitcon’s mystique. It also constrains how much it is prudent to hold in a portfolio, at least from a risk management perspective. Even an aggressive portfolio manager usually caps individual stockholdings at around 5% of the portfolio. And that number is on the high side for Bitcoin, given its high volatility. But then, risk management does not seem to be front and center for fans of Bitcoin.
Bitcoin is decentralized—therefore democratized—currency! It’s true that decentralization is essential to Bitcoin. But mining Bitcoin leads to a virtual arms race, and to an inevitable consolidation by the largest and best-financed miners. And should the increasingly centralized miners collude to control over 50% of the mining power, they could then control the Bitcoin ledger and erase or augment it however they chose to. Currently, 0.1% of miners, (about 50 miners), control 50% mining capacity. So, not very decentralized, even now.
Bitcoin is the center of the most stable system humanity has ever seen! Whatever. But while we’re on the subject of stability, let’s talk about stablecoins, crypto’s tether to the world of fiat currency, principally the dollar. The dominant company for stablecoins is, appropriately enough, named Tether. Tether is not audited, does not make disclosures of its reserves, and indeed, regulators say it has misrepresented its backing. Already, the CFTC has fined Tether for making false and misleading statements. Perhaps Tether will get its act together, or will be superseded by another stablecoin before a “cryptopocalypse” occurs, but positioning a shaky operator at the nexus of crypto and fiat is not a sign of a stable, well put together system.
Bitcoin is too big to fail! If Bitcoin went to zero, its effect on wealth would register like a so-so down day for the equity markets. It is largely held by individuals—the bulk of it by a small set of individuals. The consumption side of the economy doesn’t depend on the fortunes of Bitcoin and the holders are not large enough nor integrated enough into the financial system to where selling other assets to make up for losses on Bitcoin would create contagion. (And in fact, a swath of adherents consider financial assets anathema.)
Granted, a smattering of businesses dabble in it, but if Bitcoin went to zero, we wouldn’t see material failures to fund inventory, maintain production, or service loans. Large institutions are involved with Bitcoin for trading or client facilitation because they go where the money is. There can be political and promotional motivations to appear to be on the bandwagon as well. For example, my sense is the announcement by New York’s new mayor that he will be taking his first paychecks in Bitcoin is nothing more than a signal that the city wants to be the business center of the crypto universe.
Bitcoin attracts an ever-widening circle of adherents and investors, many of whom would not otherwise be engaged in financial markets, whose support is grounded more in zeal than in reason and who carry an uncritical conviction that Bitcoin is a sure thing without consideration that it could fail, never mind how. These are essential elements of the Greater Fool theory, which posits that profits can be had only if others are pulled in to subscribe even more fervently to the hopes and dreams of the original stakeholders. Like Wile E. Coyote overrunning the cliff and finally realizing he is standing on thin air, failure comes when a critical mass of investors wake up to the fleeting nature of the object of their belief.
Rick Bookstaber is co-founder and head of risk at Fabric. He previously held chief risk officer roles at Morgan Stanley, Salomon Brothers, Bridgewater Associates, and the University of California Regents, and served at the U.S. Treasury in the aftermath of the 2008 financial crisis. He is the author of “The End of Theory” and “A Demon of Our Own Design.”