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Bubbles and Manias: Can Crypto Learn from the Mistakes of History?

My economics class is inundated with readings on bubbles and manias. Over the last semester, we’ve travelled from 16th century Holland, where peasants and tavern-goers gave up their livelihoods for pretty flowers; we shook our heads at the arrogant excesses of 1920s America, when stock market speculation was a national pastime, and we laughed at the the more ludicrous bubbles such as the Beanie Baby Boom, which saw soccer moms engaged in court battles over priceless stuffed toys. Key takeaway: human beings can assign value to anything. When this happens in large numbers, we almost always succumb to herd mentality, incentives misalign, and people get hurt in the process.

Beanie Babies

So what do we do when we find ourselves in the midst of a bubble? Cryptocurrencies are the perfect example of how irrational exuberance can drive an entire industry, and if you’ve looked at the charts recently, you’ll know that we are paying a very heavy price for that exuberance. A few years ago, it might have been tempting to dismiss the real growth of the industry, but the involvement of institutions and regulators tells us that digital assets are here to stay. With liquidity drying up and subreddits deep in mourning, now is a good time take a step back and ask ourselves how we got here, and more importantly, what we can do to shape where we’re going.

Historical economic bubbles (The Economist)

Back to the basics

One of the common patterns in any economic bubble is that very few people actually know what they’re talking about. In the early 2000s, financial jargon produced such terms as “synthetic CDO” — “a collateralized debt obligation made up of insurance payments from a credit default swap on other collateralized debt obligations made up of mortgage-backed securities”. Got it?

With crypto, we’ve been no less spared the linguistic creativity of the people creating the rules as they go along. As with all bubbles, poor journalism and inevitable information asymmetries are to blame. “Cryptocurrency” has become synonymous with “blockchain” which has become synonymous with “decentralized”. All three represent distinctly different concepts, so let’s rehash the basics:

Cryptocurrencies are an asset class; they’re cryptographic tokens on a distributed ledger (a type of data structure) called a blockchain. “Blockchain” thus refers to the basis technology and cryptocurrencies are a tool within the ecosystem. Tokens can be roughly divided into three classes, depending on function:

  1. Security tokens: These function much like normal securities; where the purchase of the token is motivated by the anticipation of future profits in the form of dividends or, most commonly in crypto economics, price appreciation.

  2. Utility tokens: These tokens give holders present or future access to a product or service.

  3. Payment tokens: These tokens are the simplest form of “digital money” and function much like fiat currency, usually with the advantage of better security, privacy, or efficiency. They offer no further functions or links to the development of a project.

The ICO (Initial Coin Offering) is a token-based crowd sale. It’s the crypto version of an Initial Public Offering (IPO) with two major differences: a) most ICOs are conducted at the beginning of a project’s life cycle in order to raise funds for future development and b) ICOs protect the equity of founders, allowing them to raise large amounts of money with little accountability to their investors (and often none, as we’ll see below).

Now, back to the bubble.

The power of narrative economics

If there’s one thing I’ve learned through my involvement in this industry, it’s that even deep in the thick of bubbles, in the frothiest of suds, proponents of The Next Big Thing will always find reasons to explain the weaknesses away. This is because bubbles are psychological in nature before they are economic.

The Nobel laureate Robert Shiller coined the term “narrative economics” in 2017. He was one of the early economists to embrace behavioural psychology as a driving force behind markets, and now he thinks it’s time to draw from the arts and humanities, too.

Robert J. Schiller quote

The crypto narrative has been so successful because it is delectably intuitive; it speaks to the core of what the modern human being idealizes and fears. We want decentralized societies where trust exists — and doesn’t at the same time. We want to be independent of governments. We’re selfish yet steeped in the ethos of equality and egalitarianism, so we desire complete control over our money, reputation and identity — all within a perfect, self-regulating system that we invented ourselves.

And then we slapped some arbitrary tokens onto the vision and watched the cash roll in.

Three things helped the cryptocurrency bubble grow:

  1. Timing. After the collapse of the US housing market, the world reeled in shock as systemic contagion spread like wildfire. Everyone watched as their cousin, brother and neighbour got laid off work, while Wall Street executives were showered with millions. The banks were too big to fail and the taxes of those retrenched workers were used to bail them out. So when the mysterious Satoshi Nakamoto published his/her/their/its paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System”, it not only made sense, it spoke to hearts.

  2. Hyperconnectivity. The power of social media intensified the crypto hype exponentially. Networks were dangerously easy to leverage. A single message on Facebook or Telegram could influence thousands to take the plunge and set up a wallet. Within minutes, they could set up a bank transfer and start trading in a market that quickly became driven by speculation.

  3. The regulatory grey area. Digital money? Utility tokens? Securities? If investors had a hard time wrapping their heads around cryptocurrencies and blockchain technology, regulators were still in the depths of a murky swamp. The lack of regulatory barriers made innovation easy, cheap and dangerously lucrative.

Bitcoin price movement

And so the story was passed on — at conferences, at meetups, at Burning Man, on Telegram channels, in memes. At first, people tried to convince themselves it wasn’t a bubble — myself included. My excuse is that in 2017, I was still a college freshman in San Francisco living off hackathon food, lured in by the free tokens that were dished out just for showing up on time. But after doing a bit of consulting, working at a cryptocurrency exchange and generally becoming wiser, I now know that any time people have to be vocal about something not being a bubble — well, it’s probably a bubble.

Vitalik Buterin

Growing the bubble vs. expanding the pie

What makes a bubble a bubble is not just that many people are investing their money into an rapidly-growing asset. A bubble is defined where an asset price rises above the level justified by economic fundamentals. The possibility of Uber being valued at over $120 billion is a strong sign of a bubble in the gig economy. I found an article from 2014 titled “Latest sign the tech bubble’s really here: Uber valued at $17 billion”. Then, at $40 billion, people anticipated the burst. Well, here we are. Uber, Lyft and a number of other gig economy giants are set to go public in 2019; the bubble is still hovering enticingly above us, and only time will tell whether it bursts or slowly deflates.

Price action in traditional markets supposedly follows anticipation of future profits, which can be tracked by metrics such as quarterly reports, competitive analysis, and customer satisfaction. With crypto, however, the Initial Coin Offering (ICO) has broken this relationship. Three major flaws stand out:

  1. It is incredibly easy to raise money. Projects have literally raised millions — sometimes billions — of dollars through massive online campaigns. ICOs can be celebrated for the fact that they have decreased the barriers to venture capital, but the danger is that startups that gain liquidity too fast often don’t know how to manage their excess. Millions of dollars get squandered on marketing campaigns, sponsored events, and elite conference after parties instead of actual development. It’s also necessary to question who is investing, and on what fundamentals those decisions are made. Investors all over the world who have been spurred on by irrational exuberance and the advice of “experts” have thrown their money into projects without so much as reading a white paper — a tool that has now gained the same legitimacy in this industry as a PowerPoint presentation.

  2. There literally is no accountability, so price is arbitrary. ICOs have even fewer metrics than IPOs for tracking real value. Founding teams are the ones who set initial token price, not banks or a group of seasoned investors.There is no incentive for projects to release important data on growth. Massive information asymmetries mean that investors can only track “success” through price, but price is not telling a complete story because it is based largely on speculation. Economic fundamentals are cast aside, and thus the value of an entire industry is one grand scheme that no one really knows how to read.

  3. Misaligned interests. What incentive is there for project founders to commit to the next ten years if they cash out their first millions on day three? Because the nature of the ICO allows founders to retain full equity, investors lack skin in the game. This might not be a problem in an IPO, where the company has typically reached a level of maturity for it to survive the volatility of the stock market, but for a project in its early stages (where often even the minimum viable product is still in the pipeline), token price devaluation can spell disaster. There are a good number of people who invest in ICOs not because they believe the company will be successful in 5 to 10 years, but because they stand to make a profit in the price appreciation that immediately follows token listing. They’re in it for the pump and dump. These skewed incentives dampen the rate and quality of innovation and make it very difficult for real growth to occur.

As of late 2018, there are approximately 1000 dead coins — the tokens of failed crypto projects — still floating around the cryptosphere. A recent study by small team at Boston College in Massachusetts found that a mere 44.2 percent of token projects are active into the fifth month or beyond. Unsurprisingly, in this report, it was found that startups “sell their tokens during the ICO at a significant discount to the opening market price, generating an average return for ICO investors of 179%, accrued over an average holding period of 16 days from the ICO end date to the listing date.”

Let’s pretend that it isn’t so bad that thousands of people make poor investment decisions every day. What makes this relevant to our study of bubbles is the element of systemic risk; this is what entrenches the cycle of those poor decisions, and is what makes bubbles so dangerous. There are two glaring red flags in the crypto industry right now:

Firstly, we’ve devised a way to profit even from the failing projects. Secondly, the lack of accountability means that the creators of those projects will rake in the profits when they uphold their promise to investors, but face absolutely no consequences when they don’t. They will win when they win, and win when they should lose. There’s a giant pool of money almost guaranteed to be made.

According to Crypto Fund Research, crypto funds now constitute 20 percent of the total hedge fund launches in 2018. What these funds do is drive up the demand for crypto projects, but because regulation and best practices haven’t caught up, more money won’t necessarily lead to better standards. It will just lead to bigger initial valuations and investor “pumps”, during which time many will stand to make huge amounts of money, followed by inevitable “dumps” where less informed investors lose out considerably. This is directly analogous to what happened pre-2008. The higher the demand for structured financial securities, the more supply there was, with little heed for the actual strength of the underlying assets. An expanding bubble does not equate to a larger economic pie.

All hope is not lost

In an interview in June 2018, Agustín Carstens, General Manager of the Bank for International Settlements, reiterated his belief that cryptocurrencies represent “a bubble, a Ponzi scheme and an environmental disaster.”

I disagree. Cryptocurrencies represent an alternative way of doing finance, raising money and assigning value. More importantly, they’re a tool that can be used to transform many of the broken, inefficient systems we interact with every day. Whether you identify as an “enthusiast”, a seasoned investor, a sceptic, or a wholly disinterested human being , cryptocurrencies will shape your future in some way. They will be the back end to better international payment systems. Tokenization will be the architecture behind incentive systems that shape societal behavior.

But right now cryptocurrencies are failing miserably. When was the last time you used bitcoin to actually pay for something? Until we find a solution that provides real utility and sustainable scalability, the market will continue to be driven by the mindset that fuels all security bubbles — the gung-ho belief that prices will always go up.

What’s needed now, from developers, exchanges, regulators and consumers, is a systemic approach to how we build the industry from the bottom up. If ethics are scarce, build them into the system. Create locking periods on project financing and introduce transparency and accountability mechanisms that are tied to real growth and innovation. Regulators need to protect consumers without stifling incentives for development. Exchanges need to own up to their responsibility in shaping best practices and implement better due diligence and security. Community managers and marketers need to cast their eyes for one second off user base and revenue and question what role they play in spinning grand illusions and selling flawed incentives to real people.

The crypto industry has lost sight of why it exists. This technology which we all so vehemently believe in will work only if we acknowledge our collective responsibility for making it better. To shake our heads in hindsight is not enough; we need to start shaping what comes next.

In years to come, economics students may be studying the “Bitcoin Bubble” and drawing the same lessons as were drawn from history’s more serious contenders: the Dutch tulip bubble, England’s South Sea bubble, Japan’s real estate and stock market bubble, the Dot Com Crash, and most recently the US housing crisis. Fortunately, the magnitude of the risk is nowhere near these economic disasters — yet. But we’d be naive to think that history could not repeat itself.


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