The Dutch started paying a premium for owning those rare flowers. But after a while, a virus hit the flowers changing their appearance and giving them ‘flames’ in colour. This helped to increase the price of the flower.
As a result, more and more people started paying multiples of the initial tulip price. Governed by the fear of missing out, people started selling their assets to buy tulips. This resulted in an extreme boom for the tulip price which was once sold for the price of a luxury home (!).
Since no one was willing to pay more for a single tulip, a decline followed. The madness had to stop. People started selling their tulips in a frenzy mode and despite offering lower prices, no buyers were willing to pay any higher for a flower. Fortunes were lost in the so-called “Tulipmania bubble”.
This story my friends reminds me of today’s crypto-world. We see an extreme increase in the price of digital coins which were once trading for next to nothing. If I remember right, one of the first transactions were two Papa John pizzas bought for 10,000 bitcoins – $80 million dollars if the pizza boy held on their bitcoins!
Bubbles usually occur when people don’t look at the intrinsic value of the asset. They buy assets simply because they’ll definitely sell it soon to other people for a higher price. It always goes up after all!
If you’re interested in economic bubbles, like I am, have a read of the South Sea bubble (1711), the Florida real estate bubble (1929) or look no further than our own 2008 mortgage-backed securities 😉
But let’s take it from the beginning.
What is Bitcoin?
Back in 2008, our wonderful banking system failed us all. This led to a financial crisis that was so strong people lost faith in the system.
And a new crypto-world emerged from that. Satoshi Nakamoto created a digital coin called Bitcoin. It’s worth mentioning that nobody knows if Satoshi is a real person, a team or a mysterious nickname. As the legend has it, Satoshi remained anonymous similar to how anonymity is preserved when making Bitcoin transactions. See what they did there? 😉
So Bitcoin is a currency living on the internet and can be traded globally almost for free. A businessman in the US can send bitcoin money to some Lithuanian software developer instantly and without costs.
This strong network of computers around the world operates these transactions and anyone can join. Those computers are called miners. They also help discover new bitcoins by solving complex math problems. For mining and for helping with validating transactions, miners are rewarded with Bitcoins.
Blockchain is the technology behind Bitcoin, and you can think of it as the history of all transactions that have ever happened. Every computer in the Bitcoin network knows about all the valid transactions that took place and will be stored there forever. If you think about it for a while, you can find other interesting use cases, apart from money. Storing, for example, all the legal transactions between property owners!
Since everyone buys and sells in bitcoins there is no need for foreign exchanges, middlemen and more importantly, failing banks!
When sending money across the globe, and especially small amounts the fees are so high that is really not worth doing. Bitcoin can be traded around the world very cheaply and everyone can hold the same currency.
Bitcoin, also, cannot be controlled by any government. The amount of GBP (£) floating around in Britain is controlled by the central bank.
A committee decides whether we should print more or less money depending on the current economy. Here’s an excellent video on how the economic machine works by Ray Dalio. You may have heard of “The Fed” in the US which is really controlling these complex monetary policies.
The central bank also operates fractional banking. This means that they only hold a small percentage of your customer deposits, say 10%, and they lend your other 90% to people and businesses in order to boost the economy and make profit.
With Bitcoin, THERE IS no government! Noone says we should create more bitcoins and inflate or deflate the currency. More coins are created in a stable and predictable way according to a predefined algorithm that cannot change.
only $21 million coins can ever be created! Sort of like… Gold
Which is what drives people crazy. If there is a limited supply of coins, each coin will be extremely valuable if the demand increases.
Speaking of gold, gold is a precious metal that so many generations have used to store their wealth. Because of its physical nature and limited supply, gold can preserve its value over time.
During 27 B.C, Roman Centurions were paid around 40 ounces of gold per year.40 ounces of gold today is worth around $46,000 – the equivalent of what a US Army captain is paid today! Same amount of gold 2,000 years ago, same amount of gold as salary today.
People call Bitcoin “digital gold” because it has similar properties and can also be traded on the internet.
So there you have it. Cryptocurrency is becoming more and more popular today. One global currency, history of all transactions, decentralized nature without governments involved and no bank fees.
Everyone says Bitcoin is a bubble
Things become more interesting when the value of the recent cryptocurrencies is going crazy. In October, a single Bitcoin was worth $7,000, in November it’s worth $11,000!
Had you bought $100 worth of bitcoins in 2010, you would now be $75 million richer 😉
In fact, the volume of crypto transactions has become so big that CME, a big financial organization announced it will soon allow Bitcoin futures trading on its platform. NASDAQ, the famous stock exchange will support Bitcoin futures in 2018 too.
Of course, whoever states this doesn’t say the obvious: You should hold onto your bitcoins throughout these years to realise some gains. It must have been so easy to sell your bitcoins for a loss, let’s say in 2014 when for many years nothing is happening.
As you can see from this graph, Bitcoin’s growth makes the Tulip bubble look like a US treasury bond.
We have not seen something like this before and whether a Bitcoin supporter or not you’ll have to admit history broke a new record here.
To understand if Bitcoin is a bubble we have to see what previous bubbles consist of. The data will tell us.
Bubbles consist of 4 things:
- Extreme increases in price of an asset (high volatility)
- Buzz, fear of missing out
- No real connection between the selling asset price and its true price. Would you pay £100k for a tulip?
Looks like there isn’t a better candidate than our Bitcoin version 2017. Everyone talks about it and everyone thinks it’s a bubble. So why doesn’t it burst then? This is an interesting question.
Should I buy some cryptocurrency? Maybe buy Ethereum?
The recent increases in cryptocurrency prices make it even scarier to enter the market at its peak. An even trickier challenge is to try to evaluate a bitcoin. How much should it be worth? Should it cost $100 or $100,000? Why?
How do you know if Bitcoin is too expensive or too cheap at this point to make a rational decision on whether to buy?
In case of stocks, a simple valuation would be to take its future dividends paid at present time. That’s how much the stock is worth. In plain terms, you kind of know that if the company keeps earning at this rate, you will get a share of the profits back.
A pack of tomatoes costs £2.50. If you go to the supermarket and tomatoes today cost £4.00 you’ll say “no, thanks” and wait until they become cheaper again.
In case of a digital coin, there is no way to calculate what the intrinsic value of a digital coin should be. Also, the internet world has not adopted cryptocurrencies yet. Therefore, the only way to spend them is to sell them and spend dollars instead!
Buying Bitcoins is Like going to the supermarket and buying tomatoes without a price tag, knowing that you cannot eat them, but only sell them later on!
Even if you believe in the blockchain which I’m a strong supporter of, the dust needs to settle first. The Blockchain is an amazing technology which can improve the world like the internet did.
Property owners will only have to agree on blockchain upon selling their house and the validity will be there for everyone to see. It can help fight fraud and make this terrible bureaucratic process simpler.
Speaking of agreements, Ethereum is another interesting technology built on Blockchain. According to its philosophy, connected computers around the world run “smart contracts” which are agreements between two parties without any middleman or any intervention. Imagine you place a bet with your friend and the computers will pay someone the winnings after a game finishes.
But Michael, you’re still not answering. SHOULD I BUY BITCOINS?
You probably shouldn’t buy any cryptocurrency yet unless you see it as a gamble. It’s like going to the casino at this moment. Even Jack Bogle said “Avoid Bitcoin like the plague”.
The Crypto world is very immature yet and digital exchange wallets get hacked one after the other. Tip: The recommended way to store your coins is to buy a hardware wallet like Trezor. I’m not going to spend £80 though for storing £500 worth of crypto but good to know.
Oops! I just said I bought some. That’s just play money though to keep myself entertained and if I lose everything it won’t bother me much. I used the Coinbase exchange (invite link where we both get $10 / £7 if you buy at least £100). You don’t need $10,000 to buy bitcoins, you can still buy a fraction of it.
But what about the smaller coins? Bitcoin is just too expensive. I really liked this tweet: Bitcoin sneezes, altcoins catch a cold.
Simply put, there is a high correlation in price between Bitcoin and other coins like Litecoin, Ethereum, Monero etc. Buying these doesn’t really diversify much, as the prices move up and down very similarly. However, if a use case is found for one coin this will skyrocket its price so I see some value in that.
I believe 2018 will be a very interesting year for cryptocurrencies. The US Fed may create its own crypto coin, the price will crash and rise again, and the governments will want their fine cut. I plan to write a more detailed article on how to actually buy cryptocurrency without paying any fees. What are your thoughts? Have you bought any?
Interesting articles and Resources:
- Kevin Rose Show: Bitcoin’s true potential
- Bloomberg | Nasdaq to launch Bitcoin futures in 2018
- Bitcoin original paper
- Investopedia | 5 steps of a bubble
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