Is Bitcoin a Bubble?

Is Bitcoin a bubble? Is the cryptocurrency market in general a bubble? With Bitcoin hitting all time highs today over $10,000, this is likely a question on the top of many people's minds. And if it is a game of musical chairs, when will the music stop?

I believe that there are two ways to determine whether or not the the rise in price of Bitcoin is warranted depending on where you feel Bitcoin derives it's value.

1) Demand Driven Value

The price of a commodity will generally be determined by simple supply and demand. That's easy enough to understand, the open market does its thing to produce fair prices for all players involved. But what is often forgotten is that the things driving that demand are equally as important as the fact that the demand exists.

Imagine you were really into art and all of a sudden the market for art was hot. You decide to sell all of your expensive pieces to some enthusiastic investors at an auction. You are paid handsomely and you decide you must have a knack for picking valuable pieces of art, so you take the profits and buy even more art. The investor meanwhile is doing the same thing with the pieces he/she just bought off you, as are the people who are ultimately buy it from them.

What you quickly figure out in this example is that there seems to be huge demand for all things art in the market, but very few people actually want to use or retain the artwork for a long period of time. That doesn't seem like such a problem until the day that the classic automobile business has taken off and now the Ferrari's and Aston Martin's are the hot investment and nobody wants anything to do with art. You are evidently screwed, left holding a ton of "valuable" artwork and no one willing to buy it at the "right price" (the price you paid). This is how in retrospect you can tell that there was in fact a bubble and that it has officially burst.

The lesson here is that even though there might have been a huge market demand for the artwork and a lot of money changing hands for it daily, that does not necessarily translate to real value. People who see Bitcoin going to the moon often have this valuation mindset that if the number of transactions and capital changing hands increases, then demand is obviously much higher. In reality, if every purchase is just the attempt of one trader to sell the Bitcoin to the next trader and no one is actually using it for purchases or sees value in holding it for many years as a store of value, then it starts to not look so different from the art example.

At least for the first question, we know that no one is really using it for transactions in their daily lives simply because that would be entirely impractical. With wait times that last hours, $10 fees, and little merchant acceptance, we can rule out that any significant portion is real world transactions. Alright, so if a lot of the demand is not real, then what has driven the transaction volume so high in the past year?

One example of how Bitcoin's "demand" could in many ways be artificial is the required fiat to crypto conversion that takes place when entering or trading within the market. Currently, if you would like to enter the cryptocurrency market, you are more or less forced into converting from fiat to Bitcoin, Litecoin, or Ethereum because they are the most accessible from the outside. Then once converted you can convert again to whichever currency you really want. While not worthless, this toll-bridge creates potentially billions of dollars in transactions that have little or even nothing to do with the value individuals see in Bitcoin propping up its price. The question is, if there were more gateways from fiat available (as there one day will be) and base trading pairs, would people pick Bitcoin to transact. The answer is most likely not as other currencies are cheaper and faster for processing these transactions meaning Bitcoin could stand to lose much of it's "demand" over time. This leaves us with the store of value argument as where Bitcoin derives it's value, gold 2.0.

2) Is Bitcoin the New Gold?

Gold, like Bitcoin, has very little utility and is generally valuable as a result of scarcity. Where gold and Bitcoin differ however, is in the number of them that exist. Bitcoin has now hard forked twice in the past year already leaving people questioning which is the real Bitcoin. This is something that, for all the advantages of Bitcoin, gold is not at risk of. The idea of scarcity is very important for Bitcoin as it is one of its primary value drivers. The question is, will this value be eroded when there is a Bitcoin for every day of the week? Or if an alt coin emerges with real world utility and no hard fork threats, can it potentially take the crown as the leader of the crypto space leading an exodus out of Bitcoin? Only time will be able to answer these questions, but my inclination is that if the future mirrors the recent past and Bitcoin continues down this road of community erosion and hard forks, it becomes a tough sell that it has the fundamentals to become gold 2.0.

In conclusion, I think that one way to protect yourself from a bubble, if one does exist, is to invest in things that have real use cases and end users. Services with these elements, even if they are overvalued and speculative, can continue to grow as a service that cannot go away because people actually find value in them and do not want to stop using them. Similar to the internet boom in the early 2000's, some of these currencies will be things we use on a daily basis and those will be the ones that continue to grow and perform beyond any speculative bubble that may form and burst with time.

Disclaimer: I am not a financial adviser, and this is not financial advice. These are merely my observations on the market as I see it today. Thanks for reading, feedback encouraged!