Even though 2017 was Bitcoin’s most profitable year, 2018 is ending up with the biggest losses in the currency’s market capital since its advent. Many traditional economists believe that bitcoin represents a huge bubble that is destined to burst, especially since its massive gains were driven, at least partly, by newbie buyers and speculators. As bitcoin price has plummeted below $5,000 for the first time since October 2017 last Monday, observers have started to believe that the bitcoin bubble is about to burst, especially as most of 2017’s massive gains have been wiped out.
A recently published paper explored bubble behavior across bitcoin markets throughout the period between March 19th, 2016 and September 2018. The study utilized the test methodology proposed by Philips and colleagues in 2015 to identify periods of bubble behavior. Also, the study relied on the Log Periodic Power Law model proposed by Filimonov and Sornette in 2013 in order to identify critical time points along the course of the development of the bubble. The study identified multiple periods of bubble behavior occurring in 2016 and 2017, yet most of the bubble behavior took place during 2017. The methodology used in the study identified December 6th, 2017 to be the critical time point for the crash of the bitcoin bubble. However, following January 2018, neither of the used approaches managed to provide evidence of undergoing bubble periods.
Why can bitcoin represent a financial bubble?
A financial bubble or a market bubble represents trading taking place of an asset at a price range that markedly exceeds the intrinsic value of the asset. It could also be referred to as a situation throughout which an asset price seems to be based on speculations and implausible views about the future.
As shown in the below figure, a financial bubble can be marked into the following 5 phases:
1- Substitution phase (stealth phase): an increase in an asset’s value
2- Takeoff phase: speculative purchases; traders buy now to sell at a point in the near future for massive profits
3- Exuberance phase (mania phase)
4- Critical phase: begins to shorten the buyers, as a large percentage starts to sell
5- Crash phase (blow off phase): the price sinks
When considering bitcoin, the takeoff phase took place in 2012, and its popularity rose towards the end of 2013, when its price briefly exceeded the $1,000 mark. The subsequent boom phase is marked by prices surging slowly initially and then gaining momentum as more and more traders step into the market. This is probably what took place in late 2015, when, following a long quiescent phase, bitcoin price exceeded the $300 mark once again, slowly surging towards $1,000 early in 2017.
The second half of 2017 can also mark the mania, or euphoria, phase during which caution is overlooked as an asset’s price skyrockets. This is what happened as bitcoin price exceeded the $2,500 mark, nearing $20,000 in December 2017. The mania phase is also characterized by people borrowing extensively to finance their speculative investments. Even though no accurate information exists regarding the extent of borrowing related to bitcoin trading, multiple indicators denote that bitcoin’s mania phase took place in 2016 and 2017. A recent survey showed that around 18% of bitcoin investors have bought their coins using their credit cards. Moreover, besides credit card purchases, in 2017, multiple bitcoin exchanges began to offer margin trading options. On the other hand, BitFlyer, the Japan based bitcoin exchange, reported in December 2017 that some traders leverage their capital up to 15 times in order to finance their bitcoin purchases.
If bitcoin is really a bubble, then we might be about to enter the critical phase, or the profit taking phase, during which investors can cash out their investments before the bubble bursts. Actually, we might have already started to enter into this phase, especially since bitcoin price has dropped by almost 25% during less than two weeks.
Conventional economists and asset valuation models are not sophisticated enough to explain the recent movements in bitcoin price. Most of these models propose that bitcoin is overpriced, ignoring the numerous innovations and economic concepts introduced via this blockchain based cryptocurrency. The next couple of years will help us determine whether bitcoin is nothing more than a bubble that will burst sooner or later, or a revolutionary financial asset that the market is yet to properly appreciate.