Bitcoin 'bubble' prices 'have a lot further to fall', Capital Economics analysts warn

Updated

Bitcoin will not replace national currencies and cryptocurrency prices are in one of the biggest bubbles in history, which is set to burst, warn analysts from Capital Economics.

In a 13-page research note, London-based economists Vicky Redwood and Kerrie Walsh outline in detail their reasons for believing that bitcoin does not have a bright long-term future, even if the blockchain technology behind it does.

Ms Redwood, in particular, should know a thing or two about currencies, having worked at the Bank of England after studying at Oxford and the University of Warwick.

From what she knows, she does not like the look of the current cryptocurrency speculation.

"Claims that cryptocurrencies will replace established fiat currencies are rubbish; our view is that bitcoin is a bubble," the authors argued in their report.

"Indeed, the latest price falls suggest that the bubble is bursting — although with prices still 10 times higher than a year ago, they have a lot further to fall yet."

The note was released after the bitcoin price plunged by around a quarter in about a day, with other major cryptocurrencies such as Ethereum and Ripple falling by even more.

One of the biggest problems with cryptocurrencies is that they do not have what analysts call an "intrinsic value" — unlike shares, they do not pay dividends; unlike housing, there is no potential rent; unlike gold, they are not physically useful or even pretty.

Cryptocurrency devotees counter this by arguing that so-called "fiat currencies" — money issued or backed by central banks — are also intrinsically worthless.

"Of course, modern paper currencies don't have any intrinsic value either. But unlike dollars, for example, bitcoin is not backed by a credible authority, such as a central bank or government," the report countered.

"Indeed, it is argued that bubbles are more likely to occur in markets where the fundamentals are hard to assess and participants base their investment choice largely on past price movements."

Some argue that bitcoin's value will be in supplanting gold as the world's preferred safe haven store of wealth.

If that was the case and, given bitcoin's fixed maximum supply of 21 million, its price rose to match gold's market capitalisation, the Capital Economics analysts estimate that the cryptocurrency could rise from around $US10,000 to $US630,000.

However, that would assume that bitcoin was the sole accepted cryptocurrency, whereas its dominance is currently being challenged by more than a thousand rivals.

'All the hallmarks of a classic speculative bubble'

The economists also warn that few current bitcoin investors appear to have done such calculations and risk analysis before speculating.

"Most people are buying bitcoin, not because of a belief in its future as a global currency, but because they expect it to rise in value," they wrote.

"Accordingly, it has all the hallmarks of a classic speculative bubble, which we expect to burst."

It may be doing so at the moment, having fallen around 40 per cent from its peak value in December to around $US11,200 at 10:30am (AEDT), and having briefly fallen below the psychological $US10,000 level in the past day.

Bitcoin rose around 20-fold in price over 2017 to hit a peak around $US19,000, according to some monitors such as coinmarketcap.com.

But, take a moment of pause for some dubious national pride, as bitcoin still has a long way to go to beat one of the world's biggest ever major bubbles, that of Australian resources firm Poseidon in 1969-70.

"This was triggered by the Poseidon company's discovery of a promising site for nickel mining in September 1969," the report explained.

"Poseidon stocks rose from $0.80 in early September 1969 to a peak of $280 in February 1970, before they crashed. Accordingly, they rose 350 times over the space of just a few months.

"If this is anything to go by, we clearly cannot rule out bitcoin prices rising even further before they crash."

That means that Ms Redwood and Ms Walsh are not calling the end of the bitcoin bubble just yet.

"When it will fully burst is anyone's guess and prices could yet rise again, before they fall further ahead," they added.

'Only a few cryptocurrencies will make it'

But they are still firmly convinced it is a bubble.

"Bitcoin is displaying some classic bubble properties. For instance, any company that even mentions the word 'blockchain' sees an immediate jump in its value," they noted.

This happened recently when Kodak's share price surged after the struggling imaging company announced it was launching its own cryptocurrency.

This avalanche of new cryptocurrencies is a key reason why the economists believe there is a bubble in many of the existing ones.

"Even if we assume that cryptocurrencies in general have a long-run future, only a few will make it and no-one knows which ones these are," they added.

Limited fallout from bitcoin crash

The good news is that, aside from draining the savings of a handful of millennial enthusiasts and wealthy tech speculators, Capital Economics believes the wider fallout will be limited.

"At the moment, a bitcoin crash would not have wide economic consequences. Bitcoin's market capitalisation is still small; it is not held by institutions; and it has little correlation with other financial markets," they noted.

"If the price of bitcoin fell to zero today, the paper losses would be equivalent to a 0.5 per cent fall in US equity prices."

Not that the risk will necessarily remain low, especially if the bubble does re-inflate.

"The more that bitcoin becomes a mainstream asset class, the greater the risk of fall-out from a crash," they wrote.

"The advent of bitcoin derivatives trading, for instance, has made it easier for institutions to get exposure to bitcoin, potentially raising the systemic risk of a large drop in prices."

As for their claim that the possibility of bitcoin replacing fiat currencies is "rubbish", the economists point to some of the reasons why governments moved away from the gold standard to floating exchange rates.

"A key feature of most cryptocurrencies is that they have an exogenously determined supply, meaning that governments or central banks cannot inflate away their value," they wrote.

"But this means that swings in money demand therefore lead to big changes in prices or activity.

A widespread adoption of bitcoin could prompt a re-run of the problems seen under the gold standard.

"If bitcoin were to be used globally, then — again, as with the gold standard — all countries would effectively end up with fixed exchange rates.

"This would severely limit their scope to deal with changes in domestic economic conditions."

Useful role for blockchain and digital currencies

But the analysts do see a potential role for central bank digital currencies (CBDCs), despite Australia's Reserve Bank governor talking down the idea recently.

"Blockchain technology could make it feasible to offer all individuals and firms an account at the central bank and, crucially, to allow them to exchange money in the same decentralised way that bitcoin does," they wrote.

"Varying the interest rate paid on these accounts would give central banks another monetary policy tool.

"Indeed, if physical cash were phased out altogether, central banks would have the option to set negative interest rates.

"Meanwhile, people would have a risk-free way to hold funds.

"However, if people moved their money from commercial banks to the central bank at times of uncertainty, bank funding would become significantly more volatile and credit growth would become squeezed."

Allowing businesses and households to bypass banks for simple transactions could also boost economic growth.

"Bank of England researchers have estimated that CBDC issuance of 30 per cent of GDP could permanently raise GDP by as much as 3 per cent due to reductions in real interest rates, distortionary taxes and monetary transaction costs," the Capital Economics report added.

Outside the financial sector, the underlying blockchain technology behind bitcoin also has a wide range in uses, from facilitating transactions and trade, to maintaining government records such as tax, health and property transfers.

Topics: money-and-monetary-policy, consumer-finance, regulation, australia

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