One of the greatest bubbles of all time was the Dutch Tulip mania that collapsed in 1637. At one point before the collapse, a couple of Tulip bulbs were worth enough to buy a house.
I can only imagine the sweet schadenfreude of the average Dutch citizen watching the demise of their fellow countryman when the bubble burst. This was probably the first recorded speculative bubble.
So what caused that bubble to occur? For this discussion, let’s replace tulips with Bitcoin. No this is not an arbitrary bait-and-switch metaphor. The two possess the same dynamic and the example is more recent.
According to the website Zerohedge, the entire Bitcoin market is worth 60 billion (a few years ago, this is not current). The price of Bitcoin has gone up and down. Repeatedly. What is causing this behavior?
First, cryptocurrencies and Bitcoin are a new type of asset. Early on buyers didn’t know who owned it, and by how much. This can easily result in over-pricing due to a lack of information and the market’s inexperience in trading the asset.
A lack of liquidity is another reason. According to Bloomberg – 1,000 people own 40% of Bitcoin. Just a handful of individuals. Zerohedge says 95% of the Bitcoin market is traded by 4% of the market. So ownership is concentrated. Since such a small number of people own and trade Bitcoin, buying by even a small number could increase the price a lot. And even a quite small reversal could send the price down more than expected. Much more.
One of the primary reasons for Bitcoin’s price variance is that there was no way to trade against it. No way to execute a short.
A short sale definition is when an investor (speculator) borrows an asset (such as a stock or bond) and sells it. Then hopefully buys it back later for less than what they sold it for. The investor then returns the asset back to the original lender and keeps the difference as a gain.
Financial theory states that an asset’s price is decided by the most optimistic buyers if you can’t trade the asset for a gain – either as the asset appreciates or declines. For example, without a short mechanism if a speculator thinks a cryptocurrency price is too expensive they will just sell. And wait until the price goes down to re-invest (or not). The remaining owners will be the optimistic ones and tend to buy more. Thereby driving the price up.
This idea is supported by a bunch of academic papers that say that high levels of optimism in a market without an ability to short can cause an asset to be priced beyond its intrinsic value. A paper in 1978 by David Kreps and J. Michael Harrison of the Stanford Business School first made that argument. Dilip Abreu and Markus Brunnermeier of Princeton also published work along those lines. There are others making the same point.
The lack of an ability to short-sell may explain Bitcoin’s performance. In the past it has been easy to buy and hold Bitcoin but really hard to short it.
In December 2017 the trading of Bitcoin futures began with government approval. This was in the middle of the huge increase in the underlying Bitcoin price. As futures began trading Bitcoin’s price started dropping. It may be a coincidence. But then again, maybe not.
Future and derivatives contracts can be quite esoteric and far removed from the underlying asset. Sometimes assets can be assembled in highly risky ways and resold as bundles. This may be dangerous for the economy in general and for individual investors too. The risk is best demonstrated by the subprime mortgage debt crisis in 2008.
But don’t give up on futures and derivatives. From a macro perspective these contracts if handled intelligently can play an important role in making sure a market works well. They can help ensure that prices do not get too far out of line.
For an individual investor, when examining a security where there is no ready market with no contrary (negative) pricing opinions being expressed, take extreme care to make sure you are getting a good value. As Warren Buffett has said, “price is what you pay, value is what you get.”
