Cryptocurrencies have gained considerable mainstream attention this year. To some, they are seen as a solution to inefficiencies present in the fiat currency ecosystem from a policy perspective as well as an operational perspective.
Others consider cryptocurrencies and the technology around them as too risky to replace the fiat currency system, as we know it.
Bitcoin stands out among available cryptocurrencies perhaps due to a first mover advantage phenomenon that has seen the brand develop fast, gaining global traction and legitimacy across the financial industry.
In fact, most of the other cryptocurrencies are derivations of bitcoin’s protocol seeking to improve its technology and economic philosophy.
An interesting phenomenon though has been bitcoin’s price development. In 2017, bitcoin’s price has surged from $999 at the beginning of the year to its highest value so far of $17,160 all within a period of less than a year.
Notably, this price development has been marked by intermittent large price swings for example gaining and losing $1,000 intra-day.
Wiping away millions of dollars in the cryptocurrency market during such price drops. Bitcoin’s intrinsic value remains unclear.
As a result, the banking industry and regulators are making efforts to understand the implications of this undeterred and unregulated currency with regard to future policy setting.
In the absence of a clear consensus on bitcoin’s intrinsic value, the recent surge in price points to an interesting phenomenon - speculation.
The net effect of actions from speculators anticipating a price gain is the formation of an economic bubble. Further driving the price of the item in question beyond its intrinsic value – a value that is yet to be established in the case of bitcoin.
Bubbles tend to be seen ex-ante following their full lifecycle. Once a bubble is established, sophisticated speculators anticipate its peak and potential events that may trigger a pricking of the bubble.
Some pick up their profits and begin to exit the market. If and when the pressure to exit the market increases among participants, that marks the beginning of a downward spiral leading to a market crash.
At the moment, it is challenging to predict where the bitcoin market lies, with a potential increase or drop in its value. Going by the occasional sharp price drops, it is clear that a certain margin of the price is inflated by speculative activity and could be inferred as attempts at a correction and by extension busting of the bubble.
Speculative bubbles are a known phenomenon in the history of financial markets. The first recorded bubble (Tulipmania) is dated as far back as the 17th century in the Netherlands - the world’s leading flower market to this day. Back then the item of admiration was a tulip bulb.
Tulip flowers were introduced into Netherlands from the Ottoman Empire (modern day Turkey) and raised significant interest among the Dutch following publication of a book on tulips by botanist Prof Carolus Clusius.
Tulips with distinct colour streaks were highly prized and the most sought after. Their popularity and rarity made tulips a symbol of art, fashion and culture getting positioned as a luxury item whose price went out of sync with their utility value.
The entire nation got into the tulip bulb purchasing frenzy as people spoke of making high profits by trading tulip bulbs and getting bizarre offers to sell their tulip bulbs.
At some point tulip bulbs were used as currency, in 1633, a couple of bulbs were exchanged for real estate property.
As of 1636, tulips were fully traded in exchanges across Netherlands. Prices continued to soar, giving way to speculators who drove the market further out of proportion in hope of quick and high profits.
It is recorded that at some point, 12 acres of land were offered in exchange of a tulip bulb of the Semper Augustus variety.
Such was the exuberance in the tulip market. Prices went so high, that speculators could not keep up leading to a deadlock in trading activity.
The overheated tulip bulb market collapsed abruptly. Authorities stepped in to suspend all contracts and sellers were granted rights to sell their bulbs at market price and buyers would be responsible for the difference between the contract and market price once the authorities set the contract settlement prices.
In retrospect, tulips may not compare to the highly sophisticated modern day bitcoins for what they are worth, but the behavioural aspects of asset markets where instability and irrationality may cause prices to rise so high and collapse rapidly cannot go unnoticed.
Dennis Muiruri, via email