4 Thoughts on the Crypto “Bubble”

There’s been a lot of talk about whether Bitcoin, or crypto overall, is a bubble. Some say absolutely. Many suspect it’s likely, but argue that as with most bubbles, it’s difficult to know for sure. After all, the Economist called Bitcoin a bubble in 2011 when it was at $2.50 and again in 2013 when it was at $1,000. And Tyler Cowan used to think it was a bubble, but now isn’t so sure.

I’ve had many fun discussions about this with friends and family, and have been increasingly reading and thinking about the topic. So I’d like to share a few thoughts.

1. The total market capitalization of all cryptocurrecnies is $740B – this is a bubble

The market cap summary at coinmarketcap.com is a helpful reference point. Bitcoin represents about 30% of the $740B in crypto value, and Ethereum represents another 18%. As of today there are 1,089 cryptocurrencies with tracked value:

  • 42 of them are valued at over $1B
  • Another 167 are valued between $100M-$1B
  • And another 576 are valued between $1M-$100M

This seems absurd. 42 cryptocurrencies worth over $1B? I suspect some of these are truly innovative and experimenting with potentially value-creating blockchain technologies. But most probably aren’t.

Let me put this in perspective, two different ways:

  • $740B is about 80% of Apple’s $910B market cap. Apple is the largest US company, and actually the largest public firm in the world. It’s a company that designs and sells, among other things, expensive and complex smartphones that are owned by one in seven people on the planet. And they also directly employ about 120k people.
  • $740B is 1/400th of the total estimated global wealth of $250T. Think about that one for a second. If you add up all the real estate, companies, commodities, precious stones and metals, art, and everything else everyone on the planet owns, cryptocurrency now represents about 1/400th of that.

This’s a lot of crypto wealth. I’m convinced blockchain technologies are innovative and show lots of potential. But it’s difficult to justify current valuation levels given that most use cases, other than serving as an anonymous store of value, haven’t yet been proven at scale.

So I suspect the overall “asset class” is in bubble territory and will likely correct at some point.

That said, I’m hesitant to single out Bitcoin or Ethereum and call them a bubble. They might be. But there are many compelling arguments that these coins have become a legitimate store of value. And in this role they might be fulfilling some of the function historically held by assets such as gold, albeit with much more volatility.

For example, they’re generally an anonymous place to store value, isolated from certain traditional geopolitical risks (but possibly at risk of new ones such as a cryptocurrency ban), and not highly correlated with equities and bonds. Those are many of the reasons investors hold gold.

And for reference, the total value of all existing gold is $7.5T, about 10x the total value of all crypto. So “Store of value” assets such as gold have historically represented a sizable portion of global wealth, and there’s a case to be made that crypto is taking a piece of this pie.

But crypto hasn’t replaced gold and other assets like it. 1,089 cryptocurrencies worth over $1M can’t all be a legitimate store of value.

I obviously have no clue how it will all play out. But here’s one plausible scenario:

  • Most of 1,089 cryptocurrencies will turn out to be worthless when the hype dies down
  • The largest ones continue to be volatile but some will maintain much of their value
  • A small subset with truly innovative models or technology will maintain their value, and some will likely even create lots of new value

If this were to happen, the total market cap of all cryptocurrency could fall more than 50% to $350B or so, with may cryptocurrencies wiped out entirely, while certain coins such as Bitcoin or Ethereum could maintain much of their value and never have a bubble-like correction.

2. Just because there’s likely a crypto bubble doesn’t mean the technology isn’t innovative

Many people have told me that the underlying technology is so innovative, it can’t be a bubble. But both can be true.

I was reading about Virgin Hyperloop One yesterday. I believe the company is doing innovative and potentially disruptive things in the transportation sector. It’s currently valued at $750M, or 1/1000th of the crypto market. That valuation feels reasonable given where they are in the product development and testing process. If I learned they were recently valued at $750B, I would still think the technology is innovative and potentially disruptive. I’d just also think that anybody investing at those levels was likely buying into a bubble.

The best analogy I have is probably the 2001 dot-com bubble. The internet hype funneled trillions of investment dollars into new internet-based business models, most of which turned out to be bad businesses. That didn’t mean the internet wasn’t innovative or disruptive. Many of the pioneering companies just didn’t get the model right, couldn’t execute, were too early, or were exploiting the hype.

For the past 16 years after that crash, thousands of companies (and the investors that funded them) have gotten it right, creating trillions of dollars in new value from the internet. It just took time. The models that turned out to be right needed to be thoughtfully explored and tested, the ecosystem needed to develop, and in some cases adjacent technologies needed to catch up (e.g., telecommunications infrastructure).

So even if crypto is a bubble now, blockchain technologies could still prove to be important and value-creating to the economy in the long-run.

And there’s reason to believe that a “long-run” time horizon is appropriate. Matt Levine, via Tyler Cowan, raises an interesting point about the potential for integrating blockchain principles into the financial system:

I also think it is noteworthy that actual cryptocurrency exchanges exist to get around the limitations of blockchain-based settlement. It’s hard to short bitcoins or buy bitcoins on margin, which is why exchanges exist and use off-blockchain methods (lending you money, keeping custody of your bitcoins, etc.) to allow you to do those things. (Sometimes that’s a mess!) It’s not like you’re using the blockchain to buy bitcoins with dollars on a cryptocurrency exchange; you’re using your credit card. If you want to rebuild the regular financial system along blockchain principles, you have to wrestle with the fact that even the bitcoin financial system doesn’t really operate on blockchain principles.

Coinbase, the first crypto focused startup to reach uncicorn status, is a perfect example of this.  They essentially run a cryptocurrency exchange and brokerage, making it easy for the average person to transfer cash from their bank account to buy Bitcoin, Ethereum, and Litecoin, and then manage them in a Coinbase account. In other words, they built a $1B+ business not by innovating on blockchain technology, but by making cryptocurrency look and feel more like the traditional assets held in a brokerage account.

Technological hurdles are another reason to believe it will take a significant amount of time for the technology to prove out. There are transaction processing limitations for many blockchain technologies at the moment, including the absurd amount of energy consumed in the process. I’m sure smart people are working to solve these, but there’s some path dependency with existing technologies, and it will take time to fix.

3. People who consider crypto an alternative to a diversified portfolio are going to get burned

A quote from one of Fred Wilson’s posts stuck with me: “I was showing my daughter’s friend an app that helps people save and invest and he said to me ‘I don’t need that, I just buy some ETH every week.’ I said ‘that’s a good plan until it isn’t.’ ”

Fred, who’s a prominent VC and long-time investor in the blockchain space, has shared lots of sound advice on his daily blog about how to approach and manage crypto in an investment portfolio:

  • For those who have already made a fortune: “Taking money off the table is smart portfolio management. It is very different from selling your entire position, which could be brilliant but is equally likely to be a mistake… If you are sitting on 20x, 50x, 100x your money on a crypto investment, it would not be a mistake to sell 10%, 20% or even 30% of your position.”

“True believers” in crypto might want to have 10-20% of their net worth in crypto assets. For many of these true believers that would be down from 80-100%.

So, what do I think is a reasonable asset allocation to crypto for the average investor?

Well to start… [we] have about 5% of our net worth in crypto assets, across a number of vehicles; direct holdings, USV funds, token funds, etc. We have a fairly diversified crypto portfolio, likely much more diversified than most folks could do on their own.

I think that’s likely at the high end of what the average person should have, but I also think its not a ridiculous number for the average person to have.

If you had to pin me down on a number, here is where I would end up:

-young, aggressive risk taker – 10% of net worth in crypto

-sophisticated investor seeking a high performing portfolio – 5% of net worth in crypto

-average investor, slightly conservative, but with some appetite for risk – 3% of net worth in crypto

-retiree seeking to preserve portfolio value and generate income – 0% of net worth in crypto

  • For those deciding on how to get into crypto: “I am a fan of dollar cost averaging and building a position over time, sometimes a long time. I have been buying Bitcoin since early 2013 and Ethereum since last year. I keep buying but never that much at one time. Just a little bit every week. You can build a pretty big position that way, but you have to be patient and you have to keep at it.”

So basically, if you’ve already made a lot of money in crypto, it would be smart to take some money off the table (even if you’re still a “true believer”). If you haven’t and are considering how much to invest, 0-5% of your net worth is probably the right answer, ideally diversified. And if you’re deciding how and when to get in, start small and build up to the 0-5% position over a long period of time.

This’s all sensible advice.

But I keep reading about people who are still “all in” on Bitcoin or Ethereum. These two coins can still go up, and may serve valid roles in a diversified portfolio. But going forward, nobody is going to make 100x or 1,000x on either of them. There’s a logical ceiling. If Bitcoin were to go up another 1,000x, it would be worth as much as everything else in the world. It just couldn’t happen.

The only way to earn 100x-1,000x returns in crypto at this point is to identify and invest in the next Bitcoin or Ethereum, if there even is one, or in companies that play a valuable role in the ecosystem. Most people who try will get it wrong.

So there’s much less upside at this point, and without any obvious intrinsic value, it could be a long way down. Anybody that would be uncomfortable losing their entire crypto position, should be diversifying.

4. ICOs only make sense if the coin does something useful

It’s hard to ignore ICOs. Beginning in June of last year, more money was raised in ICO’s than from early stage VCs. Some projections suggest 2017 ICO funding likely exceeded $5B.

The most fascinating part of this is that there’s a new way for a certain type of initiative to raise a meaningful amount of capital without ever giving away ownership or having to be structured as a for-profit company in the first place. Kickstarter might be the last example of a successful new non-equity early stage fundraising mechanism.

But the key here is “a certain type of initiative”. For 99%+ of companies, an ICO is not a reasonable fundraising mechanism. That doesn’t mean some won’t succeed when they shouldn’t in the midst of all the hype. Plenty have, and more probably will, and those who bought the coins will lose out when they become worthless.

So what do I mean by “certain type of initiative”? I mean a company or project that has developed a model where the coin does something useful, something valuable.

I’ll start with a few examples of valuable things Bitcoin did in its very early stages. It facilitated:

  • Money laundering
  • Anonymous purchases of black market items such as drugs and weapons (e.g., Silk Road)
  • Tax avoidance and cross-border money transfers
  • Experimentation with blockchain technology

The first three were generally illegal, but very valuable to certain people. The fourth laid the groundwork for subsequent blockchain innovation.

As I understand it, Ethereum has solved meaningful problems in the distributed computing and contracts space, also creating value.

At this point though, the primary function of both Bitcoin and Ethereum, aside from speculation, is likely a store a value. In this way they are similar to gold, as I described above. And storing value is something useful.

But we don’t need hundreds of new coins to serve as a store of value. We already have two gigantic ones, and many more of material size competing for their spots.

The consensus seems to be that two other valuable roles for blockchain technology are related to contract management and asset ownership tracking. ICOs for innovative new solutions in these spaces may make sense.

I’ve also heard some interesting examples of coins serving as payment for distributed P2P cloud storage space, with the coin price representing the cost per GB. That seems like a reasonable model to explore with an ICO.

But most companies don’t have innovative blockchain-based solutions to these types of problems.

It was funny to hear last week that Kodak announced plans for an ICO. Techcrunch indicated its stock immediately jumped 89%, and shared that “Kodak’s ICO is designed to develop a blockchain system to secure digital photography rights and ensure photographers receive royalties.”

Ok, so this use case does fall under the contract management and asset ownership tracking value roles I described above. But even if Kodak nails the blockchain technology behind it, which is a big if, will the coin be useful?

No. For a couple reasons. Matt Levine sums in up well at Bloomberg View:

Ohhhhh no. Look: Kodak wants to run a web crawler and a central database of photographs. You don’t need to do that on the blockchain. It also wants to run a marketplace to match buyers and sellers of photographs. Again you don’t need to do that on the blockchain. You certainly don’t need your own currency to do that; lots of markets — the stock market, the supermarket, the existing market for photographic licensing — run on dollars, and what is convenient about dollars is that if you get dollars for licensing your photographs you can spend them at the supermarket.

But here is the best part of Kodak’s announcement…

Kodak, unlike many cryptocurrency newbies, is a real company, albeit one that is somewhat reduced from its glory days. It is real enough to have real lawyers, anyway, so it has to do the initial coin offering of KodakCoin legally. And by now everyone accepts that speculative initial coin offerings — particularly ICOs of tokens for use on not-yet-existing platforms — are securities, and so have to be either registered with the Securities and Exchange Commission or issued under an exemption from registration. Kodak has sensibly decided to do an exempt ICO using a 506(c) private placement, which means that all purchasers of KodakCoins must be accredited investors, generally requiring either $200,000 in income or $1 million of net worth.

Which means … that you can’t use it? Want to buy some KodakCoins to pay for photos on the KodakOne platform? Great, fine, if you’re a millionaire or a company, but middle-class individuals will not be able to buy KodakCoins.

That does not sound very useful.

To add the the absurdity of the ICO frenzy, I couldn’t help but laugh yesterday when reading this NYT article, “Everyone Is Getting Hilariously Rich and You’re Not.” It’s worth a skim, and I think this quote sums up a lot:

Mr. Gardner leaned back into the sofa and rested his feet on the table. He recently did an I.C.O. for a start-up after-party. “You can I.C.O. anything,” he said. He runs Distributed, a 180-page magazine about cryptocurrency that comes out about once a year. He is now raising $75 million for his hedge fund, Ausum Ventures (pronounced “awesome”). He said his closest friends are moving to Puerto Rico to get around paying taxes.

“They’re going to build a modern-day Atlantis out there,” he said. “But for me, it’s too early in my career to check out.”

Given the amount of capital flowing to ICO’s, we’ll obviously continue to see many more into 2018 from the momentum alone. Some as PR (e.g., Kodak), others to capitalize on the hype and take money away from those gullible enough to fall for it (e.g., a start-up party), probably quite a few led by misguided companies that feel compelled by their boards, shareholders, or peers to do something in crypto (e.g., Kodak), and maybe a small few where it’s the right fundraising approach for something innovative.

So while I continue to find the ICO model fascinating, it only makes sense if the coin is useful. I remain skeptical of how many of today’s coin models will prove to be of value in the long-run, I don’t think they are a viable funding option for most startups, and I suspect a big theme of 2018 will be increased regulation and oversight as more of these models blow up.

That’s all for now. As always, I’d love to hear any thoughts or reactions.

And in full disclosure, I own some Bitcoin, Ethereum, and Litecoin.

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2 Comments

  1. Sam, great post–really thoughtful discussion of Bitcoin’s value. As you point out, the only significant non-illicit use case that anyone can come up for bitcoin is as a “store of value.” The analogy continually used is gold. But gold is not the only non-security, non-cash store of value: there is real estate, gems, fine art, and lots of other items that are defined by their limited supply. What sets them and gold apart from bitcoin is their relative illiquidity. If a “store of value” can be traded frictionlessly, then can it truly be a “store of value”? That is, for those investors who care about maintaining long-term value as a hedge against inflation or downturns in more liquid asset classes (or to prepare for the apocalypse), bitcoin’s liquidity makes it a scary long-term investment.

    I also fail to see why blockchain need to have anything to do with bitcoin. A digital distributed ledger has all sorts of potential use cases (land registration, copyright management, trade verification, etc.), but none of those use cases require that underlying technology have anything more than a token value. It would seem to me that bitcoin’s volatility is antithetical to those use cases. The idea that people would pay radically different transaction costs depending on the underlying market for the verification mechanism would seem to be the death of any market that would benefit from said verification. And why does the supply of this mechanism need to be limited? Is there any value in limiting its supply? IP addresses are a wonderfully useful tool for identifying the unique source of Internet activity, but their biggest weakness–like phone numbers before area codes–was the fact that there weren’t enough of them. Hence, ipv6.

    So, to recap: Bitcoin is too volatile and liquid to be a reliable store of value. And its limited supply runs counter to its most plausible use cases. Where can I sign up??

  2. Thanks for the comment Micah. And for encouraging me to reopen comments on the site.

    One thought in response:

    Great points about different types of assets that can serve as a store of value. I think every single one of them has unique characteristics that make them better or worse under different economic scenarios. You point to a bunch of examples that need to be physically stored. They all have the benefit of being easy to proverbially “bury in your back yard.” Which is great under certain “worst case” scenarios. But many people keep gold in a brokerage account through ETFs (i.e., the ETF trust stores it on the shareholder’s behalf) or even futures contracts. In these cases, the value still tracks the price of the asset, and it can still serve certain purposes such as an inflation hedge, but pretty useless if the trustee disappears. I don’t think a necessary characteristic of a “store of value” asset is that it can be physically stored, or that it can’t be traded frictionlessly, even though most have these characteristics. Some people just might want a liquid, tradeable, frictionless currency that isn’t directly controlled/influenced by a central bank and doesn’t require a large financial institution to administer. Crypto might be the only “store of value” that had those characteristics.

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