As the bitcoin price surged past US$13 400 over the last week, an old debate has resurfaced: Is it a bubble and will it burst?

Bitcoin was labelled a bubble from its earliest days. The bubble epithet appeared in 2013 when it was just $266, and has been repeated just about every year since then.

It seemed to defy conventional investment understanding. Share values are underpinned by earnings, and bonds by interest payments. Bitcoin, like gold, has no such underpinning. How, then, do we explain its extraordinary performance as an emerging new asset?

Two factors help explain this:

Its wider adoption, including from large institutional investors; and
Its relative scarcity (there will only ever be 21 million coins minted).

Fiat currencies such as the rand and the US dollar suffer all the frailties of centrally controlled currencies that have been recorded back to Roman and even Babylonian times. Rulers who control these currencies just can’t seem to help themselves — they eventually inflate their way into oblivion by printing more coinage, so violating the scarcity principle at the core of all sound money.

US fund manager and contrarian Peter Schiff, never a great fan of bitcoin, tweeted last week: “If you measure the size of asset bubbles based on the level of conviction buyers have in their trade, the bitcoin bubble is the biggest I’ve seen. Bitcoin holders are more confident they’re right and sure they can’t lose than were dot-com or house buyers during those bubbles.”

Is Schiff right about the bitcoin bubble? It appears he may be, but not in the way he imagines.

“Since bitcoin’s inception, many intelligent investors have observed that it appears to be a bubble. They are more right than they know. If we define a bubble asset as one that is overvalued relative to intrinsic value, then we can think of all monetary assets as bubble assets,” writes Matt Huang in a recent research paper for Paradigm.

Nobel laureate Robert Shiller observed that gold is a bubble that’s lasted thousands of years. It has some industrial uses, but it’s value is underlying value is a matter of belief. “We can think of money as a bubble that never pops (or that hasn’t popped yet) and the value of fiat currency, gold or bitcoin as relying on collective belief,” writes Huang.

Doubled

Blockchain company Etherbridge notes that since the beginning of 2019, the bitcoin network has almost doubled its number of active addresses from 550 000 to just shy of one million by August 2020. The users are coming and finding utility in the public payment system that is bitcoin. The confluence of growing usage, rising miner profitability and strong savings behaviour of investors is lining up bitcoin for another bull market.

“We can think of money as a competitive market like any other. Gold dominated for centuries not by accident but by possessing important features such as being scarce and unforgeable. Today, fiat currencies (those issued by central banks) dominate largely through local monopoly power, but all monetary assets still compete globally, with gold, US dollars and euros favoured as reserve assets.”

All money relies on its “network effect” – the number of people using it – as a key determinant of value. It must also be a store of value, easily transportable and fungible (every unit is the same as every other unit).

Cryptocurrency Prices by Coinlib

Bitcoin meets this all these criteria with the added advantage that it is almost infinitely divisible.

Huang says each bubble has a familiar pattern. High-conviction investors start buying when bitcoin is boring and unloved. The resulting rise in bitcoin price attracts media attention, which then attracts investors (or speculators), many with lower conviction and shorter time horizons. This drives the price of bitcoin higher, which drives further attention and investor interest. This cycle repeats until demand exhausts and the bubble crashes.

“Although painful for those involved, each bubble leads to broader awareness and motivates bitcoin’s underlying adoption, gradually expanding the base of long-term holders who believe in bitcoin’s potential as a future store of value,” according to Huang.

Huang says bitcoin is unlikely to challenge the US dollar as the leading means of exchange and unit of account (at least anytime soon). Instead, it is likely to earn a place alongside gold as a sensible part of many investment portfolios. “This has already begun with an early-adopter, tech-forward crowd, and we expect it to grow to include a broader set of investors and institutions over time. Eventually, central banks may come to view bitcoin as a complement to their existing gold holdings.”