Cryptocurrencies Hit New Highs. Should we be terrified?

Probably.

Bitcoin, Ether and, the most recent joke, frenzy, and punch line, Dogecoin, have increased 10x to 20x over the last 12 months. A spectacular return, but can it last?

Probably not.

The forces driving the eye-watering returns are the same as those that drove the insanity behind GameStop: the equivalent of a trading floor in every pocket funded with excess cash looking for disruptive investment opportunities and charging forward like an out of control herd – or lemmings – however you want to envision it. Cryptocurrency became the overwhelming target of Reddit day traders and mobs. Social media influencers, led by various forms of PT Barnum imitators like Elon Musk and many less sophisticated contributors, combined with the public listing of Coinbase to create a massive rally.

Digital Assets

The Ethereum platform emerged as a more useful tool for secure contracts and the creation of digital assets, with NFTs (nonfungible tokens) as the most recent example. Ethereum is the blockchain-based computer network that backs most NFTs. But it is more important than that because it represents a powerful and secure platform on which to create unique digital assets. Ether, the in-house currency on the Ethereum platform, has risen to record levels as more people adopt the technology. NFTs are Bitcoin-like tokens connected to a digital work of art or other real-world item and sold as a unique digital property. But this may merely be a sideshow to the most important development.

Decentralized Finance

This looks like the real game-changer. Currently, decentralized finance seems to be an underestimated opportunity, but it can become a powerful force in global finance. This is primarily because the creation of digital assets means that the Ethereum platform can be used for many diverse financial and other business opportunities that require the transfer of contracts, assets, and other forms of value securely. The biggest opportunity is finance, enabling the connection of capital with borrowers, entrepreneurs, and investors. This is perhaps the most interesting and sustainable form of value creation because it is a fundamental disruptor to global finance – a multiple trillion-dollar opportunity.

Speculation

And then there is the dark humor in all this. In other words, Dogecoin – the modern-day equivalent to tulip bulbs (remember, even Isaac Newton lost money in the tulip bulb craze so, don’t think you are that smart). Individual investors used social media to send asset prices soaring, and no move defines the power of memes more than the absurd rise in the price of Dogecoin. It is a cryptocurrency that was created as a joke but has risen more than 100x this year, from around $500 million to a peak of $80 billion. It was a social media-based feeding frenzy swooping up day traders and uninformed speculative masses.

The joke, that everyone is in on by now, is that Dogecoin’s creators never intended for it to have any meaningful value. Traders instead are speculating that it can keep climbing solely on social-media momentum. That can leave investors more vulnerable to losses and sharp price swings when the hype fades. The music will stop, and no chairs will be left.

Sentiment and Momentum

Cryptocurrency’s wild swings are a warning to investors. It may be some form of inflation hedge or store of value, it has no long-term history as either, and its value is closely tied to sentiment and momentum. If sentiment turns against it, the price falls dramatically, and rising prices are digital currency’s most attractive feature for new investors (speculators, in reality).

Although Bitcoin is becoming more mainstream and is recommended for institutional investors as a component to portfolios more and more, there is a limit to that institutional demand as prices soar. We have seen just recently demand from institutions has dropped and, correspondingly, Bitcoin prices have dropped substantially. There is tremendous leverage and “tale of the whip” effect on even the most established digital coins, like Bitcoin. Volatility will remain.

It’s Speculative and We are Highly Leveraged – What Could Go Wrong?

Trading volume has increased dramatically over the last 12 months (perhaps no coincidence that it occurred during a stay-at-home pandemic), and a growing pool of investors are using multiple tools for speculation. For example, derivatives have overtaken spot trading, and more than $200 billion of trades in digital assets are occurring daily.

The growing use of cryptocurrency derivatives is significant because investors use extremely high leverage, amplifying returns substantially. But, when the market turns the other way, it’s disastrous. This derivative trading is occurring on lightly regulated cryptocurrency-derivatives exchanges that allow much higher leverage than a U.S. exchange such as CME Group. It is unlikely, especially in the face of inevitable losses to come, that this will continue to be the case. Leverage, and most likely many other aspects of cryptocurrency, will be reined in by regulators.

Yes, That’s $2 Trillion

Bitcoin, Ether, and Dogecoin, among others, are now collectively valued at more than $2 trillion, up from $260 billion a year ago. Dogecoin alone – with a market value of about $70 billion – is worth more than 75% of the companies listed on the S&P 500. Although the digital currencies have surged in recent months, as an asset class, they remain a fraction of global markets for stocks (about $40 trillion), bonds (about $180 trillion), and gold (about $12 trillion).

It’s Not a Currency

Despite making inroads, Bitcoin and other digital currencies are still only a tool for speculators. There is no prospect of stable value enabling the fair exchange of assets for goods and services. It is a store of value, but much like any speculative asset, it can be a store value that fluctuates wildly.

That is not to say that some speculative assets, whether they be works of art, sports cars, or digital currencies can’t ultimately have long-term value and generate excellent investment returns. But digital coins are only one part of the digital asset platform, and will most likely prove to be a sideshow. The real opportunity for value creation, sustainability, and appreciation is the right business model and digital platform for the creation of digital assets that are easily and securely exchanged.

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