Earlier this year, the economist Richard Thaler was recognized by the Nobel Committee for his contributions to behavioral economics. Mr. Thaler’s work challenges the very notion that individuals are ‘rational’ actors looking to maximise their utility, a cornerstone in the fundamentals underlying the study of economics. 18 years ago, Fed Chair Alan Greenspan coined the term “irrational exuberance”, a phrase used to describe a situation where asset prices get way ahead of themselves, think Dot-Com bubble circa 2000. Much of that exuberance can be attributed to the ‘hot hand’ fallacy that Mr. Thaler studied.
His thesis highlighted the phenomenon where individuals who experienced past success, in what can only be described as random events, will believe to have increased chances of success with every additional attempt they complete. It is akin to having some success with black 17 at a roulette table and believing that the probability of future success, black 17, will only increase with every additional roll of the dice, completely ‘irrational’. This concept is also one of the reasons why bitcoin prices make me feel extremely uneasy, if not slightly cynical. As prices continue to soar, anxious investors and naysayers will continue to draw parallels to the Dutch Tulip bubble of the 17th century, as well as the Dot-Com bubble mentioned above, as reasons to stay clear of bitcoin and all its friends.
At the heart of it, there is undeniable value in the cryptocurrency, especially the underlying technology supporting it, blockchain. For most things in life, price is what you pay and value is what you get. It is wrong to discredit the fear-mongering surrounding the elevated levels around which this currency is trading. By the same token, it is also near impossible to assign a floor or a ceiling to the currency until we have a firm understanding of the dynamics for which the currency can be used as a legitimate store of value.
Over the past few months, my brother and I decided to learn more about cryptocurrencies and blockchain technology. So we assembled an in-house cryptocurrency mining machine that uses an algorithm to mine the most profitable currency at the moment. The currency we mine is the carrot for our efforts. It is the reward we receives for helping to grow, maintain and ‘update’ the blockchain (the underlying P2P ledger). From a miner’s perspective, there is limited value to the cryptocurrency were it not for the reward at the end of the tunnel. While digital currencies don’t require blockchain technology to function, the lack thereof takes away from its value proposition, making it no different than regular currencies that change hands digitally.
The wild gyrations in the price will likely continue as more people, corporations and governments begin to embrace it, while others clamp down on it, mostly for what is perceived to be the nefarious or malicious intent for its uses. Eventually, regulations will catch up to the cryptocurrency, more exchanges will begin trading it and more institutions will buy into it (PWC in Hong Kong just accepted payment for services rendered with Bitcoin). That said, there will come a tipping point. I think this period of irrational exuberance will be followed by a meaningful pullback that brings the currency back to reality and its uses are revisited. Gone are the days when gold or bartering facilitated daily commerce, which is why it remains to be seen whether cryptocurrencies will be able to fill that void and be embraced for their primary function, daily commerce.
This then raises the specter: does Bitcoin have an identity crisis? Is it a store of value, much like a commodity, is it a currency, or a bit of both? Until such time that these questions are answered, investing in cryptocurrencies will not be for the faint of heart.