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The Bursting of the Bitcoin Bubble: An Autopsy

Marcello Minenna is the director of the unit of quantitative analysis and financial innovation of Consob (Italian Commission of Stock Exchange and Companies), the authority of the Italian government responsible for the regulation of the Italian stock market as well as assistant professor of stochastic finance in London. Graduate School of Mathematical Finance and Luigi Bocconi University in Milan. He is an economic and financial columnist in leading Italian and international publications.

Sixteen months after a maximum value of $ 19,100, bitcoin is now trading at around $ 5,000. Despite its great distance from the historical maximum, today's price is good news for the market, as the recent increase may be the end of the collapse produced by the violent explosion of the digital currency bubble in 2018. Since December 2017, the price of each digital asset fell, on average, by 80%; for bitcoin was the second collapse ever recorded, a sharp drop even for an unconventional asset that historically has been showing very high and falling cycles. In 2011, the price fell 93 percent – from a high of $ 39 to $ 2 – while in 2013, in just a few weeks, the price rose to $ 1,151 and then to $ 177 over a 12-month period.

It is not certain that this time it has reached the bottom, despite the encouraging events of recent weeks: Historically, the phase of rapid decline is followed by a stagnation of the price that can last for years, called in cryptoinvierno jargon. "

In the context of a generalized speculative bubble, the so-called "altcoins" became, in addition to any technical evaluation, simple variants more volatile and less liquid than bitcoin, almost perfectly correlated with each other. This feature made any attempt to diversify the risk between different crypto-actives useless.

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Price behavior of BTC and ETH

1 year rolling correlation

Among alternative currencies, we should mention Ethereum, the digital currency classified as the second in terms of capitalization, which was exposed as a technical platform for the proliferation of initial currency offerings (ICO). These UCIs have been used to cover real offers of public purchase, through the collection of financial resources under the protection of regulators and the financing of suspect, weak or doubtful projects. Most of these initiatives invariably destroyed economic resources or became a veritable fraud in which the defensive capacity of investors was substantially nullified.

Subsequently, the pricing pattern during the bitcoin bubble closely followed the asymmetrical behavior of its predecessors, starting with the Tulip bubble of 1637, passing through the bubble of the South Sea Company to the last outbreak of the dot-com bubble. 1999-2000.

After a moderate upturn phase, there was a very rapid vertiginous phase of vertical price growth for about nine months, with final buying hysteria in December 2017, a month in which the price more than doubled, from a base which was already very high. The summit was played with a classic "double peak" in January 2018, synchronized – not surprisingly – with the peak in global stock markets and the peak of liquidity released to the world economy by the big central banks. Since then, the price of bitcoin has declined almost uninterruptedly, with very rapid collapses and shorter and less convincing recoveries, with relative decreasing peaks.

What is the floor of this incredible descent?

In this sense, we must bear in mind that bitcoin, its clones and the rest of the digital coins do not have their own intrinsic value. Prices are determined simply by the intersection between supply and demand in the different currency markets; These are often very low net prices, which differ from each other in hundreds of euros without effective arbitrage between different markets due to the structural limits of the bitcoin and settlement platforms. Therefore, it is very difficult to think about determining what the fair value would be.

Often, for traders working in these markets, technical analysis is the only tool for interpreting price movements. This paradoxically means that the price dynamics, determined by the collective actions of traders, sometimes follow the forecasting standards of technical analysis.

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In this general scenario, it is worth trying to isolate the main factors that determine the rise and fall of bitcoin and other altcoins. The role played by stablecoin tether has been predominant in the phase of rapid price increases between March and December 2017.

A stablecoin is a digital currency anchored with a fixed exchange rate to a fiduciary currency that is traded in the currency market such as the dollar or the euro. Its existence is justified by the fact that, currently, the conversion between fiduciary and digital currencies remains slow and laborious, since it requires a transfer of resources from traditional banks to the exchange of crypts through payment systems. cross-border banks whose settlement may take several days.

The conversion between digital currencies is instantaneous and allows the operators to protect themselves using stable currencies of the high volatility of the prices of bitcoins and altcoins. It is clear that 1 tether does not equal 1 dollar because it can not be converted freely, although the company itself has always stated having a dollar reserve corresponding to the amount of tether issued and circulating on the exchanges. However, for traders, price performs the same function as the dollar; therefore, it is irrelevant whether there is total or partial convertibility.

In April 2019, there are at least eight different stablecoins in the market that offer the same tether service, but by 2017 the tether dealt substantially with a monopoly that strongly influenced the price trend in the various exchanges as evidenced by a statistical research analysis held by the University of Austin, Texas. What happened has a lot to do with the fact that the company that issued the chain was actually controlled by Asia's largest crypt purse, Bitfinex.BTC Price and Techer Capitalization

Rolling Correlation

Looking at the data (see the charts above), we can see how the price behavior of bitcoin (and other altcoins) in the "pumping" phase of the bubble is perfectly correlated with the emission of new tether in the exchanges. As the above research shows, it is statistically likely that the Bitfinex bag has artificially boosted the dizzying purchase of digital coins by issuing increasing amounts of barriers. In a phase of exponential price increases, issuing securities without adequate dollar hedging is a profitable strategy. In fact, speculators could buy digital coins with newly issued tether, with the possibility of reselling them at a higher price and replenishing dollar reserves. The sign of sharp price increases in ever-accelerating times has contributed to the growth of the media frenzy that has attracted retail investors with little experience in digital assets often unaware of the huge risks. related to the terminal phase of a speculative bubble.

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The long contraction in prices, which has not yet been completed despite its recent recovery, was due to two main factors operating in two different time phases. Between January and April 2018, the fall was due to demand and therefore was determined by the flight of speculators fearful investors, very exposed to losses due to purchases made at very high prices. In this classic sale of panic, it can be seen that the support of a growing emission of tether was also lacking in the exchanges. In fact, since February, the growth of the current in circulation has slowed and stabilized, indicating that in a declining market, the strategy of issuing an uncovered barrier was no longer profitable.

In June 2018, the price apparently found a floor of about $ 6,000, a level up to 10 times higher than the price that Bitcoin had at the beginning of 2017. At this time most speculative investors have disappeared. and the volatility of digital currencies was drastically reduced as the trade was diluted (see chart below). Many analysts believed that, at this stage, $ 6,000 was the minimum level needed to offset the energy costs of the miners who were digitally "coining" the new cryptos. Until then, the need for a growing population of miners to cover the rising costs of production was a force that supported the growth of digital asset prices.

1 year rolling

However, this fragile balance was not sustained. In November 2018, the announcement of another difficult bifurcation between digital coins that sought to create a new clone of bitcoin without substantial innovations caused a price earthquake that broke the fragile balance struck. In this deteriorating context, the determining factor of the fall in prices seemed to be the supply and was related to the digital currency mining community. In fact, a substantial portion of the miners abruptly altered their bitcoin hash rate to clonal coins in the hope of gaining free profits from the risk of blockchain bifurcation, as happened several times in the phase. bubble rise.

But by the end of 2018, things were changing: the anomalous change in computing power took the bitcoin support and dragged the price of digital assets in a downward spiral, including the clonal coins in which the miners had invested heavily. . As a result, some of the miners, who were already losing out before this recession, were expelled from the market, causing – for the first time in history – a decrease in the global computing power of the network. bitcoin, which collapsed by 50% in just a few weeks (see the figure below). In this short time, bitcoin and altcoins fell into free fall, never experienced in the burst phase of the demand-driven bubble, suffering losses of about 70%.

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By 2019, the "Darwinian selection" of the miners seems to have stopped, as evidenced by the recovery of the overall hash rate of the network, albeit at a more moderate pace. The bitcoin protocol provides an automatic self-regulating mechanism so that the cost of extracting foreign currency tends to decrease due to the decrease in computing power of the network. This periodic adjustment allows marginal traders to return to the market at a lower cost.

In the first months of the year, crypto-crashes slowly recovered their value, but the real surprise came on April 2, when, in just an hour, bitcoin shot at almost $ 1,000, surpassing $ 5,000, a new resistance that basically, was maintained over the following weeks.

It is unclear what led to this leap (perhaps an algorithm-generated order or a bitcoin-related liquidity constraint, followed by a forced buy-in of market share quotes). After all, several analysts have recently predicted a short-term increase, and knowing the triggering event matters little. The real question is whether the market is returning to high mode. Multiple factors support an affirmative response: the gradual recovery of the market capitalization of some stable currencies – first (see chart below) – the erosion of available bear resources, the return, albeit moderate, of several banks central to an accommodative monetary policy and uncertainty linked to relevant phenomena worldwide (the crisis in Libya, trade tensions, Brexit's enigma and the forthcoming elections in the European Union), which increase the attractiveness of digital currencies.btc

2019 could be a new starting point for digital currencies given the slow recovery of investor interest. Investments in technological innovation and infrastructure have never ceased, and the interests of institutional investors go beyond the short-term speculative frenzy. Regulators are also intervening gradually in the reorganization of these border markets. Crypto-winter may be smaller than expected.

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