Is the Cryptocurrency Market Experiencing a Bubble?

As bitcoin breaks to fresh highs above $1700 and the altcoin market has displayed a phenomenal increase in value, many in the community are wondering whether cryptocurrency is in a bubble. According to data from coinmarketcap, many altcoins have started to recover, but sentiment remains mixed, begging the question of whether altcoins are due to crash hard, or whether they will remain tethered to bitcoin and follow the most valuable cryptocurrency higher.

There are many reasons why the cryptocurrency market may not in a bubble. Firstly, it could be argued that the fundamental value of these new technologies is slowly being uncovered and explains the recent surge in the valuation of altcoins. The knowledge barrier to cryptocurrency is quite high; first you must get your head around bitcoin, then altcoins such as litecoin, ether, and monero; it may be difficult to most to get their head around what is a good cryptocurrency and the recent surge may reflect a deeper understanding of the ecosystem. Intuition and research take time to hit home and new money is entering. For instance, using the number of poloniex users as a gauge for new money, we see that the number of market participants has increased substantially. On the other hand, the majority of these users may be margin trading, contributing to speculation rather than uncovering value.

Secondly, it could be suggested that cryptocurrency is not a bubble yet, as the majority of crypto market participants are using intuition, technical analysis and quantitative analysis, instead of reflexive behaviour that leads to herding in asset markets and consequently bubbles. For instance, just for the BTC-USD pair, we see there are many original ideas for trades on TradingView, numbering thousands over the past few months.

There are some great analysts in the cryptocurrency space, with a wealth of knowledge, viewpoints and experience. For example, Willy Woo points to the market capitalization to transaction value ratio for bitcoin to highlight that the cryptocurrency is far from being in a bubble. This measure is analogous to the price-equity (P/E) ratio commonly used to assess stocks.

https://twitter.com/ARKblockchain/status/861248756762771458

As the chart above shows, the market cap-transaction value ratio is nowhere near the level witnessed in the late-2013 bubble, implying that the true fundamental value of bitcoin is just being discovered and that a bubble is far off.

The events that have unfolded since August 2016, such as the Bitfinex hack, the crackdown on Chinese exchanges and Japan’s accommodation of bitcoin, may have pushed us into a different ‘state,’ toward the realization that cryptocurrency is making progress along the S-curve of adoption.

Also, the framing effect may have influence of our perceptions of whether there is a bubble or not. It could be argued that the fractional reserve system is unsustainable and is the largest bubble of all-time, with stocks, real estate and many other assets overvalued. We tend to think in terms of fiat, so it could be that fiat is in a bubble, and the relentless rise of cryptocurrency is a just a consequence of this.

During an asset-price bubble, market participants engaged in herding become willing to pay increasingly exorbitant prices for popular assets. If the case can be made that the majority of people in the cryptocurrency market are driven by reflexive behavior rather than intuition and creativity on their own part, then we can be certain that we are experiencing an altcoin bubble. Herding behavior leads to a self-reinforcing acceleration of price increases. If we want the price to go higher, we can make it go higher by following others and buying on cues from others. Bubbles are often a self-fulfilling prophecy, which may explain the unbelievable rise of Ripple which displayed growth in excess of 100 percent in under 24 hours during early May.

Twitter user PlatoWright points out an anomaly in the valuation of Ripple, as well as Ether, where the overall market capitalization with future supply included is 60 percent of the value of bitcoin for Ripple and 359 percent for Ether.

@adam3us Something really weird in valuation of ETH and XRP. Two non-decentralized cryptos. (approximate analysis) pic.twitter.com/sPfTHhRLGB

— Plato Wright (@PlatoWright) May 8, 2017

Notice for other altcoins, such as monero, litecoin and ether classic, the figure is below 10 percent, suggesting that Ripple and Ether are, relatively speaking, overvalued.

Another reason we may be in the middle of an altcoin bubble is that we are seeing some signs of possible malinvestment. For example, questionable amounts of money being raised through Initial Coin Offerings (ICOs). Since July 2014, around $400 million has been raised via ICOs, most with little to no working prototype. Most projects have not yet launched. Many participants may just be throwing money at these projects hoping for a return, with little knowledge or data to ascertain the riskiness of investing in such ventures, a key ingredient for a bubble.

Low returns in equities and low interest rates around the world is precipitating a flow of money into the cryptocurrency space as well as unfavorable local currencies, which could be augmenting the valuation of altcoins. Also, inaccuracy of the measure of market capitalization may also be distorting investor’s decisions and perspectives.

Zach Herbert, Head of Operations at SiaTechHQ, states the measure of market cap is so powerful because it allows investors to quickly assess total valuation of an asset. But an inaccurate market cap calculation means that you are not able to properly value a token without doing extensive research. And of all the sites comparing cryptocurrencies, it was found that circulating supply was used instead of total supply, misleading many investors.

“Every site we could find that lists out tokens by price, volume and market cap does so based on circulating supply rather than total supply.”

When adjusting for total supply, we see that Ripple, Fargocoin and Gnosis’ market cap’s all increase dramatically, pushing them ahead of Litecoin. Also, the market capitalizations for Stellar, Golem, Storjcoin X, and SingularDTV are deflated when using circulating supply rather than total supply.

Another key detail overlooked when examining market capitalizations is the inflation factor; a new metric recommended to be included in the rankings which will indicate how the next five years of token inflation will affect market capitalization.

When looking at the inflation factor, we see that Zcash has a very high inflation factor exceeding 800 percent, meaning that currently the valuation may be too high. Similarly, ether and ether classic have an inflation factor of 99 percent, while litecoin, monero and PIVX have inflation factors more similar to bitcoin.

SiaTech has reached out to the major cryptocurrency metric sites, such as coinmarketcap.com, coincap.io, cryptocompare.com, to request that they institute these recommendations and could prevent an altcoin bubble from getting too out of hand. With reliable metrics, more sensible investment decisions will be made and it is likely that a higher proportion of market participants will trade based on intuition and creativity rather than following the herd. 

Advances in neuroeconomics may one day identify a bubble in real time, but for now, we have to ascertain the state of the market based on other factors. While it is most certain that bitcoin is not in a bubble, altcoins as a whole may be experiencing herding effects and distorted valuations may be contributing to a bubble forming. On the other hand, some altcoins may be undervalued and it may take a large cryptocurrency crash for the most worthy ones to shine through.