Will Bitcoin Crash and Burn?

Bitcoin-Crash

It seems like bitcoin’s value is on a constant rollercoaster ride. After its share price skyrocketed to an all-time high of $19,346 on December 17, 2017, it lost 33% of its value just five days later. By February 6, 2018, bitcoin’s share price plummeted to a low of $5,967, losing over 69% of its peak value.

But a month later in March, bitcoin seemed to be recovering: its share price shot up 92% to $11,432. Since then, bitcoin's value has fluctuated in the same pattern: the month after its price soars, it plunges. And the month after its price plunges, it soars.

Bitcoin’s value is mired in uncertainty, which begs the question: will bitcoin ever completely crash? Before we answer this question, though, we need to understand why bitcoin is so volatile, why it’s so popular, and what could bring it down.

Why Is Bitcoin So Volatile?

Even though bitcoin is technically a currency, it trades more like a commodity. There’s a limited supply of bitcoin in circulation and a ton of consumer and investor demand for it. So just like gold, market forces set bitcoin’s share price.

But the main difference between bitcoin and a commodity like gold is that the cryptocurrency’s market capitalization of $120 billion is tiny compared to the total value of gold mined, which is a staggering $8.3 trillion.

With such a small market size and significantly less volume of buy and sell orders, relatively small changes in the demand for bitcoin can significantly influence its share price.

What Drives Demand for Bitcoin?

Scarcity and Utility

Items that are both rare and useful have value. Gold is expensive because it’s rare, hard to find, and has utility -- you can make things with it.

Bitcoin is in a similar boat. It’s relatively rare because there will always be a limited supply of bitcoins in circulation: about 17.2 million bitcoins today, and 21 million set as the maximum amount of bitcoins that will ever be available. Most of the public knows about this cap too, which increases the cryptocurrency’s perceived scarcity even more.

Bitcoin is relatively useful because it’s a currency and an asset. With an estimated 2.9 - 5.8 million bitcoin users and thousands of merchants accepting it as a form of payment, bitcoin is the most widely accepted cryptocurrency in the world.

Everyone also knows about bitcoin’s meteoric share rise, and with five percent of Americans currently investing in bitcoin and an additional 21 percent considering adding the cryptocurrency into their portfolios, bitcoin is one of the hottest assets on the market.

Network Effects

Since bitcoin’s value doesn’t depend on a corporation’s financial health and performance, their value and potential to thrive depends on the growth of its network, like users, miners, and developers. According to Metcalfe's law, the more connections users make with each other in bitcoin’s network, the more valuable it becomes to its users and the general public.

A good example of the power of Metcalfe's law is the adoption of the internet. At first, no one used it, so it didn’t provide a lot of value to people. But when the internet grew in popularity, people started using it more, connected with each other on it, and even did business on it, making it more valuable for its users and increasingly necessary for the people who weren’t using it.

If the majority of the world's consumers and merchants start using and accepting bitcoin, the cryptocurrency would do what the internet did to society: become commonplace and necessary to buy everyday things.

Blockchain

Another thing that gives bitcoin value is the public’s faith in its underpinning technology: blockchain. Blockchain is digital, public ledger that no one can edit or delete, making economic transactions faster, safer, and more transparent.

Even though the majority of businesses haven’t adopted blockchain, the world’s biggest corporations believe it will happen soon -- all ten of the largest U.S. banks have collectively invested $267 million in six blockchain companies and one consortium.

Speculation

In most market bubbles, like the dot-com bubble or the financial crisis, the public thinks a company’s stock or an asset will guarantee lofty returns in the future -- investors are willing to buy these assets at a much higher price than its real value. This increases the asset’s perceived value, demand, and, ultimately, price. But if these companies or assets don’t perform up to their expectations, their share price will plummet as fast as they soared.

For instance, in 2000, Amazon had sales and earnings that really couldn’t justify its peak stock price of $113 per share. Like most internet companies, the meteoric rises in their stock was unsustainable. And once these companies started to fail and bursted the dot-com bubble in late 2001, Amazon's extremely overvalued shares decimated its stock, which dropped 95% to $5.51.

Bitcoin has strikingly similar characteristics to Amazon during the dot-com bubble. Its share's meteoric rise seems unwarranted and driven by optimism -- in fact, 96% of economists believe bitcoin’s soaring price is due to speculation.

Bitcoin isn’t a legal tender backed by any government, a tiny fraction of the world’s customers and merchants transact with it, and blockchain isn’t widely used. So why does it have so much value?

Its because the public has great confidence in bitcoin's potential. They think countries will start accepting bitcoin as currency and every business will adopt blockchain one day. And this optimism makes them more willing to buy bitcoin at a higher price now to reap the sky-high rewards later, which also raises the cryptocurrency’s demand and share price. 

But if bitcoin and blockchain don’t live up to their potential, bitcoin’s demand will drop and its price will plunge into a free fall, bursting its bubble.

Things That Can Thwart Bitcoin From Reaching its Potential

Along with speculation, there are three main factors that could stunt bitcoin’s growth:

Bad Press

Headlines of bitcoin crashes and leaders of the largest financial institutions in the world questioning its validity hamper the cryptocurrency’s public perception. In fact, after the CEO of JP Morgan, Jamie Dimon, said he would fire anyone who traded bitcoin at his investment bank in 2017, bitcoin’s value immediately fell by 6%.

Increased Government Regulation

Bitcoin is a decentralized currency with no central authority overseeing it, letting you avoid banks and traditional payment processes to purchase goods and services. This attracts a wide spectrum of supporters -- from people who love the idea of a currency with no inflation or central bank, to criminals who love the idea of dealing illegal items without having to leave a digital footprint.

Banks and financial institutions are concerned with bitcoin’s ability to help criminals launder money and commit crime, so no government has adopted it. And recent news on cryptocurrency regulation makes any government adoption of bitcoin even more unlikely:

  • In February, India’s finance minister said that the country won’t recognize cryptocurrencies as legal tender and would be proactive against its widespread use in illegal activity.
  • Facebook now requires bitcoin and cryptocurrency advertisers to go through an approval process. The social network has also banned initial coin offering ads.
  • UK prime minister Theresa May said that they will heavily scrutinize criminals who leverage cryptocurrencies, like bitcoin.
  • US treasury secretary, Steven Mnuchin, said that the US economy will impose more regulations on cryptocurrencies, like bitcoin.

Lack of Security

If bitcoin wants to be the currency for the world, consumers and merchants need a safe place to store their funds.But cryptocurrency’s security issues could destroy the trust and use of bitcoin.

Last year, two exchanges went bankrupt after hackers stole the majority of their funds. And in the last few months,cyber thieves have stolen hundreds of millions of dollars from cryptocurrency exchanges.

Yo Kwon, the CEO of Hosho Group, a company that specializes in securing applications that leverage blockchain, estimated that cyber thieves have hacked about one third of all cryptocurrency exchanges at one point and will prey on more.

Will Bitcoin Crash and Burn?

A lot of people believe in blockchain technology and bitcoin’s potential as a global currency and asset. But unless the business world adopts blockchain and merchants accept bitcoin as a form of payment, only time will tell us when bitcoin will completely crash and be forever known as the biggest bubble in economic history.