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April 3, 2013

BitCoin - is it a bubble?

Filed under: Uncategorized — admin @ 12:21 pm

There were three times in my life when I felt sure enough of my financial reasoning to recommend a certain investment to all my friends. The first was when Google went IPO. The second was some obscure moment in Microsoft’s history, and the third is very recent.

About a month ago I started recommending to all my friends to get bitcoins - fast. My reasoning went as follows:

  • BitCoin is a currency
  • Other things being equal, the value of a currency is tied to to how many people and organizations will accept it for things others value
  • We are only at the start, and more merchants are going to be accepting BitCoin every day, especially as it gets easier to do so
  • Other people will realize this soon, which will drive up the price of the currency.
  • I am typically among the middle-early-adopter when it comes to techy stuff, so if there’s a bubble, it still has a long way to go as BitCoin articles go mainstream

That was a month ago. And if you got BitCoins in the last month, you saw them gain a lot of value on the exchanges. But the question now comes up: with charts like this, is it a bubble?

In my opinion: Yes, but more importantly No! The meteoric rise of BitCoin is related to network effects because it is a medium of exchange. It is not unlike the meteoric rise of facebook or of pinterest. While Metcalfe’s Law has historically been too optimistic in predicting the value of a network based on its size, something like n log n is not at all unreasonable.

The fundamentals of BitCoin suggest that it is poised to grow far beyond where it is today, since more merchants means more users, and more users means more merchants. However, the hype surrounding BitCoin may push the markets far ahead of its current growth. So that’s where the danger of the bubble comes in. This is like investing in facebook in its early days and asking if it’s a bubble. At the end of the day, I think BitCoin has all the fundamentals to legitimately go to $10,000 or even $100,000 a coin. Whatever price you’re probably paying for BitCoin today will seem a bargain a few years from now.

All this leads many people to want to take a long term long position in it, which will drive its prices even higher in the next few months. In monetary terms, BitCoin is going to be hoarded for quite a while and experience massive deflation, which will have an interesting effect on its adoption by merchants. It’s very attractive for a merchant to accept a currency for their products that will be worth more tomorrow, so in short, both sides are incentivized to try to get BitCoin as its prices rise and rise.

We’re just at the beginning of the BitCoin craze. Now you may even be able to cash them out using ATMs in Cyprus. There’s a lot of opportunity around BitCoin and making it easier to trade them for actual things, but also a lot of regulatory risk up ahead.

On the other hand, if you care about BitCoin as a currency, you should probably be careful of Gresham’s law.

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