The problem with bubbles is that you can almost never tell it's a bubble when you're inside of it. Somehow you think it will go on indefinitely. We like that narrative. It's a lovely fairytale with the happy ending we all feel we deserve. 

The analogy I like to use is that of fish inside a fish tank.  They are oblivious to the fact that there is anything "outside." When we're inside a bubble most of use behave the way the fish do, oblivious the the threat of what's outside. The concept of "outside of the bubble" makes no sense. All we experience is what's inside. If there is an outside then, of course, it must be no different than what's inside. The same rules should apply. That's almost always a formula for a very rude awakening when the bubble bursts. 

Oddly Familiar 

Don't get me wrong, if you've followed some of my prior columns about  Bitcoin, and its larger context of cryptocurrency and the Blockchain, you know that I'm anything but anti-cryptocurrency. I firmly believe that the trajectory of technology and society will go in the direction of an economy with ever decreasing friction. Cryptocurrency is a crucial part of that and as a concept it's here to stay.  

I thought the same of the dotcom movement in the late 90s and early 2000s. The concept of commerce, disintermediation, and personalized experiences made perfect sense. It was the inevitable trajectory of the web. However, believing in the long-term trajectory of any radically new technology does not imply that every technology, company, or product that tries to break ground in the short term will survive to be part of the long-term value creation. 

For example, by some estimates nearly 5000 companies shut down, went bankrupt, or were acquired (at a fraction of their value) and $5 trillion of stock market value was wiped out when the dot-com bubble burst in 2001.   

Seventeen years later we've finally started realizing the promise of the dotcoms. "But wait," you say, "what about Amazon, Google, Facebook? Those dotcoms were incredible investments. Right, and you would have picked those particular companies in 2001, why?

I've little doubt that the same will happen with cryptocurrencies.

Place Your Bets

There are 1,500 separate cryptocurrencies today that are tracked on with a total value of about $600 billion. Trying to bet on the winners in that sort of a horse race is an incredibly risky bet.

But perhaps that risk does not deter you because you're an aggressive investor and you have money to lose if it comes to that. In addition, it would seem that if you use the dotcom bubble as benchmark we still have plenty of headroom before cryptocurrencies reach a similar tipping point based on overall market value. 

However, there is something potentially much more insidious than a hedge bet going on with cryptocurrencies. It's something that potentially amplifies the risk to the point where you are not only gambling on a small pool of winners or the timing of a bubble, but also being manipulated into what may well turn into one of the greatest cases of bubble-driven wealth transference we've seen since the dotcom frenzy.

An important caveat before I go any further. I do not believe that the following applies to every cryptocurrency, token,, or Initial Coin Offering (ICOs). However, I'm just as unsure about which ones it does apply to.

Bitcoin Behind The Curtain

As recent paper in the Journal of Monetary Economics makes some disturbing claims about how and why cryptocurrencies like Bitcoin may be rising so quickly. The authors claim that significant price jumps in Bitcoin (specifically a 10 fold increase that they based their research on) have been the result of market manipulation by one or two individual actors, aided by the use of bots that conducted massive fraudulent trades on major cryptocurrency exchanges.

The paper looks specifically at the two year time frame around the take down of the Mt. Gox Bitcoin exchange in 2014. For some time that was the largest single act of fraudulent cryptocurrency trading involving the theft of 744,000 Bitcoins worth $350M at the time. (That's approximately $6.7 billion in value at the current price of Bitcoin.) However, Coincheck, coincidentally also a Japan-based cryptocurrency exchange, reported on January 26th of 2018 that it lost $533M worth of NEM tokens.

According to the authors of the study, and as reported in Techcrunch, "Despite the huge increase in market for these other cryptocurrencies are very thin. The number of cryptocurrencies has increased from approximately 80 during the period examined to 843 today! [The actual number today is 1,500] Many of these markets are thin and subject to price manipulation."

"While risk is never distributed symmetrically to all investors, a significant asymmetry, in which one or two actors can control a market, is clearly not a level playing field which an investor would tolerate in any other context."

Cryptocurrency traders will make the case that the markets for crytopcurrencies are thriving and resilient, pointing to the fact that while it took nearly three years for Bitcoin to recover from the Mt. Gox incident, it took only days for cryptocurrencies to bounce back from the Coincheck fraud. They'll also point out that Coincheck has promised to refund 80% of the value of the NEM tokens to members of their exchange. There are correct on both counts. However, keep in mind that the overall value of the Mt. Gox heist is still an order of magnitude greater using current values.

There's Risk And Then There's This

So, does all of that mean that fraud is just a natural part of the cryptocurrency ecosystem and that, as with any other financial systems, there is always the risk of fraud and theft? Clearly, you'd have to be a very naive (oblivious, might be more accurate) investor to expect that this sort of risk can be eliminated, especially in a very volatile market. The question, however, is to what degree is that risk the result of manipulation by a few malicious, malevolent, or simply self-serving actors who can tilt the playing field in their favor rather than organic market forces which every investor is subject to? While risk is never distributed symmetrically to all investors, a significant asymmetry, in which one or two actors can control a market, is clearly not a level playing field which an investor would tolerate in any other context.

I have no doubt that this point of view will ruffle the feathers of the crypto-disciples. It was just as heretical to claim that the great advances being promised by the dotcoms in 2000 were leading us into dangerous territory. Again, I'm not denying the long-term destination, just the reality of a very bumpy path to get there.

I'm reminded of how in the animated film Finding Nemo the only way for Nemo to get out of the fish tank and back into the ocean was by getting flushed down the drain.

Nemo made it. Another Happy Ending.

This isn't Disney.

The complete study is available at the Elsevier site or at Science Direct. It's less than 20 pages and required reading for anyone investing in cryptocurrencies.