The Bitcoin Bubble Hasn’t Burst Yet, But The First Signs Of Trouble Are Brewing

By: Ifrah Law

By: Karl Smith and Casselle Smith 

The value of Bitcoin, the hottest and most widely traded virtual currency, plunged a little over a week ago, after China’s central bank issued a statement that the government is banning financial institutions from trading in the virtual currency.The price of a single Bitcoinfell from roughly $1200 on December 5th to less than $600, early morning December 8th. Thereafter it recovered somewhat selling for around $700 as of December 16.  At the time of this posting (12/18), the price had fallen once again to $571.

This time last year, Bitcoin were selling for roughly $13 apiece. Economists and financial experts have struggled to explain the meteoric rise price to investors and to a public increasingly interested in the virtual currency.  In many ways, the soaring price for Bitcoin looks like a classic bubble: Speculators pay out of the nose for Bitcoin, hoping to unload them to an “even greater fool” who will come along later with the same plan. At first blush, this type of bubble appears to resemble a pyramid scheme that must inevitably collapse once all potential speculators have bought in.

Bitcoin, however, has important features that differentiate them from other bubble-prone assets.  The fact that the crash coincided with a change in policy from the Chinese government makes it even more likely that the special features of Bitcoin have played an important role in their use.

The design of Bitcoin allows for almost completely secure and anonymous transactions.   Users don’t have to trust that a bank or other financial intermediary will keep their information secret. For the most part, the very nature of a Bitcoin transaction does this. Consequently, the currency has attracted substantial interest from users engaged in illicit transactions.  Some of these are of the kind familiar to American readers. The website Silk Road, for example, specialized in selling narcotics and accepting Bitcoin as payment; it has been shuttered by U.S. law enforcement.

The Chinese government’s ban on Bitcoin arose from a different sort of illicit transaction that is less familiar to Americans because it are designed to get around regulations that the United States does not impose… Here’s the rub: the Chinese government limits its citizens’ ability to invest outside of the country because it wishes to provide a large pool of capital available to Chinese industries.  Since Chinese investors have limited choice, Chinese banks can offer them paltry rates of return that guarantee that the value of their investments will fail to keep up with inflation.  Naturally, Chinese investors wanted a way out, and many of them turned to Bitcoin.

Chinese investors would buy Bitcoin using the local currency, the Yuan. They would then transfer the Bitcoin to a bank or other financial institution outside of China and have that institution sell the Bitcoin and invest the proceeds outside of China. When the investor was ready to cash in, she would simply instruct the financial institution to sell the foreign investments, use the proceeds to buy Bitcoin, and then transfer the Bitcoin back to her.

This loophole allowed Chinese investors to earn higher rates of return without being caught by the authorities. For a time, the Chinese government allowed the loophole to remain open. On Wednesday, however, the Chinese government banned financial institutions and, importantly, online platforms like Biadu.com, from doing any business in Bitcoin.  Baidu is a Chinese search engine that, like Google,forms the backbone of how users connect online. Without Baidu’s help,finding someone to buy or sell Bitcoin in the first place becomes exponentially more difficult.

Fear that the Chinese market for Bitcoin would dry up seemed to lead speculators to dump the currency following the announcement.  It also exposes the fundamental weakness of Bitcoin: while they allow enormous anonymity for users, connecting with a broadbase of other users requires using a platform which almost necessarily does not seek anonymity. If it did, potential users would not know of their existence.

Regulators don’t have to crackdown on users themselves but simply on the websites and platforms that connect them.

There is no readily apparent US or European analogue to the Chinese monetary policy that motivated the country’s crackdown. Hence, China’s stance does not necessarily indicate that an international sea change is afoot with respect to the legal nature of Bitcoin and other emerging virtual currencies. Nonetheless, to the extent that Bitcoin’s surge in value was precipitated by Chinese investors’ thirst for international investment capabilities, the recent crash highlights the currency’s deep vulnerability to changes in financial regulation around the world.

Karl Smith is the Creator and Chief Curator of Modeled Behavior, a leading international finance and economics blog currently hosted on Forbes. He blogs mostly on macroeconomics, rationality, philosophy, and futurism.