Chapter 2. Understanding The Cryptocurrency Market

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Chapter 2. Understanding The Cryptocurrency Market

The cryptocurrency market has undergone an extraordinary evolution. Starting as an obscure digital currency worked on by a tiny community, it has progressed into an asset which many take as a serious consideration for their portfolio, business operations, or personal use. The cryptocurrency market capitalization is valued around $210 Billion US Dollars at the time of writing (Q4 of 2018). This is down from an all-time high of over $830 Billion in January 2018. The current market capitalisation is around the same as the market capitalisation of large public companies such as Pfizer, Mastercard, and HSBC Holdings.

Throughout history, there has been a typical story of how new markets have developed. First, the smart money enters the market. This is followed by the institutional investors and by the time the retail investors have the opportunity to enter, prices in the market are already after appreciating significantly and may be due a correction.

Cryptocurrency Bull Market Graph

Cryptocurrencies are the first market which has managed to turn this model on its head. Retail investors were the first with the privilege to access and invest in the market. Institutional investors steered clear as too much reputational risk was on the line for such a controversial asset class. However, the pressure is increasing for more and more institutional investors to get involved. Derivative products are being developed and traded on public exchanges which tackles the concerns of many institutions in regard to compliance. The CBOE currently lists Bitcoin futures and plan to launch Ethereum futures shortly down the line.

This chapter is going to cover the topsy-turvy story of how cryptocurrencies arrived at a valuation larger than most public companies and will also take a dive into the unique properties of cryptocurrency assets. We will assess what are the similarities between cryptocurrency assets and other more traditional assets and what are the key differences.

The Evolution of the Market

The development of Bitcoin has had the most significant impact on the development of the cryptocurrency market as a whole. The original cryptocurrency has represented a huge percentage of the entire cryptocurrency market cap for almost its entire history. At the time of writing, Bitcoin represents about 54% of the cryptocurrency market cap. The below graph shows the dominating percentage of Bitcoin in the evolution of the market. The lowest percentage Bitcoin ever represented of the cryptocurrency market was about 32% in January 2018.

Cryptocurrency Market Explosion

Cryptocurrency Market Cap Explodes over 100x in the space of a few years

For this reason, the first step in explaining the cryptocurrency market and its evolution will be explaining the progression of Bitcoin from a valueless network to a cryptocurrency worth over $10,000. We will cover the booms and busts Bitcoin has undergone in its short history, along with some of its most important moments. We will then extend into the proliferation of altcoins and some of the speculative frenzies and price swings that came with it. The chapter will wrap up by delving into what are some of the unique properties of cryptocurrency assets, how they compare with traditional assets, and what cryptocurrencies role will be in global markets.

Bitcoin’s Journey – From Valueless to Validation

Bitcoin has often been labelled digital gold. Its unique properties have made it attractive to many as a digital store of value. But many also seriously question this and raise concerns about the wild price volatility Bitcoin undergoes.

The best way to tackle these concerns is with a modern-day example. Venezuela has spiraled into economic and political turmoil over the past few years. It’s fiat currency, the Venezuelan Bolivar has become essentially worthless with annual inflation being estimated to be over 100,000%. The Café Con Leche index which tracks the price of a coffee with milk purchased with Bolivars shows annual inflation at 150,000% Bitcoin purchased even at the price highs above $20,000 would have held its value order of magnitudes better than the Bolivar.

Fiat currencies (Euro, USD, GBP etc.) are the easy comparison. What about public equities? Are shares in public companies not a better store of value than Bitcoin? Public shares reflect the future expectations of company performance and will grow in value as the economy grows. However, time and time again, public shares have been proven to be unpredictable and risky. The average time expectancy of a publicly listed company in the S&P500 is under 20 years. Public companies can also be at their most vulnerable just when they are looking at their strongest.

Take Lehman brothers for example. The stock recorded profits from 2005 to 2007 with a net income of $4.2 Billion reported in 2007. The price reached $86.18 in February 2007. In September of 2008, the investment bank filed for bankruptcy. While the business seemed to be performing strongly with large profits in 2007, just over a year later shareholders lost their investments.

2008 Lehman Bankruptcy Crypto Effect

But you may think it is not fair to use a stock that went bankrupt. Let’s use one whom many believe is the greatest company which exists today, Amazon. Amazon shares purchased in the peaks of the 1999 dotcom bubble would have taken almost a decade to recover. One of the strongest companies purchased at a time when market confidence was at an all-time high would have tied up investors capital for ten years before showing a return.

Amazon Stock Price Recovery

While Bitcoin price has had volatility over its short life, its network has grown from strength to strength. There are over 10,000 nodes operating the network and daily transactions are typically above 200,000. The hash power which is representative of the security of the network has been consistently increasing and is currently around 50 Million terahashes per second. Bitcoin is also designed to be a deflationary currency which means the value of the currency is expected to increase while there is a corresponding fall in the value of goods and services.

This does not mean it is riskless. A digital asset whose security depends on that of the health of the network gives rise to other risks. Imagine a scenario where the majority of the hash power is controlled by one entity or a scenario where several large miners collude to act maliciously. However, these risks are frequently discussed and assessed. Decisions are made by stakeholders to probabilistically reduce the chance of an event which harms the network occurring.

The properties of Bitcoin as an asset has hence resulted in it being seen as a digital form of gold. In Q1 of 2017, many believed a pivotal event occurred as the price of Bitcoin reached parity with that of gold. However, the market cap of Bitcoin is still minuscule compared to that of gold. The market cap of gold is $6.9 trillion whereas that of Bitcoin is approximately $115 Billion at the time of writing. The below illustration shows the development of Bitcoin price and some key developments as it reached parity with Gold and the price index below shows the past two years of performance.

Bitcoin Reaches Parity With Gold

Bitcoin Reaches Parity with Gold

Bitcoin History Price Graph Image

Altcoin’s Journey – Business on Blockchain

Much of the effects we have in the world are nonlinear. We see it everywhere. The majority of the profits go to the largest enterprises. Ants can lift about 10,000 times their body weight compared to humans that can lift around one to two times their body weight. A small change in an input variable can result in a drastic change in an output variable.

The same can be said for altcoins. For much of the existence of cryptocurrencies, altcoins played a relatively minor role in the market. Up until 2016, Bitcoin alone still represented 80% of the entire market capitalization despite altcoins being around nearly as long. But over the years, awareness grew gradually and understanding of the technology grew steadily deeper. The number of mentions in major news outlets referring to Bitcoin and blockchain continued increasing year after year while altcoins remained mainly in obscurity.

Until altcoin awareness exploded. The nonlinear effect came into play. All the years of steady increases catalysed into a major euphoria regarding the potential of altcoin projects.

The number of altcoin projects rapidly increased. Prices in altcoins began to rapidly increase as well as investors began to reassess their value. The ideas for business on blockchain boomed. If you typed blockchain followed by almost any traditional business model into Google search, you were nearly sure to find someone either discussing it, developing it, or doing it!

While many altcoins were developed to form the same function as Bitcoin, more began to burgeon to build business ideas on the blockchain. The power of decentralizing traditional business concepts became an attractive venture for many and this reflected in price and market capitalization. While cryptocurrencies whose function was similar to Bitcoin’s were priced approximately to reflect the share of the remittances or store of value market that market participants believe they can take, a lot of altcoins are different. Altcoins that are applying a business model to the blockchain needed to be assessed based on the ability of their decentralized technology to take the market of a centralized business. For example, Siacoin is a platform and cryptocurrency which serves to create an ecosystem that decentralizes file storage. Siacoin’s price and resultant market cap (market cap is calculated by multiplying the price by current supply) will reflect the share of the file storage market investors perceive Siacoin can capture going forward.

Another cryptocurrency, Golem, looks to decentralize the market for cloud computing. Its price will reflect the share of the cloud computing industry investors believe Golem can capture. Seeing a pattern?

As a whole and on a long enough time scale, the theory is markets will act rationally. Any price moves which fluctuate too far from the underlying value will be brought back by buyers and sellers looking to capitalise. That does not mean that markets do not sometimes act irrationally. Investors can get swept up in bouts of euphoria and also lose all hope in lengthy crashes. This applies to all markets including altcoins. With the application of blockchain to businesses being a new model, prices can widely fluctuate as investors try to assess the market. Investors also need to decide what they value in this area. Investors are also assessing what they place value on. As noted in chapter one, blockchain is a technology which is slow to change. Some altcoin projects trade off the level of decentralization for an increased amount of throughput and scalability. Others have the utmost emphasis on security. We are still in the beginning phases of the market developing what is valuable and what is not.

Cryptocurrency Assets Versus Traditional Assets

Cryptocurrencies have their own properties which make them vastly different from more traditional assets.

Returns

Up until now, cryptocurrencies have provided extraordinary returns. From the first pricing of Bitcoin at 7/100 cents, investors have seen the cryptocurrency rise to above $20,000. Other assets have been no less extraordinary with Ethereum rising over 1,000% in 2017.

In a growing market, those that survive are expected to provide huge returns. We have seen some of these returns already but if you compare the cryptocurrency market size to that of traditional industries, the potential is there for more of these returns. However, it will become more and more difficult to get outsized returns as the industry grows and more and more investors arrive in the space driving prices up.

Risk

Cryptocurrencies entail a different type of risk than other assets. With the industry still in the developing phases, many projects will be expected to fail and eventually exit the market. Industries go through a number of stages and we are still in a phase where many projects are being developed and ideas are blossoming. As the industry develops, the competition will intensify and projects which can’t tailor their business model to the market needs will be shaken out and eventually, a few large players will remain.

Industry Life Cycle

Industry Life Cycle

There is also the ICO’s which we will cover in further detail in Chapter six. This mostly unregulated instrument has attracted numerous scams and teams seeking to fund their project without giving up shares to investors. However, some have also been hugely successful such as Ethereum.

The key point here is that there is a greater risk of loss of capital when it comes to investing in cryptocurrencies. Investors need to be willing to put in the time to discern whether a project has the right ingredients to succeed or whether their capital is never going to be seen again. Chapter five and six will provide analysis frameworks which can be applied in determining this.

Volatility

Cryptocurrencies are absolutely a volatile asset class. It is not uncommon for cryptocurrencies to undergo double-digit percentage movements within a day. Billions can be added to or taken away from the cryptocurrency market cap in a matter of minutes.

As the market develops, it becomes less volatile. This is due to a greater amount of capital coming into cryptocurrency, greater trading volumes, and more mechanisms to ensure investor safety spawned from regulations. But for the moment, it remains one of the most volatile instruments. There are some equities which trade with more volatility than cryptocurrencies but these are rare. While Bitcoin has gone through periods of low volatility this year, altcoins will be expected to be wildly volatile for a long time yet. One of the biggest factors which play a role in this is liquidity.

Liquidity

Liquidity refers to the number of buyers and sellers there are in the market for an instrument. It can be analysed via the order book. A thinly traded market refers to an illiquid market. It can be seen by a lack of buyers and sellers in the market. When the price is trading in a thinly traded market, it can often jump from one price to another with not much fluidity due to the buyers and sellers in the market being sparsely apart.

On the other side, a thick order book refers to a liquid market. There are many buyers and sellers and the price trades with more fluidity. An order book consists of bids and orders at different prices. A bid is a party that is wishing to buy for a given price. A bid of $100 for 1 Raketech (an imagined cryptocurrency for the sake of this example) means that a buyer is willing to buy the amount of 1 Raketech for $100. An offer is a party who is willing to sell at a given price. An offer of 1 Raketech for $101 means that the party is willing to sell 1 Raketech for the amount of $101.

For a trade to occur, either a buyer needs to accept an offer or a seller needs to accept a bid. The spread is the amount between the highest bid and the lowest offer. If the highest bid for Raketech is $100 and the lowest offer is $101, this means the spread is $1. Liquid markets typically have the lowest spreads. The exchanges which offer the most liquid markets for Bitcoin will mostly have a spread of $0.01.

Coinbase Pro Bitcoin EUR Order Book

Coinbase Pro Order Book for Bitcoin

Supply Schedule

Supply schedule refers to the rate at which the instrument comes into existence. The mechanism through which this occurs varies widely from instrument to instrument. In a fiat currency, the supply schedule is determined by the central bank which issues the currency. If the central bank decides to print an extra 60% of the current supply in existence, then the supply will increase by 60%. With gold, it depends on the amount which can be mined from the ground. The situation is similar for natural commodities such as oil. What about equities? An initial number of equities is issued in the initial public offering (IPO) and management can decide to issue further secondary shares. An excessive issuing of shares by a company typically will result in a significant depreciation of share price.

The supply schedule for cryptocurrencies is coded into its network. Bitcoin has a deflationary schedule whereas the time goes on, the amount of newly minted Bitcoin which is issued decreases. This is due to the halving occurring every 210,000 blocks (approximately every four years). This a key element to many investors that place value in Bitcoin. In many assets, there can be no certainty as to the future supply. Investors in Bitcoin have the certainty that there can only ever be 21 Million Bitcoin and that there will be less newly minted Bitcoin every four years. The rate of inflation and the resulting total supply curve can be seen below.

Correlation

Correlation represents the relationship between two assets. It is a figure between -1 and +1. A perfect correlation of 1 means the two assets will move in completely in sync. A 10% increase in one asset will lead to a 10% increase in the other asset. A completely negative correlation of -1 results in a 10% increase in one asset meaning a 10% decrease in the other asset. However, perfect correlations are virtually non-existent in the natural world. Almost everything ranges somewhere between. The number represents the strength of the relationship and the sign represents whether the relationship is positive or negative. The table below shows how to interpret the strength of the relationship based on the correlation figure.

Strength of Correlations

For much of its history, cryptocurrencies have been seen as an asset class which is completely uncorrelated with other asset classes. Over more recent years it has begun to start to have a slight correlation with equities. This may be due to a depreciation in equities resulting in a demand for cash and pressing investors to sell their cryptocurrencies for fiat currencies. The lack of correlation is seen as a beneficial property by many as if the rest of investors portfolio may often decline together due to correlated assets being in together. The table below shows the correlations of cryptocurrencies with other major assets classes. As time goes on, the correlations between cryptocurrencies and other asset classes are expected to grow as cryptocurrencies continue to become more mainstream and the same group of investors trade it that trade other assets classes. Correlation is a key consideration of diversification in putting an overall portfolio together which we will go over in further detail in the final chapter.

Underlying Value Versus Speculative Value

As an asset class develops less and less of the price represents the speculation of traders and more will represent the actual metrics which underline the utility it provides. While cryptocurrencies are growing, many are still speculating on what it can become and this is reflected by wild movements in price. But as it progresses, more of the price and movements will reflect changes in the underlying network or asset. For example, as the monetary value and transactions conducted on the Bitcoin network increase or decrease, it will be representative of the utility of the network and its usage.

Reader Exercises:

Now you have a better understanding of how the ecosystem developed. Play around with some tools that will give you a better understanding of projects which interest you!

  1. Go to Coinmarketcap.com and look through the assets. This is the most popular cryptocurrency data provider. It lists assets in order of their total market cap.
  2. Go to Blockchain.info to find data on what is going on in the Bitcoin Network
  3. Go to Etherscan.io to find data on the Ethereum network

Once you’re ready, proceed to chapter 3.

 

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