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Cryptocurrencies: the Ultimate Bubble

Updated: May 17, 2022

Remember cryptocurrencies? Actually, that is a little unfair as they are still popular and thus still have much further to fall. Bitcoin and its various clones are ingenious but represent the ultimate bubble. At least with tulips or, indeed, bubbles, you get something tangible – ok, so you don’t get much oil and water in one bubble. Cryptocurrencies also help people evade taxes and purchase narcotics more easily so likely will be banned once governments get their acts together.

"The IOU was perhaps one of humankind’s greatest inventions"

The problem I have with cryptocurrencies is that they do not satisfy the necessary attributes of a currency, nor are being treated as currencies by many or perhaps most of those who ‘buy’ them. ‘Should I invest in Bitcoin?’ is an absurd question because currency by definition is not a financial asset but a medium of exchange (that I was asked this question by three taxi drivers and a security guard in a matter of days earlier this year makes it all the more worrying).

The IOU was perhaps one of humankind’s greatest inventions. Institutionalising them - making them fungible – and appointing banks as their intermediaries should be right up there too. Without IOUs, the sellers of morning milk and evening ale would have been unable in days gone by to do business with each other. Milk man (later to become known as the milkman) would accept a piece of paper from ale man (hmm) on the basis that ale man would not only have stock but would also take back his piece of paper in exchange for a pint.


This system however was inefficient because the IOUs were specific to two parties and because of structural imbalances (a housebuilder was unlikely to build a house for the milkman in exchange for a piece of paper promising, effectively, 100,000 pints of semi-skimmed).

Enter the banks.

Once banks arrived on the scene, ale man could go to his bank manager and say that he wanted to borrow some ‘money’ to buy some milk (for his porridge, perhaps). Bank manager would consider such things as ale man’s stock of ale and his willingness and ability in the past to pay his debts. All being well, he would extend him credit by giving him one of the bank’s own IOUs to give to the milk man.

Not only that. He also told the town’s population that the bank’s own IOUs could be used for anything! To provide reassurance, he promised that he’d take back the IOUs in exchange for an amount of a valuable substance such as gold in the event they couldn’t be used for some reason.

Credit creation is something that is widely misunderstood. Many think that banks lend out deposits, as if the deposits existed before the loans. Wrong. When banks lend money, they create the loan then create the deposit by placing funds - the loan amount - in the account of the borrower (sometimes banks stipulate that the money bypasses the borrower as in the case of mortgages but it still ends up as a new deposit in the account of the seller of the property).

In the case of cryptocurrencies, this does not happen. There is no intermediary assessing the credit quality of a borrower. Yes, effort goes into creating new cryptocurrency - also known as mining - but this is not the same as the work that banks do.

The banking system works because the integrity of the system is protected by banks acting in their own interest. While the deposits that banks create may be fungible, the loans they create are theirs. Not getting paid back by borrowers comes straight out of the bank’s equity.

I suppose a more simple point to make is that currency is supposed to be a store of value and treated as such. How can something that can fall by 10% in one day be considered a store of value? Of course the reason cryptocurrencies are so volatile is that they are not being treated as currencies but as investments. Herein lies the ultimate flaw in the ultimate bubble.

Bitcoin hit its highest price in December last year at the same time that the Google Trends score in relation to the term “Bitcoin” (see notes below) hit its maximum score, 100. Since the score could not go any higher, it could only go down. It is entirely logical that interest in the term “Bitcoin” on Google Search correlates highly with interest in Bitcoin itself and thus the price of Bitcoin.

Published in Investment Letter, June 2018

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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