Here's what will happen when the Bitcoin bubble bursts

Here's what will happen when the Bitcoin bubble bursts

The word that's on the lips of every economist these days is "Bitcoin", and it's safe to say that the cryptocurrency has got many people worried. Many thought that the financial fad would be nothing more than a flash in the pan. But the allure of big bucks has given Bitcoin an unexpected longevity. First invented and released as open-source software in 2009, the system of peer-to-peer sharing and digital transfers have made it easy to use, and there have been real success stories.

Bitcoin is, of course, a digital form of currency. However, it's a bit more complicated than you might think. They are actually random sequences of numbers and letters which humans "mine" using complex computer programs to estimate their value. Once the sequence is correctly guessed, you will receive that Bitcoin and know how much it is worth. The profit comes through the transactions, since it's easier to buy Bitcoin rather than mine them yourself.

Once purchased, you can use the sequence to store cash or share it, and once you have obtained 50 Bitcoin, it is called a "block". Blocks are collectively referred to as "blockchains", which contain the history of every other transaction which has occurred in the Bitcoin network.

A Bitcoin advertisement. Credit: Getty

But is it all too good to be true? Certainly, that's the question that any sound economist will ask themselves when things seem to be going too well. Just think back to the 2008 housing market crash. Back then, nobody could have expected the housing market to have imploded so spectacularly, but the perfect storm of subprime mortgages, synthetic CDOs and bonds led to complete chaos. Is the bubble going to burst in the same way with Bitcoin?

Well, traditionally bubbles occur when a new resource or piece of technology is exploited beyond its capacity to make money - like when the dot com bubble burst in the late nineties after too many people attempted to invest in websites. Media coverage also makes the bubbles expand, drumming up more and more publicity for overzealous investors to join the craze. It's possible that the rampant speculation of Bitcoin's price would overestimate its fundamental value; add to that the fact that the value of Bitcoin has soared, but with many fluctuations along the way, and things look somewhat grim for the future.

The issue of implosion rests on the fact that the majority of the estimated $366.8 billion in Bitcoin's market value is in the hands of a Silicon Valley oligarchy, which operates most of the large-scale cryptocurrency mining. As Garrick Hileman, a University of Cambridge financial researcher, explains: "It will be like 2000, when the tech bubble popped. The largest and strongest players, the Amazons of the crypto world, will consolidate and propel themselves further ahead. But a lot of bitcoin companies – exchanges, wallet companies, etcetera - will go out of business."

A sign under bottles of spirits which references Bitcoin. Credit: Getty

If there was eventually enough accumulated debt and credit to constitute a financial crisis, then the collapse of Bitcoin could end up contaminating other forms of cryptocurrency. For example, alternative cryptocurrencies which have also experienced a boom in investors, such as Ethereum, Litecoin and Monero, could potentially end up guilty by association, and lose their value. But for this to occur, miners would have to start getting into serious debt. If cryptocurrencies developed a model where they could start getting into debt through lending and credit, then a crash is all but inevitable.

Some cypto-exchanges have already begun to flirt with this as a viable business model. Japanese exchange BitFlyer allows its investors to borrow up to 15 times their original cash deposit to purchase Bitcoin. That's all very well when their value is increasing, but where their value to drop irrevocably, then those people would end up penniless. Other, more obsessive miners have reportedly ended up remortgaging their homes just to buy more.

One outcome is certain: a Bitcoin implosion would mean that cryptocurrency would have to become more regulated. Financial authorities will be forced to become more interventionist, and governments will inevitably introduce legislation that would restrict Bitcoin profits. As Brent Goldfarb, associate professor of management at the University of Maryland states: "It would create regulatory pressure on the currency ... There would be an upswing in complaints and political pressure to do something about [bitcoin]. That's what created the US Securities and Exchange Commission, which was established after the crash of 1929.”

A visual representation of Bitcoin. Credit: Getty

Much like the issue of net neutrality, enforcing regulation on a digital currency that was intended to be used anonymously would be challenging. One obvious thing for governments to do would be to impose stricter rules on cryptocurrency exchanges. As a result, Bitcoin would recede. The currency would return to the shadowy corners of the dark web, only used by libertarians and anarchists suspicious of government interference. But the important thing to remember is that this is only one possible outcome. There are plenty of Bitcoin supporters who believe that they could be worth hundreds of thousands of dollars in the near future.

 

Featured illustration by Egarcigu