Monday, March 6, 2017

There is No Bitcoin Bubble, Yale Economics Professor Says

Vikram Mansharamani is a lecturer in the Program on Ethics, Politics & Economics at Yale University who recently explained why Bitcoin is not in Bubble territory.

Is There a Bitcoin Bubble That’s About to Pop?

Mansharamani is a lecturer in the Program on Ethics, Politics & Economics at Yale University and a senior fellow at the Mossavar-Rahmani Center for Business and Government at the Harvard Kennedy School. He is also the author of “Boombustology: Spotting Financial Bubbles Before They Burst.”
vikram-mansharamani-368x206

In a recent article in LinkedIn he asks: Is there a bitcoin bubble about to burst?

He has developed a  framework for spotting bubbles in his bestseller book, Bubbles & Busts. The approach is based on the application of five lenses and generates a probabilistic assessment of a forthcoming bust.

The book’s central thesis is that it is only by adopting a multi-disciplinary perspective can we hope to understand boom-bust cycles. The five lenses he identified to view and diagnose bubbles are: microeconomics, macroeconomics, psychology, politics, and biology.

Mansharamani refers to a lens being checked as a pointer to a bubble, a blank lens as a pointer to no bubble, and a half-check as in between.

However, he made a couple of mistakes in his analysis of the Bitcoin market, which I have pointed out to him on Twitter and will elucidate below.

Lens 1: Microeconomics

“Most of the time, efficiency logic works and deviations from equilibria tend to self-correct,” Mansharamani explains. “However, there are instances in which reflexive dynamics are able to overcome the self-correcting force and creative self-fulfilling extremes.”

He takes the Classical efficient markets theory learned in Economics 101 and applies an amendment derived from George Soros’ Theory of Reflexivity.

Therefore, the question is: Has the higher Bitcoin price been accompanied by higher demand (unstable market) or lower demand (efficient market)?

Mansharamani says the evidence is inconclusive on this. He says Bitcoin’s increasing role as a safe have asset means Demand for it increases during political and economic crises even if the price rises. (He gives the example of the price rise that happened after Brexit). Against that, he says, trading volumes have declined in recent months.

Lens 1: Half-Check

Lens 2: Macroeconomics

The second lens concerns the effects of debt and leverage on asset prices. From his book:
“the relationship between debt, collateral (i.e., down payment or equity amount), and asset prices has the potential to create a toxic cocktail that can greatly improve or deteriorate one’s financial condition quite rapidly.”
From his LinkedIn piece:
“I don’t see any evidence that leverage is fueling the potentially elevated prices. There are no futures contracts that enable large exposures with minimal collateral. There are no options that provide de facto leverage.”
Lens 2: Blank

Lens 3: Psychology

He writes:

Overconfidence and new era thinking are the hallmarks of my third lens, psychology. Whenever individuals develop a devout belief that ‘it’s different this time,’ buyers beware. It is rarely different and asset prices have never risen indefinitely. Rather, they generally go up and down, and in this regard, bitcoin prices are no different.

This is clearly evident in the Bitcoin space, with prominent figures from Silicon Valley like Peter Thiel and Henry Blodget along with Kim Dotcom forecasting a price of a million dollars a bitcoin.

Lens 3: Check

Lens 4: Politics

How do Government regulations  affect asset markets? With any asset, regulations can distort prices by either artificially increasing or dampening supply or demand. They can also introduce Moral Hazard.

When it comes to bitcoin, are there any artificial government interventions that are supporting bitcoin prices? No. On the contrary, regulators are trying to discourage interest in bitcoin. Just look to China.

And when it comes to moral hazard, there are no signs of it in bitcoin land. No one bailed out those who lost millions when bitcoin exchange Mt. Gox fild for bankruptcy. […] Many bitcoin market participants are transacting with open eyes, fully aware of the risks of doing so. There is no FDIC protection, no Federal Reserve put.

Lens 4: Blank

Lens 5: Biology

An application of epidemic logic to the study of financial bubbles can help gauge the relative maturity of manias. If we analogize an investment hysteria to a fever or flu spreading through a population, the variables of concern to us would include the infection rate, the removal rate, and perhaps most importantly, the percentage of the population not (yet) affected.

“When it comes to bitcoin, the number of potential buyers (i.e. those still vulnerable to infection) is very large indeed. To begin, it’s not particularly easy to buy Bitcoin and that’s deterred institutional investors. Specialized exchanges, online wallets, and the need to protect private keys create huge friction in transactions, keeping many potential bitcoin buyers away. There isn’t an ETF, at least not yet.

Lens 5: Blank

Summary of Mansharamani Diagnosis

“So on my five point scale, with five being a ‘virtually certain bubble likely to burst imminently,’ bitcoin only registers one and half points. On the margin, this means that the stage may be set for it to become a bubble, but it doesn’t appear to be one yet,” he explains.

I have used the Traffic Light color-coding to visualize the results. Green means no signal of a bubble. Amber means a bubble might be forming. Red means Bubble!

bubbles1

Incidentally, this agrees with Vinny Lingham’s analysis that there is no current bubble, but that a price of $3,000 could put is in bubbly waters:

“I’m not overly concerned with a Bitcoin price of $2,150 as a result of external factors like an ETF approval, which positively impact the supply/demand curve — but if it goes well past this, into the $3,000+ territory due to mania/short squeezes/media hype/FOMO and other triggers, then alarm bells will go off for me and we start approaching bubble territory.”

Corrections to Mansharamani Diagnosis

I have corrected a couple of errors made by the Professor about the Bitcoin market. As follows:

Lens 1: Microeconomics

Recall, the question is, then, has the higher Bitcoin price been accompanied by higher demand (unstable market) or lower demand (efficient market)? The Professor uses trading volumes on exchanges as a proxy measure of demand and activity, as reported on Bitcoinity.org.

He notes trading volumes have declined recently and concludes demand has declined with rising prices.

The Trading Volumes picture is muddy. Chinese Exchanges accounted for more than 90% of global trading volumes until Q1 2017 as a result of extreme leveraged trading and zero-fee trading.

The People’s Bank of China (PBoC) banned margin-trading in January 2017, and the Chinese exchanges then stopped offering zero-fee trading. As a result global trading volumes crashed even as the Bitcoin price continued to surge (after a temporary fall in the price).

Bitcoinist_PBOC

But there was no such crash in trading volumes at exchanges outside China that charge fees in the more traditional business model. So global trading volume is not a good measure of demand.

Better proxies for demand are transactions and transaction fees. Both have continued to rise strongly as the price has surged from June 2015.

tx
 and

 As a result of this correction, the status of Lens 1 changes from Unchecked (not a bubble) to Checked (bubble).

Lens 2: Macroeconomics

 This lens is all about leverage. The Professor wrote:
I don’t see any evidence that leverage is fueling the potentially elevated prices. There are no futures contracts that enable large exposures with minimal collateral.

 Well, until January 2017, there was extreme leveraged trading on the Chinese exchanges. The South China Morning Post (SCMP) gave us an insight into the crazy margin trading that was taking place.

“I have taken on big risks when making leveraged betting, but the collapse of the trading system made me unable to run stop-loss orders, so I think the platform should compensate for investors’ losses,” one trader explained.

Ahead of the market crash, the trader had borrowed 9.95 million yuan from Huobi by pledging a principal consisting of the 409 bitcoins he already owned. He then bought a further 1,228 bitcoins with the loan, the SCMP wrote.

Furthermore leveraged trading is available on Bitcoin Futures contracts at Bitmex Exchange.

However, leveraged trading is now forbidden in China, and trading volumes on BitMex are quite small relative to global trading volumes. Therefore Lens 2 would have been Checked (bubble) in January 2017, but as a result of new regulation of exchanges in China it is now Unchecked (not a bubble).

As a result of these corrections, on the five point scale, with five being a “virtually certain bubble likely to burst imminently,” bitcoin registers two points. That is half a point greater than in the original diagnosis.

In other words, there is no bubble but we are slightly closer to the emergence of a bubble than Mansharamani thinks. The professor’s diagnosis and the corrections I made to it are summarized below:

Is Bitcoin entering another bubble? Let us know below!

Images courtesy of Twitter, LinkedIn, Shutterstock, Blockchain.info

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