Don't invest in cryptoassets unless you're prepared to lose all the money you invest. Cryptoassets are high-risk investments, and you are unlikely to be protected if something goes wrong.Take 2 mins to learn more

Thanks to our supporters

brand imagebrand image
Daniele-Bianchi.jpeg-e1618569444777.jpg
read

Bubbles, Technological Innovation and Bitcoin

Concerns about financial bubbles in cryptoassets have intensified, given the rapid and unprecedented rise in their market capitalisation (currently at almost $2 trillion) and return of high volatility.   The very existence of bubbles in financial markets is somewhat controversial in the academic literature. In…

Share

Share to Facebook
Share to Twitter
Share to Linkedin

Concerns about financial bubbles in cryptoassets have intensified, given the rapid and unprecedented rise in their market capitalisation (currently at almost $2 trillion) and return of high volatility.

 

The very existence of bubbles in financial markets is somewhat controversial in the academic literature. In either case, bubbles are mostly considered a negative phenomenon, considered financially wasteful and economically, and perhaps even socially, destructive. For instance, almost $6 trillion of value evaporated after the dotcom collapse in the early 2000s, and the global economic system crashed when the subprime mortgage bubble burst in 2008.


The typical view in economics and finance is that bubbles are essentially driven by investor euphoria, irrational exuberance and often unrealistic expectations of ever-increasing cash flows, which make prices temporarily decouple from fundamental values.

 

Fuelled by self-reinforcing feedback loops, prices run up until they crash, with destabilising effects socially and economically. Famous historical examples are the Dutch tulip mania in 1637, the South Sea bubble of 1720, the stock market crash of 1929, the dotcom bubble of the early 2000s and the great financial crisis of 2007-2008. Note, however, that not all bubbles are necessarily solely due to an irrational decoupling from market prices and economic fundamentals.

Technological Bubbles

The financial and economic literature seems to pay less attention to financial bubbles that are not necessarily wealth destroying, but rather an important process for innovation in various domains. For instance, in her work on technological change, Perez (2009) argues that there could be a type of financial bubble which is inherently linked with major technological change.

 

The argument is more complex than it seems. While on the one hand, financial bubbles can be generated by the way the market absorbs anticipated technological revolutions, on the other hand, financial bubbles can help attract the financial capital necessary to fund and develop disruptive technologies at the frontier of innovation. In both scenarios, one may think of financial bubbles as being the result, or at least capable, of accelerating breakthroughs in technology and science. In other words, the argument in favour of so-called “technological bubbles” is that, without investor euphoria and excessive risk-taking, many technological innovations may never have happened. An example that is commonly referred to is the dotcom bubble. A rapid net inflow of capital into the emerging technology of the internet, it has been argued, accelerated the development of “innovation champions” over the longer term.

 

Conceptually, it is not surprising that financial bubbles and speculative investments are concentrated around new technological innovations and industries. If anything, asymmetric information and arbitrage opportunities tend to be higher around new and possibly disruptive businesses. On the other hand, investors tend to be more attracted by the possibility of abnormally high returns, compared to the paltry of low, perhaps even negative, returns of other traditional investments.

 

Perez (2009) argues that each technological innovation is triggered, or is followed, by a financial bubble, which allocates excessive amounts of capital to a given emerging technology. After a so-called “installation” phase, in which an excessive inflow of capital drives the initial installation of a new technology, there is a crash or “turning point”. After that, the emerging technology emerges and is deployed throughout the economy, across industries and societies. According to Perez (2009) and subsequent research, these three steps – installation, bubble collapse, and following deployment – characterise the rise of technological revolutions throughout history, from the first industrial revolution to the dotcom bubble.

 

One may argue that this is the reason why during technological bubbles there is a decoupling of market valuations and fundamentals, very much like that suggested by standard economic theory. One possible explanation lies at the core of the typical funding structure of technological innovations; the funding of new technologies by euphoric investors is often decoupled from the expected returns on investments, particularly in the short term.

 

As a result, almost irrespective of the underlying economic value, financial bubbles mobilise financial resources which are core to the development of new, possibly sustainable technologies. This is very much linked to a “trial-and-error” type of reasoning, according to which financial bubbles make available capital, which is wasted for the most part, but would not be mobilised otherwise. This is obviously against a typical rational-expectation, utility maximization argument, whereby investors seek to maximize their final wealth. It is for this reason that technology and financial bubbles have not always been seen as two sides of the same coin.

 

In this respect, financial bubbles are not seen as market failures, but rather as a “net-beneficiary” for society in the medium to long term. This is almost irrespective of the fact that financial bubbles in the short term can inflict pain and large losses to investors, as the ultimate benefit is for society as a whole and not just investors.

Blockchain and Technological Bubbles

The idea that the internet would radically transform the economy was behind euphoria and excessive capital inflow during the dotcom bubble. Ultimately, that intuition was correct, despite the fact it costed almost $6 trillion in losses at the burst of the bubble. Investors of companies such as Amazon and Google have been able to justify the intangible value of these companies, therefore rationalising dotcom investments at large. Investment in dotcom start-ups could, thus, be rationalised as they had a risk-return trade-off similar to a call option.

 

A similar argument can be made for DLT, for which the existence of a financial bubble has been repeatedly questioned. While potential scalability of the technology is still unclear, an increasing number of firms are now diving into this new technology. Although this could simply be the result of “fearing to missing out” and inflated expectations, it does not necessarily mean that the extraordinary financial commitment of investors is irrational or foolish.

 

One key aspect that is often overlooked by media and commentators regarding the so-called Bitcoin “bubble” is the new and innovative financing models, which often take place in the form of tokenization. The latter refers to the process of issuing a token that digitally represents a tradable asset in exchange for funding. In many ways, this is an evolution of the securitization process. This offers the potential for more efficient financing and possibly accelerates capital flows, but also possibly the build-up of financial bubbles. Because transaction of tokens and the tokenisation process typically is completed with smart contracts, transactions can be automated, but lack regulatory oversight, as regulators struggle to keep up with the pace of innovation. Intermediaries can possibly be removed from this process, which makes transactions fast and efficient, but also potentially present risks not present in other financial assets. However, tokenisation allows for logic to be encoded into these financial assets, potentially allowing for greater compliance and risk oversight, once regulatory, compliance and best practice frameworks catch up with this rapidly evolving technology.

 

In addition, tokenisation also is associated with investments in start-ups and new high-tech projects, often in the form of new Initial Coin Offerings (ICO), Initial Exchange Offerings (IEOs), Initial Security Offerings (STOs), fair launches, etc. These fundraising mechanisms make start-up investing more accessible to mainstream investors. New technology investing is typically restricted to accredited and professional investors who invest in the equity of start-ups, typically through VC investment models, with only a few exceptions such as crowd funding, which are limited to the amount they can raise. While tokenisation “democratises” the capital raising process and the participation in financial markets, it potentially makes early stage investing more prone to bubbles through increased access to capital and less sophisticated retail investors, which then requires a closer regulatory oversight.

 

Through these fundraising mechanisms, larger amounts of money have been able to enter earlier in the technology evolution cycle, while this technology is still, arguably in the so-called “installation” phase. This is before the “turning point” phase, which is where innovation driven financial bubbles typically occur. This technology has seen retail money enter before the institutional “smart money”, which typically marks the start of speculation around transformative technologies.

Concluding Remarks

The key question, which is largely still unresolved, is to what extent DLT and cryptoassets can be thought of as “productive” bubbles for society.

 

It could well be the case that investments in DLT are simply a reflection of instinctive hype by the media and market commentators. One aspect that may help to clarify this is the very nature of the technology and the capital involved. While it is true that there is an epidemic of speculative trading for most of the floating “shares”, it is also true that most of the capital for smaller cryptoassets is still in the hands of the developers actively building and developing the technology and infrastructure. Compared to a typical speculative investment in financial derivatives, e.g. during the great financial crisis of 2008-2009, for DLT and cryptoassets, it seems clear here that there is currently limited risk of wider financial instability implications in the broader economy. In this respect, while destructive for some investors, the current so-called cryptoasset “bubble”, ultimately, could provide the technological foundation for the broader adoption of DLT in the next years and decades. Time will tell.

Bibliography

Perez, Carlota. “The double bubble at the turn of the century: technological roots and structural implications.” Cambridge Journal of Economics 33.4 (2009): 779-805.

Daniele Bianchi
Daniele Bianchi
Economic Consultant at Aaro Capital

Visit aaro.capital for more information

You may also like

Article-Thumbnail-Cesar-Cerrudo.jpg
listen

Cybersecurity in crypto: Attack on DeFi Exchanges

What exactly happened in the biggest hack in DeFi? Can it happen again? As the ecosystem grows, its market has also experienced a huge pump with a current market capitalization of over $121 billion. However, this growth has also shined a light on cybersecurity issues….

Read more
obi-nwosu-e1618557591836.jpg
read

Decentralisation – coming to a screen near you

You should never laugh at people from the past, unless you’re comfortable with future generations mocking you. But it’s still funny to think that in the early days of radio, families used to gather in front of their giant, sideboard-sized sets and stare at them…

Read more
Henry-Burrows-Featured-Image.jpg
read

Crypto-backed property purchases are on the rise among first-time buyers

Traditional businesses are partnering with blockchain intelligence firms to facilitate house purchases for a new generation of young crypto entrepreneurs. In December 2017 two properties were purchased in the UK with Bitcoin.  The purchases sparked excitement that Bitcoin-backed property transactions would become commonplace, reflecting the…

Read more
Onchain-Reaction-Featured-Image.jpg
listen

Onchain Reaction with Tom Salter – Who Has Been Driving Bitcoin’s August Price Rally?

Tom joins to review Bitcoin’s price rally, along with the aftermath of Chinas’s crackdown in July and the explaination behind the market’s current bullish picture.

Read more

Recommended

Subscribe to us

Understanding your dog for dummies cheatsheet

We use cookies on our website to give you the most relevant experience by remembering your preferences and repeat visits. By clicking “Accept”, you consent to the use of ALL the cookies.