History doesn’t repeat itself, but it does rhyme as Mark Twain famously quoted. The current climate as observed in cryptocurrency certainly bears a striking resemblance of the 2000s dot com crash.
374 Initial Public Offering (IPOs) (US$84.63billion*) and 541 IPOs (US$111.78billions*) were sold in 1998 and 1999 respectively, prior to the dot com crash in 2000. Currently, 46 Initial Coin Offering (ICOs) (US$96millions) and 139 ICOs (US$2.1billions) were sold in 2016 and 2017 (as of 31st August 2017) respectively. Witnessing a huge increase in coins offering for a wide variety of uses. This inevitably draws our attention to ICOs and its underlying technology. *values as of 2017, adjusted for inflation
ICOs have been around for a couple of years now, most notably with Ethereum raising funds through the sale of Ether to fund the development of the Ethereum platform. This has all been good, where developers with exceptionally good ideas raise funds to build out their product. However in recent years, ICOs are getting lots of attention from entrepreneurs and opportunists as an alternative form of raising capital, bypassing traditional financing methods (equity/debt financing). With 867 cryptocurrencies and counting (as of 31 August 2017), each advocating on a big idea that would revolutionize an industry. From coins for data storage to payments for writers, cryptocurrencies were introduced into the market and funding crowdsourced from both sophisticated and non-sophisticated investors through intense marketing campaigns. This presents real risks to the startup/investing community as traditional financing not only provides capital to new companies, but stringent due diligence will be conducted and terms are incorporated into contracts to ensure the viability of their business models and instill discipline to entrepreneurs running their businesses. With fundraising bypassing these investors and to the wider community (crowdfunding) the lack of insight and due diligence towards the companies raising funds, while also being misled by the marketing materials produced, retail investors are not in the position to make informed decisions with their investments.
As this phenomenon takes place over and over again across time, more toxic companies are being funded and more capital is being poured into the industry thereby driving prices up leading to the overvaluation of companies. This certainly draws resemblance to the dot-com crash in 2000 where among multiple factors from the market, driving up the prices of companies. Along with bullish speculations by the wider community investing their monies without proper due diligence led to the irrational exuberance of the market which resulted in a painful correction in the mid-2000.
In the 1990s, it almost seems like anyone with an idea and a business plan can raise funds to start a company. For every conceivable subject or every kind of clientele, there are Internet companies that catered to specific needs, raising millions of dollars of funding, and IPO-ed at billion-dollar valuations with no concrete plan on how to achieve profitability.
Companies create illusional hype about their ideas/product and over exaggerate their matrices while instilling investors with the fear of missing out on the next big, which drives time to their IPOs (in the 90s) and ICOs in the current market. In the unregulated sphere of cryptocurrency, where no one is held accountable for what they’ve pitched and millions of dollars involved, ethics are bound to be flouted, rules to be bend and irrational behaviors to occur.
At the same time, risk-free interest rates remain low, which sets the benchmark for returns across other asset classes, thus makes investors hungry for higher returns. An increase in demand will very quickly follow by an increase in supply capitalizing on the irrational demand and that’s the natural phenomenon of the market. This is where the problem arises, with the insatiable hunger of investors to find the next Uber/Bitcoin, due diligence will not be at the top of their priority as the fear of missing out sets in. Investors wanted big ideas more than a solid business plan. The hunger for high growth internet companies in the 90s led to the dot com crash, demand for high yield securities in 2007 led to the subprime mortgage crisis, while the demand for cryptocurrencies led to the increase in ICOs in recent years but would we see a major correction to the cryptocurrency market, which could be the catalyst for a wider market correction? Nobody knows, but there are several signs one can draw from to form their own conclusion.
The general consensus is that the market currently trades on the higher end of the spectrum, with a huge number of securities overvalued and investors having a hard time to identify good deals (Private Equities are sitting on US$936Bn of dry powder) to invest in.
The extreme volatility nature of crypto and its relatively new technology makes regulators wary and they are scrambling to identify the best way to keep them in check. Governments across the globe have raised their concerns about cryptocurrencies and issued guidance on them, while the recent ban of ICOs in China and the shutting of crypto-exchanges in China led to a sharp decline in crypto-market. Let’s be honest, there are no real-life applications for cryptocurrencies yet that would spur mass adoption, with the bulk of movement volume generated by traders and retail investors speculating on these currencies.
Don’t get me wrong, I’m long-term bullish on blockchain technology and cryptocurrencies, however in the short/medium term correction of the crypto market will set in as regulations are formed, consolidation of cryptocurrencies, irrational demand subsided as retail investors grasp a clearer understanding of cryptocurrencies. This will form the foundation for the long-term sustainable growth of the cryptocurrencies as standards are in place and networked applications with genuine use cases created. Much like the dot-com bust, companies will emerge from the bear market and grow into market leaders of the new economy. Like it or not, blockchain technology is here to stay, only when applications are built and iterated to serve the market that true value of the technology will be created.
Every asset class derives its fundamental value from its ability to deliver a genuine use case to the wider market. The more value the asset class delivers to the wider community the higher its fundamental value thus its traded price, which is reflected by its fair value in the market. However with the current irrational exuberance and unwarranted bullishness of the market towards cryptocurrencies, driving prices of these altcoins several times its fundamental value, which brings about two feasible outcomes in the near future. 1. Blockchain technology matures quickly and applications are built on these cryptocurrencies protocols to create genuine use cases that are suitable for mass adoption to increase its fundamental value significantly. 2. Experience a market correction when its irrational exuberance fades and have a steep decline in fair value price to reflect its fundamental value.
Traditional valuation techniques no longer work on crypto, as value distributed across the blockchain technology differs from traditional companies. Joel Monegro puts it succinctly, “The market cap of the blockchain protocol always grows faster than the combined value of the applications built on top since the success of the application layer drives further speculation at the protocol layer.” The value of bitcoin/ethereum increases overtime assuming they come out as the benchmark lies in the networked application that runs on top of the shared data layer of blockchains. As discussed initially by Fred Wilson, Bitcoin/Ethereum will increase in value overtime just like how Visa/Mastercard achieved strong economics as use cases for their technology matures, while networked applications built upon their protocol are forced into commodity pricing. Before these scenarios play out, cryptocurrencies remains a speculative medium where irrational investors are betting on the upward trend of these currencies and retail investors being inflicted with the fear of missing out syndrome, buying up whichever currencies are available in the market.
History provides good learning points for us to take away, however a good proportion of the workforce and investors who entered the industry were not primed to appreciate and experience the dotcom bubble as it took place close to two decades ago. More needs to be done to educate the public to appreciate the economics of the market.
P.S. Oh, and if you see your neighbors’ grandparents participating in ICOs as well, it’s probably time to pull the plug.