Have you experienced FOMO? That is, fear of missing out.
I have to admit I have at times when it comes to bitcoin and other so-called cryptocurrencies. While the prices of these digital currencies have gone up, down, and all around, they are still worth a lot more than just a few months or a year ago. Bitcoin's price has doubled over the last six months and is up ten-fold over the last year. Compare that with the 16 percent gain in the stock market, or the 6 percent increase in national house prices; Philadelphia house prices are up even less.
But if you have FOMO now, get over it. Bitcoin and its brethren are a bubble. That is, many of those who have been buying bitcoin are buying simply because its price has been going up. Their thought when plunking down U.S. dollars, euros or any other fiat currency – currency backed by a government – for a bitcoin is this: If the price has increased so much in the recent past, it will continue climbing in the future.
Some cryptocurrency zealots take great umbrage with this bubble talk. They believe that cryptocurrencies will replace the dollar and other fiat currencies. To be sure, there is a niche for bitcoin as a way to pay for illicit activities in an effort to avoid jail, or for citizens of busted nation states – Venezuela comes to mind – to avoid having their property confiscated.
Some legitimate retailers accept bitcoin in what seems to be more of a marketing gimmick. A real test of bitcoin would be if any government allowed citizens to pay taxes in cryptocurrency. As far as I can tell, there is only one small Swiss town that does, and payment values cannot exceed a few hundred francs.
Without some great leap in technology, the cryptocurrencies will struggle to go mainstream. A big problem is that their value will always fluctuate wildly, since there is no link between demand for the coins and their supply. Demand is determined by a range of factors, presumably including how much people are buying with the coins. However, supply is effectively determined by how quickly so-called miners of the coins solve difficult math problems.
In our fiat currency system, this demand-supply problem is solved by central banks like the Federal Reserve. Fed professionals monitor demand for dollars and ensure there are enough to maintain their value. That's the Fed's job by law. This system has its challenges, but all in all has worked admirably for more than a century.
Another big problem is that cryptocurrency miners need increasing amounts of computing resources, which require lots of electricity, to solve those math problems. Each bitcoin transaction uses roughly the same amount of electricity as one household uses in a week. This is such a problem that miners are migrating to such places as Iceland, where geothermal energy is cheap, and to Tibet, which has hydroelectric power.
There is also a question whether transactions using cryptocurrencies can be processed quickly enough to become a viable alternative for making our payments. Processing speeds are slow and getting slower as bitcoin-based transactions ramp up. But there is a lot of ramping up to do; there are about 300,000 daily bitcoin transactions compared to some 150 million on Visa's network.
As with any bubble, no one knows when or how this one will burst. The cryptocurrencies experienced a bit of a return to earth earlier this year when their prices fell sharply, but that wasn't their true comeuppance. That will likely center around initial coin offerings or ICOs, which represent a stake in a project or other investment paid for by bitcoin or another cryptocurrency. The number of ICOs is rapidly proliferating, and while the bulk of these endeavors are likely on the up-and-up, it wouldn't be surprising if some are fraudulent and ultimately collapse, pricking the bubble.
Regulators, including the Securities and Exchange Commission, which is charged with protecting investors from such fraud, have noticed but have yet to take much action. That will change once the bubble does burst. While this will be painful for cryptocurrency investors, it won't mean much for the broader economy. Too few of us have felt the FOMO and actually gone out and purchased cryptocurrencies, at least so far.
The risks these intrepid investors are taking also have an enormous potential upside. They are effectively funding the development of the blockchain and smart-contract technologies behind cryptocurrencies. Attracted by these path-breaking technologies and the fortunes being made, the world's best and brightest are feverishly working on the problems that bedevil the adoption of cryptocurrencies. Their efforts may well unlock the enormous potential of the underlying technologies and fundamentally change how our economy and society work.