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10:41 AM
Andrew Waxman
Andrew Waxman
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Bitcoin Joins the Academy of Other Financial Market Bubbles

While not as significant as bubbles in the housing market or Internet tech sector, the recent examples of bubbles in gold, Bitcoin and carbon are worth studying from a risk management perspective.

2013 has seen the return of the bubble. In fact, three investment bubbles have burst so far in 2013: gold, carbon and bitcoins. Unlike the 2008 bubble situation, these issues have not caused a massive level of financial market dislocation.

But that is not because we have fixed what ills us. We are still ill; rather, it is because these markets do not have the level of investment and inter-connectedness that other markets do. Nevertheless, it is interesting that these bubbles burst at the same time, and there may be a connection between them.

First, what exactly is an investment bubble? it is where the value of an asset has been driven up to a point where it is far beyond the usual value levels or what is reasonable given normal market functioning. Recent examples, of course, include the Internet and housing bubbles, both of which had a massive impact on the economy.

The Tulip craze in Holland in the seventeenth century that saw a run up in the value of a tulip is possibly the classic case of a bubble in history. The term was likely originated with the South Sea Bubble. All these asset bubbles share similar features; a run up in the value of an asset multiple times beyond its intrinsic value aided and abetted by cheer leaders and their wiling listeners and buyers. So was it any different this time?

First, let's take the gold bubble. Gold found a willing investment community in the past five years or so from a nexus of gold ideologues, inflation bulls, and of course, most likely, the majority, speculators. The price of gold hit a high of close to 1900 dollars an ounce in 2011, before falling by 28 per cent, with a 9.4 per cent drop in one day on April 19. Gold was supposed to be the defense against a global economic collapse. Why the sudden drop?

The value of gold it turns out was closely tied into an investment thesis that sees gold as a safe haven against a global currency collapse brought on by feckless government spending and high debt. So with the fear of economic collapse fading and the battering of the credibility of that thesis (see Should we Ban Excel?), analysts have been changing their tune. Perhaps governments were not about to collapse and their currencies with them, after all. As analysts revised their price targets for gold, price declines quickly followed.

The second bubble — that of carbon credits — has declined also fairly precipitously in recent weeks: the European carbon market price fell from 25 Euros a ton in 2008 to just 5 Euros in February. This was in no small part due to overly generous carbon allowances for firms: so many carbon credits were given out that firms barely needed to reduce their emissions to meet the requirement. As a result the demand for additional allowances eroded and price declines quickly followed.

People had expected the European Parliament to recognize the fact that the pain of pollution had become too insignificant to achieve the desired for policy objectives by taking a significant number of allowances off the market. Such action could have changed this dynamic and forced the price up.

However, on April 16 the European Parliament voted against the plan to do so and this led to the price of carbon emissions collapsing by more than 40 percent in a day. Even the European pro-environment political establishment, when faced with economic hardship, chose environmental pain over economic pain. Carbon emissions trading is heavily dependent on regulatory and environmental support. Once that underpinning went away, the price could only reflect the true levels of supply and demand.

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The third bubble to have recently burst is that of Bitcoins. Bitcoins are a product of the virtual economy, intended to fuel trade over the Internet by creating a virtual currency that allows peer-to-peer transactions without the need for banking intermediaries. The exchange rate for a single Bitcoin quickly rose this year from 20 dollars in January to an intraday high of $266 on Wednesday, April 10, before falling to $186 later that same day. Three days later a single Bitcoin was worth just $54.

In a way, the investment thesis was similar to gold, a currency with which the government cannot mess. The price spike in Bitcoins came at the same time as the Cyprus crisis further undermined faith in the global banking system.

Clearly, however, this is fundamentally a story of a bubble and speculation that there is no real efficacy yet to this currency. It is all posited on a future state where banks no longer work, governments have shut themselves down because of too much debt, and individuals are finally free to do business directly with one another. The price rise made no more sense than the price drop, which was precipitous when it happened. The most well-known of the investors who were hurt in the price collapse were the savvy, social network entrepreneurs — the Winklevoss twins.

In general, of course, it is impossible to know you are in a bubble until it is too late and it has burst. Tales of irrational exuberance have not stirred the investment community or regulators before. In the case of the bubbles we reviewed here, none has the import of a housing market or an internet economy.

At the same time, it is worthwhile studying them from a risk management and avoidance perspective. One should be aware when an investment is propped up by an investment thesis, whose values lives or dies on the rightness of that thesis. In addition, one should beware of those proclaiming the deaths of governments and their currencies. They are more robust than you might think. It has been a long time since the days of the Gold Standard and they are unlikely to return.

Andrew Waxman writes on operational risk in capital markets and financial services. Andrew is a consultant in IBM's US financial risk services and compliance group. The views expressed her are those of his own. As an operational risk manager, Andrew has worked at some of the ... View Full Bio
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