It’s not hard to see the parallels between today’s cryptocurrency craze and the stock market crash of 1987. Both involved clueless regulators and unfettered markets.
No one knew what to expect because only a handful of people on the planet understood the technical connections between derivatives markets and stocks. Exchanges were based in two different cities with two different sets of rules.
Now comes Bitcoin and its brethren. We know even less about how Bitcoin is valued — it’s embedded in software only a handful of people understand — and what’s driving the price.
While Bitcoin’s market cap could eclipse that of Apple, that doesn’t increase its market transparency. We know far more about Apple, its products and executives that we do about the shadowy origins of Bitcoin and its miners.
History provides some examples of how markets can implode without warning. Diana Henriques‘s masterful “A First-Class Catastrophe” provides telling details on how the 1987 crash occurred and how regulators were caught flat-footed.
“Black Monday (1987) was the worst decline since 1929,” Henriques told a meeting of business journalists at a SABEW conference on Oct. 13. “There was balkanized regulation and the two top regulators had opposite views on the crisis.”
Although the 1987 crash didn’t trigger a recession, Henriques says regulators are still befuddled about how to avoid another crash. They failed spectacularly in 2008 and are even more hamstrung by the existence of more than 60 stock exchanges in which computers are not only running the exchanges, but are doing most of the trading in micro-second bursts.
So it stands to reason that virtual currencies are even more problematic. While blockchain is a game-changing technology that could change everything from contracts to global banking, it’s still a black box to most investors. With stocks, you know that there are a finite number of shares and derivatives called options based on their future prices.
Share prices are listed every minute an exchange is open. You can find out who’s trading big blocks, get earnings estimates and know nearly everything about a company’s financial state.
Not so with cryptocurrencies. What is the source of their valuation? Pure speculation? Animal spirits? “The market can remain irrational longer than you can remain solvent,” according the great economist/investor John Maynard Keynes, who made that observation in the 1930s.
Still, the circus show is what drives Bitcoin. Commentators and investors continue to focus on the wrong thing. Prices can’t go up forever.
Panics and loss of confidence have triggered market sell-offs over hundreds of years. Think tulips, Louisiana swamp land, Florida real estate and tech stocks. Markets are indirectly connected through herd psychology.
One massive sell-off could spill over into other investments. A crisis in obscure credit-default swap derivatives fueled the 2008 stock/real estate meltdown and recession. Could Bitcoin tanking ignite a confidence crisis in common shares? It sounds illogical, but markets are rarely rational when everyone’s selling in fear.
Ultimately, as investors (and skeptical observers), we should “focus less on market declines [and run ups] and more on market structure, especially when it falls apart,” Ms. Henriques wisely counsels.
What is the structure of the cryptocurrency market? Is it a giant, flimsy tent that can be blown down in the next storm or a steel-beamed skyscraper?