Founded in 2016, Ceteris Paribus is A student-led economics and finance publication at Davidson College.

Efficient Market Hypothesis & Bitcoin

by Ezan Karim

 

In February of 2014, a House of Cards episode aired that featured a character purchasing Bitcoin; it was the first time I had ever heard of the digital currency. At the time, Bitcoin was commonly used for transactions that people wanted to keep hidden from government authorities, such as dark net trades. The idea of an entirely digital, untraceable, and government unregulated virtual currency sparked more than a bit of curiosity on my end, so I decided to look further into cryptocurrency. I learned that the Winklevoss twins, venture capitalists and former creators of HarvardConnect, made significant investments in Bitcoin and other altcoins (notably Etherum) beginning in early 2012, including the Winklevoss Bitcoin Trust in 2013. I purchased a less than single bitcoin; which, at the time, was worth slightly under $600.

 

It started as a single piece of paper: Bitcoin: A Peer-to-Peer Electronic Cash was published under the pseudonym Satoshi Nakamoto in 2009. Unnoticed to most investors and the general public, the guide detailed how the decentralized system would work, and in 2010, 1 BTC was up for sale for 10 cents.

 

On December 17, 2017, Coindesk’s Bitcoin Price Index reported an all-time high of 1 BTC = $19,783.21, a thoroughly unprecedented and exponential spike from the not-even decade before the currency’s creation. If I had made the investment to buy a handful of BTC back in high school, I would have acquired enough virtual currency to pay for my Davidson education. Since December, we’ve observed a minor crash in the BTC market. As of late March 2018, the price of one Bitcoin has climbed back down to around $7,400.

 

Some Bitcoin enthusiasts, like the contributors at Forbes, remain optimistic. They use the recent report from Morgan Stanley to suggest Bitcoin’s price recent decline since December mimics the Nasdaq tech bubble in the late 1990s. What the report fails to notice, is that unlike the tech bubble, the bitcoin rout happened at over 15 times that rate. Bitcoin has all the trademark features of a standard speculative bubble that is destined to burst, just like the dot-com fiasco and US housing crash that triggered the global financial crisis.

 

Nouriel Roubini, prominent economist and professor at New York University’s Stern School of Business (commonly known as the individual credited for predicting the 2008 global financial crisis), considers bitcoin the “mother of all bubbles”. Perhaps the best way to understand the Bitcoin bubble is through a model developed by Hyman Philip Minsky, a post-Keynesian economist. Minsky classifies the process into five stages: displacement, expansion, euphoria, financial distress and burst. Roubini isn’t particularly enthusiastic about the future of Bitcoin, and while we may not be near the distress stage he feels that we are nearing it.

 

 

The significant increase and dramatic plunge in price are raising concerns about the state of the financial market. Market analysts are seeing the burst in the Bitcoin bubble as inevitable and an indicator for a future market crash.

 

Here’s my take: the market won’t crash. However, the existence and potential burst of the Bitcoin bubble should finally to allow us to question the efficiency and volatility of the system of our financial markets.

 

Traditionally, the efficient market hypothesis has been widely accepted. This theory is based on the notion that market prices reflect the information relevant to the value of any asset. If this is true, market prices are the best estimates of the value of any investment and financial markets should be relied on to allocate capital investment. A direct implication of the theory that it is impossible to "beat the market" consistently on a risk-adjusted basis since market prices should only react to new information.

 

While the EMH isn’t as strongly adhered to now, it still serves as a central background assumption of economic policy. The hypothesis survived the absurdities of the dot-com bubble in the late 1990s, as well as the derivative market failures that contributed to the global financial crisis in 2007-2008.

 

The theory hasn’t failed us entirely yet, but it will with the Bitcoin bubble. At the least, each of those earlier scenarios began with a plausible premise. The rise of the internet has transformed our lives and given rise to some very profitable companies. As for the derivative assets that gave us the global financial crisis, they were viewed favorably in light of a widely-held theory, known as the “Great Moderation,” that proposed that major economic crises were a thing of the past, as a result of certain systemic changes in the way developed nations ran their economies. The theory was backed by leading economists and central bankers. When it comes to BTC, however, the playing field is entirely altered.

 

Bitcoin was created with the intention of being used as an unregulated method of payment, a way to displace existing government currency; but, once the bubble burst, most if not all theorists accepted the reality that this would not happen. In comparison to three months ago, much less people now believe that Bitcoin has value as a currency. Rather, the new thought is that Bitcoin is a “store of value” indicative of how scarce it is, since only 21 million BTC exist. Personally, I don’t really buy this claim, and neither do most economists. Yet, it’s just another shot at the outdated efficient market hypothesis.

 

For the sake of argument, consider that Bitcoin really is a store of value. In this scenario, prices of assets are completely arbitrary and unrelated to relevant information. Once again, the EMH theory is entirely invalidated. If the rise of cryptocurrency has shown anything, it is that it is unbelievably easy to create a scarce asset. Every day, more crypto or ‘alt-coins’ are being created. What makes that different from any actual financial asset? Stocks could be priced merely on the basis that people choose to value it highly, not based on future earnings potential.

 

If EMH is a valid theory, Bitcoin has no underlying value, and financial markets should eventually recognize that, cutting the price to zero. But, that hasn’t happened--and it won’t. Futures for trading Bitcoin have been occurring the past few months, and current futures contracts extend into June this year. Bitcoin will retain its value well into the near future.

 

So what is the takeaway with Bitcoin? It’s inevitable to overlook the fact that a financial currency with an entirely arbitrary value and potential to burst has been successfully introduced in all of the world’s most complex financial markets. For now, let’s hope Bitcoin won’t bring financial markets crashing down. More importantly, we should hope that regulators wake up and realize the need to cut markets down to size.

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