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November 28, 2018

Cryptocurrency: Nuclear Winter

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We are entering a ‘Nuclear Winter’ period of Cryptocurrency – perhaps similar to late 2013- early 2015 or perhaps much worse.  The next 2-3 months will determine the extent of the damage and whether we can expect another big bull market in 2019-20, or whether this is the beginning of a bear market similar to the 2000 Dot Com crash.

 

How We Got Here

Bitcoin was started in 2008 by the still-anonymous Satoshi Nakamoto.   The innovation behind bitcoin was the blockchain and solving the double spend problem, where one user sends a unit of money to multiple people while claiming that they only sent it to one person.

+ Blockchain and Digital Currency – how the blockchain works

Since the first time bitcoin traded on May 22, 2010 (10,000 bitcoins for 2 Papa Johns Pizzas in Florida), it had a meteoric rise to $20,000 USD in December 2017.

Bitcoin History Price Chart

There were several notable dips along the way, most notably during the November 2013- January 2015 period where bitcoin fell from $1,140 to $150, an 87% decline; therefore, it is not yet certain whether this correction will be much like 2013-2015, and drop to a ~12-14 month bottom, or something more comparable to the Dot-Com Bubble crash where prices of most technology stocks fell by more than 90% and took many years to recover if at all.

+ Bitcoin History Price Chart

The comparison the Dot-Com Bubble era is salient when you consider how much the leading technology stocks of the day fell from their top in 2000 to the bottom in 2002:

2000 Dotcom Bubble Stocks

 

Compounding the problem is the fact that there are many ‘altcoins’ in addition to Bitcoin (Ethereum, Litecoin, Ripple, etc) that also rose from pennies to multiple dollars, creating inflated market caps of several billion dollars per coin at the peak.  The total Cryptocurrency market cap increased from ~$17bn USD in January of 2017 to a peak of ~$800bn USD in January 2018.  At this moment, total Crypto market cap is $121bn. Bitcoin accounts for about 55% of that market cap (~$64bn), while the rest of the top 10 cryptocurrencies have a value of ~$21bn.  This demonstrates that the majority of the value of cryptocurrencies are concentrated in the top end of the market, making the vast majority of other altcoins almost worthless in real terms.

We got here because of the ‘network effects’ of cryptocurrencies where the increase in value in one currency (ie. Ethereum) drove profits to flow into other currencies, while at the same time the base currency (Bitcoin) increased exponentially relative to fiat currencies (USD, EUR, JPY).  Further momentum into Cryptocurrencies was created by the creation of ICOs (Initial Coin Offerings) which became the IPO of the blockchain era.  This created a cycle where coins traded purely on their perceived value in relation to the Top 10 coins, each one promising to be ‘the next Bitcoin‘ or ‘the Uber of blockchain.’ In reality, there has never been any use case for Cryptocurrency other than a transfer of value.

Despite the crash in price, volume on the Bitcoin blockchain has continued to increase exponentially in 2018.  Daily transaction volume reached more than $3bn USD in November 2018.

Tx Per Day

 

But will it be enough for Bitcoin and Cryptocurrency as a whole to thrive in the future?

Nuclear Winter

  • Technical Breakdown in Price – charts indicate that bitcoin broke a pivotal long-term support at around $6,000 earlier in November and are headed to long-term levels of around $3,000 (chart from Twitter).   While charts only tell part of the story, a breakdown in price of this nature can create ‘negative convexity’ where the price goes lower and lower, thereby causing more margin calls and more people to panic sell.  In many markets, this can signal ‘capitulation’ or some kind of bottom in the market, but in the case of bitcoin there are various permutations and combinations for miners (who secure the bitcoin network) that could result from the price dropping below a certain level.  That magical level seems to be $1,000, well below current prices (~$4,000).  More analysis on price below.

“As the price of Bitcoin keeps falling, the fraction of the total outstanding hardware that is offline and up for grabs at ridiculously low prices will increase. Now, it’s probably already over 40%, but it might be 90% in the near future (if the price falls to $1000). This is a problem for Bitcoin, because it means that a “51% attack” on the Bitcoin network becomes feasible, and potentially profitable”  François Chollet Medium 

  1. Bitcoin Price Chart

  • Hashwars in BCH – a long and complicated story to cover in full detail, but the simple version is that Bitcoin Cash (BCH) split off from Bitcoin Core (BTC) last year.  In the world of Cryptocurrency, we call this a ‘fork,’ meaning a new chain.  Within BCH there are two sides:  Dr Craig S. Wright (who claims to be Satoshi Nakamoto though no definitive proof has been found) and Calvin Ayre (founder of gambling site Bodog); versus Roger Ver and Jihan Wu.  The former duo command the BCHSV (Satoshi’s vision chain) while the latter duo command BCHABC.  Effectively a war of hashrate (military equivalent of artillery), it is a winner take all battle for control of the BCH chain in its entirety. @ProfFaustus did foreshadow this conflict, and this likely created the tension in the market that led to the breakdown in price below $6000.  What complicates matters further is that BCHSV is gaining traction, and has promised to turn their attention to BTC (Bitcoin Core) next, and crash the prices below $1,000 in the process.  The problem with a war like this, from the perspective of the whole market, is that it is a zero sum game in the short/medium term, and the potential for value created in the whole market to be destroyed is high.   One chain (BTC or BCH) may take the whole cake, but not without bringing down the whole market to ‘nuclear winter’ levels.

BCH Hashrate

  • ICO Crackdown and Lawsuits – number 2/3 in the market is Ethereum (current market cap $12bn USD), which has a runup last year from $10 USD per ETH to over $1,400 based on a few key factors: the perception of being ‘bitcoin 2.0‘ and the ability to for any company to use the ERC-20 token to raise money for their own token in an ICO.  Billions were raised and billions have been lost, with the average ICO down more than 90% from its peak price.  The problem for many companies and their founders is that the US SEC (Security and Exchange Commission) has ruled that many, it not all, of such ICOs breached Securities Laws and must pay.  There are so many potential problems that can arise from these regulations, including civil litigation from investors, federal charges, and perhaps most importantly, a massive drawdown in Crypto funds (via companies who raised money in Cryptocurrency like $ETH) to pay settlements, fines or staff.

 

Outlook and Scenarios

At this moment in time, the market is bouncing ~20% off of the bottom ($4,300 BTC, $120 ETH), creating a sense of optimism that the ‘bottom is in’ and the uptrend will resume.  But as mentioned above, until three of the above conditions are cleared, the market will not resume it’s bull trend.  Recovering above certain price levels, clearing out further uncertainty, and resolving legal issues are the keys to long-term growth in the industry. Therefore, here are three possible scenarios from here:

  1. Bottom in Q4 2018 – bottom is either in ($3,500), or will come in December (around $3,000 USD) and the market begins to stabilize.  We should start to see some positive use-case momentum (payments, etc) and less speculative use of core protocols, ushering in the possibility to recommence the uptrend in Q1 2019 and possibly see another bull market born from there through 2020;
  2. Continue downward for another 3-6 months – if we do see a major upheaval around any of the top 3 protocols (BTC, ETH, BCH), this could cause the market to continue to drift downwards for another 3-6 months and form a bottom in Q1-Q2 2019.  Such upheaval could cause a dramatic leg down in price, but clear the way for an equally dramatic upswing in price in late 2019 through 2020;
  3. Bear Market sets in long-term- as Governments and Central Banks start to use Cryptocurrencies in their own countries, they will make it very difficult for decentralized digital currencies to survive on their own two legs.  If the Crypto ecosystem splits itself and can’t find on-chain consensus around one or two major protocols, it leaves the whole ‘decentralized’ ecosystem open to attacks and ultimately the death of a ‘decentralized dream.’ It’s the possibility for another ‘war’ between Central Banks and Bitcoin for example that could create a long-term bear market for Cryptocurrency.  IMF Head Christine Lagarde has recently called on governments to create their own digital currencies;  however, this should be taken with a grain of salt, as Commercial Banks made the same grand proclamations in 2014/15 and ultimately failed, leading to the ensuing bull market in 2016-2017.

We see Scenario 2 as most likely.  While it will be interesting to see if the BCH War has a further impact on the broad market beyond this quarter, there is still too much turbulence between Cryptocurrency and Regulators, coupled with a lack of real-world traction, to see the market regain its footing without further downside.  Possible capitulation for Bitcoin to ~$2,000 and Ethereum to ~$50 would be enough to bring in a wave of buyers to form a bottom.  From there on out, the market will look more for real-world transaction and less for fancy roadmaps and conferences.  This could open the door for competition in the Top 3 that are not currently mentioned, meaning that now more than ever, the opportunity exists in the ecosystem to be part of the next big Cryptocurrency.