Bitcoin believers may disagree, but most experts are in agreement that the run-up in its prices is a bubble. The question for them is when, and not if, its price will crash. As a corollary to that question, what will be the effect of such a crash?
Will a Bitcoin Price Crash Affect the Entire Economy?
The Financial Stability Oversight Commission recently came out with a report listing challenges to financial stability, and digital currencies merited a very brief mention. According to the agency, virtual currencies have a “very limited” impact on financial stability. This is likely because the current bitcoin ecosystem is fairly small.
Subprime mortgages were the last serious financial instrument to destabilize the U.S. economy. That crisis occurred due to the confluence of a complex cocktail of factors. Actors from the mainstream economy were active participants in the process. For example, subprime creditors across the United States took out faulty loans. Big multinational banks repackaged these loans into derivative instruments and sold them to investors, who propagated these sales through different parts of the economy. Collateralized debt obligations further spread the leverage contagion across the world.
At the height of the crisis, Citigroup Inc. (C) had originated an estimated $19.7 billion in subprime mortgages. Bear Stearns, an investment bank which collapsed in the aftermath of the crisis, had a “vast portfolio” of derivative instruments related to subprime mortgages.
In contrast, bitcoin is yet to overcome its renegade status within the financial services ecosystem. The increase in its prices has occurred within the confines of unregulated exchanges that are yet to pass scrutiny by regulatory agencies. Based on recent reports, the main players in these exchanges are individual investors and bots. (See also: Why Do Crytocurrencies Have Buy And Sell Walls?)
Big banks and investment firms have largely stayed away from the bitcoin craze and their exposure to cryptocurrency markets, if any, is limited. While it is true that bitcoin-related stocks have risen in valuation, their numbers are low.
A measure of the finance industry’s caution is the relatively subdued response to CBOE futures trading even though bitcoin’s price has jumped by more than 1,800 percent over the course of this year. Even as a clearing agent for CBOE bitcoin futures, Goldman Sachs is reportedly demanding a 100% margin for bitcoin trades. (See also: Bitcoin Futures On CBOE Vs. CME: What's The Difference?)
Instead of the subprime mortgage crisis, the bitcoin bubble’s denouement may be similar to that of the "tulip mania" that occurred in Amsterdam during the early 17th century. Prices for tulips, imported from Turkey, surged during that bubble as “cobblers, carpenters, bricklayers, and woodcutters” participated in it.
But the collapse in tulip prices had a limited effect on the overall Dutch economy because serious financiers stayed away. According to Dutch historian Nicolaas Posthumus, only casual traders participated in bidding up prices for tulips for greed and profits. In the end, it was these people who were affected when prices collapsed. Similarly, a crash in bitcoin prices will trigger a sell-off and affect a very small number of people.
What Will Happen to the Cryptocurrency Ecosystem?
Online publication Axios has come up with an estimate of $250 billion as the monetary impact of a bitcoin crash. But that estimate betrays an incorrect understanding of the utility and markets to cryptocurrencies. There is already substantial investment in blockchain, the technology underlying bitcoin. Besides this, bitcoin’s price movements suggest that it is emerging as a store of value. Cryptocurrencies are also useful as a means of exchanging value within closed ecosystems.
That said, it will be some time before their utility is realized within mainstream applications. The current rise in prices for most cryptocurrencies is mostly the result of a domino effect from bitcoin’s surge. It is quite likely that a bitcoin price crash will result in a correction in their prices as well. It is also certain that the vast majority of cryptocurrencies that populate the current listings will disappear. Only digital currencies that have defined business models and clear utility within mainstream society will survive a crash.