The Bubble Index

Where Bitcoin Will Go Next

According to the latest financial research stock bubbles are the result of endogenous factors, such as positive feedback loops or simply monkey see monkey do. We can apply this research to Bitcoin and other cryptocurrency prices.

Mid November 2013 I was able to correctly predict Bitcoin’s imminent December crash using a Log-Periodic Power Law (LPPL) oscillations tool. I had asked T. Taylor of The Bubble Index and the LPPL Market Watch to analyze Bitstamp’s historic BTC-USD price data. He replied that he had already intended to do so anyway and promptly returned with his analysis.

As Bitcoin’s price was nearing $1,000 at an exponential growth rate, it seemed likely that a bubble was forming. Taylor’s analysis and the resulting graph, dated November 16th (before the crash), showed the likelihood of a crash based on 50 or 100 day probabilities:

Copyright (c) 2013 LPPL Market Watch (Source)

Understanding LPPL stock market predictions

The prediction came true, but of course nobody believed it until it really happened. A day later, on November 17th, the graph was also posted to the Reddit /r/BitcoinMarkets page. Its top rated comment still reads:

They must have a lot of experience with the adoption curves of crypto-currencies. (permalink)

Note that this comment contains the assumption that it would be required to ‘have experience with the adoption curves of crypto-currencies’ in order to be able to predict cryptocurrency bubble crashes. This is not the case! The predictable power of LPPL analysis of financial does not require to know any such external factors.

Taylor’s tool is based on the extensive research by brilliant professorDidier Sornette, director of the Swiss Financial Crisis Observatory and author of the book Why Stock Markets Crash. The key insight is that financial bubbles are the result of endogenous factors, for example positive behavioral feedback loops. Or in layman’s terms: monkey see monkey do.

Because external (exogenous) factors play no role in the formation of financial bubbles, the earlier Reddit comment about ‘adoption curves of crypto-currencies’ is a red herring argument. Adoption curves are themselves the result of internal (endogenous) factors, not governed by any external influence.

The cost of securing the Bitcoin network

But why has the Bitcoin price continued to drop ever since the December crash? When will it go back to the moon?

To answer this question requires to understand why the Bitcoin price is really dropping. Professor Nicolas Courtois from University College London provides the answer: most cryptocurrency mining algorithms n suffer from programmed cell death, possibly including Bitcoin.

Courtois published a paper On The Longest Chain Rule and Programmed Self-Destruction of Crypto Currencies (May 2014). The paper explains several design flaws in the Bitcoin protocol. One especially depressing find is that securing Bitcoin’s through mining, currently rewarding miners up to 4,000 Bitcoin per day, is an extremely high cost. As Courtois put it at a recent Bitcoin conference I attended, “Imagine pitching Bitcoin to the Federal Reserve Bank, it sounds like a perfect system for transactions, but — oh, by the way — it will cost over a billion USD per year to pay miners’ fees.”

It means that Bitcoin has a hidden transaction cost. Miners do not hold their coin. Instead, they are required to cash out over 90% of their mined Bitcoins to pay for their increasingly expensive hardware, maintenance and personnel investments. Here’s a damning calculation of the true cost of a Bitcoin transaction:

Date: October 3rd, 2014

The Bitcoin price is $375

Miners receive a 4,000 BTC total reward for today and will cash out 90%, or 3600 BTC, equalling $1,350,000

Today there will be approximately 70,000 Bitcoin transactions (source:Blockchain.info).

In conclusion, the hidden cost of a Bitcoin transaction today equals $19.29 (1,35m / 70k).

Bitcoin investors are paying for the miner’s costs! Trying to explain this information in a comment on CoinDesk, I was not understood. One commenter replied, “What are you smoking? Bitcoin has a 0.0005 BTC fee an no more!” Apparently, the concept of a hidden transaction cost is so abstract that religious masses aggressively deny to see it.

Bitcoin’s transaction will only become affordable if adoption increases the number of transaction by a hundred-fold, thereby lowering the hidden cost to about $0.20 at current Bitcoin prices. But how can Bitcoin achieve a 100 fold increase in adoption?

Where Bitcoin will go next

Recently, September 2014, Taylor posted an update to the Bitcoin Bubble Index called ‘The Bubble Contour’. This time showing a different type of graph:

Copyright (c) 2014 LPPL Market Watch (Source)

The above graph shows Bitstamp price data for Bitcoin 2011–2014, clearly showing the April 2013 and December 2014 crashes, the 2014 decline, and halted price development. The way to interpreted this graphs is that different color shades correspond to the likelihood that prices are the result of bubble formation.

According to this graph, Bitcoin current September-October 2014 prices appear not to be the result of a bubble.

My personal opinion is that Bitcoin’s price now depends on consumer adoption. That means: not just people buying Bitcoin for speculative reasons, but using Bitcoin as a means of payment or transaction. Otherwise, without a clear use case, Bitcoin is dead. Ask Western Union why they don’t already use Bitcoin for remittances? (Answer: security cost.)

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The Bubble Index by Mathijs Koenraadt is licensed under a Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International License.