by Misha Lepetic
"To be in the world like tulips in a garden,
to make a fine show, and be good for nothing."
It seems appropriate that, in its waning hours, the phantasmagoria that was 2017 should have delivered an investment bubble equal parts preposterous and inscrutable. And so we witnessed the stratospheric rise of bitcoin and a veritable menagerie of other cryptocurrencies. Even more appropriately, in a year that made an art out of ratcheting up the tension, this bubble has yet to pop, despite the near-vertical rates of appreciation, followed by a retrenchment that has itself stalled out, leaving us with a most unsatisfying denouement.
In a rush to make sense of it all, many people were happy to pronounce bitcoin (along with cryptocurrency in general, and blockchain as well, because sure why not) as just another episode of the madness of crowds. Knowing glances were cast back to past bubbles, epitomized by the pets.com sock puppet, JP Morgan's shoeshine boy, and of course tulipomania.
But such a rush to judgment can be its own form of madness. To be sure, in these binary times it's difficult to tread a subtler line. The suggestion that we should be pursuing far better questions isn't necessarily the same thing as claiming that ‘this time is different', even though the two stances are easily confused. Instead of dismissing cryptocurrency as the latest demonstration of humanity's inability to learn from its past mistakes, we may rather use it as an opportunity to inquire about the nature of value, and what difference the future may make in relation to the present.
Beginning with the ur-phenomenon of tulipomania, we can find both striking similarities and differences between it and the current situation. For one thing, tulips are a real thing – that is, a commodity. As Mary Astell implies above, flowers may not have much going for them, but they are pretty to look at, and in an affluent society, that counts for something (it ought to be noted that gold is similar, in that its practical value, as jewelry and an industrial metal, is far outstripped by its value as, well, gold). So it was for the Dutch, who saw in tulips a signaling mechanism that rapidly got out of hand.
At the apex of the tulip pecking order was the Semper Augustus, which is relevant to our story for two reasons. The first is that it was exceptionally rare, and partly because of this, deemed correspondingly beautiful. The second is that it was, from a biological perspective, fatally flawed. Regarding the former, James Grout recounts the rarefied place it occupied in the tulip trade of the time:
[In the spring of 1624, chronicler Nicolaes van] Wassenaer again wrote about Semper Augustus. Only a dozen examples even existed, all owned by a single individual, whose name he does not disclose but who refused to part with any of them, even though each one would have cost 1,200 guilders—a price that would remain high only if he did not sell. The next year, Wassenaer reported that 2,000 and then 3,000 guilders had been offered for a single bulb but the owner still could not make up his mind what to do. If this mysterious connoisseur was, in fact, the fabulously wealthy [Adriaen] Pauw, who also was a director of the Dutch East India Company, money would not have been as important as the flower's beauty. But this obduracy must have made it even more coveted. A Semper Augustus weighing 200 asen (a third of an ounce) was said to have sold for 5,500 guilders in 1633. Just before the crash, a price of 10,000 guilders was being asked—an exorbitant amount that would have purchased a grand house on the most fashionable canal in Amsterdam, or clothed and fed an entire Dutch family for half a lifetime.
So we have a buy-and-hold strategy that seems to have been executed purely for…aesthetic reasons. How odd! Of course, Pauw was the one-percenter's one-percenter. Individuals possessed of such dizzying wealth find unique objects to be an all-but irresistible proposition; they are the final frontier of wealth (the exemplar for our time may well be not fine art or private islands, but the tale of Martin Shkreli and the one-of-a-kind Wu Tang Clan album). But it's inconceivable for anyone to hoard bitcoin for aesthetic reasons, since no cryptocurrency actually exists in the physical world. Waving a spreadsheet in someone's face is a pretty unsatisfying way to show off your wealth.
The telling detail in Grout's description, though, is that the price ‘would remain high only if he did not sell'. This is commensurate with the current state of cryptocurrency in general, and bitcoin specifically, mainly because its anticipated value, driven by its alleged transactional prowess, has yet to materialize. Thus those with large holdings, charmingly known as ‘whales', have found themselves somewhat hamstrung by their circumstances. As early adopters, they have profited immensely, but only notionally, since even today bitcoin needs to be converted to fiat currency in order to be useful. Futhermore, bitcoin's structure makes all transactions and accounts visible (albeit anonymous). As a result, market observers warily monitor the largest ‘wallets' for any sign of selling, dreading the moment that greed suddenly transubstantiates into fear, thereby setting off a debilitating chain reaction in the crypto markets. Indeed, recent estimates conclude that 40% of bitcoin is concentrated in the holdings of 1000 people, somewhat undermining the notion that the design of cryptocurrency will ensure its wide distribution.
Of course, Adriaen Pauw could afford to put a premium on Semper Augustus's affective virtues. This was obviously not true for the majority of punters who were flipping lesser bulbs to one other, and for whom entire livelihoods – if not lives – were at stake.
The second interesting point concerning Semper Augustus is the biology behind its appearance. Its striking, broken variegations were actually caused by a type of mosaic virus. The structural integrity of the flower was affected as well, causing the petals to weaken and sag, hence the somewhat decadent appearance of afflicted varietals, such as the Augustus and the Viceroy. It's no wonder that these flowers found great favor with painters who were interested in portraying the transience of life and beauty (the subgenre of still-life known as memento mori). More perniciously, the virus's effects would compound over generations, weakening the bulb until the flower could no longer bloom. In fact, neither the Semper Augustus nor the Viceroy exist today. Even though the biological drivers were unclear to the participants of tulipomania, it's noteworthy that an intrinsic aspect of the bubble was a sort of guaranteed depreciation of the assets in question.
Perhaps because of this, the number of such bulbs remained roughly the same for the duration of the bubble; this seems to find a correspondence with the design of many cryptocurrencies. A fixed issuance of virtual coin is a design feature, quite clearly libertarian in philosophy, that is intended to be deflationary in nature (as far as economics goes, libertarians consider inflation to be the gravest of sins, and is the foundation of their long-standing distrust of central banking). For its part, the last bitcoin will be released sometime in 2040. This limited issuance is exacerbated by the fact that bitcoin can easily be lost, whether through hacking or mere carelessness. It's sufficient to misplace one's cryptographic keys, for example by throwing away an old hard drive, resulting in the loss of a small fortune (the fact that this fortune is notional is evidently of little comfort). In fact, current estimates imply that 17% to 23% of all currently extant bitcoin has been lost forever. It's a good thing that the protocol allows for the subdivision of each bitcoin into 100 million parts.
Of course, a key consequence of a deflationary asset is that the reward structure incentivizes early adopters, who do little more than hold significant quantities of the asset (hence the pod of ‘whales' described above). This can be good policy at the asset's inception: a reluctance to sell may guarantee a price floor and relegate volatility to the margins. But this must be balanced against the fact that bitcoin is intended to be a practical solution to the perceived ills of fiat currency. In order for it to do that, the cryptocurrency must undergo significant development, both in its internal protocols and the surrounding infrastructure.
Here are a few of those changes. There is the speed with which the network verifies transactions; at this moment, it's something absurd like seven per second, whereas Visa manages tens of thousands in the same span of time. The verification of these transactions is also subject to an unpredictable levying of fees: the more overloaded the network, the greater the fees. One user recently transacted $25 of bitcoin and wound up paying $16 in fees – a 40% charge that would make even the most callous payday lender blush (or drool). Even if one disregards the fees, the steps needed to sell bitcoin can take a positively Kafkaesque course, as evidenced by this Twitter thread. The levels of computer literacy required, as well as the rank faith that one's personal information will be handled correctly, makes it clear that bitcoin is not nearly ready for prime time yet. As the author of this thread muses, "is it really money if you can't use it nor convert it to something else?" This is not even to mention the fact that there is no recourse mechanism for cryptocurrency loss, whether this is as a result of theft or mere fecklessness.
Nevertheless, when people insist that bitcoin has no ‘real value', I have to wonder what is meant by ‘value'. In the stock market, valuation is assessed by the expectations of a firm's future cash flows. A simple calculation yields the net present value (NPV), and this becomes the yardstick by which a current price is judged. Is the current price of a share above or below the NPV for that share? In the world of cryptocurrency, NPV does not apply, as none of these assets are designed to produced cash flows per se. So if we assume – perhaps generously – that early investors are not speculating, that there is in fact some sort of true belief at work here, on what are they then basing their investments?
Quite simply, it is the anticipation that all, or enough, of the shortcomings mentioned above will eventually be resolved. Participants will be able to move frictionlessly between crypto and fiat currencies; transactions will be as instantaneous as has been advertised; fees will no longer be onerous; exchanges and other middlemen will be trustworthy; and there may even be recourse and arbitration mechanisms put into place. This is, obviously, a lot to ask for. Furthermore, assuming that all of this infrastructure eventually slides into place, what resemblance will the bitcoin of the future bear to today's phenomenon, especially if regulators get involved? Will it really be that different from any other monetary instrument?
But it should be kept in mind that the value of any currency or asset is, ultimately, a social construction. Gold is a good example. As I parenthetically noted above, its uses for jewelry and industry are trivial compared to its perceived value – which is derived from its perception as a store of value. There's no there there, to paraphrase Gertrude Stein's quip about Oakland. And yet we all pretend there is. When it's said that a bunch of folks ‘just made bitcoin up', this in fact is a banal observation that can be applied to all sorts of things that we consider to be valuable. Adam Smith posed a celebrated paradox about why diamonds are more valued than water, although it's not a paradox so much as an illustration of the difference between value-in-exchange and value-in-use. Diamonds, like tulips, are generally useless, but depend on their value arising from scarcity, as well as the consensus that a particular configuration of carbon atoms is more beautiful than another. Cryptoassets currently reside in this category of scarcity (if not beauty, although I suppose there is a recondite beauty when considering the mathematics involved), but the ambition is to transition to the latter, value-in-use domain. This is where the commitment of the true believers lies: a long shot, but one I wouldn't dismiss out of hand.
This is because the enterprise of value fabrication does not end with the asset in question. Just as important are the markets that support it, and these too are made and remade as its participants see fit. Market-making for cryptocurrencies is still in its infancy, even moreso than the currencies themselves. If you are interested in buying a lesser-known coin, there may be only one or two exchanges that list it, and you will likely only be able to purchase these coins with bitcoin or the other broadly distributed cryptocurrency, Ethereum's ether. In any case, liquidity will be very thin, and since these exchanges are not regulated by anyone, hacking, incompetence and general delinquency also come with the territory. But there is also an enormously powerful force at work here, which is the ability for developers and investors to boldly remake not just individual currency designs, but also entire market structures and rules with extraordinary speed. The purely digital nature of cryptocurrency is both a gift and a peril; not needing to warehouse thousands of tons of possibly perishable commodities while a committee decides on a raft of bylaws holds a certain indisputable charm.
Of course, there is no reason why this sort of remaking can't be pressed into purely venal service; enough such violations of trust may well sound a death knell for the very concept of cryptocurrency. After all, people have been gaming market structures for as long as it has suited them. Which brings me to the final point of comparison with tulipomania. There is, in some quarters, a suspicion that there wasn't actually that much of a bubble in tulips at all. A bubble, to be clear, is when prices become disastrously uncoupled from an asset's fundamental value. November 1636 to February 1637 constituted the peak of price action for tulips, but, according to Earl Thompson, writing in the journal Public Goods, a funny thing happened on the way to the crash:
The famous tulipmania…was an artifact created by an implicit conversion of ordinary futures contracts into option contracts in an imperfectly successful attempt by Dutch futures buyers and public officials to bail themselves out of previously incurred speculative losses in the impressively price-efficient, fundamentally driven, market for Dutch tulip contracts. There was thus nothing maniacal about prices in this period. Despite outward appearances, the tulipmania was not a bubble because bubbles require the existence of mutually-agreed-upon prices that exceed fundamental values. The "tulipmania" was simply a period during which the prices in futures contracts had been legally, albeit temporarily, converted into options exercise prices.
Thompson's point is that the Dutch who found themselves holding exaggerated futures contracts on bulbs basically rewrote the rules for these futures, turning them into options that later expired, with a minimal loss of capital (unlike futures, which would have required a payout). The historical ‘artifacts' are the phantom prices that were never actually paid out by anyone, ie, the strike prices that were never reached on the converted options. Thompson's contention is that these prices are the ones that we record as the height of the bubble. Whether or not one agrees with Thompson, or of how much this matters, this sort of Kobayashi Maru maneuver is what financial engineers excel at when the going gets tough. The difference is only really in whether this exercise in refactoring reality is used for constructive or avaricious purposes.