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There are many episodes of bubbles and crashes in economic history such as the Dutch Tulip Mania, the Mississippi Bubble and the South Sea Bubble, or the more recent Dot-com and U.S. housing bubbles. However, bubbles observed in cryptocurrency markets dwarf any major historical bubbles in terms of magnitude and have been far more protracted. A team of researchers observed that mining seems to play a crucial role in bubble formation. And that high price volatility is an inherent feature of a mining protocol, which seriously limits any prospects for such assets becoming a medium of exchange. For their investigation, the researchers developed an experimental framework that is highly flexible and allows for future research in examining the price stability of other (digital) currency designs.

Although cryptocurrencies were originally devised as a communication protocol that facilitates decentralized electronic payments, they are increasingly recognized as an investment vehicle. The first and perhaps most prominent cryptocurrency is Bitcoin. Bitcoin alone constituted a market capitalization of over $1 trillion at its peak price in 2021, which is comparable to the market capitalization of all companies in the German DAX index.

Out of the eight most popular cryptocurrencies, five clearly resemble bubbles, including Bitcoin. It is puzzling why Bitcoin exhibits such extreme bubbles since it does not generate any income such as dividends or interest. Furthermore, it is different from commodities as it is intangible and has no potential in being incorporated in the production of any further products in the way, for example, gold does. Therefore, the conventional economic valuation measures cannot be directly applied to cryptocurrencies.

The risk of speculative bubbles in cryptocurrency markets spreading to other financial markets and ultimately to the real economy is increasingly likely.

Cryptocurrencies: for speculative purposes

Yilong Xu, Assistant Professor at Utrecht ľ¹Ï¸£ÀûÓ°ÊÓ School of Economics (U.S.E.) explains: Nowadays, the majority of individuals who own cryptocurrencies are not holding them as a substitute for cash, but rather for speculative purposes, as research shows. As more investors hold cryptocurrencies in their portfolios, the risk of speculative bubbles in cryptocurrency markets spreading to other financial markets and ultimately to the real economy is increasingly likely. This is known as financial contagion.

What separates decentralized cryptocurrencies from conventional assets is the underlying blockchain technology. Blockchain is a public ledger that records coin ownership, but many permissionless cryptocurrencies such as Bitcoin require a consensus mechanism to determine who has the right to add new information to the network, which is called Proof of Work, also known as mining.

In the beginning, you could do the mining on your own computer, but because of the increased interest in it, you have to have specialised devices. There are even so-called ‘mining farms’ of hundreds of thousands of specialized devices running at the same time, trying to solve the puzzle.

Once miners get rewarded with bitcoins, they won’t give it away cheaply

But that cost will be internalised by the miner. So, once they get rewarded with bitcoins, they won’t give it away cheaply. And won’t immediately sell, to compensate for their effort and to make profit – unlike in gold mining. Bitcoin mining companies will also time the market. We believe that this is contributing to the price – it won’t easily crash.

If you have a demand shock – a crisis of some kind which increases the demand for bitcoin, the miner cannot say: okay we will work overtime and produce more bitcoin. This is not possible. The network is not very accommodating to demand shocks; the algorithm dictates everything. Approximately every 10 minutes a new block will be put on the chain, a new puzzle solved. This mechanism makes it very stable. If the demand surges, the difficulty will also be higher. Long term, the supply will be stable. This is a contributing factor for a bubble.

Also, there is a maximum amount of bitcoin (of which they say it will be reached in approximately 2140). And the rate of return for mining (the block subsidy) is going to reduce over time. With bitcoin, every four years, the value of the coin subsidy will be half of its previous value. This most recently happened on Saturday the 20^th of April. The block subsidy changed from 6.25 BTC to 3.125 BTC. This halving might have an upward pressure on the price. Eventually, there will be no new bitcoins mined, but still 21 million coins in circulation.

The rate of gold supply is going up all the time, that of Bitcoin is going down

Mining causes bubbles

If you look at the history of goldmining, the output is actually increasing over time, Yilong Xu goes on. It is not really a limited resource in that sense, as new gold mines are being discovered. They have created that narrative of scarcity to induce people to buy gold. The rate of supply is actually going up all the time. That of Bitcoin on the other hand is going down over time. Bitcoin is much more deflationary in this sense. If the demand doesn’t disappear, it will become more valuable over time. But It can still fluctuate. If nobody is interested in bitcoin, it can crash to zero.

Study in a controlled laboratory setting

Studying bubbles using observational data is challenging. For one thing, the fundamental value of the asset is unknown and highly debatable, making the definition of the bubbles less clear. For another, there are many confounds in the field that cannot be controlled by researchers. The researchers therefore wanted to study whether defining features associated with bitcoin mining process affect mispricing in a controlled laboratory setting. According to the research team, their study is the first on the link between the specific features of the Bitcoin technology and bubble formation in the lab.

One of the biggest advantages to study financial markets in the lab is that we can clearly define the fundamental value of the asset and communicate it clearly to the participants, Xu explains. This way, bubbles can be clearly observed by comparing trading prices with the fundamentals. In the baseline treatment without any features of mining, prices follow fundamental value closely. Once we add mining, while holding everything else the same, we find large bubbles in the market. It turns out that prices in the first few periods of the market follow in lockstep with the mining costs: people first mine the coins and sell the coins on the market with a little markup. As the mining costs are increasing, it creates a momentum that results in a bubble.

When mining is centralized in such a way that only a subgroup of people has the privilege to mine, the surge is much earlier. We think this has to do with the exponential growth of mining costs. As time goes by and with more people are interested, the mining costs will be rising. So, they think: if I want to buy, I want to buy early. The creates a strong initial demand early in the market.

We say: the miner creates the value by means of the mining costs. But not everyone agrees with this point of view.

No fundamental value

Cryptocurrency is not a traditional asset that generates revenues or dividend – on which you can estimate or calculate the value, says Xu. It is completely different. Does it have value? In our paper* we say: the miner creates the value by means of the mining costs. But not everyone agrees with this point of view. There is no fundamental value that we can speak of, and therefore it is impossible to define a bubble in real life using observational data.

You might think of the value of the asset on the long term. The right range that seems reasonable. Again: what were the costs to produce these assets, how much to maintain the network, and on the basis of that you can estimate a reasonable price for each unit of bitcoin. But it is all an estimation, and nobody can tell you whether this is a bubble or not, in reality.

Other consensus mechanisms

In order to understand which cryptocurrencies are prone to bubble due to their specific supply scheme, a case-by-case examination would be necessary to identify those that share the key properties of Bitcoin the researchers identified in this study. Cryptocurrencies featuring a less rigid supply scheme, flexible adjustments in token supply might mitigate price volatility.

The experimental framework the researchers developed for this investigation is highly flexible and allows for future research in examining the price stability of other (digital) currency designs. And if central banks around the world have the ambition to issue their own digital currencies (known as CBDCs), the need for a more stable mechanism is clearly evident.

More information

Would you like to know more about this? Please contact Yilong Xu: y.xu3@uu.nl

*Read the paper: ‘Does mining fuel bubbles? An experimental study on cryptocurrency markets’ by Marco Lambrecht (Hanken School of Economics & Helsinki GSE) Andis Sofianos (Durham ľ¹Ï¸£ÀûÓ°ÊÓ ) and Yilong Xu (Utrecht ľ¹Ï¸£ÀûÓ°ÊÓ) in Management Science.