Throughout the whole history of modern civilization, the economy was developing in cycles, and there are many samples of true financial booms when the stock-market rush created bubbles and led to catastrophic crashes. One of the most famous cases was the so-called Tulip Mania in the Netherlands back in the XVII century.
There were, are, and most likely will be other examples of bubbles that absorbed capitals worth billions of dollars. For instance, the Dot-com bubble, the mortgage crisis, and another very modern thing that is not even history yet and that we all are witnessing: cryptocurrencies, a hybrid of money and digital technologies that affected the whole modern world.
Reserveum Group believes that there is an economic pattern at the base of those financial bubbles.
The problem is that investors never want their investment object to stop growing in price. Let’s see it in this funny example:
A story about aliens and magic beans.
Let’s imagine there is a small planet with one thousand little green men on it. From this thousand, 200 are sick and 800 are perfectly healthy. Then there is an expedition from the Earth, and it brings an unknown thing — a magic bean. The bean is magical, just one bean is enough to cure a green man of any disease.
Enterprising aliens start trading these beans in the exchange, the price grows every day, more and more green men learn about the magic power of the beans and use them for restoring their health. But with time, there are fewer and fewer sick aliens.
However, the aliens don’t want to sell the beans for less, there is a whole financial industry — the investment funds put money into bean-processing companies, banks give loans on the security of the beans, etc.
Of course, there are some who fall ill again, but the number of buyers always surpasses the number of newly-ill green men, and the rumour spreads of the unusual product that is not only useful but also a good source of income.
And then comes the day when all the green men who needed it have tried the beans and they are temporarily not needed anymore. Then the “black Thursday” comes, the price for the beans falls drastically, and the new bubble bursts out.
How to prevent a financial bubble?
It is necessary to create a protocol that would regulate the speed of the asset price change to prevent the financial bubble effect. The speed of price change for any asset should reduce as the total volume of the funds invested into the asset gets closer to the total volume of the market that is using this asset.
Let’s get back to a more realistic example — the Tulip Fever that started off in the Netherlands in 1636.
Back then, the economy of the Netherlands was just reviving after depression, and the tulip market thrived because of the Dutch Golden Age. Having gained some financial stability, the people rushed to invest their savings better. The demand for tulips was so sustainable that it built the trust of investors and small-scale speculators. At the beginning of the boom, it went pretty well, the investors were counting their future income, but the more counterparts there were included in the trading, the faster the prices grew. As a result, from November 1636 to February 1637, the prices for tulip bulbs grew by scores. A rare breed bulb could be sold for 5000 guilders. while a regular tulip bulb could cost 1500.
But due to the seasonal nature of the asset and the limited supply, the trading was mostly done with futures, and the speculative rage turned most of the deals into chains of futures contracts which were resold dozens of times and were not backed by anything. Unstable as it was, there were two more fundamental factors added up: new campaigns of the Thirty Years’ War and another pandemic of plague. The risks were undermining the very basement of the bubble, it was enough for just one participant of the chain to drop out of the game, and the whole building was broken. The panic began, and in just several days, all tulip trading in the country stopped. Most players lost all of their savings, many went bankrupt — this is a natural result of all financial bubbles.
But history has a funny tendency to repeat itself from time to time. Maybe people forget their past mistakes, or maybe they optimistically believe that no such thing can happen to them. One way or another, financial bubbles come up again from time to time, and they always bring people to the same finale.
Can we have another Tulip Mania in the future?
Cryptocurrencies are believed to be today’s financial fever for the world, and we must admit, it has some ground. There are all the features present: cryptocurrencies are mostly not backed by anything, they are only popular with the hype and the interest to the modern technologies, also, they are most often used for speculations. All of that cannot but remind of financial bubbles, and this is the opinion the majority of the world shares.
But the Bitcoin crash has been predicted regularly since 2017, meanwhile, it keeps growing in volume and price startling the critics and sparkling even more intimidating forecasts and at the same time increasing the number of followers. There is the key difference between Bitcoin and the Tulip Mania coming to life — Bitcoin is slowly turning from a speculative instrument into an investment asset. We can say it is unprecedented since there has never been an asset that started from nothing and eventually built 888,97 billion USD worth of trust.
What is the difference between modern blockchain technology and the Tulip Mania?
It’s easy: large investors are attracted by the concept itself, which is — decentralization and anonymity. The opportunity to release a part of the capital from the taxes and the government control was so tempting that a large influx of investment was almost inevitable. After that first step, there was a domino effect, and there were more and more new investors flocking into crypto, building the upward trend and at the same time providing insurance for each other.
Another important factor that supported trust in the new technology was the fact that they were based on the open code and are subject to mathematical analysis. Even now there are protocols created that enable people to control the supply and demand of different coins with, say, a smart contract. Which, of course, was impossible in the times of tulip bulbs.
But as you understand, the basement that holds the whole trend of modern technologies have no chance against the main risk for every asset — market panic. It can be started by anything — hacker attacks, negative news, government interference, key investors leaving. It is unknown if the major investors could support the rate with big buy operations in times of drawback, their investment goals are unknown as well. Over the 12 years of Bitcoin, the world has made little progress in cryptocurrencies integration into the economy, tokens are accepted as a payment very rarely, mostly in related industries. So the risk that Bitcoin will turn into another bubble are still there.
If we compare the market charts of tulips to Bitcoin, in the beginning, the Tulip Fever looked very optimistic too. In 1635 and 1636, the growth was steady, and nothing showed any signs of the looming catastrophe. The Bitcoin trends look stable as well, but it all may change once there is a rush in the market. For instance, the forecast of 100 thousand USD per Bitcoin can attract a whole army of speculators, which may very well happen in 2022 already.
However, it doesn’t mean that all cryptocurrencies are only temporary speculative assets. If we put the right characteristics into the coin algorithm, it can really become an alternative to modern money.
See how the price moves in the charts above: with low demand, the growth rate is steady, but the higher the demand, the faster it grows. The reason behind this impulsiveness is in the limited market volume since there are not too many people taking part in it, most of them adventurous people who are ready to risk for high profits. This is why the dynamics for such speculative assets is always the same.
But if we see cryptocurrencies as effective money that will replace fiat money in the future, they have to be different. We wrote about that in the article called “the Anatomy of Stablecoins” and dwelled on the structure of cryptocurrencies that can easily rival the regular money, and maybe one day even replace it. But let’s not come down to a thorough description, we’ll only list the main principles of such tokens:
1) The emission volume is controlled by the market participants;
2) Every token is backed by an equivalent amount of another cryptocurrency;
3) The amount of the reserve needed to create a new token grows over time;
4) The speed of token rate growth is built into the algorithm and correlates with the inflation.
These are the algorithmic stablecoins that can become an asset that would fully protect itself from becoming a bubble.
To prevent the stock exchange bubble effect, the speed of the asset growth should reduce as the market volume increases and increase as the market volume decreases.
It is possible to make when the market is full, in other words when everyone turns to this cryptocurrency. It is unlikely that any of the existing stablecoins reaches this level, but algorithmic stablecoins have all it takes for that.
Learn more about the protocol Reserveum.