The growing Bitcoin bubble – is it worth the risk?

Bitcoin is now trading up 40% just a year ago, and other cryptocurrencies have seen price surges of up to 18,000%. But is it a golden opportunity, or a bubble in imminent danger of collapse? And is crypto worth the environmental cost? Article by Nick Green.

When you step inside a Bitcoin mining factory, the size of an IKEA superstore, stacked high with glowing banks of computers stretching as far as the eye can reach, pumping out heat, roaring loud as a jet plane, you’d be forgiven for wondering if the world has lost its mind. Just one of these giant sheds can house over 20,000 mining ‘rigs’ – each a computer many times more powerful than a good laptop – and one factory in Iceland alone consumes more power than all that country’s homes put together. Collectively Bitcoin uses more electricity than the Netherlands or Argentina, and that’s before you factor in the hundreds (in fact, thousands) of other cryptocurrencies in existence.

What’s it all about? The basic principle of cryptocurrency is simpler than many people think. It’s the same basic premise as buying gold. Gold has long been used as money for two key reasons: it’s rare, and it’s very hard to fake. This makes it a reliable token of value. The same applies to crypto-coins: they are ‘mined’ by solving complex sums that only vast computers (see above) can handle. So when you have a coin, you and the whole world know it’s real. Forging such a coin would be futile, since it would cost you as much as the real thing (and would in fact be the real thing).

So the idea of cryptocurrency as usable money is absolutely sound. It’s digital gold. The problem is, people aren’t just using crypto as ordinary money, but as an investment. In its early days, Bitcoin would surge in value by hundreds of percentage points in just a few months, followed by similarly sharp falls. The pandemic heralded one of its strongest surges, over 200% over the course of 2020, to achieve a record high price. Meanwhile some more junior cryptocurrencies such as Ethereum and Dogecoin are currently offering returns of up to 18,000%.

Faced with these surreal growth figures, a lot of people have become evangelical converts to the Bitcoin cause (there’s even a name for them – Bitcoiners – with ‘Nocoiners’ being the disparaging term for those who don’t believe the hype). Who wouldn’t want an investment that can multiply your money exponentially? The problem is, investments just don’t do that. Bubbles do.

The fact that all cryptocurrency is just a bubble is probably its worst kept secret. The money that fuels the massive price rises comes solely from other investors pouring their capital into it, in the hope of riding the surge. The name for such a phenomenon – where investors’ money alone generates the returns – is a Ponzi scheme. Cryptocurrency investment may be a voluntary version of one, but otherwise the description fits very well.

As the governor of the Bank of England, Andrew Bailey, said recently, ‘[Cryptocurrencies] have no intrinsic value … Buy them only if you’re prepared to lose all your money.’

The high cost of gambling on cryptocurrencies

One of the many investors who have learned this lesson the hard way is Craig E of Lincolnshire. Unable to afford the high-priced Bitcoin, Craig ploughed several thousand pounds into the reassuringly-named cryptocurrency SafeMoon. Despite some slightly different rules intended to reward those who hold onto the coins for longer, SafeMoon is ultimately no different from any other crypto in terms of its price volatility. However, its current low price – just a fraction of a fraction of a dollar – may tempt many investors into thinking it’s a low-risk investment. Buying something that costs far less than a single penny might seem to have no drawbacks. But of course, people don’t just buy one.

Craig’s purchases initially did well, so he increased his holding to £4,000 (borrowing on his credit card), only to see the SafeMoon price crash. It lost him nearly £3,000 and put him in debt. After this eye-opener, he was quick to understand how the currency was generating its returns. Investors are encouraged to invite other people to invest, driving the price up. But then, when earlier investors sell their coins, the price falls again – leaving the new investors out of pocket. ‘It does almost feel like a Ponzi scheme,’ Craig admits. ‘I should have known better than to risk money I didn’t have, and I should have been more cautious.’

Craig partly blames himself for choosing a minor cryptocurrency, but the plain fact is that this sort of loss can occur with any crypto, including the major ones like Bitcoin and Ethereum. The price of Ethereum hit an all-time high recently, while Dogecoin – a currency founded as a joke – has attracted massive real interest due to backing from Elon Musk, who announced that his firm would accept payments in it.

The soaring prices of all these cryptocurrencies means that the combined value of the crypto market is now in excess of $2.5 trillion – or nearly twice that of Amazon. And yet none of these currencies actually produces anything, or is attached to any tangible assets. All that value derives from one thing only: the belief of investors that the price will rise even more. And this is underpinned by little more than hype and evocative brand names.

The Bitcoin frenzy is such that even major banks are falling for its lure. Goldman Sachs, which got burned in 2018 when it set up its Bitcoin desk just before a huge price crash, has reinstated the desk to trade in Bitcoin-linked derivatives. With Bitcoin soaring at present, this must have been a hard move to resist, but the odds are that history will repeat. Even the Bank of England is mooting the possibility of issuing a central cryptocurrency – named, with crushing inevitability, ‘Britcoin’ – and it has discussed with other central banks the economic merits of digital currencies.

There is a strong case to be made for digital currencies to gradually replace traditional ones. But when they are seen as a means of generating wealth out of thin air (or rather, out of terawatts of electricity and hundreds of tonnes of computers), there is a lot more reason to be sceptical.

Is Bitcoin worth it?

Can you get rich from investing in cryptocurrencies? Absolutely – just as you can get rich from playing in a casino or betting on horses. The principle is the same: you only gain money because other people, elsewhere, are paying it out. In the case of crypto, that person may simply be you in the future. It remains a zero-sum game. It also appears to be a very niche game – at least for the present. A 2020 survey of US adults found that only 4% considered themselves ‘somewhat likely’ or ‘very likely’ to buy a cryptocurrency in the coming year. And it's estimated that less than 2% of the world's population currently owns any cryptocurreny.

That’s a soberingly small figure, when one considers the sheer scale of the resources and capital being ploughed into crypto. The effort required to mine coins increases over time, as the sums become harder and the computing power needed to crack them spirals ever upwards. Processors, hard disc drives and graphics cards – all key tools in crypto factories – have suffered shortages as demand outstrips supply. The total computing power in the Bitcoin network alone is now around ten times greater than that of the 500 largest supercomputers in the world combined. That kind of computing power could offer countless practical benefits, from scientific research to tackling climate change, but instead it is being used to mine Bitcoins. Many respected commentators still claim that it’s worth the cost – and for a lucky few it may well be. But no-one really knows what will happen if (when?) the bubble finally bursts.

You will be hard-pressed to find a financial adviser who is willing to advise on cryptocurrencies – and even then their advice will probably be, ‘If you do it, you’re on your own.’ Even so, given that some banks are considering trading in Bitcoin derivatives, there may be a case for the highest-risk sliver of a well-balanced portfolio to include some form of crypto, as a wild card. Talk to your financial adviser about this, so that you’re absolutely clear on the risks versus potential returns.

If you found this article useful, you might also find our guide to tax on cryptocurrency and article on NFTs informative, too!