The structure of the Bitcoin market does not lend itself to the types of financing arrangements that typically fuel bubbles.
What we traditionally think of as bubbles in the stock market, real estate, etc… Are fueled by the changing nature of how new purchases are financed.
Initially cash flows from the asset cover the financing costs. So the income from a real estate property covers the interest payment on the mortgage and a gradual reduction in principal.
If times remain good. Lenders loosen their restrictions and for new purchases the income only covers the interest payments. With the expectation the principal will be repaid by selling the property off in the future.
If this goes on long enough eventually new purchases need to be ponzi financed. So additional borrowing is required to finance the mortgage while waiting to sell the property for a higher price down the road.
Ponzi Financing Leads to Bubbles
Once ponzi financing is in place. It is only a matter of time until the bubble bursts ala the housing crisis in 2008. Because if an asset can’t be sold before its financing dries up the owner will go into default.
Once a pattern of defaults emerges. Financing dries up completely. As lenders realize they’ve over extended themselves.
Absent financing from external sources the market collapses. Because the debt burden is to high to finance exclusively with the assets cash flows.
Check out Hyman Minsky’s Financial Instability Hypothesis if you are interested in further reading on the topic.
Bitcoin is not subject to this dynamic.
Because while individuals may suffer catastrophic losses from ill advised financing of Bitcoin purchases. Since Bitcoin is not directly linked to the financial system providing this funding.
The feedback loop present in traditional bubbles that leads to unstable financing arrangements. Is not a dynamic that can express itself in the Bitcoin market as it is currently structured.
Why It Looks Like A Bubble
The recent exponential increases in Bitcoin’s price that make it appear to be in a bubble. Are driven by the HODL phenomenon. Leading to a lack of liquidity to satiate increases in marginal demand.
Basically most current holders of Bitcoin. Don’t want to sell their Bitcoin’s.
To the extent new supply exists. It generally comes from miners looking to recoup the costs of their operations.
So the continuing rise in price reflects what it takes to pry coins out of the hands of existing holders. Which for the most part are true believers in the thesis that even with the recent rise we ain’t seen nothing yet.
So any increase in demand for Bitcoin tends to induce a large price increase. Because there are not many sellers willing to meet this demand.
Putting a Floor Under The Market
This explains why generally there has been a floor to recent corrections as well. If most holders are relatively immune psychologically to falling prices. Because of their belief that Bitcoin will change the world.
Than downward momentum stalls out. Because relatively little demand is needed to stabilize the fall given the absence of sellers.
As long as this structure persists. Bitcoin will continue to have an upward price bias with substantial volatility along the way.
Due to the lack of liquidity present in the market. Since most holders aren’t interested in selling.
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