Investing in second generation cryptos

Investing in second generation cryptos

The biggest impediment to price gains in cryptocurrencies is the ‘bitcoin beta’ trap, which we’ve discussed before.

‘Beta’ refers to the tendency of two assets to trade with a high degree of positive or inverse correlation.

If crypto A goes up 10% and crypto B goes up 10% in lockstep, then the two cryptos have a beta of +1.

The result is that the two cryptos go up and down together at about the same rate, even if they have different fundamentals.

The second problem with bitcoin is that it is headed towards US$200 (a residual value for criminals) or perhaps $0 (the subjective market value, absent from market manipulation and wishful thinking).

The greatest asset bubble in history

The 2017 bitcoin price spike at US$20,000 per coin has been shown to be the greatest asset bubble in history — bigger even than the tulip mania of 1637 or the South Sea Bubble of 1720.

Since early 2018, the bitcoin price has collapsed over 80% to its current level of about US$3,600.

The problem with bubble crashes is that they do not proceed in a straight line.

In a crash, the price will fall precipitously but then rally briefly as some see a ‘bargain’ compared with the highest price in the bubble phase. But the rally soon fades and the relentless decline starts again.

In addition to the bargain hunters (who soon lose their money), there are holders (called HODLers in coin-speak) who refuse to sell in the vain hope that the old highs will be regained.

This won’t happen, but it does mean that the full weight of selling pressure has not yet hit the market.

Pump and dump

Eventually, even the most hard-core HODLer will see reality and sell her coins, but it does not happen all at once.

So the decline continues, but it proceeds with brief spikes that never regain the prior high, let alone the all-time high.

Still, there are miners with huge investments in fixed assets (computers, chips, warehouses, engineers and electricity) who are desperate to make money in bitcoin validation and the receipt of new coins.

Their real goal is to dump their inventories of old coins, along with pumping prices high enough to cover electricity costs on current mining operations (about US$3,500 per coin).

This leads to ‘pump-and-dump’ schemes, a classic Wall Street fraud, where a few miners engage in wash sales and painting the tape to induce the unsophisticated to bid up the price of new coins.

Once the price rises high enough, the miners dump their inventories on the newbies. Then the price quickly falls, but it’s ‘mission accomplished’ for the miners until the next scheme is launched.

The chart below illustrates the latest pump-and-dump scheme.

Miners and other manipulators pushed the price up from US$3,800 on 6 January 2019 to US$4,100 on 8 January — a two-day 8% gain.

Once enough new buyers had been attracted by the rally, the miners dumped their inventory and the price reverted to a lower level. In this case, US$3,600.

IMG 1

Source: CoinDesk

The miners will take a break for the time being and then launch a new pump-and-dump scheme when they feel the time is right.

The next manipulation will begin from a lower level and not achieve the latest US$4,100 high, but it will proceed by the same dynamic of fooling those on the sidelines to pay a higher price.

Understanding the ‘high beta’ link

The other phenomenon of bitcoin beta is illustrated in the second chart below.

This shows the correlation (high beta) between bitcoin and the other two leading cryptos, Ethereum (ETH) and Ripple (XRP).

Both ETH and XRP followed bitcoin in lockstep during the 22 December rally, the 24 December crash and the extended pump-and-dump from 29 December to 10 January.

As long as this beta relationship is strong, ETH, XRP and other leading cryptos will suffer from the same instability and downtrend as bitcoin.

Even coins with solid use cases and strong technical fundamentals will be subject to this beta trap until bitcoin breaks down completely and the market begins to consider coin fundamentals instead of bitcoin mania.

IMG 2

Source: The Daily Shot

A second wave, or new generation, of cryptocurrencies is now emerging with better governance models, more security and vastly improved ease of use.

These new-wave coins represent the future of the cryptocurrency technology.

These cryptos have much greater potential to disrupt and disintermediate established payment systems and financial intermediaries such as banks, brokers and exchanges.

It is critical that investors have a robust and reliable method for distinguishing between the dead-end cryptos, such as bitcoin, and the new-wave cryptos with a chance to disrupt banks the way Uber disrupted taxis or Airbnb disrupted the hotel industry.

Second-generation cryptos emerge…

On the one hand, mature cryptocurrencies such as bitcoin, Ripple and Ethereum are showing their inherent limitations and unsustainability.

These cryptocurrencies all have major flaws in terms of investor safety and ease of use.

The solutions proposed invariably involve backing away from the original promise of safe, anonymous transactions.

Government authorities are converging from all sides looking for tax evasion, securities fraud, evasion of capital controls and other improprieties.

Second-generation cryptocurrencies have a much greater chance of competing successfully with existing payment channels such as Visa, Mastercard, PayPal and the traditional banking system.

The potential value of these new-wave cryptos can be measured by the current franchise value of the institutions that will be disrupted.

If these cryptocurrencies can disintermediate centralised financial behemoths like Citibank and the New York Stock Exchange, their value can be measured in the trillions of dollars.

Most coins have miniscule market caps, weak governance, vague use cases or all three.

In the short run, if you’re looking to invest in cryptocurrencies, stick with large-cap tech stocks.

These will be building blockchains for use by a variety of cryptocurrency issuers or large-cap financial institutions, which will be rolling out distributed ledgers with proprietary coins to provide better payment services to customers.

All the best,

Jim Rickards Signature

Jim Rickards,
Strategist, The Daily Reckoning Australia

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