Why today's bitcoin bubble recalls tulip mania and the dot.com craze

The digital currency draws throngs in South Korea and Japan, and US regulators have OK'd bitcoin futures. But the bubble could end badly for investors, with uncertain ripple effects.

The digital currency called bitcoin has made speculators a fortune, drawn in drug dealers, technology optimists, and those who distrust traditional banks.

Now, it’s ever-more mainstream. From small investors in Japan to big institutional ones in the West, bitcoin is attracting new waves of people anxious to pour money into the latest craze.

It’s hard to resist the action. Worth 6 cents seven years ago, a bitcoin now sells for more than $10,000 – a mind-blowing rise of more than 16 million percent. This year alone, it’s value jumped from $998 to a record $11,155 on Wednesday morning. Seven hours later it had dropped 17 percent, then rose above the $10,000 mark, only to drop another 15 percent on Thursday. By Friday, it was up around $10,500.

“I talk to a lot of people and they say: ‘I have bitcoin’ – average households, many colleagues, friends,” says Daniel Heller, a fellow at the Peterson Institute for International Economics and former official at the Bank for International Settlements and the International Monetary Fund. “It’s definitely very big.”

It also looks like a financial bubble, he and other financial experts say.

Research firm Birinyi Associates ranked bitcoin No. 3 among historic bubbles, – behind an 18th-century French venture to explore the Mississippi River and a single-day surge in Qualcomm stock in 1999, but ahead of the stock boom of the Roaring Twenties (No. 9).

There’s one crucial difference with the 1920s boom and crash that helped usher in the Great Depression: The digital (or crypto) currency is not so widely owned by mainstream financial institutions that a dramatic drop in value could trigger a big financial crisis, Mr. Heller says.

But that could change as bitcoin or similar digital assets increasingly go mainstream.

“What is happening in crypto currency is the entry of traditional financial incumbents into the space,” Lex Sokolin, global director of fin-tech strategy at London-based Autonomous Research, writes in an email.

Unlike historic bubbles, such as the Mississippi Bubble in France or Dutch tulip mania in the 1620s, bitcoin is not confined to a single nation of investors. Its price keeps surging as new countries come on board, albeit with volatility and some full-blown crashes early on.

A shift to Japan

For much of bitcoin’s existence (it was invented in 2008), China has been the center of bitcoin “mining.” Mining is the term for highly intensive computing that solves mathematical problems to create new bitcoin.

But when China cracked down on bitcoin exchanges in September, the action quickly moved to Japan. The Japanese government had already set the stage five months earlier by creating the world’s first national licensing program for cryptocurrency exchanges.

Now, bitcoin is all the rage.

“It’s a strong bull, but it’s going to end eventually,” says Yoshimitsu Jimmy Homma, director of the Japan Digital Money Association and chief executive of United Bitcoiners. “So some buyers will lose a lot of money.”

Ditto for South Korea, another place where bitcoin buying has surged as banks and other institutions made it easy to purchase cryptocurrencies.

“There's really nothing to invest in anymore,” says John Saeyong Ra, founder and chief executive of Bitcoin Center Korea. Savings accounts offer no real return. Stocks and real estate are lackluster. “Cryptocurrency and bitcoin became something rather more exciting. It comes with higher risk, but Koreans tend to be a little more risk tolerant.”

A US surge next?

The next stop for the bitcoin surge could be the United States. On Friday, Chicago-based CME Group, the world’s largest futures exchange, announced it would start trading bitcoin futures starting Dec. 18. Federal regulators have also cleared trading for CME’s rival Cboe, also based in Chicago.

Futures contracts, which allow traders to hedge their bets and reduce their risks when buying speculative products such as bitcoin, represent the further mainstreaming of the cryptocurrency. Asset managers are creating cryptocurrency trusts and other investments for sophisticated investors, says Mr. Sokolin of Autonomous Research. What’s lacking are instruments, such as a well-known mutual fund or exchange-traded fund, that would allow ordinary investors to get involved.

That “would be a game changer,” he says.

Underlying these digital currencies is a revolutionary technology, called blockchain, which creates secure records of digital transactions and can safeguard digital assets from counterfeiting or theft. The so-called “distributed ledger” technology promises to make financial transactions simpler and cheaper and could create brand new markets that entrepreneurs haven’t yet dreamed up.

But there’s a dark side, too. In the wake of bitcoin’s success, more than 200 other currencies have sprung up, unregulated. Some are legitimate, some not. Bitcoin is usually the onramp to purchasing these currencies.

“There are scammy ventures that promise you the next bitcoin,” says Leo Weese, president of the Bitcoin Association of Hong Kong. “These funds often do target people who have absolutely no idea what's going on.”

That’s a huge concern, especially in those areas of the world where ordinary investors are already buying in.

Classic ingredients for a bubble

In Japan, “bitcoin is still not a super common topic yet,” says Mr. Homma of United Bitcoiners. “Almost everyone knows the word, but my guess is that only 5 or 10 percent understand what it is…. We need to be very careful about speculation and trading, otherwise people will lose a lot of money, because this is too volatile of a market.”

“It's kind of a fear of missing out [on a great investment] that's also playing a part,” says Mr. Ra of Bitcoin Center Korea. Some investors just focus on the upside. “They will just borrow money or do margin trading and they just gamble.”

These are classic ingredients for a speculative bubble. And bitcoin has its own alluring story, as all bubbles do. The revolutionary technology was invented by Satoshi Nakamoto to allow consumers to use a currency outside the control of the world’s central banks. No one knows who Nakamoto is or whether that name represents a person or a group.

The true value of bitcoin is also a mystery.

“People have always been saying that this is one of these things that can go between $0 and $1 million per coin,” says Mr. Weese of the Bitcoin Association of Hong Kong. “So this is something that, if it succeeds, can become very big.”

Mr. Heller of the Peterson Institute is skeptical the currency is worth all that much. Still, when he started his research, he spent $120 to buy bitcoin. Now, his stash is worth $2,400.

Will he sell?

“I am just holding on like many of the others,” he says.