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JOHANNESBURG - After the exponential growth of the exchange rates of cryptocurrencies the exchange rates to the US dollar slumped.

Bitcoin, by far the largest cryptocurrency with 48 percent of the market, rose spectacularly from $970 (R12751) in the beginning of last year to nearly $20 000 in December last year when the bubble popped and is currently trading at around $7 700.

Although the cryptocurrency tanked by more than 50 percent, its exchange rate is still eight times higher than at the beginning of last year.

Perhaps you had the vision that virtual currencies was the way to go and got into the market at base level prices or you missed out like me. With Bitcoin’s exchange rate down by more than 50 percent from its highs the question is what now. If you missed out - should you get into the market or if you have some - should you take your profits and head for the hills?

Bitcoin’s exchange rate as a proxy for cryptocurrencies has all the makings of a major bubble that burst. To get a feel for what is lying ahead for the cryptocurrency market is to compare Bitcoin’s exchange rate to the four famous bubbles in history.

The methodology that I used was to compare the movements in indices 11 months before the ultimate highs and 19 months after the ultimate highs. The first bubble was the South Seas bubble in 1720.

While most economists and analysts focus on the behaviour of the shares of only two companies, namely Mississippi and South Sea, many more were traded. Through various sources on the internet I was able to calculate an equally weighted index for French and British shares.

The second bubble burst in 1929 and I used the Standard & Poor’s Composite index behaviour over the given period.

The third bubble that burst was driven by tech stocks in 2000 and I, therefore, used the Nasdaq index as proxy over the given period.

The fourth famous bubble that burst was the global financial liquidity crisis induced by sub-prime lending and the demise of Lehman in 2008. I used China's Shanghai index as a proxy over the given period.

According to a good friend of mine, Professor Eon Smit, who is arguably one of the top statisticians in this country and former director of the University of Stellenbosch Business School, the different phases of the speculative bubbles are well described in the literature, but the consistent timing and duration of the bubbles are new to him.

Given the technical nature of cryptocurrencies the most relevant bubble was probably the tech stocks as represented by the Nasdaq index in 2000. It is uncanny that the Bitcoin exchange rate to the dollar has been following the same trend as that of the Nasdaq index in 2000 pre and post the burst of the bubble over the past 19 months.

But how does a cryptocurrency such as Bitcoin function?

It is aptly described in a document requested by the European Parliament's Committee on Economic and Monetary Affairs authored by Marek Dabrowski and Lukasz Janikowski of the Directorate-General for Internal Policies in July this year.

“The Bitcoin system functions according to a set of rules known as the Bitcoin Protocol. When person A wants to pay a certain amount of bitcoins to person B, payment instruction is placed in the system, along with other payment instructions. Miners validate payments and record them in a newly created block by solving a computationally demanding mathematical problem that is created and specified by the Bitcoin Protocol.

Miners get compensation for their services in two forms: fees and freshly minted bitcoins that are created in the process of validating the transactions. Miners compete with each other, as the compensation is paid to the first miner that solves the problem, meaning that the system favours miners with the strongest computational power.” At this stage only a limited number of companies accept Bitcoins as means of payments but it gives consumers greater ability to purchase goods and services directly online.

The use of cryptocurrencies as payment is likely to grow as the move towards a cashless society gains traction. The most important benefits of cryptocurrencies are low transaction costs, the high speed of the transactions, anonymity, higher security of personal data and limited interference by public authorities. As cryptocurrencies do not exist in physical form it has to be exchanged online and is, therefore, a convenient way to do cross-border transactions with no exchange rate fees.

The potential disadvantages are theft or fraud, while they may be exploited by acts of crime such as terrorism and drug dealing. Although many countries welcome cryptocurrencies, others such as Iceland and Vietnam have banned them while Russia is planning to ban them later this year. While China is one of the world's largest cryptocurrency markets, all banks and financial institutions are prohibited from dealing in cryptocurrencies, but individuals are free to trade between themselves.

The total trade in Bitcoins over the past seven days averaged $500 million a day, while the current market capitalisation is $150 billion. At its high in December last year the total trade in Bitcoin averaged more than $2.5bn over a seven-day period.

It can be assumed that most of the trade was for speculative purposes and it could be that the market was cornered by some speculators as it is highly unlikely that most of the trade was to purchase goods and services online.

The major characteristic of cryptocurrencies is therefore that they are subject to significant and unexpected exchange rate fluctuations.

Dabrowski and Janikowski are of the view that “exchange rate fluctuations could (but do not have to) be the result of involvement in a Ponzi scheme or the build-up of a price bubble.”

Bitcoin or other cryptocurrencies are not legal tender and not backed by any central bank or other assets. Even Vitalik Buterin, the founder of the second largest cryptocurrency Ethereum, warned some time ago that cryptocurrencies are really not the best place to put your life’s savings since they are new and “hyper-volatile,” with the possibility to “drop to near-zero” at any time.

I strongly support the creation of exchange-traded funds cryptocurrencies as well as cryptocurrency futures, as it will afford the ordinary investor and speculator the opportunity to trade in this speculative animal and to hedge current holdings in cryptocurrencies.

Will the Bitcoin exchange rate continue to track the final leg of the Nasdaq index’s burst bubble in 2000? Your guess is as good as mine.

Ryk de Klerk is an independent analyst. The views expressed here are not necessarily those of Independent Media.