Bitcoin Cash Proves That Markets Aren't Rational

At this point it should be fairly obvious that traditional finance theory is not fully equipped to explain cryptocurrencies. They're so new and outside of our conception of traditional finance that no one really knows how to value them. Should they be valued like fiat currencies? Commodities? Dutch Tulips? How about a combination of the three?

Nevertheless, it's worth noting that cryptofinance is not entirely divorced from traditional finance. Cryptocurrency traders still share a lot of the same lexicon as fiat currency traders: markets have bid-ask spreads, arbitrage opportunities are quickly gobbled up, and traders still use Ichimoku Clouds in an attempt to predict price movements. At the end of the day it's just a market, and markets follow the laws of supply and demand. So maybe it's not so different after all.

What the hell is a fork?

Okay, so maybe forks are a bit foreign of a concept to traditional finance theory. The US Dollar can't fork, gold can't fork, and shares of Apple can't fork. Bitcoin just forked. On July 31 we had Bitcoin, and on August 1 we had Bitcoin and Bitcoin Cash. What does that mean?

I'm not the right person to dive into the technical details and politics of how forks work. But, it boils down to the idea that Bitcoin (and all cryptocurrencies, for that matter) is more about agreeing on a version of history than it is about holding a tangible asset. And each block in the block chain represents a point in the history of a decentralized ledger.

A fork occurs when there is a disagreement over that history. Then, we get two versions of history that share a common origin. In an overly-simplistic example: our history consists of t0 -> t1 -> t2. At t2, Alice has 10 Bitcoin, and Bob has 5 Bitcoin. When t3 rolls around, Alice and Bob disagree over the state of the world due to a botched transaction. Bob thinks he has 7 Bitcoin, and Alice thinks he has 6. They agree to disagree, and continue with their own versions of reality. In one version of history (t0 -> t1 -> t2 -> t3A) Alice has 9 Bitcoin A and Bob has 6 Bitcoin A. In the other version (t0 -> t1 -> t2 -> t3B) Alice has 8 Bitcoin B and Bob has 7 Bitcoin B.

Keep in mind, both of these histories are co-existing in the real world where (crucially) both Bitcoin A and Bitcoin B can be traded for fiat currency at some price deemed fair by their respective markets.

So, what happened to the price of Bitcoin in USD?

Let's say you owned 1.00 Bitcoin (valued roughly at $2,700) on the morning of August 1. Then the fork occurs. Now, on the morning of August 2, you own 1.00 Bitcoin (still valued roughly at $2,700) and 1 Bitcoin Cash (valued roughly at about $360 immediately after the fork).

One day your cryptocurrency portfolio is valued at $2,700. The next day, after the fork occurs, your portfolio is valued at $3,060. What?

You don't need to know much about finance or Bitcoin to realize that this shouldn't happen. The global cryptocurrency market capitalization shouldn't jump up by $5 billion in an instant. No new information about the value of Bitcoin-flavored cryptocurrencies suddenly came to light. The fork was completely expected, and nothing unsurprising happened.

One could argue that underlying reason for the fork (increasing the block size) added some amount of value to the cryptocurrency ecosystem -- but it was entirely expected! If you thought the block size increase would add so much value, you could have invested in Bitcoin Cash before the fork by buying more regular Bitcoin!

What should have happened?

Who the hell knows? As coindesk will tell you, a fork is not a stock split. When a stock split happens, the supply of the stock doubles, and the price halves. So, you go from having one share of AAPL worth $150, and end up with two shares worth $75. This is supply and demand at work. The demand stays the same, but the supply increases.

But a fork actually isn't all that different from a stock split. Yesterday, the supply of Bitcoin-flavored cryptocurrencies roughly doubled. So the only way that the global market capitalization of the cryptocurrency market could reasonably jump up by $5 billion is if demand also increases. Is this demand justified? I'd say not because (at the risk of repeating myself) no new information entered the public sphere.

What I expected to happen was to see the price of (original) Bitcoin drop roughly by the price of Bitcoin Cash. This would represent the investors of Bitcoin-flavored cryptocurrency rotating the holdings in their portfolios such that Bitcoin and Bitcoin Cash were valued in correct proportion to one another.

What the hell do I know?

It's totally possible that I'm missing some key technical detail of the fork. But then again, markets aren't rational. If I've ever seen a nail in the coffin of the efficient market hypothesis, this is probably it.