Chris DeRose is a software developer, bitcoin evangelist, public speaker and lead developer of Drop Zone.
In this opinion piece, DeRose draws parallels between the South Sea Bubble of the 1700s and the current craze for ICOs, warning that the parallels between the two are “uncanny”.
Ye Fools in Great-Britain, repent in your Folly
Bewailing the Loss of your Money and Lands,
Unto your Vexation, ’tis fled from the Nation,
And Blockheads and Ninnies have got it in hand.”
– The Bubblers Medley, circa 1720 (Yes, really)
The Spanish King, Charles the second, was dead. And there were no heirs apparent to his throne. The War of the Spanish Succession had begun.
With Spain’s weakened leadership, and unable to defend its territory, a power vacuum formed through which nearly nearly all European nations vied for control of Spain’s undefended land.
The war that started in 1701, raged on for nearly nearly 15 years and ended by treaty. The war ended without anyone clear victor, but the treaty resulted in significant changes to European and American territorial boundaries.
What was left of the eviscerated Spanish mainland was given to Philip V, a member of the French nobility who held the closest genealogical claim to the Spanish throne. What was received by Britain and France was the title to ‘New World’ territory in North and South America. What was received by all participants, was debt and the need to build and rebuild trade routes upon the new redistributed land. Enter Britain’s ‘South Sea Company’.
The South Sea Company was formed via a partnership between the British parliament and the Bank of England in the year 1711.
The structure of this company was like many others in the 17th and 18th centuries. The company came into existence through a royal charter, and was given a monopoly on part of the monarchy’s commerce. In the case of the South Sea company, this monopoly was granted over the trade in the newly conquered Spanish territory.
At the time of commencement, shares in the South Sea Company were primarily issued by conversion of war debt. The debt from the Spanish War, assessed at £10m, was assigned to the South Sea company for repayment. And at the option of an existing bondholder, that debt could instead be converted into equity into the new venture.
It was a good deal for the state, as the debt was removed from its books and import tax revenues could be collected from the company. And for a while, it was a great deal for debt and shareholders. So, when the Treaty of Utrecht was signed in 1713 by all parties involved in the war, the ship that was the South Sea Company was ready to set sail.
The big sell
It’s tough to say just where the South Sea ‘bubble’ itself started, as the run up was caused by the culmination of many small decisions, each made with the best of intentions for shareholders.
Marketing for the South Sea Company was unusually aggressive out the gates, with fantastic tales being told about the spoils awaiting export from the new land. Further, there was a complex front-running strategy that enabled legislatively privileged insiders to buy government bonds before the announcement, and ‘sell into the pump’.
Later accounts of this time would reveal that the marketers of this security knew the tales of wealth were not sustainable at the time, but felt that, with the capital received, surely some profit would follow. Sure enough, as the claims of surefire returns were being propagated, the South Sea Bubble began its ascent.
Unique to the South Sea company’s launch, and for the first time in British history, investors were courted from outside those with close ties to the monarchy. The perceived potential to share in the gains of this elite group were too good an offer for the common man to pass down. And, the buying and selling of the stock developed into a new form of gambling in which the country as a whole began to play.
As the South Sea Company’s valuation began to grow, and expectations of great wealth compounded, promoters of the South Sea Company started to realize that they too could emulate its success by creating their own companies and issuing stocks. For the ICO speculators of today, this is where the bubble begins to get significantly more interesting.
Initially, these ‘bubble companies’ (Yep, that’s just what they were called) had plausible enough goals. In a time that preceded the invention of the ‘white paper’, these companies instead drafted marketing literature that was quick to read and high on aspiration.
The initial companies were fairly benign in their focus. And, at first, most companies were focused on insurance, product and utility endeavors. To quote the canon of buttcoin, these companies could fairly be synopsized as having ‘but with the new world’ goals for their corporate strategy.
Over time, as the public’s appetite for extraordinary investment opportunities continued to grow, the claims of these bubble companies grew equally extraordinary. No regulatory oversight or specialist review was needed at the time, so claimants began to pitch companies which claimed they would achieve: “the making iron with pit coal”, “the transmutation of quicksilver into a malleable fine metal”, “the making of rape-oil” and, of course, “a wheel for perpetual motion”.
At the height of the madness, the most famously ethereal company of the bubble promised, without irony, “a company for carrying out an undertaking of great advantage, but nobody to know what it is”.
As the mania grew, promoters and proto-exchange operators began to appear on the streets of London. ‘Stock-jobbers’, as they came to be known, began to market their paper on the busy streets between london’s coffee houses.
The stock-jobbers would buy and sell the newest schemes to passers-by for a commission on the sale. These promoters were notoriously unscrupulous, and as the front men for many of the unsavory offerings, and they would also become the first to be held responsible by buyers whose investments fell short of the promise.
The start of the end
Adjusted for inflation, at its peak, the South Sea Company’s market cap would equal $4tn in ‘real’ (inflation adjusted) terms. Nearly all the country’s bureaucracy, aristocracy and businessmen held significant exposure to the scheme. Even Isaac Newton was heavily invested in the company before its downfall. Oracles, it would seem, were equally unable to predict outcomes in times of manic fervor.
As the South Sea company reached its peak valuation, a confluence of events caused its downfall. In December of 1719, having yet failed to achieve any profit, the South Sea company was unable to pay its year-end dividend to shareholders.
This default started a snowball of action amongst politicians and bankers. Some bankers began to realize that increasing valuations could not continue indefinitely. Meanwhile, politicians began to see that investments in bubble companies, which were still technically illegal, competed with investment stake in their South Sea Company holdings.
In January of 1720, a parliamentary commission was held on what should be done about the fervor. Through a series of compromises and scandals, the commission concluded that only companies with a royal charter could be bought and sold. By June of that year, the Bubble Act reaffirmed the illegality of bubble corporations and put an end to the trading of their stocks.
The final nail in the coffin was due to an investor credit program of which the first payments were due in August of 1720. At that time, investors began to sell their holdings to make due on the payment, and this started the initial selloff.
What happened next, should be unsurprising. Bankruptcies began, and within months had reached all time highs. As the losses mounted, then compounded, everyone was affected. Notable bankruptcy included that of Isaac Newton, who upon losing the near entirety of his life savings proclaimed:
“I can calculate the movement of stars, but not the madness of men.”
By the end of 1720, the price of the South Sea company stock had fallen 90%.
Investors revolted against the stock-jobbers, the company founders, and the politicians who they blamed for losing their wealth. The mobs formed, and justice was demanded. Extraordinary claims that were once pitched and traded as foregone conclusions, were finally tested. Many of those who were responsible for the extreme claims fled the country. Those that remained faced jail and asset confiscations.
Though many of the stock-jobbers escaped prosecution, they faced an inordinate public backlash in the form of mockery, ridicule, and disdain. Famous amongst this backlash is a lengthy written condemnation of their work by Daniel DeFoe (the author of “Robinson Crusoe”), a popular deck of playing cards commemorating the folly, and numerous plays written to ridicule the stock-jobbing profession.
With the resulting contraction of the entire economy’s growth, the South Sea Bubble was the great depression of its century, and the Bubble Act remained in effect thereafter for over 100 years, restricting the growth of investment markets until it was finally overturned in 1825.
Unregulated, and without peer review, the investment economy had turned into a perverse and unsustainable Keynesian beauty contest. The South Sea Bubble never returned a profit on its operating expenses during the entirety of the bubble, and what little trade it did attempt (mostly in slaves) was performed at a net financial loss.
Lessons for today
If it’s not clear by now, the parallels between the South Sea Bubble and today’s ICO market are… uncanny.
As a new class of investor was given access to a securities market for the first time, and without any regulatory safeguards, this market quickly degenerated into a gambling racket where unscrupulous businessmen catered solely to the speculative markets, without any concern for long-term sustainability and non-speculative capital inflow.
Not only that, these pitchmen starved out investment in modest, but actually profitable endeavors. The burden of this environment resulted in substantial externality costs borne by the entirety of the market.
Given the chance, investors will rationally jump at the opportunity to be the second greatest fool. And to promote long-shot schemes over modest and humble endeavors.
Whether bitcoin itself goes the way of the South Sea Company has yet to be determined. But what is certain is that, if and when the SEC chooses to restrict the growth of this sector, much like British parliament’s enactment of the Bubble Act of 1720, prices for these ‘undertakings of great advantage’ will quickly fall to zero.
Sailing ship image via shutterstock