Recently, a friend of mine sent me an article explaining how a cryptocurrency, Dogecoin, created as a joke, now boasts a market capitalization of $2 billion. I was shocked: the market deemed this currency valuable when its own creator had not. After looking into this issue, I realized that the success of the entire cryptocurrency industry is no more logical than the rise of Dogecoin.
In 2018, it is becoming increasingly clear that so-called “virtual currencies” are not legitimate currencies. They fail to fulfill the functions a currency is supposed to perform. Rather than regard cryptocurrencies as currencies, markets treat them as highly valuable investment vehicles. However, there does not seem to be any evidence to justify this treatment either. This article attempts to demonstrate a critical flaw in virtual currencies: there is no sound answer to the question, “What justifies cryptocurrency prices?”
A Tech Revolution?
Blockchain, the technology behind cryptocurrencies, has enormous potential. Countless academic articles could be written about this infrastructure. Bitcoin itself started with such a paper. In 2008, the currency’s anonymous founder, Satoshi Nakamoto (a pseudonym), invented a system that could support “a purely peer-to-peer version of electronic cash [that] would allow online payments to be sent directly from one party to another without going through a financial institution.” I encourage computer science enthusiasts to read Nakamoto’s paper in its entirety, but, for the purposes of this article, the reader needs to know that the technology crowdsources the transaction confirmation process. Market participants, who perform this auditing job, are colloquially called “miners.” The consolidation of miners’ computing power maintains a public ledger of transactions. Participants essentially “vote with their CPU power” on whether a transaction was ordered with good faith. When the combined computing power of honest miners is greater than hackers’, the system is thought to be virtually impenetrable. Though the network itself is safe, hackers can indirectly hack investors’ holdings in intermediary digital wallets. This level of security is analogous to a physical currency that can never be counterfeited or stolen.
Due to its decentralized network, the platform’s success hinges on incentivizing enough honest actors to ensure the ledger’s integrity. Anyone who has read the comments section of any forum knows that there is no shortage of bad actors on the internet, complicating Bitcoin’s task. Surprisingly, though, the commission system seems to have attracted enough miners to achieve a reliable, public ledger system.
Bitcoin transaction fees are determined by a demand-supply mechanism. Investors, who order a transaction, require miners to facilitate that transaction. Their willingness to pay for this service constitutes the demand for the validation of trades. In turn, the supply is formed by miners who are willing to allocate their computing power to validate these trades at market prices. The price mechanism enables miners’ limited computing power to be allocated efficiently.
In the short run, the supply of computing power is fixed. Therefore, when the demand for transactions increases, fees rise unless existing miners expand their operations and new miners quickly enter the market. For example, tremendous trade volumes in December 2017 more than quadrupled transaction fees, from seven dollars to thirty. The free-floating transaction fee is evidence that economic incentives are built deep into this technology.
Unsurprisingly, Bitcoin’s use of the public ledger system has many prominent supporters. Sir Richard Branson, the billionaire businessman and founder of the Virgin Group, equated Bitcoin to his own ventures and commented that this infrastructure is “driving a revolution.” Branson is not alone: technology magnates like Microsoft founder Bill Gates and the Alphabet executive chairman Eric Schmidt are also hopeful for this technology’s future.
A New Currency?
It is well-known (though rarely voiced) that the singular force affirming the legitimacy of the American dollar, Euro, or any other fiat currency is the public’s faith in the system. That trust is derived from governmental backing and expediency. The system is stable insofar as it facilitates a useful medium of exchange, store of value, and unit of measure. Despite the ostensible success of existing monetary policies, many disgruntled libertarians (including the University of Chicago’s Milton Friedman) have been longing for a new system that would remove the government from the equation. Their wishes seemed to have come true in 2009 with Bitcoin, the first prominent digital currency of its kind. Over the last decade, Bitcoin and its variants have disrupted the financial industry and economic conventions. Yet, this disruption is not caused by the emergence of a true alternative currency: such a virtual currency has not emerged. Instead, Bitcoin’s success has been fueled by the unjustified view that cryptocurrencies are somehow reliable investment vehicles.
Over the last year, cryptocurrencies have experienced tremendous growth. The total market capitalization of all publicly-available cryptocurrencies went from around $17 billion to a high of around $830 billion—an approximately forty-eight-fold increase in value. In the same timeframe, gold prices (USD/kg) rose from around $38,000 to $43,000—an approximately 13 percent appreciation. Crude oil prices (USD/bbl), starting around $53, reached around $63—an approximately 19 percent increase. Cryptocurrencies dwarfed the growth in both of these highly-demanded commodities. Comparing market cap to prices might not always be completely accurate. For example, if Bitcoin supply increases but its price does not fall proportionally, the market cap increases. Yet, clearly the price does not necessarily increase. So, this comparison between cryptocurrencies and commodities need to be taken with a grain of salt. Nevertheless, the drastic difference between 4,800 percent and 19 percent is telling. This level of growth strongly suggests that markets see virtual currencies not as currencies but as investment vehicles.
Cryptocurrencies are partly victims of their own success. Their prodigious growth causes drastic variability. And this volatility makes digital currencies unsound stores of value. Adding to their troubles, their decentralized validation systems make them a cumbersome medium of exchange. Moreover, no mainstream analyst would ever use cryptocurrencies to measure the value of an asset—just as s/he would not value the S&P 500 index in terms of Tesla stocks. That is, on all three accounts of what a currency should be (a store of value, a medium of exchange, and a unit of measure), free-floating cryptocurrencies like Bitcoin fail. Ultimately, all evidence points to the fact that virtual currencies are currencies only in name.
A New Investment Vehicle?
If cryptocurrencies are not real currencies, considering that the markets view them as very valuable, their value should be derived from somewhere else—right? Unlike conventional stocks, Bitcoin and its variants do not have underlying assets and thus do not generate cash flows. So, their intrinsic value is not analogous to the intrinsic value of a stock. And, unlike conventional commodities, currently-available cryptocurrencies cannot be used as inputs for any sort of production. In other words, they are not a useful commodity. Moreover, the underlying technology that is said to ensure investors’ faith in the system is not even proprietary. Anyone can copy it. That is why there are more than a thousand different competing cryptocurrencies.
So far, there does not seem to be an economic rationale for cryptocurrencies’ unparalleled success. Despite this short-run irrationality, many observers have faith that, in the long-run, markets will rectify the discrepancy between empty speculation and real value. As legendary investor Warren Buffet remarked, “I can say with almost certainty that [cryptocurrencies] will come to a bad ending.”
Proponents of virtual currencies could highlight some features and present them as value drivers. First, they might assert that society is benefited by the decentralized system’s endorsement of any and all transactions made on the platform. Unlike Bitcoin and its variants, proper institutions attempt to intercept transfers made for unlawful purposes. Financial intermediaries like Venmo are legally obligated to monitor the flow of funds. Some people see the independence afforded by cryptocurrencies as invaluable. However, this level of liberalization is opposed even by UChicago’s Nobel-winning economics professors Eugene Fama and Richard Thaler, and anyone else who is not allergic to law and order. It is hard to understand how the complete lack of oversight can be seen as a benefit to society when many studies suggest that cryptocurrencies fuel terrorist activities, drug deals, and money laundering.
Here, I am compelled to respond to the claim that unlawful activities could not be funded with cryptocurrencies if these so-called currencies were not a store of value and medium of exchange. This claim fails to distinguish between current market trends and conditions that economic theory predicts will prevail in the long-run. This article demonstrates that cryptocurrencies are not real currencies from a rational, economic standpoint. Yet, clearly, markets have deemed that these platforms are somehow valuable in the short-run. Hence, criminals can use virtual currencies for their illicit activities even if valuations are unreasonable and artificially propped up.
A second claim could be that the extensive network of miners creates value for platforms by assuring market participants that their investments are safely maintained. But this argument seems to assume some sort of stability in computing power allocation. Miners are not contractually obligated to continue using Bitcoin or any of its variants. As blockchain is open-source, miners can swiftly migrate between different platforms with essentially zero switching costs. In other words, the added value that miners bring to any particular cryptocurrency is temporary and malleable.
Another claim could be that the decentralized system creates value by circumventing commercial banking fees. However, this view is only half right because most, if not all, market participants, after selling their cryptocurrencies, transfer their balances to their bank accounts anyway. Moreover, cryptocurrency transactions are not free. The cosmetic difference between a banker’s collecting the fees versus a programmer’s collecting them does not improve consumer well-being. Altogether, the arguments made in favor of cryptocurrencies are flimsy at best. It seems that there are too many programmers and not enough economists in the camp of Bitcoin and its variants.
For a long time, cryptocurrency markets have been left to the free market’s own devices. Interestingly, cryptocurrencies have been mostly overlooked by the financial sector. The adoption of Bitcoin and its variants by financial institutions would confer sorely missing legitimacy to these decentralized exchanges. However, a groundswell of institutional support is highly unlikely as the founding principle of cryptocurrencies is anti-institutional in nature. In any case, without protections from the government, so-called currencies like Bitcoin are open to market manipulations and crashes. Hence, if the implementation of cryptocurrencies does not evolve, the very idea of wealth management by decentralized networks could collapse alongside Bitcoin prices. A solutions is immediately clear. Cryptocurrencies could be refined to serve as real currencies.
Despite all the shortcomings of these early cryptocurrencies, anchored digital currencies have great potential. Moving past speculative instruments, consumers have a natural demand for safer versions of digital currencies. Use of cash has been steadily declining in modern times, and a vast majority of funds are already kept digitally. Therefore, the idea of anchored cryptocurrencies is compatible with current consumer trends. A fixed exchange rate between digital and physical currencies could make cryptocurrencies functional for the general public. However, the integrity of this currency peg could probably be sponsored only by a reputable institution with the authority to enforce monetary policy: central banks.
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Ege Y. Ercan
Ege Y. Ercan is an economics major in the College. He has interned at the Central Bank of the Republic of Turkey and is a research assistant for Dr. Simcha Barkai's UChicago research team, focussing on economic impacts of anti-trust enforcement.