Making sense of cryptocurrencies

From your Uber driver to that long-lost Facebook friend, it seems everyone is jumping on the cryptocurrency bandwagon.

The narrative has dramatically evolved from flash-in-the-pan plaything of digital obsessives, to a global movement that has the world’s major financial institutions and governments taking notice. So will cryptocurrencies become the poster child of a speculative bubble, or find themselves a core component of the digital economy? 

What are cryptocurrencies?

Cryptocurrencies have been around for almost 20 years but the first cryptocurrency that has received widespread acceptance is Bitcoin. Bitcoins are created when complex mathematical problems are solved via computer to create a ‘block’. Each block is stored on the blockchain, a ledger of all transactions that is decentralised and distributed across a network of computers and transparent to all to prevent cheating. The source software to create a Bitcoin limits the total amount of Bitcoins to 21 million (there are currently over 18 million in circulation) with the number of coins created per ‘block’ increasingly diminishing the closer that ceiling approaches. As a result, it takes more and more computing power, and more and more energy to power those computations to produce Bitcoins, and manage the blockchain. The potential environmental cost is large, with Cambridge University researchers estimating Bitcoin already consumes as much power as the Netherlands.¹

All cryptocurrencies are designed to act as a form of payment or store of value and most operate outside the control of governments or corporations, making them particularly attractive to entities looking to hide financial transactions like money laundering.

That makes them different from Fiat currencies, e.g., US dollar, British pound, etc., which are currencies linked to a country and its specific economic conditions as managed by their central banks, and operated on highly regulated exchanges.

The lack of a regulated marketplace for cryptocurrencies, by contrast has led to numerous scams, ranging from Ponzi schemes to fake exchanges and currencies.²

Speculative bubble or the future of money?

The stratospheric rise in the value of cryptocurrencies like Bitcoin – which rose from $US7,690 a year ago, to $US62,600 earlier this month, for a market capitalisation of $US1 trillion, has been fuelled more by speculative frenzy, rather than any resounding use case. The huge surge in financial stimulus from governments worldwide is driving investors into risky assets – with cryptocurrencies driving the most outsized returns.

But while some companies, such as Tesla, will accept Bitcoin as payments, there is limited widespread use of the cryptocurrency as a unit of exchange. Indeed, the very volatility experienced by Bitcoin and others would make it near impossible for any retailer to price goods to account for the wild fluctuations.

Investors in cryptocurrencies have likened it to holding gold as a hedge against market fluctuations of equities or fiat currencies, positing that as a store of value it sits outside of the economic dynamics that move markets. Many consider that as inflation resurfaces, both markets and currencies will be hit but that cryptocurrencies will be immune.

But currently Bitcoin, for instance, only has value inasmuch as people think it will be worth more in the future, a scenario that only really works if you follow the logic that it will eventually replace all currencies, argues a leading professor from the London School of Economics.³ If Bitcoin doesn’t replace existing currencies, he says, then its value theoretically should fall to zero, leaving many investors burnt.

But there is certainly momentum behind crypto assets and new cryptocurrencies are being launched regularly. Combined with Bitcoin’s $US1 trillion market cap, the total current value of cryptocurrencies sits around $US2 trillion, but it remains a small component of the investment landscape.

The US share market alone, for example, is valued at around $US49 trillion;⁴ the global value of gold (according to the World Gold Council in 2019) was $US9.6 trillion⁵, and the global forex market, according the Bank of International Settlements (Dec 2019), transacts $US6.6 trillion per day.⁶

Precious metals like gold and silver have been traded for millennia, and shares and currencies have been traded since the 1600s, making those markets deep and robust. By contrast, despite the meteoric rise in value, cryptocurrencies are still in their infancy, and prone to wild swings in value based on sentiment. 

The inability to properly price a cryptocurrency like Bitcoin is also problematic. Whereas a share is a claim to ownership in a company with sales, customers and physical assets, and currencies are backed by the power of a nation state and its economic prospects, a Bitcoin relies on the value the market is willing to pay. It’s unclear how much the price of cryptocurrency comes from scarcity, the potential for application or the entrepreneurial story behind it.

What cryptocurrencies and blockchain technology do represent is the potential to transact in a far more seamless way that is appropriate to the digital landscape evolving worldwide. Frictionless payments that can take place at scale is the holy grail in a future where billions of connected devices will interact autonomously with each other. Of course, you could also argue that frictionless payments are rapidly becoming part of transacting with the money we already use, and national currencies have worked just fine as a store of value for millennia. 

With a well-regulated, long-standing and effective payment system already a central institution of the global economy, what would it take for cryptocurrencies (particularly given how many are competing for attention) to become a widely accepted medium of exchange? Most of the world’s financial experts still argue that crypto will always be a bit player, rather than the mainstream. Some speculate it could become a financial instrument that mirrors the price of the asset (like gold and oil).  Although we may not be adopting cryptocurrency for our everyday payments anytime soon, we can expect blockchain and crypto innovation to continue to be adopted across industries as part of the worldwide digital evolution.

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¹https://www.bbc.com/news/science-environment-56215787
²https://www.fool.com/the-ascent/buying-stocks/articles/protect-your-wallet-8-bitcoin-scams-to-watch-out-for/
³https://voxeu.org/article/what-happens-if-bitcoin-succeeds
⁴https://siblisresearch.com/data/us-stock-market-value/
⁵http://www.perthmintbullion.com/au/blog/blog/20-07-02/How_big_is_the_global_gold_market.aspx
⁶https://www.bis.org/publ/qtrpdf/r_qt1912f.htm