Cyber Assets, Digital Currencies, and Money

new abstractIt does seem that we in an era where language has been debased.  Friends on Facebook are not friends in the way that word has traditionally meant.  Grande at Starbucks does not mean large, but it is their second-smallest serving. 

In 2013 and 2014, the desire for an alternative to fiat, central bank controlled currencies were called Alt-Coins.  Now, as interest has grown, they are often referred to as cryptocurrencies.  However, crypto and currencies are names that do not have their common meaning.  Crypto refers to secret allegiance to a political creed.  This is an unnecessary obfuscation and gives an aura of a cult.  Currencies refer to money, and yet rarely are the cryptocurrencies used to purchase goods or services or retire financial obligations.   

Economists mean something specific about money.  It is a means of exchange.  It is a store of value.  It is a unit of account.   Cryptocurrencies do not provide any of these functions.  This could, of course, change in the future, but there is a contradiction at the core.  If cryptocurrencies are to be a preferred alternative to central bank money, then it makes sense that they are hoarded.  However, the more they are hoarded, the less they are used as a means of exchange and do not reach that critical networking mass.

Some places that do accept Bitcoin, the most popular and largest among the cryptocurrencies.  But this seems to be more a novelty and marketing ploy.  A company that accepts the cryptocurrencies faces exchange rate risk as it was just paid in a “foreign currency.”  This may seem acceptable provided the crypto-currency is appreciating, but corporate treasury offices, for the most part, do not seek to be profit-centers of the business.

Given what appears to be the historical link between money and taxes, we thought that a test for the viability of this crypto-currencies is if a sovereign accepts them in for payment.  A small town in Switzerland (Chiasso), near the Italian border, says it will accept Bitcoin for taxes but caps it at CHF250, which also makes it a bit of a novelty. It also begs the question what will the town do with the Bitcoins, as there is not much that town can buy with them.

In the US, before the Federal Reserve, the banks in different states would issue bills that would trade at discounts in other locales.  It was as if there were as many different monies as states.  This seemed to be hindrance inter-state trade and the development of a national economy.

Imagine that each state has its own currency.  It would be terribly inefficient.  This was the case in Europe before the advent of the euro.   A shopkeeper now willing to accept cryptocurrencies for payment might need a  huge price matrix as there are over 100 presently  Given the high fixed costs and practical considerations, perhaps there is a tendency for a natural monopoly of currency issuers.

In the polemic zeal and in the face of surging prices, the inefficiencies and limits on the ability to scale have been brushed over.  Consider, for example, that now there may be 300k Bitcoin transactions a day.  VisaNet, just to pick one of the main credit card companies, can process  56k transactions messages a second.   For Bitcoin, the most active of these cryptocurrencies do not need to simply double or triple is speed to compete with an alternative.  Visa.net  can handle more than 150 mln transactions in a single day.

The price to pay for a decentralized payment system is high.  Consider that the mining (solving extremely difficult mathematical problems and the confirmation of each transaction requires a great deal of electricity, which is why the miners (who are also verification services) are increasingly located in areas that have cheap electricity.  Estimates suggest that each Bitcoin transaction uses roughly the same amount of electricity as a US household may use in a week.   The Bitcoin runs counter to conservation and concerns about the environment.

The cost of producing a Bitcoin is a function of the price of computing power needed for the mining and the validation process.   More computing power is needed to solve the mathematical challenges and this, in turn, requires more electricity.   One estimate suggests that the Bitcoin ecosystem was using around the same amount of electricity as 2.26 mln homes.    Bitcoin currently accounts for around half of the daily turnover of cryptocurrencies.

Many argue that cryptocurrencies are anonymous, but this is not as true as it is supposed.  Reports suggest that there are currently people in jail who used Bitcoins to procure contraband.   The US tax authorities are also working with a company called Chainanalysis, which monitors the cryptocurrencies for high frequency and large trading.   The state has at least two legitimate interests.  Illegal activity, including money laundering and financing for terrorism and the avoidance of taxes.  Despite the talk among many participants in how much money they have made, only 802 people reportedly paid taxes on their Bitcoin profits in 2015, according to press reports.

Some proponents assert that the cryptocurrencies are unseizable, immutable, inflation-resistant, non-correlated to other assets and are a store of value.  Yet these claims have not been proven.   They simply have not been around long enough to know if they are indeed immutable, inflation resistant and non-correlated to other assets.  The price of many cryptocurrencies appears too volatile to be a store of value yet.  They are experiencing amazing price appreciation for sure, but that is not evidence of a store of value.

Are cryptocurrencies not correlated with other asset prices?  The ample liquidity and the high levels of capital sitting on corporate balance sheets and intermediated by the financial system are driving all asset prices higher.  All risk assets are having a banner year, like the corporate bonds, emerging markets, and high yield bonds.  Consider that MSCI Frontier Markets (equities) is up more than a third this year and Emerging Markets are up nearly 24%.   Isn’t it possible that the cryptocurrencies are correlated to risk assets, and when the broad risk appetite changes and the lower quality assets are marked down, that the cryptocurrencies also fall?

While cryptocurrencies may be disruptive, they have not negated the economic principle of trade-offs.  There is no free lunch.  In order to achieve a functioning, trustworthy, decentralized payment system is extremely expensive.  It leaves a large environmental footprint and has low transaction capacity.   Do most transactions really need to bypass a central third party, like a bank or credit card company?

Owing to the anonymous and decentralized nature of cryptocurrencies, it is difficult to speak to the market structure.  However, two things appear likely.  First Bitcoin ownership appears highly concentrated.   Many miners also have had to pool their computing power as the math problems become more difficult.  Second, the value of the daily turnover appears to be around 5-10% of the market cap (outstanding dollar value of all Bitcoins).  It appears that most Bitcoins are not traded or used as a means of exchange to buy goods or services.

Still, the stellar appreciation of many of the cryptocurrencies has fostered a sense of FOMO (fear of missing out).  The CME is in the process of launching a futures contract on Bitcoins, which will be among the first ways one can short the Bitcoin in real time if one was so inclined.  Others are looking for ways to participate.  Some banks are looking at whether they can accept a client’s cryptocurrencies like they would other assets.  To be sure the ecosystem is still evolving.  The underlying problems with them as a form of currency or a store of value, the non-correlated characteristic claims, the environment footprint, and the difficulty in scaling is not addressed by a futures contract, an ETF, or the like.

Stocks and bonds are assets.  There are agreed upon models of valuation.  There is an income stream or earnings stream associated with them.  There is a debate in the literature whether currencies are an asset class.   Central banks may issue their own digital currencies.  These would likely be digital forms of their current currencies and not new instruments.

The future of cryptocurrencies may not lie as an alternative to fiat money issued by sovereigns.  It may not be in crypto anything.  It may be a new asset class, a cyber asset that enables decentralized applications.     These applications are related to cyber assets as emails are related to the internet.  Its still early days for the development of such assets, and just like when the internet was commercially launched, investors (as opposed to speculators) need to be careful of being sold vapor-ware by well-meaning zealots as well as some that may be less well-meaning.