Cryptocurrencies have taken the world by storm. At a price of about $43,000 as of the writing of this newsletter, Bitcoin has a market capitalization of $815 billion, based on 18.9 million tokens in supply. Ethereum has a market capitalization of $390 billion.[1] So, cryptocurrency is for real.
Note that cryptocurrencies themselves are not SEC-approved or listed securities, which means we can’t invest directly in them due to the regulations that apply to us. In October, the SEC approved the first cryptocurrency ETF, which uses derivatives to track bitcoin. In addition, publicly-traded companies approved by the SEC trade on the exchanges and hold cryptocurrencies, providing indirect exposure. The SEC is evaluating other ETFs but declined to approve an ETF that invests directly in cryptocurrencies.
We cannot recommend investing in cryptocurrencies, partly for regulatory reasons and partly because they are too speculative. Instead, we are providing an economic analysis of what bitcoins are and how they might impact the financial system. These are observations and opinions. Our opinions are subject to debate, and we may revise our opinions in the future. However, this is our effort to frame the issue and how to potentially think about cryptocurrencies.
The first cryptocurrency was Bitcoin, launched in 2008, defining itself as “a decentralized digital currency that enables instant payments to anyone, anywhere in the world. Bitcoin uses peer-to-peer technology to operate with no central authority: transaction management and money issuance are carried out collectively by the network.”[2]
Bitcoin transactions are: permissionless and borderless, anonymous, private, censorship-resistant, fast, cheap, irreversible, online, and always available. Bitcoins cannot be printed or debased, with only 21 million bitcoins that will ever exist. It has no storage costs, is easy to protect and hide, with no counterparty risk, and can have divided ownership.[2] Cryptocurrencies eliminate the middleman in transactions, like banks and financial institutions, with transactions that can occur across the globe.[3]
The most popular cryptocurrencies are Bitcoin, Ethereum, Bitcoin Cash, and Litecoin. A web search will quickly turn up lists of hundreds of various cryptocurrencies. Of these, Bitcoin and Ethereum are by far the largest.
From Bitcoin’s own definition, its primary selling point appears to be secrecy. In addition, cryptocurrencies are also often seen as an alternative to banking and credit cards. It is this latter part that offers insight into cryptocurrency’s long-term appeal.
Crypto as a Form of Money
One thing that makes cryptocurrency so exciting is the possibility of replacing money, like dollars or Euros. If it could dethrone the dollar, that would be tectonic. Therefore, this is worth exploring in detail.
Money is a bit of an ambiguous concept. It is a concept that people often get confused about. What is money? Money performs one or more of two functions: a medium of exchange, and transactions.
The phrase, “medium of exchange” has a tricky definition. This is not the same as a medium for transactions. “Medium of exchange” means that all other assets and liabilities are valued in reference to the currency. In the US, everything is priced in dollars. It turns out that is true in many parts of the world, even if dollars are not actually used to buy and sell things or for transactions. Therefore, even though Tesla once accepted bitcoins as payment for its cars, its cars are still priced in dollars and the bitcoins were either converted to dollars or transferred to an investment account.[4]
As a medium of exchange, money needs a critical feature: a stable and predictable value. In order for it to have a stable and predictable value, it must be trusted. The value of a currency is often referred to indirectly as its inflation rate: the higher the inflation rate, the more rapidly the value depreciates.
In contrast, a transaction currency (also referred to as a “medium of account”) is a currency in which transactions are conducted. For that to work, it has to be widely accepted by buyers and sellers in the context in which it is used. That context was historically geography – the dollar was accepted in the US, while the pound was accepted in the UK.
A currency can be a transaction currency but not a medium of exchange. Or it could be a medium of exchange but not a transaction currency. In the old days, before 1971, the dollar was a transaction currency but not a medium of exchange. The medium of exchange was gold, as the dollar’s value was determined at a fixed exchange rate to gold. Gold was the medium of exchange, but not (usually) a transaction currency.
Central banks and monetary economists have determined that a low but stable inflation rate of 2% to 3% is optimal in the US and most developed economies. That inflation rate is low enough to be predictable and stable, but positive enough to supply liquidity to the economy so as to overcome various “frictions” – or the slowness of the economy when adjusting to various shocks that routinely hit it. The pandemic, for instance, was a very large shock, but every year there are many little shocks or changes that impact the economy, and a little extra liquidity helps to smooth out those adjustments.
When the inflation rate is unstable, or the value of money is not stable, lots of bad things can happen. Instability begets more instability: people change their behavior to protect their wealth, savings rates can rapidly go up or down, debts can increase (with deflation) forcing liquidations of assets, and banks can be destabilized as they intermediate saving and borrowing.
Note that this does not mean that inflation or deflation is always bad – temporary inflation or deflation can be a sign of health in a recovering economy that is adjusting from a major economic shock.
Currently, we believe that crypto’s price volatility is way too high for it to function as a medium of exchange. Bitcoin has been on a wild ride: just since April Bitcoin has gone from a high of $65,000 to around $29,000, back up to $70,000, and currently is just about $43,000.[5] That just doesn’t cut it for money when it comes to stability.
High price volatility often results from a lack of liquidity: the markets are not deep enough and participants are too few, with trading volume affected by a few big buyers and sellers, or by relatively unimportant news events. High volatility can also result when there is very high degree of uncertainty about the future. Paradoxically, the high volatility can actually temporarily increase the price of the asset, under a framework called option pricing theory.[6]
Gold also turned out to be too volatile for modern economies. While gold was the medium of exchange for centuries, the system proved to be too unstable in the 1930s and again in the early 1970s. Based on our own internal research, we estimate gold price volatility (standard error) to be roughly 8% annually, relative to trend.[7]
Since 1971, most modern currencies, including the dollar, are “fiat” currencies. That means that the value is not fixed to the value of gold or some other asset, and the supply is managed by the central bank and adjusted to meet demand. The dollar is now both a medium of exchange and a transaction currency. Since we went off of the gold standard, the average annual volatility of the dollar has been much less than that of gold, especially since the early 1980s.
Crypto functions by limiting supply. In this sense, it is a lot like gold – gold’s supply is also fixed for practical purposes. Rather than being determined by nature, Crypto imposes the limit via computer algorithms. In the case of Bitcoin, the limit is 21 million tokens to be reached around 2040. The basic premises of Crypto is: fixed supply, higher trust, and partial anonymity.
Is crypto’s supply really fixed? Bitcoin’s supply is fixed. But new cryptocurrencies are created all of the time. The emergence of copycats undermines a cryptocurrency’s appeal, and could even undermine trust in it – as a medium of exchange.
Crypto for Transactions
Crypto is a store of value. That means that one can buy it and it has value. However, as we have seen that value is not stable. This is true about a lot of things: gold, bonds, real estate, stocks, fine art, etc. Therefore, these assets do not function as mediums of exchange. Were the dollar to fail, then people would probably move to the next best thing as their medium of exchange: which right now is gold.
Crypto may be a transaction currency. It is useful for eliminating banks and/or transacting across borders. Indeed, that may be its primary benefit, rather than as a true currency. However, transaction currencies typically function by fixing their value to some other currency, like the dollar. Most cryptos (except stable coins) have floating exchange rates, forcing vendors to convert the crypto back into dollars or other currency immediately, or absorb the risk of the crypto’s volatility.
A key argument in favor of crypto is the ability to transact securely. We live in a world where our Amazon accounts and credit card numbers get hacked regularly, and we have to monitor our banks and credit record to ensure nothing untoward has happened. Personally, I just added two-factor authorization to all of my ecommerce accounts where my credit cards are exposed, which is a pain but necessary. I pick my credit card company partly by how easy it is to get them to make me whole when I find false charges on my statement (no questions asked). And if we think this is a problem in the US, let’s not get started about poor countries. The ability to transact in a secure – and stable – electronic currency is pretty attractive.
Crypto also looks like a system of regulatory arbitrage. Traditional banks are encumbered by an extensive system of regulation, often for good reasons though sometimes not. Crypto allows consumers and sellers to bypass much of that regulation to engage in cheap and easy transactions.
Are governments threatened by crypto? China has aggressively banned it. However, China’s financial system operates on high levels of central government control and comprehensive surveillance. Their economic model is premised on the ability of the government to control transfers, as well as borrowing and saving. Crypto’s secretive nature may be a torpedo to the heart of that system of control. However, China doesn’t have a reserve currency – its currency value is mostly set in reference to the US dollar and is not really floating (though it does allow its currency to appreciate and depreciate modestly). Therefore, China’s reaction appears to be unique to China.
The US government is interested in regulating it, but the concerns expressed are twofold: the risk that the cryptos will go to zero and investors will lose money, and the concern over its use to launder money and engage in illegal transactions. And US regulators like to engage in surveillance as well, and are worried about regulatory arbitrage. Cryptocurrencies do not appear to be threatening the dollar itself. To that end, US banks are likely pushing for more regulation of cryptocurrencies, but also seem intent on cashing in on it.
Conclusion
Our conclusion is tentative because this is a rapidly evolving space. We do not currently believe crypto is money in a technical sense: as a medium of exchange, nor does it really function well as a transaction currency. We do believe that it holds considerable promise in securely transferring money in transactions and across borders, is potentially a disintermediating force in the financial system. It functions as a store of value primarily because of its security. If its volatility can stabilize then it might work as a transaction currency.
We also believe owning it holds considerable risk. The current investment interest may be a bubble that could deflate as investors chase the next new shiny thing. High volatility assets often form bubbles, as the volatility itself can temporarily increase the asset’s value as investors seek to take advantage of the volatility. Indeed, if it is to be successful as a currency of any kind, the volatility will need to settle down, and that does not necessarily mean settling down at a higher price or even at the current price.
As always, feel free to reach out and discuss any questions you might have!
[1] January 14, 2022. Source: Factset. Market capitalization is defined as the supply of tokens multiplied by the price. Market capitalization is not equal to the volume of money invested, and is a number that can change rapidly. If every owner of tokens were to sell simultaneously, the amount withdrawn would not equal to the market capitalization, and would probably be much less.
[2] Bitcoin Wiki, https://en.bitcoin.it/wiki/Main_Page
[3] Coinbase, What is cryptocurrency? | Coinbase
[4] Tesla accepted bitcoin as payment from March to May 2021, and in July Elon Musk indicated that it would accept bitcoin when there was evidence that at least 50% of the energy consumed by bitcoin comes from renewable sources. In an SEC filing in October, Tesla said it might consider accepting cryptocurrency as payment.
[5] January 14, 2022. Source: Factset.
[6] This is very technical, so we won’t bore you with the details. But basically, when an asset has high price volatility, participants have more opportunities to make money, so will bid up the price of the asset. This works until the volatility drops. In other words, it works until it stops working. This only happens in instances of very high volatility.
[7] One theory of gold holds that gold’s value does not fluctuate, and that all measured price volatility of gold is really just measuring the volatility of the dollar. This theory of gold’s value is rejected by the majority of monetary economists, but is implied by information easily found on the Internet.
The views expressed are not necessarily the opinion of Commonwealth Financial Network and should not be construed directly or indirectly, as an offer to buy or sell any securities mentioned herein. Bitcoin and crypto currencies are not offered by Commonwealth. This material is for general informational purposes only and is not intended to be a substitute for professional financial, tax or legal advice.
Advisory services offered through Commonwealth Financial Network®, a Registered Investment Adviser. Financial and exit planning services offered through Alliance Private Wealth LLC are separate and unrelated to Commonwealth.