Cryptocurrencies - Questioning The Value Proposition

Authored by Stephen Englander via Rafiki Capital Management,

Bitcoin is deciding whether this is the moment to crash and burn.

My conjecture is that cryptocurrency holders are trying to decide whether to abandon Bitcoin because its limitations mean it will be superseded by better products or bet that it can thrive despite them.

The dilemma is that once you stop pricing Bitcoin and its derivatives as new assets that will head to the moon, the pricing model is more conventional and much less breathtaking.

We discuss these issues below.

Below we go through some of the questions on why Bitcoin and cryptocurrencies have certain characteristics, and whether these characteristics are needed or even desirable.

  1. Is Bitcoin Netscape?
  2. How limited is the supply of cryptocurrencies?
  3. If Bitcoin crashes what happens to other alt-currencies?
  4. What asset market lacunae do cryptocurrencies fill?
  5. Why mine?
  6. Why distribute the ledger?
  7. Do cryptocurrency transactions need coins or tokens?
  8. Can you make cryptocurrencies KYC and AML compliant?​

1) Is Bitcoin Netscape?

Bitcoin emerged in the shadow of the financial crisis, when the reputations of the financial and economic policy community was at a post-1930s low. It is designed for a world in which there is no confidence in major fiat currencies. Bitcoin gives you pseudonymity
  New York, 16th January 2018 (albeit imperfect), the distributed ledger means that transaction records are unlikely to disappear, the mining can take place anywhere and there are built-in incentives for miners to keep mining.

The question is whether there is a problem that the original Bitcoin solves in developed economies. Some Bitcoin characteristics superficially suit a ‘Mad Max/Hunger Games’ world, but add little now. My suspicion is that even in the Mad Max world, the value of Bitcoin will be de minimis since hard assets will be the currency, not an abstract string of code. 

Bitcoin may nonetheless be optimized for parts of the world that have harsh capital controls or dysfunctional governments, and for illicit transactions (although even here better versions exist). The characteristics listed above are helpful in preserving capital where security of capital and asset ownership does not exist.

Pseudonymity, a distributed ledger and mining do not seem essential in developed economics and may even be drawbacks for many useful applications of the technology. It seems straightforward to design a cryptocurrency that is optimized for enabling cheaper transactions and recording of asset transfers and other transactions within the developed economy financial system. Some of these already exist and may be gaining on Bitcoin. Over time they may well supersede Bitcoin.

There are paths by which Bitcoin could remain dominant, helped by its first mover advantage. However, there are likely many more paths by which it becomes a footnote either by cryptocurrencies that have functionality in transactions but not as a store of value, or because competitor alt-currencies are just better.

2) How limited is the supply of cryptocurrencies?

One of the weakest element of the Bitcoin/cryptocurrency origin mythology is the limited supply. That argument is still used to justify pricing Bitcoin off gold and other stores of value. As if Bitcoin cannot be replicated cheaply and indefinitely. Forks are increasingly popular because it feels like you are getting additional cryptocurrency for free. But some may notice that is an arbitrary supply increase. 

There are no barriers to entry on the crypto space, other than a good story about the niche that your coin is filling. The number of ICOs tells you that it is easy and cheap. There are big incentives to get in on the ground floor of a cryptocurrency that has even moderate acceptance.

3) If Bitcoin crashes what happens to other alt-currencies?

The possibility that Bitcoin is superceded by better alt-currencies has important implications for the class. In fact, it likely determines the future pricing structure of these currencies.

Bitcoin’s price does not have a floor because it does not have a fundamental pricing model like equities and bonds. If its price starts falling because other products are available and better, there is little to stop it. As a thought experiment, say Bitcoin was trading today at $14k and stayed there for three months. Six months from now it dropped to $14 and stayed there for three months. What would you look at to figure out which was the right price?  The run-up in Bitcoin created a mystique of one-way trading which is being shaken but the pricing requires faith that there will always be demand. This is far from guaranteed given the existence of alternatives with better characteristics.

If Bitcoin crashes, investors in other alt-currencies will likely become more demanding in terms of the value proposition and link value to functionality, rather than faith. I can value a cryptocurrency that collects a fee for performing or recording transactions, but that value is likely to be different than as an alternative to gold or fiat money. This means pricing alt-currencies off credit card companies, depositories and other companies that provide similar transactions and recording services. That valuation is likely to be much more prosaic than the valuation now attached to cryptocurrencies as assets.

4) What asset market lacunae do cryptocurrencies fill?

If you are not afraid of a financial breakdown, confiscation of your assets or the feds, can you pin down the asset characteristics of a cryptocurrency that give them value? Do they allow you to hedge risk, choose a preferred point on the asset market risk-return curve, give you a share in some productive asset, or shift consumption from now into the future in a reliable way?  

There are assets that are not much good in transactions (gold, the S&P ETF that you own) and transactions vehicles that are not great as assets (your VISA card, cash, the ATM at the corner dive that spares you the trouble of going to the bank). For now focus on the asset side and ask how capital in developed economies is better allocated because cryptocurrencies exist. (We discuss transactions functionality below.)

Enabling young people to invest in human capital without the rationing, naivete and moral hazards of current student loan programs would concretely improve savings-investment efficiency. I am trying to think of an analogous asset market problem that crypto assets help resolve.

The blockchain and other innovations associated with Bitcoin potentially could make transactions quicker, cheaper and less risky. However, this relates to their transactional functionality but is not here or there with respect to their desirability as an asset.

If you believe that capital controls are immoral, you can argue that coin and other cryptocurrencies allow you to protect your assets by skirting such controls. That is not a big issue in G10 economies, but there could be a genuine debate elsewhere. If you believe that taxes are not moral or that arms/drug dealing is, you can make a similar case for cryptocurrencies link. Most of us need a lot of convincing before we swallow that.

So I still struggle to determine a DM asset market problem that it solves. South Korea and a couple of other countries are rumored to be taking actions to limit or stop speculation in cryptocurrencies on the view that it is a waste of time and resources and does not contribute to the public good. 

A similar motivation was behind Montreal banning pinball in public for decades after 1955. I was a personal victim of the ban in my youth. There is an element of paternalism in limiting a very narrow and specific set of transactions, while allowing you to blow your fortune on horse races or at the casino. However, most of us have a hard time discussing our ‘investments’ at the race track or casino.

5) Why mine?

Mining in Bitcoin and its clones provides incentives to maintain the distributed ledger.  It is also extends the analogy between Bitcoin and gold, which is a very effective marketing device. It is clear there is a colossal waste of energy link.  

Digiconomist estimates that USD2bn worth of energy is being consumed to mine USD14bn of BTC. That means that the electricity cost is 14% of maintaining the blockchain and almost 1% of the Bitcoin market cap and likely to rise. It looks increasingly that cryptocurrency mining will be heavily concentrated in the locations where electricity is grotesquely mispriced. 

Originally the mining was probably intended to deal with the collapse of fiat currencies. You would have a bunch of miners and maintaining a bunch of blockchains and manipulation would be close to impossible. Mining has now become so concentrated that there is a possibility that the transaction record could become corrupted by collusion among big miners, or that transactions costs could be artificially elevated. 

Talking about large numbers of independent, decentralized cryptocurrency miners is like talking about the family farm in US agriculture. It’s a nice image but nowhere close to reality. Stories of individuals buying power plants to mine cryptocurrencies further weaken the narrative of a decentralized system that is coalition-proof link.

The only reason to have mining now is because it has become a defining characteristic of cryptocurrencies, even though it has no real purpose, except to jump start interest in new currencies by offering high returns to the initial miners. Given the huge built-in inefficiency of mining process, the question is can you get the benefits of a cryptcurrency without the mining process. Some altcoins do not have mining and this is likely the direction future coins will take.

6) Why distribute the ledger? 

The distributed ledger solves the problem of how to maintain the integrity of a decentralized system. It doesn’t establish a need for such a decentralized system or justify the costs that are associated with it.

What is the marginal benefit of the 51st ledger out there? You must fall back on the Mad Max world to really need so many replicative ledgers. Then you must believe that computer systems will be running. 

One of the selling points on public blockchains is that their dispersion would make them impervious to hacking and corruption. With mining operations so specialized and concentrated, that argument has gone be the boards. I have seen discussions in which it is argued that the gaming the blockchain would be self-defeating and will not happen, but that is not the same as demonstrating that it cannot happen. 

For many purposes private blockchains are likely to be more efficient. The need for replication is limited. Whether the security of the distributed blockchain exceeds that of private blockchains is unclear, as are the relative costs. Especially when there are a lot of transactions concentrated among a small number of participants, we are likely to see private rather than public blockchains dominate. My expectation is that we will come to see blockchains as clubs, rather than villages.

7) Do cryptocurrency transactions need coins or tokens?

My credit card enables me to transact across states and countries. But it doesn’t require that I buy a credit card asset or token. Say cryptocurrencies make cross-border transactions or asset transfers less expensive, or we use a blockchain to record transactions and contracts. It is obvious that fees will be charged for this service, just as the credit card company charges. But do we need a tradable asset with a fluctuating price as the medium for such transactions or records You can simply pay a fee to have the sale of your house or your employment contract put in the registry? Having a coin or token associated with these transactions doesn’t improve functionality.  

Once you accept the view that cryptocurrencies will make it easier to execute and record transactions, but are not themselves assets or a store of value, coins or tokens have as little inherent value as the token used by children to establish their right for a ride on the merry-goround. The firms that perform the transactions will have a value, just as credit card companies do, but that doesn’t mean that the coin linked to the service will have anything but a momentary value.

8) Can you make cryptocurrencies KYC and AML compliant?

Cryptocurrency exchanges within developed economies all have some form of AML and KYC compliance. There are some AML compliant cryptocurrencies but my sense is that the ones that promise complete anonymity are far more popular. It appears that Bitcoin and most clones are not quite as anonymous as once advertised, but it also takes some effort to de-anonymize. So, if you are trying to hide from your partner how much you paid for the Rangers playoff tickets, you are pretty safe. However, if the authorities were interested in your particular transaction, they are likely to be able to figure it out as well. 

Outside of DM economies it is likely that KYC and AML are not observed meticulously. Public blockchains record these transactions so they are not invisible, but they are harder to track than those made within organized DM exchanges with strict KYC and AML vetting. The question is whether the coexistence of a legitimate DM core and potentially shady non-DM spokes (or maybe a shady core and legitimate spokes) is feasible in the long term. My conjecture is that the coexistence will break down and that there will be a growing distinction between cryptocurrencies that operate fully within the global financial system and those that facilitate outside the system transactions.

Concluding comments

Cryptocurrency technology is likely to serve as the basis for executing asset transfers and storing the record of transactions and contracts. Mining, anonymity, and the distributed ledger are not relevant for most of these purposes. The case is not really made that cryptocurrencies are assets and that means that the current pricing proposition is shaky. It is possible that a private issued ‘fiat’ cryptocurrency will trade alongside other assets, but it is still not clear what would give it value.

The underlying proposition is like the Marxist interpretation of history. The intellectual breadth and audacity are breathtaking. The ability to think through ex ante how a new, decentralized currency asset could be constructed and maintained is remarkable.  But that doesn’t mean that the underlying premises are correct, or that it solves a problem anyone really worries about.