Disruptive innovations all have at least one characteristic in common. They percolate through an economy seeking a best use scenario because it’s the market, and not the inventor, that makes a determination of utility. Cryptocurrency is undergoing such a moment and it may be hampered by use of “currency.” Is it a currency or a security?
Cryptocurrencies have proliferated like rabbits. One study concludes there are 1,448 of them and the number is growing. https://coinmarketcap.com/all/views/all/ In a world of central banking, reserve currencies and sophisticated trading markets, is there a place for this asset category? There is little doubt that cryptocurrency is a disruptive innovation but its existence begs the question of what’s being disrupted.
Some advocates say that cryptocurrencies are a new form of currency that skirts the limitations of government-controlled currencies by avoiding regulations. But those principles also represent hard-won knowledge about how markets work and how best to control inflation and ward off the worst effects of recession. Also, there is little of value backing up cryptocurrencies which makes them pawns in a confidence game at worse or just another fiat currency at best. But other fiat currencies, like the dollar, are backed by “the full faith and credit” of the nation state and its ability to tax or otherwise use the assets under its control to support the value of currency.
Others look at this asset class more as investments akin to securities that can fluctuate on open markets. It’s possible cryptocurrencies are both or neither but the current rollercoaster ride seems tailor-made for figuring it out.
It’s possible we may have to get used to a duality of uses for this asset class. Sometimes cryptocurrencies act like currencies while other times they act like securities. As a metaphor, this is reminiscent of the quantum duality of light—it can be described as an energy wave (electro-magnetic radiation) as well as a particle of zero mass (the photon). We routinely use the best definition for a circumstance. Or consider silicon, a “semi-conductor” a material that can act as either a conductor or a resistor depending on the electric current flowing through it.
Currency and banking
As it stands cryptocurrencies are not very good currencies. Their value changes depending on the whims of the market and there is no central banking facility to maintain liquidity in times of financial stress or to manage inflation and the money supply. Cryptocurrency can be used in transactions the same way that Monopoly money can be—under very specific circumstances and so long as both parties agree.
As we’ve recently seen, cryptocurrencies are not great stores of value either, because their value can fluctuate significantly within a day or a week. Stability in a currency is vital for without it, people would be resistant to spending it if they felt that the price was likely to rise or they would be resistant to own it if they expected it to inflate and become valueless in the near term.
Securities and finance
Markets for cryptocurrencies act more like stock exchanges and we’ve seen wild swings in recent trading of Bitcoin, the grand daddy of the group. So cryptocurrency seems to be a better fit as a security whose value is expected to fluctuate.
Fluctuation can be a good thing. I was a guest on the streaming show, “The Gillmor Gang” last week when the discussion turned to cryptocurrency. Another guest, Keith Teare, a venture capitalist involved with cryptocurrencies, described his use of crypto to raise capital for his venture funds. His method avoids the typical funding process of raising big contributions from a small number of investors. Instead it can raise any amount from average investors by selling cryptocurrency. Tears’ description and explanation begins at the 46-minute mark and it’s well worth the time.
Unlike a crowdsourcing model in which people invest money at face value, say $100, Teare’s model generates heavily discounted cryptocurrency and sells it to investors while giving the hard currency raised to startups. For example, he might issue a crypto dollar with a value of one cent based on the value of the startups in the portfolio. As the startups progress through time the value of the currency increases (or not). At some point your investment is either worthless in which case you’ve lost one cent on the dollar or it’s worth potentially more than the face value of the cryptocurrency.
Generally, if you invest this way in a portfolio and not an individual company the chances of all portfolio companies going south is small and the odds of your investment becoming worth more than one cent on the dollar in the future is reasonable. But wary investors will note that this scheme operates outside of the rules of the Securities and Exchange Commission (SEC) in the US and similar bodies elsewhere. So, sadly, there’s room for the unscrupulous to game the system.
Nevertheless, in this process the cryptocurrency acts more like a stock or a bond or possibly some as yet unnamed derivative that combines aspects of each. The cryptocurrency is far from being a legal tender for all debts but in the right situation it’s a good fit. In this model it’s easy to see how cryptocurrencies could proliferate, each securing part of a transaction such as a venture fund, in the same way that bonds are issued for a particular debt offering. So at the end of the day, the cryptocurrency acts both as a security and as a currency, that’s the duality.
When crypto currency is used for discrete commerce or as an investment it works reasonably well. Teare’s use of crypto is a good example of using it as a form of a bond. Like a bond, it is heavily discounted initially and its value fluctuates but it still generates value in a kind of interest payment.
Cryptocurrency is more likely to be a disruptive innovation in finance but not one in banking and currency. It’s too volatile to act as store of value but might well have a place as a token of debt or more broadly as a security such as a bond with some stock attributes.
As a currency cryptocurrencies lack the necessary central banking infrastructure so it will be hard gaining traction there. The exception is that convertibility to dollars, Euros, or another established currency enables a cryptocurrency to access part of the beneficial aspects of conventional currencies such as the liquidity provided by central banks.
So as long as there are real currencies and the central banks needed to keep them functioning, it’s difficult to see how they replace conventional currencies. But it’s also hard to see how they harm functioning economies unless they all evaporate. This is an area of concern for anyone who appreciates how involved Russia and China are in cryptocurrencies. A hostile power intent on doing harm to the global economy could, in theory, flood the market is bogus cryptocurrency inflating them and rendering them useless and valueless.
Proponents of cryptocurrencies point to blockchain technology, a distributed ledger system designed to make it virtually impossible to carry off such a scheme. Two years ago one might have said the same about social media and democratic systems.
A recent article in the New York Times Magazine, “Beyond the Bitcoin Bubble,” by Steven Johnson observes,
“The Bitcoin bubble may ultimately turn out to be a distraction from the true significance of the blockchain.”
and blockchain could ultimately be the tail wagging the dog in all this.
My two cents worth
It is entirely possible that the disruptive innovation of cryptocurrency has not found its niche yet. If the market for cryptocurrency tanks, its use as a neo-currency will be over. As a way to raise money and reward investors crypto might face better odds especially if it can find its niche.
Here’s an idea.
The conventional economy seems reluctant to embrace the infrastructure needs of a world in crisis over climate change. Cryptocurrency could turn out to be the financing arm of a movement that builds more renewable power generation and distribution or that finances new ecosystem service provisioning. For example, increasing the amount of fresh water available to support populations in arid regions is such an ecosystem service. So is supporting a Green Race that promotes more photosynthesis planet-wide in an effort to reabsorb atmospheric carbon.
As we said at the start, inventors create products but the marketplace is responsible for defining best uses. In this, the experiment in cryptocurrency is not over by a long shot.
Take a look at this article from today’s New York Times. It tells us too much you don’t want to know about Bitcoin. It’s down about 35 percent from its peak of–what, just a week or two ago? To reiterate, this is not how a store of value works. Bitcoin isn’t even unique; there are far too many crypto-currencies out there. The fact that you can trade BTC on exchanges and even buy options on them is ominous. Recall Michael Lewis’ fine book and the movie that came from it, “The Big Short.” The big winners will be the options traders who bet short on the commodity ahead of the crash. Happy Holidays–I’m talking to you Donald.
There’s a useful Op-Ed in today’s New York Times that we should all take to heart. In “The Economy is Partying Like It’s 2008,” Desmond Lachman, a resident fellow at the American Enterprise Institute, a former deputy director in the International Monetary Fund’s policy development department and a former economic strategist at Salomon Smith Barney writes of the economic warning signs all over the economy right now.
Certainly, the American economy is doing well, and emerging economies are picking up steam. But global asset prices are once again rising rapidly above their underlying value — in other words, they are in a bubble.
Most importantly, according to Lachman, people who ought to know better are keeping mum over what should be the warning signs. Even worse, where ten or so years ago there was a bubble in real estate, today there are bubbles—plural—all over creation.
Stock values are at lofty heights that have been reached only three times in the last century. At the same time, housing bubbles are all too evident in countries like Australia, Britain, Canada and China, while interest rates have been driven down to unusually low levels for high-yield debt and emerging-market corporate debt.
So many bubbles bursting in close succession would make the job of putting everything back together a great challenge especially for an administration that doesn’t have the, uh, intellectual resources of the George W. Bush administration, which at least had Henry Paulson over at Treasury and a consensus for Keynesian economics. In 2008 everything went to hell in a hand basket when Lehman Brothers failed because it massively over invested in the sub-prime mortgage market.
Bitcoin or more generally cryptocurrencies might be the next Lehman Brothers in waiting. In 2008 Lehman had assets of $680 billion supported by only $22.5 billion of firm capital.
The demise of Lehman posted on Wikipedia says.
From an equity position, its risky commercial real estate holdings were three times greater than capital. In such a highly leveraged structure, a 3 to 5 percent decline in real estate values would wipeout all capital.
We face a similar situation with Bitcoin right now. I am not a finance guy and do not offer investment advice, so please don’t view this as anything more than bloggertry, to coin a phrase. But, hey, there’s about $300 billion in Bitcoin out there and more if you count the ICOs of similar instruments. Bitcoin are non-sovereign, they have nothing like the full faith and credit of the United States (or even Brazil) behind them, they are not regulated and there are no central banks waiting to provide liquidity in the event of a market hiccup.
On the contrary, they are dark holes into which real dollars are poured. It doesn’t help that exchanges and hedge funds are beginning to trade them and options on them. Recall that in the mid-2000’s exchanges and brokerages began trading in CDO’s, fancy options backed by mortgages that ranged from solid to sub-prime. When the sub-prime market wobbled, CDO’s and the brokerages supporting them became unsteady and Lehman failed bringing down the whole world financial system.
Yes, we got through it all but not without ruining lives and it took a decade of lackluster economic activity to get back to where we were before the crash. The problem as Lachman sees it is that,
Economic policymakers seem to have lulled themselves into a false sense of security by trusting the stricter bank regulations put in place after the collapse of Lehman Brothers in 2008. They seem to be turning a blind eye to the dominant role that so-called shadow banks (hedge funds, private equity funds, large money market funds and pension funds) play in the American financial system now.
Bitcoin’s trading is nearly all retail and in the shadow banking system where it can’t be regulated. Small investors are Bitcoin’s greatest entrepreneurs. It seems reasonable that, like Ebola emerging from the jungle, we could see a financial contagion emerging again from the shadows and Bitcoin appears to be a vector.
Bitcoin’s end may be forecasted in its recent price run up (I intentionally didn’t say value because it has no intrinsic value). Late last week the digital currency traded above $20,000 for the first time according to an article in the New York Times. That article also noted that the crypto currency started the year below $1,000 and as recently as this October coins could be had at a now very attractive $5,000 each.
The Times article said the factor driving the new interest is the increasing interest from Wall Street and for good financial reasons,
At the current cost, the value of all Bitcoin in circulation is about $300 billion. To get a sense of how big that is, all the shares of Goldman Sachs are worth about $90 billion.
But the only comparison should be with other currencies like the dollar. Bitcoin’s price is tiny compared to the M1 money supply, a measure of dollars in circulation. M1 is hovering near $3.6 trillion according to the Federal Reserve Bank of St. Louis.
M1 is a good jumping off point because it reminds us that real money is regulated by something other than the marketplace and that regulation is much more transparent. Every major country and currency has its own version of such an index except in Europe where some countries use the Euro but the principle is still the same. In contrast, Bitcoin has Coinbase, a San Francisco company providing brokerage services. We should note that Coinbase’s systems went kaput for an afternoon last week. That’s not exactly something to make you warm and fuzzy.
But the valuation (ok, I said it) is like blood in the water for Wall Street. Hedge funds and brokerages are lining up to trade in Bitcoin. Said the Times,
Coinbase now has more account holders than Schwab, and it has struggled to keep up with the growth.
But more troubling is the looming trouble that Bitcoin could deliver the the financial system,
The path for large investors has been smoothed by the Chicago Mercantile Exchange and Chicago Board Options Exchange, which have been racing to roll out Bitcoin futures contracts. Most banks are already signed up with these exchanges and consequently can immediately begin trading the contracts. The options exchange has said it plans to start trading on Sunday [December 10].
My friends involved in this say that Bitcoin and other crypto currencies provide a measure of freedom from government regulation, which is more conducive to doing business. But all of this freedom only reminds me of the words of Anatole France, an early 20th century poet, novelist and journalist, and Nobel Laureate, “The law, in its majestic equality, forbids the rich as well as the poor to sleep under bridges, to beg in the streets, and to steal bread.”
I see this run up as potentially destabilizing to the global financial system and quite possibly the black swan that the Trump administration didn’t see coming that produces its first real test. The fall out from the test might turn out to be worse than the crash.
I have been against crypto-currencies since I first heard of them simply because they are Ponzi schemes pure and simple. They are the financial equivalent of the perpetual motion machines of the middle ages, not that there were any. Inventors were just trying to invent them before real science entered the picture.
At any rate a Ponzi scheme uses current inflows to pay “profits” to the earliest “investors” and the earlier you get in the more you make while the last one into the scheme finds he has no chair when the music stops.
The price of a single Bitcoin is currently well above $8,000 and as the accompanying graphic shows it is one of the biggest asset bubbles in history. It’s going to hurt a lot of people when the bubble bursts because the damage won’t be confined to the owners.