A Skeptical View Of Cryptocurrencies

Recently, I have seen a lot of discussion on Twitter about cryptocurrencies, and their validity.  The arguments basically boil down to proponents arguing that this technology is the future of currency, and others pointing out a range of problems from "what's the basis of valuation?' to "jeez, something about this technology doesn't smell right/good/whatever".  

A Little History

Proponents of Cryptocurrencies who argue "it's the future of currency" often talk disparagingly about so-called "fiat currencies", arguing that they are just as arbitrary a construct as a cryptocurrency, and that nation-states can play around with them at will. 

This is only partially true, and it disregards the historical evolution of currency which continues to bind its value.  Today's "fiat currencies" didn't just spring into existence unbidden. They arose from a series of social and political forces.  Once society started to move beyond simple barter exchanges within a community, things got complicated.  

Yes, you could trade for goods and services, haggling over what each one was worth each time.  The person who repaired the sickle the farmer used to harvest grain - how many sheaves of grain should they get for doing that? What about the person who spent their day harvesting berries? The problems with barter are still with us today. Have you ever stopped to consider the cost of a barrel (50 gallons) of Coca Cola with the price of a barrel of oil?  It's a bit shocking.

Over time, wealth came to be measured in terms of "precious metals" (gold, silver, etc), and the wealthiest started to accumulate these.  (and, in the case of the Romans, their temples often became repositories for large amounts of treasure which was used by the state to pay for various things). 

Currency, per se, emerged out of a need to have an agreed-upon value of precious or semi-precious metals for exchange. Those who had reserves of these metals, and the political power to do so (those without political power usually lost their fortunes to those who did - the ability to raise an army being a significant factor), started to issue coins in an effort to standardize trade within their immediate spheres of control.  

Socially, currency became accepted as useful means to normalize transactions that decoupled the good or service being exchanged from the value of that good or service.  So, coming back to our sickle repairer example earlier, instead of the sickle repairer having bundles of grain he had to figure out how to unload, he just had a small pile of coins to buy other materials he needed to live.  Sure, there would be arguments about whether one or two coins was too much to pay for a jug of milk or a bundle of wood, but most at least agreed that the coin itself was valid. 

Moving Into The Modern Era

Of course, when we start talking about trade between realms, the valuation of coins once again becomes an issue.  Over time, we have shifted from a model of basing that valuation on the accumulation of precious metals to a more abstract notion of the value of a nation's currency is based on the country's relative performance economically, and other more abstract measures such as indebtedness, future prospects, and so on. 

Physical currency remained dominant for years, but relatively recently (the last 20 years or so), it became less commonly used.  For example, cheques came to replace a pay packet filled with cash; direct deposit replaced cheques, and more recently online banking and e-transfers have replaced many common transactions that used to be done by cheques or hard currency.  In the last 18 months, I haven't conducted a significant transaction by cash due to the COVID-19 pandemic - everything has gone through some kind of electronic transaction. 

Abstraction As Justification

Proponents of cryptocurrency like to argue that because the modern day state-issued currencies are largely handled electronically now that they are just as abstract as cryptocurrencies.  This is true to a degree - most of us don't have the background to accurately assess the economic and political factors that end up driving a currency's valuation on the market.  It simply doesn't work that way. 

State issued currency has a long, historical presence in commerce, and it is still well accepted as a means of valuing transactions, even when they cross national boundaries. In other words, centuries of use and its gradual shift into the realm of digital transactions have developed and maintained a level of social acceptance that grants the state fiat currency validity even as it has become increasingly abstracted from the very tangible metals that it once was connected to. 

The equivalency argument made regarding cryptocurrencies lacks an appreciation of the importance of that social acceptance. Without acceptance and trust, no currency has a meaning. Monopoly money is not accepted as currency outside of the game; casino chips are only seen as "currency" within a casino. Therein lies the first major obstacle for cryptocurrency to overcome - acceptance.

Valuation and Skepticism

While we can to a reasonable degree understand the relationship of a national currency to the nation's economic state, and its political status, cryptocurrencies do not have any such basis for valuation. 

This is potentially the biggest Achilles' Heel problem that cryptocurrencies face. They are essentially virtual tokens which have no apparent anchor. Bitcoin attempts to solve this problem by enforcing an arbitrary degree of scarcity within that system, but as anyone trading in antique cars will point out, scarce doesn't exactly equate with valuable.  There are many cars out there that there are only a handful left compared to say a Jaguar E-type, but somehow the E-type remains considerably more valuable. (BTW, I am not advocating antique cars as either investment or token for some kind of post-apocalypse currency)  

In recent weeks, we have watched Bitcoin rise to the lofty heights of over $60,000 (USD) per "coin", and then to lose over 1/3 of its value in the last week or two, sitting at just below $40,000 (USD) as I write this.  The wild fluctuations in valuations we have seen over this past year are stunning, but what are they actually based on?  

To be kind, from an outsider's perspective, this doesn't look much different than what used to be called the "Penny Stocks" back in the day.  Especially in the heyday of gold rush and the early oil industry, companies would spring up with all sorts of claims, the price of some stocks would go through the roof, only to see the company's owners disappear into the night with a pile of investor dollars to live on.  Those companies usually had nothing in terms of real value or assets, just promises of a big payout later. 

The current state of cryptocurrencies seems very similar.  There are a lot of them out there, and none of them appear to have a basis for their valuations. 

A free market purist would look and say "well, that's the price people are agreeing to pay for this today, therefore that's its value".  How is this any different than the penny stock scams I mentioned before, or the classic "pump-and-dump" scams that pop up on the stock markets?  

When people think of currency, they think in terms of stability.  The wild swings we are seeing right now do not speak of stability, and in fact damage the usefulness of cryptocurrencies as means of executing transactions for goods and services.  

Skeptically, Bitcoin and its stablemates like Ethereum should be treated with a degree of caution.  Since they are not yet well connected to the economic drivers that restrain and contain the fluctuations in the value of fiat currencies, it remains to be seen if they can overcome the obstacles they face in terms of acceptance and stability to become credible currencies in common use. 

[Update:  28/06/21]:  This piece from Financial Post reflects a lot of the problems discussed in this blog:  Posthaste: Why Nassim Nicholas Taleb thinks bitcoin's real value is zero

It's valid to be skeptical with cryptocurrencies.  Not everything is as simple as it looks on the surface.  When you buy into a cryptocurrency, what are you really buying, and what is driving its valuation besides speculation?