A cryptocurrency is a digital currency secured by cryptography, which makes it nearly impossible to counterfeit or double-spend. Many cryptocurrencies are decentralized networks based on blockchain technology and they are generally not issued by a central authority. Any investor can purchase cryptocurrency through an exchange. These range from popular options likes Coinbase, apps such as Cash App, or through brokers, as well as through financial derivatives such as CME’S Bitcoin futures. Whilst crypto-currencies display some features of real currency, they currently seem destined to remain a speculative assets. One of the main questions surrounding ‘crypto’ is whether (like Pinocchio who wants to be a real boy), one or more of them could ever become a real currency.
In economics, money serves four key functions. These are: a store of value, a medium of exchange, a unit of account, and a standard of deferred payment. Money does not have to have intrinsic value (at least not these days). Money does not need to be backed by gold for example (the era of the gold standard is long gone). Most currencies today are known as ‘fiat currency’. This literally means backed by government decree. Thus, money is not backed by something tangible per se, but by the issuing government and thus relies on trust and faith in that government to maintain its value. How does cryptocurrency stand up to the four tests/functions of money, and can it overcome the absence of both intrinsic value and government backing.
Although cryptocurrencies may be a store of value to an extent, they are not very good ones. This is because Bitcoin for example is highly volatile and backed by investor belief rather than government decree. This makes it a tenuous ‘currency’ to hold for basic transactions. For example, experiments such as El Salvador’s welcoming of Bitcoin as a legal tender, have gone significantly badly, and it is estimated that Salvadoran reserves have lost up to 11% of their value due to its recent fall!
Cryptocurrencies do have the potential to act as a medium of exchange though since they can be used for some transactions. However, this is questionable due to the large haircuts required to exchange crypto for cash and that few real vendors directly accept cryptocurrency. Still, in recent times, more and more companies have started to accept crypto as a payment for their goods and services. This remains fraught with danger though. For example, if one exchanges from cash to bitcoin and then back to cash, they may end up paying ~10% in transaction fees, which as a result means that lots of value has been leaked. Henceforth, showing that cryptocurrencies as a medium of exchange are not particularly practical for consumers.
A unit of account is a standard numerical monetary unit of measurement of the market value of goods, services, and other transactions. It could be argued that Bitcoin is a unit of account to a limited extent. This is because many companies don’t accept crypto as a form of payment, so many goods don’t have a “crypto price” and going from cash to crypto will also result in high transaction views. In order for a currency to be a unit of account, it must be able hold its value over time. In the context of cryptocurrency, a unit of account refers to a standardized measurement of the value of a specific cryptocurrency, such as Bitcoin. Just like a currency, Bitcoin can be used to record and track the value of goods and services and can be used as a means of exchange for transactions. Additionally, Bitcoin is divisible, allowing for smaller units of value to be used for transactions. Thus, Bitcoin can be considered to be a unit of account despite its highly erratic and volatile nature.
Once again, cryptocurrencies are a sort of standard of deferred payment, however, they may be considered to be bad ones. Bitcoin, the most popular crypto currency, cannot be used for payments very easily because it is highly volatile and so for industries like food and hospitality, where net operating margins can be less than 10%, this currency volatility could make operations unsustainable. Similarly, employees may not want to receive their salaries via cryptocurrency because if its price fluctuates substantially, they may not be able to pay their rent or buy their groceries.
Another interesting question is whether crypto needs to be backed by government. The interaction between cryptocurrencies and central bank digital currency (CBDC) is an extremely interesting field. CBDCs are digital versions of traditional fiat currencies issued and backed by central banks. While cryptocurrencies like Bitcoin operate on decentralized, blockchain-based systems, CBDCs are centralized and issued by government authorities. It is possible that central banks could adopt blockchain technology to issue and manage their own digital currencies, thereby using some of the technology developed in the cryptocurrency space. This could provide the benefits of decentralization and security offered by cryptocurrencies while retaining the stability and government backing offered by traditional fiat currencies. Alternatively, cryptocurrencies and CBDCs could exist together, with users choosing based on their specific needs and preferences. For example, some users may prefer the security and privacy offered by cryptocurrencies, while others may prefer the stability and government backing offered by CBDCs. In either case, the interaction between cryptocurrencies and CBDCs is an exceedingly important and fascinating area of study.
An argument could be made that cryptocurrencies actually have some value as talented funds (such as Tiger Global) are now investing, Silicon Valley funds like a16z have raised dedicated crypto funds and DAOs (decentralized autonomous organizations) are now being created to discuss crypto. Ray Dalio advocates for some capital allocation to Bitcoin (but on the basis of general diversification principles to any scaled asset) and large capital allocators like JP Morgan are now getting involved. The market cap of Bitcoin at $387.63billion and broad ownership by ~10% of Americans would suggest that crypto may be here to stay (after all) but could still face massive price declines. This is because there is no floor in intrinsic value other than “technical analysis” price indicators, which can be broken if people lose faith in the asset. Regulatory risk may also eliminate some of its value, but such change in regulation may not occur because regulators may receive huge public backlash. This is due to the amount of public ownership in cryptocurrencies, as a change in regulation would cut into their profits and return on investments.
Furthermore, there are some crypto games such as Axie Infinity, (however most of the value created so far has been in exchanges which is perhaps not such a promising sign), much of the value being created so far in the crypto space is not in novel projects that have created real-world applications, but in exchanges like FTX, Crypto.com, and CoinBase that only act as a broker for the currencies. They are not interested in whether crypto is really a bubble or not because they still receive transaction fees. For instance, if demand for horse manure was high, producers would sell it at scale and take a commission, maximising profit, and proving that the massive equity value in these businesses is really a function of high margins on high transaction volume and thus could be in any underpinning asset.
I would conclude by arguing that cryptocurrency is not a real currency, and hence I would propose that although Pinocchio longs to be a real boy, he simply is a wooden puppet. As Jamie Dimon (the chairman and CEO of J.P Morgan) stated, “Cryptocurrency has no intrinsic value…You are basically buying a token”. However, despite his evident scepticism, JP Morgan is beginning to invest in cryptocurrencies, suggesting that crypto is not going anywhere in the near future. My best piece of advice: “Caveat emptor”!