The ongoing saga of ever-rising market valuations for cryptocurrencies, has captured pages and pages of mainstream news and attracted millions of new investors. If six months ago, Chinese traders and miners dominated the market for bitcoin, today, the hype has spread globally, drawing in young hipsters from South Korea, older retail investors from Japan, scores of desperate middle-class types from Venezuela and crowds of techies from the U.S. At the same time, bitcoin and other cryptos have earned attention of armies of financial analysts and academics, all trying their hand at figuring out what exactly determines the market value of the new ‘currency.’ Within one month, the cryptos have moved from obscurity to Bloomberg terminals and to the futures trading on the Chicago Board of Exchange.
What’s behind the cryptos?
There are five key features of the cryptocurrencies that, as their most ardent proponents allege, underpin their fundamentals:
- Decentralized and global nature of the cryptos, which in common language means their independence from the monetary and financial authorities;
- High degree of blockchain security;
- Limited supply of key cryptocurrencies, most importantly, bitcoin, which theoretically implies their ability to hedge inflation risks;
- Anonymity, or put differently, ability to hold bitcoin and/or other cryptos beyond the reach of the coercive powers of the state; and
- High degree of blockchain efficiency in transmitting and storing information – an argument that basically says that bitcoin demand is underpinned by the blockchain technology use in a range of sectors, and by the potential for using bitcoin as a medium of exchange.
The problem with these claims is that they cannot be substantiated either empirically, or theoretically. In other words, the worldview of bitcoin fans ignores the reality of modern finance.
The myth of bitcoin’s decentralization is based on the autonomous nature of the cryptocurrency.
The technological aspect of the public blockchain being outside the regulatory and supervisory net of the national monetary authorities is true. However, as modern financial economics shows for a range of other asset classes, the decentralized nature of the asset itself does not mean that asset valuations, prices and return properties are independent of the central authorities’ decisions. Take, for example, gold – a financial asset largely unregulated directly by the financial authorities in the majority of the advanced economies, and traded globally.
Theoretically, with storage of gold available at remote locations, including safe haven jurisdictions, gold can be decentralized and act as a hedge against central banks’ policies and regulatory controls. Alas, due to its financialization via a range of investment funds, regulated investment vehicles holding gold claims, options and other derivatives traded in exchanges, and due to the fact that investors trading in gold are subject to regulations, gold does not behave independently from the regulatory interventions and monetary policy decisions.
Authorities interventions that influence the broader financial markets also tend to spill over into the gold markets.
Some recent academic research already points to the fact that bitcoin price dynamics are linked to the U.S. Federal Reserve’s rates decisions. Given growing concentration of bitcoin trades in Japan over recent months, the cryptocurrency is also likely to be paired with the Bank of Japan monetary policies into the future. Worse, Chinese monetary policies are clearly ‘centralizing’ bitcoin, both in terms of the cryptocurrency responsiveness to the Chinese money supply and capital control policies.
The key lesson from this is that in modern financial markets, multiple levels of interconnections between investors, asset classes, and monetary and regulatory policies mean that no asset class – be it purely private or directly regulated – is truly decentralized. Like gold, bitcoin is not an island in the world of traded investment instruments either.
The second part of this argument is that the markets for cryptocurrencies are truly global and, as such, have high levels of liquidity. This confuses two key aspects of investment finance: the geography of investors (which can be a potential support for arguing in favor of bitcoin’s risk diversification properties) and the concept of liquidity, suggesting that cryptocurrency enthusiasts are desperately lacking the basics of financial education.
The global markets for cryptocurrency are highly concentrated. According to Bloomberg research around 1,000 individual investors currently hold about 40 percent of the entire supply of cryptocurrency. Adding to this some additional 10 percent or so held by the various investigative agencies as a part of international and domestic money laundering and criminal investigations, around half of the bitcoin supply is tightly controlled by a small number of players. The balance is predominantly held in the U.S., China, South Korea and increasingly Japan. This is a far cry from the global diversification offered by more traditional asset classes, including U.S. and European equities, bonds and major currencies, as well as gold.
Bitcoin is hardly a safe haven for liquidity risk. A recent warning issued to bitcoin investors by the world’s largest cryptocurrency exchange, Coinbase, is case in point.2
Another set of liquidity indicators flashing red is the bid-ask spread and transactions costs, both of which are not only in excess of those found in other markets, but are prohibitive in comparison to traditional payments technologies. These create meaningful barriers to trading in bitcoin.3
Beyond those considerations, there is also an added risk to bitcoin liquidity stemming from the recent cryptocurrency-based initial coin offerings (ICOs). ICO issuers hold relatively concentrated positions in BTC, used as a capital reserve currency for the fundraising start-ups. These positions support wider bid-ask spreads on the cryptocurrency, entailing higher trading costs for currency purchasers in the rising markets and currency sellers in any downward correction. In financial terms, ICOs and other concentrated positions imply amplified liquidity risks at the time of any liquidity shock. Coupled with the Coinbase warning, the global nature of bitcoin holdings, touted by the crypto supporters can turn into a large scale market panic, should a liquidity event arrive.
Like other purported strengths of bitcoin, the cryptocurrency security is also a myth. While the blockchain mechanism is costly to hack, the real vulnerabilities in the system rest in exchanges and storage wallets. To date, there have been no major hacking successes with respect to larger traditional financial exchanges. This does not mean that they are not vulnerable to attacks, but it does suggest that regulatory and supervisory pressures exerted by national authorities do provide for some measures of centralized security in traditional asset markets. Also to date, there have been at least 11 documented attacks or breaches in cryptocurrencies exchanges.
In general, frequency of hacks and security breaches in cryptocurrency markets is growing in line with the bitcoin price-induced incentives to undertake such hacks and is already exceeding the comparable event frequency for major corporates listed on the main stock exchanges. As our recent research shows4, cybercriminals respond strongly to financial incentives in undertaking criminal hacking activities. As bitcoin value continues to rise, so will the attempts to crack the security codes protecting cryptocurrency investors. As the criminals continue to pick up the low hanging fruit by attacking individual wallets and exchanges, the incentives to systemically attack the blockchain will also rise. It is only a matter of time before the crypto’s security holy grail falls prey to the hackers.
Limited supply of unlimited forks
The argument about the limited supply of key cryptocurrencies, most importantly, bitcoin, implies their ability to hedge inflation risks. There is no empirical evidence to support either one of these assertions.
From the very top of the argument, bitcoin supply is technically restricted to 21 million units, assuming the current technology remains unaltered. However, the supply of cryptocurrencies remains unlimited due to arrival and maturing of new cryptocurrencies, and due to ongoing bitcoin forks. The argument in favor of restricted supply of bitcoin, therefore, rests on imperfect substitutability across different crypto currencies. This imperfection today is not technologically determined, but is market driven. Largest exchanges and crypto investment platforms, such as Coinbase, are de facto Bitcoin-maximizers, offering no more than two to three alternative cryptocurrencies for investors to choose from. As this market constraint is lifted over time by growing demand for other cryptos, the substitutability between bitcoin and other currencies will improve. With this, the argument of algorithmic restriction on bitcoin supply will also be diminished. Ripple, litecoin and ethereum offer an illustration of how this process works. Based on evidence from our forthcoming study, the largest substitutes for bitcoin are already starting to dilute dynamic price properties of bitcoin.
Anonymous currency, identifiable investors
The issue of anonymity of bitcoin and cryptocurrencies holdings is similar to the issues relating to its security. While the actual holding of the currency can be anonymous, investors in these currencies are still subject to legal, taxation and regulatory controls operating in the jurisdiction of their domicile and/or jurisdiction where they intend to use these funds. More importantly, need for regulated and data-captured intermediaries required to transact in the real economy using these currencies implies that what is anonymous in holding is no longer anonymous in use, or trading.5
This ambiguity between the promise of anonymity and the requirement upon the investors to disclose their holdings to tax and legal authorities in relevant jurisdictions is an added pitfall for many retail investors who can end up with unexpected legal and tax bills, facing potential penalties and fees, simply because they assumed at the point of investment that their holdings are truly anonymous.
Bitcoin is not free from capture by the coercive action of the state.
How efficient is bitcoin?
The argument that the market valuation of bitcoin is justified by the promise of the blockchain technology in reducing transactions data verification and storage costs is hard to justify in today’s markets. Current valuation of cryptocurrencies in the markets exceed US$500 billion, even though the transactions volume supported by these cryptos amounts to just a tiny fraction of one percent of the total volume of financial transactions. In contrast, Visa and Mastercard account for 55 to 60 percent of credit transactions markets and similar percentage of payments markets, with the underlying companies’ capitalization tenfold below that of the cryptos.
Beyond the disconnect between price and market shares today, there is an issue of technology itself. Currently, rapid appreciation of cryptocurrencies in investment markets has resulted in severe constraints placed on blockchain systems, with processing times running into double digit minutes even for Bitcoin-based chains. This is hardly an improvement on existent legacy systems that can process transactions with less than 1 second lags. The above bottlenecks in public blockchain technologies are manifested in shrinking, not growing, volume of real economic transactions supported by bitcoin.6
In terms of future promise, private or proprietary blockchains offer the promise of greater security and efficiency than the public cryptocurrencies. This is reflected in the proliferation of private blockchain solutions across the financial and IT services platforms (think investment banks, payments providers and IT services giants like IBM, Amazon etc). Evolution of cloud technologies and a promise of edge networks beyond today’s technological world constraints further puts into question the value of cryptocurrencies-linked blockchains as platforms for transactions management.
In summary, at present, there is no justification for the current valuations of bitcoin and a range of other cryptocurrencies. The market for cryptos exhibits all the hallmarks of a large scale, rapidly inflating bubble, driven solely by the irrational, behaviorally biased expectations of investors chasing speculative gains. All the arguments in favor of a fundamentals-based anchoring of bitcoin prices are nothing more than an attempt to justify buying the hype.