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is that cryptocurrency holders are trying to decide whether to abandon Bitcoin because its limitations mean it will be superseded by better products or bet that it can thrive despite them.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.
Is Bitcoin Netscape? How limited is the supply of cryptocurrencies? If Bitcoin crashes what happens to other alt-currencies? What asset market lacunae do cryptocurrencies fill? Why mine? Do cryptocurrency transactions need coins or tokens? 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.
