Are you considering an investment in Bitcoin? Or considering throwing some spare change at a promising alternative in the cryptosphere? Maybe unsure whether digital currency counts as ‘real’ money? The crypto-industry is rife with exciting developments, rapid environmental changes, and price movements that have made many people very happy, while news stories from less-fortunate people have caused would-be investors and consumers to question the long-term viability of digital money. Many people could have avoided harm if a comprehensive guide existed to inform investors with a base knowledge of cryptocurrency and a rubric for analyzing currencies that goes beyond the general myopic focus on short-term price speculation in the media. This multi-part guide has been compiled to make it easier to understand the value proposition of digital money, and to explain some of the factors that can affect its price and value over time.
Read the full story below.
Part One - What Gives Crypto Its Value?
Can Digital Currency be considered money?
To understand the long-term value proposition of digital money — where its benefits may accrue — we must compare it to traditional fiat money for its ability to function as money. The first part of this investment series takes a look at the functions and characteristics that cryptocurrency and traditional money must fulfil to have utility in exchange. This will allow us to better understand the opportunities cryptocurrencies present, and help us in deriving their potential value when comparing them against one another in future releases in this series.
I have included some approximate ratings of banknotes, digital fiat, and cryptocurrency in a chart below to compare how well they currently satisfy these criteria. A second chart shows how each money type could change over the longer-term under the assumption that at least one cryptocurrency enters mainstream use — where it is presumed it would have a much larger, and more stable market capitalization.
How the money types compare today:
Money type comparison in long-term, assuming cryptocurrency enters mainstream use
Money must meet three functions, and six characteristics in which to be useful for trade. The following explores these criteria and provides a brief reasoning behind the scores in the provided charts:
Medium of exchange
Money must allow us to use it to trade with those around us.
Banknotes - Great for when physical proximity to counterparty exists, but banknotes are inconvenient for trade with people over longer distances. They are not safe to carry (prone to loss and theft) which makes them less likely to reach their destination than digital alternatives.
Digital fiat - Don’t require physical trade proximity which means reduced effort to complete payments. Digital money is also more secure, which increases the likelihood of it reaching its destination, though significant delays exist for cross-border payments - which will likely improve over time.
Crypto - Transfers are near instant to any location in the world with greatly reduced costs for the privilege compared to digital fiat.
Unit of account
Money needs to act as a unit of measurement to price goods and services so we can know and compare an items value (i.e. a $10 good is worth more than a $5 good, and if wages were $5 per hour, we would know that the $10 item would cost two hours of our work).
Banknotes - Long-term track record as unit of account.
Digital fiat - Long-term track record as unit of account.
Crypto - Not an effective unit of account in the current day due to very volatile markets. The volatility largely results from lower total market capitalization. Pricing goods and services in cryptocurrency will remain problematic until this issue is resolved.
Store of value
Money must be able to maintain its value over time. If you receive payment for goods, you will want certainty that the money you received will still have value when you spend it yourself — which is why the volatility of cryptocurrency markets has made cryptocurrency difficult to employ as a medium of exchange. The larger the market capitalization of a cryptocurrency, the less prone it is to price shocks — much like a large ship doesn’t get thrown around in 5 foot swells the way a rowboat would. There exist other factors that affect the longer-term value of a currency like the total units issued. Most cryptocurrencies limit their supply, which dampens the damage inflation may have on their real value over time — a stark contrast to government money printing that nearly guarantees that it will be worth significantly less in the future than they are today.
Banknotes - Low volatility in the short term, but inflationary money printing makes it terrible for maintaining value over long periods of time.
Digital fiat = Low volatility in the short term, but inflationary money printing makes it terrible for maintaining value over long periods of time.
Crypto = High volatility for the near-term. Will stabilize if and when markets mature. Nearly all crypto have a limited supply that cannot be modified by any third party to help protect their long-term value.
The Characteristics of Money
Money needs to be resistant to wear and tear for long-term use.
Banknotes = Wear out over time, and the central bank prints more.
Digital fiat = Does not wear out.
Crypto = Does not wear out.
Money needs to be easily divided into smaller units.
Banknotes - Not divisible beyond how notes were issued.
Digital fiat - Divisible into cents.
Crypto - Infinitely divisible.
Money needs to be easily transferrable in trade.
Banknotes - Portable, but banknotes must be physically moved to destination of trade and its cost to move is higher (effort and risk of loss or theft).
Digital fiat - Portable worldwide, but expensive with significant delays in processing when crossing borders. Cross-border payments likely to become faster in the future, though fees are likely to remain high in the banking system.
Crypto = Extremely portable with near-instant processing at near-zero cost.
Money needs to be widely accepted to be useful in trade.
Banknotes - Accepted nearly everywhere
Digital fiat - Accepted nearly everywhere
Crypto - Generally not accepted, but has the same potential for acceptability over time.
There needs to be a limit on the amount of money in circulation to protect its value from inflation.
Banknotes - Short-term limitations on supply, though supply is changed at will by a third-party with persistent regularity.
Digital fiat - Short-term limitations on supply, though supply is changed at will by a third-party with persistent regularity.
Crypto - Algorithmically enforced limitations on supply, and total money supply at any point in time, and into the future is easily predictable.
All versions of a currency must have the same purchasing power. A $10 bill from 1950 should still buy $10 of goods or services today.
Banknotes - Short-term uniformity in value. Complete failure in holding value long-term. One dollar from dollar in 1913 would be worth only 4 cents today, at a cumulative inflation rate of 2352.9%.
Digital fiat - Complete failure in holding value long-term. One dollar from dollar in 1913 would be worth 4 cents today, at a cumulative inflation rate of 2352.9%.
Crypto - Depends on the currency. No correlation with downwards purchasing power has been established with Bitcoin, and despite volatility, many cryptocurrencies have achieved remarkable long-term success.
Bitcoin return to date since first traded in 2010 = 1,500,000%;
since Feb 2012 = 22,500%;
since Feb 2014 = 88%;
since Feb 2016 = 247%.
(Changing the dates drastically changes the return rates, and in some cases makes them negative).
The charts and reasoning show that while early appraisals of cryptocurrency indicate they are far from the final product, their potential to improve the way we interact with money has made a lasting stamp on the market. This potential is what gives most cryptocurrencies their value — as speculative assets reflective of a combination of potential future performance and current trade-able value. As more people see cryptocurrency not just as an investment, but as a means to redefine the way we experience money, the user base increase would mean massive crypto-industry growth with new jobs, wealth creation, and a return on crypto related investments.
The Financial technology industry is one of the fastest growing, and most promising industries for investment — and 2017 shows no signs of it slowing down. The next chapters in this series will examine the history and learned-lessons from crypto-sphere, and recommend best practices for finding and investing in the right cryptocurrencies and projects for you.