With Covid sending debt levels soaring and pushing central banks to slash interest rates towards zero or further below, the price of Bitcoin has been buoyant, breaching levels not seen since the “ICO bubble” three years ago. Some mainstream investors, spooked by the risks of a post-Covid inflation as governments monetise the debt, are starting to consider Bitcoin and other crypto (digital) currencies as a serious alternative asset, alongside precious metals such as gold and silver, whose prices have also been strong. The recent launch of a Bitcoin fund by fund managers Fidelity is just one example of this mainstream interest. But while the enthusiasm for cryptocurrencies is palpable, is there any fundamental underpinning to give confidence in their long-term value?
Three sources of value
The most obvious source of fundamental value comes from the use of Bitcoin and other cryptos for transactions. I’ve eaten a couple of excellent meals in Zug that were paid for in Bitcoin, and some Swiss Cantons will now accept it for tax payments. In July of this year Worldline, in collaboration with Bitcoin Suisse, started piloting a system that allows its 400,000+ merchants across Europe to accept Bitcoin and other cryptocurrencies from their clients and be paid in Euros, Pounds etc. The number of transactions is small but can be expected to rise as the infrastructure rolls out. Cryptocurrencies are also used for cross-border payments between individuals, where costs can fall far below those in expensive traditional channels as volumes rise and technology improves, including the increasing replacement of power-hungry “proof-of-work” methods for validating transactions with the cheaper (and more environmentally friendly) “proof-of stake” systems.
A second source of value comes from the potential to link company supply chains, payments and credit seamlessly together using one of the public blockchains, the decentralised systems that record cryptocurrency transactions. The barcode for a product could be scanned when it left the manufacturer’s factory and scanned again on arrival in the buying company’s warehouse. Those barcode scans could cause the delivery to be recorded in both company’s stock ledgers, source a third-party loan to the seller at a competitive price that reflected the credit history of the two parties, and at a later date, trigger an automated repayment of the loan by the buyer. Second-generation cryptocurrencies such as Ether incorporate the “smart contracts” needed to do all this.
The third source of fundamental value for cryptocurrencies comes from their use in finance. They can be used to provide automated hedging between fiat currencies (like Dollars and Euros) for companies or individuals making cross-border payments or investments. They can facilitate equity and debt capital-raising for companies, as in 2017 when around $6bn was raised in “Initial Coin Offerings”, and though that was an unregulated era and some of the investments were lost, part ended up with thriving companies, demonstrating the potential. Smart contracts could potentially take over many of the functions of fund managers, to provide investment funds that invest in the stock market. In short, much of the current financial services industry could eventually migrate to the crypto world.
Programmable Money: Life, the universe, and everything
Taken together, these three sources offer enormous potential underlying value for cryptocurrencies. They can become the heart of both the real economy, operating and recording logistics and production, and of financial services, making payments, loans, share transactions, capital-raising, and operating investment funds. Indeed, the very word “currency” in “cryptocurrency” is misleadingly narrow for something that is better described as “Programmable Money” and can potentially operate, in Douglas Adams’ phrase, “life, the universe, and everything”.
Crypto owners get the banks’ profits
All this means that the profits from activities that currently go to shareholders of banks and payments providers, logistics providers, fund managers, and so on, can in future be earned instead by the holders of cryptocurrencies, or other participants in the crypto universe.
While some of this can happen through explicit receipt of fees, notably the “staking” fees paid to holders of newer cryptocurrencies for validating transactions, or the “gas” payment to those operating the computers that calculate the outcome of a smart contract, there is a broader supply/demand effect that can potentially benefit all holders. As more and more activity takes place using a cryptocurrency whose supply is limited, then demand rises relative to supply, which tends to raise its fundamental value over time. And a rise in fundamental value is likely to be reflected in a price that trends upwards.
Operation of this supply/demand balance varies among different cryptocurrencies, but in general the design is, or is planned to be, such that supply will be limited. Looking at just the two largest cryptocurrencies, new Bitcoin is created every time a new block of transactions is validated, but at a rate that is predetermined to decline to zero over time, via the “halvings” that occur roughly every four years. For Ether, revisions are proposed that would “burn” (ie destroy) fees paid by those making a transaction, thus reducing supply as activity increases.
The two things needed to let crypto grow up
This helps to explain why crypto-enthusiasts are so excited. However, some words of warning are needed. Much of the potential just described above is still just that – potential. The number of transactions related to the real economy is still tiny compared to conventional channels. Companies have been looking hard at the use of the public blockchain in their supply chains, but there is reluctance to take the plunge in a big way. And with little action in those key real-economy areas, most of the financial transactions on the blockchain are adding only relatively limited value to the real economy. However, at less than 12 years old, the crypto world is not yet even into adolescence, so it’s reasonable to ask what is needed to help fulfil its amazing potential as it gradually matures towards adulthood.
The first key thing is for it to be properly regulated – without destroying its innovative spirit. Progress has been made. For example, major players such as Coinbase in the US and Bitcoin Suisse in Europe are now fully regulated by their national authorities, and Know-Your-Customer rules affecting most switches between crypto and fiat currencies mean that anyone trying to use Bitcoin for money laundering now in effect faces similar hurdles to those in conventional banking.
Second is to address the problems caused by volatility in the exchange rate between cryptocurrencies and conventional currencies. No-one wants to pay EUR500 for some Bitcoin at the start of their holiday, and find it’s only worth EUR400 when they come to settle their hotel bill. “Stablecoins” are a possible solution, these are cryptocurrencies linked to one of the conventional currencies, such as USDC or Tether for the US Dollar, or Facebook’s proposed Libra (likely to be offered in several versions each linked to a different major currency like Dollars or Euros). The problem is that despite their name, so far none of these has been completely stable, often fluctuating a couple of a percent or so relative to the underlying traditional currency, sometimes by much more. If Facebook’s Libra is successful, it may operate on scale so large that it can be kept truly stable, but as yet that lies in the future.
Another possibility, which I personally like, is simply for any unwanted currency risk to get hedged out. So a holidaymaker can exchange EUR500 into Bitcoin and also pay a small amount extra for an automated hedge, which will ensure they still have EUR500 available when they pay for that hotel. This sounds complicated but it will all happen behind the scenes, so to the users just see a simple payment in Euros. The big advantage is that in future, blockchains can be a very cheap way to process transactions, so the fees can be much less than currently charged on credit cards or banknote exchange.
In a parallel development, a CBDC (Central Bank Digital Currency) trial has started in China, with the Bank of England and Fed exploring the idea. These official currencies will be stable, and can play a crucial and valuable role in the future digital financial world. They will likely operate on a tightly controlled blockchain, making them safe and secure but also making it difficult if not impossible to develop and operate the smart contracts offered by cryptocurrencies on public blockchains. Linking the central bank world to the crypto world may potentially give the best of both. So in the company supply chain example discussed above, records for the dispatch and delivery of goods, and the corresponding financial transactions, would operate via smart contracts using a cryptocurrency like Ether, but the companies would receive or pay in Dollar-CBDC issued by the Fed. In short, CBDCs are likely to be complements to the cryptocurrencies, not competitors.
The road to long term value is opening
With better regulation, and a route emerging for stable links to conventional currencies, the road to realising crypto’s long-term value looks to be starting to open wider. However, in the short to medium term there are numerous influences that can push prices in both directions. Current ultra-low interest rates and the risk of rising inflation have supported the price of gold and Bitcoin, but if economic recovery starts to look more assured, investors will perceive that interest rates can’t stay low for ever, and that goes the other way. And, looking at a crypto-specific effect, the recent boom in issuance of “governance tokens” has helped to boost prices of Ether, but it’s possible that the short-term effect has been overdone.
Further ahead, the long-term value drivers described here may benefit different cryptos in different ways: among the younger generation, Ether still has the lead by size, but others are vying with promise of even better smart functionality and governance; while Bitcoin, though lacking the functionality of its younger siblings, still benefits from having an absolutely clear predetermined supply, as well as being the oldest, largest and best known.
Many thanks to Raffael Huber, Head of Research at Bitcoin Suisse, for invaluable input; all errors and omissions remain my responsibility. Raffael’s latest research in the Decrypt series can be found at https://www.bitcoinsuisse.com/research