Crypto is too volatile to act as money, but we can harness the technology to improve the system
Photo by Austin Distel on Unsplash
It is Saturday night in New York. Few bars and restaurants are open for business due to Covid-19, robbing the city of its usual hustle and bustle. Heading out for a drink on a narrow sidewalk is risky and the need for face coverings makes the experience awkward. Staying home is a safe and convenient bet. For restive minds suffering from the burnout of remote work, social media or a new Netflix series are the best remedies. But for a few daring individuals, the crypto exchanges are where the real action happens.
At this hour most of the crypto trade is being done in Asia. Without the critical mass of North America, there is less liquidity and a thinner order book, but also more opportunities for observant players. There is a near-endless menu of cryptocurrencies available to trade, each with their own unique technology backbones. But bitcoin remains the most popular and iconic of them all, with a market capitalization of $219 billion — more than four times the value of its closest alt-coin rival, Ethereum.
Tonight, the Bitcoin price is testing $11,500. The market rejected this level back in 2018, wiping out the final rump of bitcoin bulls in the wake of the Great Liquidation. It rejected it again in 2019. Will this be the night it finally breaks through? At around midnight, the price on the Europe-based Bitstamp exchange — one of the largest of the distributed exchanges worldwide — squeezes higher to $12,000. A beautiful W formation emerges, a pattern that technical traders look for that indicates a bullish reversal. If the price can hold here, get ready to ride the elevator up.
Then something totally unexpected happens. After ticking over $12,000, the floor is suddenly pulled out from underneath the market. The price plummets, triggering stop losses and forcing further selling on the way down. In the space of six minutes, the price falls below $10,700, wiping out $1 billion of leveraged long positions in the futures market. In the panic that ensues some try buying back in, but it is futile. Traders cut their losses and run.
Less liquidity can spell opportunity, but it can also create the perfect conditions for price manipulation. In the washout, reports emerged of an Asian whale that took profit at $12,000 and sunk the market. These whales — traders who hold massive positions and whose actions can move the market — are hard to spot until it is too late. When they come out to play, they create tidal waves of buying or selling that can capsize smaller traders. Sometimes it pays not to venture out too far from the huddle of boats, where the opportunities are scarcer, but the tides are gentler. These whales can create their own buying momentum and, when the time is right, sell out and leave the rest of the market in their wake.
This is not the first time a flash crash has spooked crypto markets. It certainly will not be the last. Just a few weeks before this latest event, cryptocurrency exchange Binance — the world’s largest by volume — was having problems of its own. One trader briefly sent the price of some bitcoin futures to $100,000, undoubtedly the result of an algorithm gone horribly wrong. “Another day in crypto,” Binance chief executive Changpeng Zhao tweeted. Perhaps this is the stoic attitude required of any trader, but crypto is in a class of its own when it comes to the capriciousness of price moves.
These exchanges are not for the faint-hearted. In this wild west of financial markets, each trader is responsible for managing their own risk, and there is no sheriff in town to keep an eye on things. For many, this is part of the appeal, but for some, the nosebleed-inducing swings are a turnoff. With many exchanges allowing traders to take on leverage and amplify their positions, price gapping can spell ruin in a matter of seconds.
The history of bitcoin flash crashes is incredibly rich for an asset that only started trading a decade ago. Regular crashes and volatile swings may be a fact of crypto life, but this makes it harder for everyday investors and institutions to get involved. The Chicago Board of Options Exchange (CBOE) rolled out its own bitcoin futures contracts in December 2017. It stopped adding new ones in March 2020 as retail interest dried up. Bitcoin is the perfect asset for thrill-seekers. A small exposure to crypto might even be beneficial for your portfolio, depending on your objectives. But if it is stability you are looking for, crypto is the worst asset imaginable.
Bitcoin really started to take off in 2013. The digital currency began the year trading at around $13.50. The price rallied in April and crested $220 before dropping under $70 in the same month. This was bitcoin’s first major rally and subsequent crash, but it did not deter investors. An even harder rally in 2014 saw the price breakthrough $1,000, only to fall back to $320 by the start of 2015.
Since then enthusiasm snowballed, and not just from traders looking for something new. Bitcoin and its associated blockchain technology gained adherents from all walks of life. Investors and day-traders, workers and bosses, libertarians and socialists, all felt drawn to the virtual currency that promised to enrich and emancipate. Bitcoin would revolutionize money and claw back power from a confiscatory government and a privileged class of insiders who benefited from the centralized system of payments and exchange.
Bitcoin’s exponential growth sounded alarm bells for experienced investors who were not sold on bitcoin’s potential as a universal payment method and were aware of the dangers of irrational exuberance. The financial crisis was now a distant memory for consumers, but for those working in financial markets, it still felt like yesterday. Hardened cynics looked askance at the college students proselytizing about blockchain and the corporates ‘pivoting to crypto’ to capitalize on the latest buzzword.
Management consultants raced to position themselves as experts, scrambling to get their heads around tokens, nodes, and nonces, as curious clients bombarded them with questions. The practical applications were not immediately obvious, and there were no commercial case studies to draw on. Most crypto projects seemed to be solutions in search of a problem. But this was something new. Companies were just starting to understand the potential. Maybe we just had to wait for the killer app.
If $1,000 was stretching the narrative, skeptics were about to be blown out of the water. Over the course of 2018, bitcoin would undergo one of the most spectacular melt ups in financial history, rocketing to a high of $20,089 by early December — a return of 1,985 percent at the start of the year. Fear of missing out was rife. Momentum this seismic was enough to make even the most experienced investors forget themselves. Day traders, many joining a platform for the first time, leveraged into the trade, making spectacular returns. Genius was measured by how early one got in on the action.
Source: Yahoo! Finance. Weekly closing values to end August 2020.
The market was ecstatic. For the true believers who had been with bitcoin from the very start, this was the ultimate vindication. The Winklevoss twins made their millions suing Mark Zuckerberg, but they made their billions investing their winnings in bitcoin. Fund managers saw an opportunity to carve out a new niche, too. Dan Morehead, a former Goldman Sachs trader and former head of macro trading at Tiger Management, launched Pantera Capital in 2013, the world’s first investment firm focused exclusively on cryptocurrencies. In 2017, its Bitcoin Fund returned 1,565 percent. When the party is this good, no one asks when it is going to end.
‘Buying the dip’ is a conviction trade. If you buy something you believe is a fundamentally sound investment and the price goes down, that presents an opportunity to buy more of that investment at a better price. Rather than succumbing to fear or self-doubt, buying the dip is the smart move that shows you have tamed your emotions. But how do you assess the fundamentals of an asset whose value is totally subjective and artificial? Other currencies might be similarly lacking in intrinsic value, but they have something bitcoin does not: government backing and universal acceptance. Bitcoin was an aspiring currency, but it was nowhere close to displacing government money.
When bitcoin finally unwound, it first dumped to $11,300 in a matter of days. Now was the perfect time for savvy traders to add to their positions. They might have been right at this point. The price sprung back to $17,580. But then came the avalanche. Over the next three months, bitcoin lost two-thirds of its value, crashing to $6,500, then fell in fits and starts to its low of $3,280 in December 2018. On the way down, dip after dip presented itself. One amateur trader, a school student who won their first three bitcoin in a game of poker, recounted a harrowing lesson in which they turned their three bitcoin into 200 bitcoin, then zero bitcoin. They were in good company. Countless holders of bitcoin lost it all. In 2018, three-quarters of Pantera’s Bitcoin Fund was wiped out. The dream was over.
Investors were not the only ones stung by bitcoin. Companies were sucked in too. Kodak, the ultimate legacy brand, waded into the crypto pool with the announcement of its own initial coin offering (ICO), originally scheduled to launch at the end of January 2018. KodakCoin would harness blockchain technology to create a permanent record of ownership for photographs and other creative digital assets, helping artists manage their intellectual property. In the digital age, companies no longer had to manage decline. They could pivot their way through new market regimes and rise from the ashes of creative destruction. Companies like Kodak had permission to become crypto giants.
Kodak’s share price jumped from $3.10 on the morning of the announcement to $13.28 the next day. But the offering came unstuck when The New York Times raised questions about the company’s crypto partner WENN Digital, “a California-based affiliate of a British photo agency that specializes in paparazzi photo licensing.” Sensing a scandal and yet more humiliation, Kodak’s management got cold feet and the ICO was delayed indefinitely. By the end of the month, one-third of Kodak’s shares were trading short.
Crypto has some impressive applications, but it is also a trap for unwitting companies seeking headlines and a quick path to riches even before a single token is issued. Luckily, the craze has died down — at least among brands — and universities and businesses are taking a more sober look at how the technology can be used to make our lives better.
But sadly, this is not the end of cryptomania. Turn your attention to the exchanges and you will see bitcoin and its alt-coin competitors are on the rise in a big way. With the world in the grip of a pandemic and central banks printing money to the last electron, investors have regained their enthusiasm for anything the government cannot touch. Bitcoin is back to build up our dreams and mercilessly liquidate them.
Money is the lifeblood of exchange. Without it, the invisible hand that gives rise to human commerce would not exist. The purpose of money is to crystalize the relationship between lender and borrower. In ancient Mesopotamia, clay tokens were used to record transactions involving the barter of agricultural goods and metals such as silver. The clay token might seem redundant to the transaction itself, but it played a crucial role. Often, the transactions recorded were for commodities that had been loaned out. The tablets were drawn up and retained by the lender, not just as a record, but as a piece of transferrable property that entitled the bearer to the outstanding goods.
This form of money has been with us for thousands of years. Even the notes issued by the Bank of England still have the words ‘I promise to pay the bearer on demand the sum of…’ printed on the front. England’s notes are no longer redeemable for sterling silver, but the history is still preserved. Today, coins and banknotes in circulation make up only 10.4 percent of the total M2 money supply. The majority of money is virtual. It exists as an idea represented electronically on servers and computer screens. Yet it carries the same legal force as physical money.
For centuries, governments have been tempted to debase the public money, betraying the trust of their citizens to ease the burden on the treasury or enrich the country’s rulers. Henry VIII was notorious for reducing the precious metal content of coins, while the hyperinflation of Germany’s Weimar Republic serves as a modern example of the potentially disastrous consequences of money printing. Government money must be backed by strong, trusted institutions if commerce is to thrive. This means pursuing policies directed at price stability, providing liquidity in regions and sectors where it is needed, and preventing systemic risks from threatening the wealth and wellbeing of all.
Adam Smith defined money by its ability to act as a store of value, unit of account, and medium of exchange. These functions operate in a hierarchy. Houses may be a store of value, but they are not suitable as a medium of exchange. Livestock may work as a unit of account but is less reliable as a store of value. This points to the anthropological view of money: that it is the result of social convention as much as government intervention. Whether it is cigarettes hoarded by prisoners in a POW camp, or cowrie shells passed around by the ancient tribes of the Maldives, what matters is that it is generally accepted by others. “Money is a matter of belief,” as Smith said.
Some may view currency and even central banks themselves as archaic vestiges of an old centralized order of payments that will soon be swept away by a digital distributed future. White papers and research notes issued by central banks on the topic of crypto can barely hide the reactionary tone: it is a fine piece of technology, but it cannot replace government-issued currency. In any case, central banks reserve the right to regulate it just like any other financial asset. Reading between the lines, governments will not tolerate competition, even (or especially) if the technology proves viable.
That will not stop virtual currencies from trying to displace the institutional framework that prevails today. From the depths of the financial crisis of 2008–09, bitcoin built a ready following among government skeptics of all stripes. No one could deny that the U.S. Federal Reserve was flying blind, lending indiscriminately and without oversight in a desperate attempt to save the financial furniture. Meanwhile, the U.S. Treasury made arbitrary calls on which institutions were bailed out and which were left to fail. So much for trust.
No surprise that the market turned to crypto as an alternative to the trillions of new dollars being pumped into the financial system. Decentralized cryptocurrencies like bitcoin have a fixed supply and no government backers responsible for issuing them. New bitcoins enter the system through ‘miners’ who compete to verify transactions by solving a complex mathematical problem known as a ‘hash’. This is serious business, involving immense computing power and even custom hardware to eke out extra speed. The nature of the Bitcoin protocol means the total number of bitcoin in circulation is capped at 21 million, although given that the rate at which bitcoin is mined falls over time, the cap will not be reached until the year 2140.
Bitcoin is a soft currency with a hard-coded supply. It cannot be interfered with in the ‘public interest’. It is unregulated and untouched by risky private banks. Those who hold it can remain anonymous, free from the prying eyes of the taxman — or law enforcement agencies. It cuts out the middleman, making financial intermediaries redundant.
Yet despite its eligibility, bitcoin has not taken off as a widely accepted currency, nor even a narrowly accepted one. There are only a handful of well-known merchants willing to transact in it. Microsoft has accepted bitcoin for use in its online Xbox Store since 2014, although it hit pause in 2018 due to the extreme volatility. Starbucks disappointed the crypto faithful when it announced in 2019 that it would start accepting bitcoin, only to qualify this by saying it would not accept payments directly but would be partnering with Bakkt, a bitcoin futures exchange. The last anyone heard it was running limited tests before the lockdowns hit in March. Whether in-store payments will finally become a reality is anyone’s guess.
In a similar vein, Amazon-owned Whole Foods keeps its bitcoin customers at arm’s length via a crypto custody app called Gemini. Gemini partners with payment processor Flexa, which accepts the crypto payment and transfers regular dollars to the merchant at the point of sale. None of these businesses hold bitcoin on their balance sheet. There were reports that Domino’s Pizza began accepting bitcoin last year. In fact, a startup called Fold began allowing users to pay for Domino’s pizza — among other food options — in bitcoin, using the Lightning network, but these are not official partnerships. Fold places orders on users’ behalf and converts payments to fiat currency. Fold accepts bitcoin, while Domino’s accepts U.S. dollars.
When we talk about cryptocurrency adoption, we should specify exactly what we mean. We are not talking about companies exploring blockchain technology, or investors using bitcoin as a hedge or speculative play. We mean merchants — everyday businesses large and small — accepting bitcoin or other cryptocurrencies in exchange for goods and services. On this measure, crypto looks like a non-starter. The few merchants that do accept bitcoin do not maintain their books or report their income in bitcoin. That is, they do not use it as a unit of account.
Source: Yahoo! Finance. Annual standard deviation based on daily returns over three years to end June 2020.
Maybe it will take time, but given its recent price history, it is impossible to see bitcoin gaining a foothold among retailers. Marketing and PR teams might be attracted to the headlines, but any rational finance head would reject the idea out of hand. A currency that trades in a $2,000 to $20,000 range within a six-month period is not a store of value. It is a pure gamble.
Bitcoin’s worth ultimately rests on whether it will be successful as money. There is little to suggest that it will be. Right now, its value is in finding a greater fool. Its fixed supply, far from being a virtue, is a serious deficiency that would create a deflationary bias if it were ever adopted. The inability to regulate supply could create severe liquidity shortages and create unnecessary hardship, just as it has in the past. As Bank of England Governor Mark Carney said, “Recreating a virtual global gold standard would be a criminal act of technological amnesia.”
But central banks cannot hold back the technological tide. While crypto assets are unviable as currencies, the technology behind it is incredibly useful. Blockchain and Distributed Ledger Technology (DLT) is especially well suited to payments and financial record keeping. A distributed ledger gives companies and other users greater access to and control over information. In the payments world, this means transactions can take place almost instantaneously and can be processed at every hour of the day, anywhere in the world. This facilitates more efficient back-office functions and can drastically reduce costs and delays.
Blockchain takes things further by offering a way to establish and share an immutable record of activity, including transactions, money transfers, loans, and shareholder records. It allows businesses to make secure peer-to-peer transactions without the need for a bank or similar intermediary. This has the potential to make our payments system faster, more secure, more transparent, and more reliable. Which is why central banks are dedicating more resources to understanding how the technology works and how they can potentially support it.
This core technology is disruptive and cannot be easily dismissed. Bringing it into the regulatory tent, rather than pushing it to the fringe, could prove the best way to manage it. As money and payments adjust to social preferences, central banks will be expected to do more to facilitate this new technology. Part of this will involve establishing an appropriate regulatory framework that protects consumers, prevents criminal activity such as tax evasion and money laundering, and maintains market integrity.
If virtual assets like bitcoin fail as currencies, then a currency that combines the advantages of fiat money with bitcoin’s blockchain technology could provide the best of both worlds. While not top of mind for monetary authorities in the current environment, it is being explored by some major central banks that do not wish to be left behind or seen to be holding back progress.
According to a survey report conducted by the Bank for International Settlements (BIS), central banks representing a fifth of the world’s population say they are likely to issue the first Central Bank Digital Currencies (CBDCs) in the next few years. While hardly concrete evidence of an impending digital revolution in government money, it is clear that central banks are taking the technology and the potential seriously. In her first press conference as President of the European Central Bank (ECB), Christine Lagarde said she wanted to see central banks leading the way on digital currency:
“My personal conviction is that given developments we see, not so much in bitcoin but in stablecoins projects … we’d better be ahead of the curve because there is clearly demand out there that we have to respond to.”
According to the BIS, there are effectively two competing designs under consideration. One is a wholesale CBDC in which central bank reserves are accessible only to approved financial institutions. The other is a retail CBDC in which anyone can access digital money issued by a central bank. Both would have wide-reaching implications for the transmission of monetary policy, financial inclusion, payment efficiency, security, and intermediation. It would also be highly disruptive, requiring central banks to carefully manage and monitor the transition. If you look at crypto assets as an attempt to create the financial architecture for peer-to-peer transactions, then it could open a new frontier. Existing payments systems must evolve to meet the challenge.
Naturally, there are valid criticisms to overcome. A CBDC would result in disintermediation, effectively kicking banks out of the payments business. It could also make financial crises worse by weakening the banks. During a financial crisis, customers would likely prefer to hold currency that represents a direct claim on central bank assets, rather than hold their savings in a private bank account. This could lead to a run on banks, depriving the banking system of capital, thereby exacerbating the crisis. It is not clear how prudential measures could address this problem, and it is another reason to expect the banks to push back hard against digital alternatives.
The other, more Orwellian, criticism is the potential for a government digital currency to be used to collect information on citizens. Some also see the workaround CBDCs as the prelude to the abolition of cash, removing the ability to transact anonymously. Transparency helps when it comes to stopping money laundering or the financing of terrorists, but how comfortable are citizens with completely doing away with cash?
CBDCs are coming, but they are not without potential threats for data privacy and financial stability. CBDCs could hand governments a pervasive new method of surveillance that could undermine trust and even lead to underground old-tech currency making a comeback. These are real issues that need to be addressed at the democratic level as much as the technological and regulatory levels. However, if governments and central banks can manage these concerns and build a safe and secure currency, there is no reason why it could not become a viable policy.
Bitcoin is not money. But it may have delivered the first popular format for a digital currency that, if properly harnessed and managed, could produce a safer, faster, more efficient, and more inclusive system of exchange. The virtual token that we know for its wild volatility, patchy liquidity, and fragmented market structure has paved the way for something remarkable. Bitcoin will go down in history, but not because it made billionaires out of bedroom traders or drove central banks out of business, but because it led to real disruption to our global system of payments, and laid the foundation for a new way of conducting commerce.