Cryptocurrency’s Conundrums

Article Graphic by Ming Yuan Dong

BRB Bottomline: Cryptocurrency faces many challenges in its acceptance as a means of transaction. Perhaps its principle problem is that businesses will not want to accept cryptocurrencies as a payment method until its value stabilizes (the price of cryptocurrencies routinely yo-yo by five percent per day), but this value can only become more stable once people start using it to actually purchase goods and services rather than simply to speculate on perceived future transactional demand. In other words, cryptocurrency’s future transactional demand will only really increase once its present transactional demand increases, since this is the only thing that will allow its value to be sufficiently stable for businesses to accept. This deadlock has no foreseeable resolution.

Crash Course on Crypto

Cryptocurrency has taken the world by storm in recent years, yet there seems to be little agreement on even the most fundamental question: What is it? It appears a simple ontological question, yet people have a multitude of different takes on the subject. Some consider it currency, others a commodity, and still others an artificial construct devoid of intrinsic value. Let’s first establish some basics about the nature of a cryptocurrency. Cryptocurrencies are digital assets designed to work like regular currencies—as stores of value or mediums of exchange between individuals and entities.

Its fundamental advancement, however, is in how transactions take place. Generally, cryptocurrency transactions take place through an innovation called blockchain, which involves using decentralized servers through private key cryptography. Essentially, people across the world run cryptocurrency algorithms on their machines, creating a peer-to-peer network that authenticates and authorizes transactions without a centralized institution. In exchange for running these cryptographic algorithms, members, called “miners,” of the network receive a “block reward,” which is a payment in cryptocurrency. This process, cryptocurrency proponents claim, reduces the risk of centralized corruption which led to disasters like the 2008 Financial Crisis.

However, one obvious problem with this decentralized processing mechanism is that whenever a transaction is processed, the system automatically creates more coins, which leads to inflation. Consider the example of Bitcoin. Because block rewards inherently involve payment of Bitcoin to miners, more cryptocurrency is constantly being created, and at a pretty fast rate—1800 new cryptocurrency are mined on a daily basis, which translates to a 4% annual inflation rate despite the theoretical maximum of 21 million cryptocurrencies. This isn’t terrible, considering that stable currencies typically have a 2% inflation rate, but it does make clear that cryptocurrency, unlike sturdy commodities like gold, will as a whole experience significant inflation over time, especially if those cryptocurrencies start being used by actual consumers.

Cryptocurrencies: Currency or Commodity

But to really understand cryptocurrencies, we have to treat them as commodities rather than bona fide currencies. A commodity is an interchangeable good that can be easily used as an article of commerce. Common commodities include crude oil, gold, silver, pork, and frozen orange juice. Cryptocurrency is more a commodity than a currency because its value routinely changes by 5% daily, making it far too volatile to be used by everyday consumers and companies. Can you imagine if by chance everything you bought in a day was discounted by 5% or 5% more expensive? Walmart’s profit margins before income taxes were just 2% in the fiscal year ending January 2019, according to its annual report filed with the Securities and Exchange Commission (SEC). Moreover, like commodities, cryptocurrencies can be easily exchanged for U.S. dollars or other more stable stores of value.

The Conundrum

Commodities have a supply and demand. The demand for a commodity is created by purchasers who believe that the value of the product will appreciate because more entities will want to consume or use it. In the specific case of bitcoin, its demand should be created by those who believe that its value will appreciate because more entities (either corporations or consumers) will want to use bitcoin in everyday transactions. However, most of its demand is currently being driven by speculation without any tangible evidence of its long-term utility. One problem here is that speculators will not stick around forever; ultimately, bitcoin will have to prove itself useful to the broad public. A second, deeper problem is that the speculators themselves prevent Bitcoin’s mass usability: Because the demand for Bitcoin today is so heavily based on speculation rather than utility, the price is unstable, and because the price is unstable, entities will generally not want to use it as a medium of exchange. This is, in essence, a chicken-and-egg problem: for Bitcoin to maintain present valuations in the long run, a greater proportion of its demand must be based in the desire to transact, but this will only occur when prices stabilize, which will only occur when a greater proportion of individuals are truly using Bitcoin to transact rather than to speculate. So, will bitcoin become a popular method of transaction? It’s possible, but it seems quite unlikely.

Cost of Cryptocurrencies

Another barrier to the long-term adoption of cryptocurrencies is high fees. For example, transacting in cryptocurrency typically costs around $0.43 per transaction, which, while acceptable for major purchases, constitutes more than an 8% fee on a $5 transaction or around 2% on a $20 transaction. Beyond this, it is also difficult to use in (particularly brick and mortar) stores. A major problem is that cryptocurrency transactions cannot be made consistently made in under 10 minutes, as cryptocurrency transactions are batched and done by the network in blocks, each of which takes around 10 minutes. As such, it would be nearly impossible for stores to verify cryptocurrency purchases in a timely manner.

That said, some proponents point out that a way around this problem is to have existing credit card companies or potential cryptocurrency payment companies vet customers and issue miniature lines of credit usable in stores, like how banks today look through clients’ financials before issuing cards. However, it would be difficult for credit card companies or cryptocurrency payment apps to verify the extent of their clients’ cryptocurrency assets. Given cryptocurrency’s current cyberinfrastructure system, this verification would require direct access to user accounts. In light of the current spate of hacks on even the most trusted companies like Equifax, customers would likely be very apprehensive about giving direct access to their accounts to even their credit card companies, let alone emerging cryptocurrency payment companies. There are very few safeguards in place to prevent unauthorized cryptocurrency transactions, so if these payment companies are hacked, many users could lose everything, which is highly unlikely to happen with a traditional bank. Furthermore, even if clients and card issuers were willing to go through the hassle of this necessary vetting, what would they gain?

Because of cryptocurrency’s transactional fees and the necessary financial reviewing costs, payment companies would be forced to charge even more than they already do, hurting both consumers and store owners. There is ultimately very little to be gained by any parties through small, day-to-day cryptocurrency transactions.

Perhaps more significant than its transaction fees and difficult payment process is cryptocurrency’s massive volatility. As previously noted, cryptocurrencies routinely face 5% fluctuations daily. For companies like Walmart, Amazon, or supermarkets in general, which have very slim margins, one daily cryptocurrency downturn can put them in the red for the whole year. As such, retailers will likely be unwilling to accept cryptocurrencies as valid payment. Perhaps more significantly, its volatility is the nail in the coffin of any chance of major business-to-business deals done via cryptocurrency. After all, when powerful entities can securely exchange funds via bank-secured transactions in U.S. dollars, why would they turn to cryptocurrency?

Take Home Points

Unfortunately for cryptocurrency proponents, transacting in cryptocurrency remains difficult; as such, there is much reason to expect its current speculation-driven demand to ultimately evaporate. It may not happen within a year, or even five, but ultimately, without tangible demand for cryptocurrency transactions among the broad populous or among major corporations, cryptocurrency’s value would massively depreciate.

To be clear, I’m not calling for anyone to take a short position on cryptocurrency. Given its current volatility, such a bet would be extraordinarily risky. That said, I certainly am not optimistic on cryptocurrency’s ultimate success and find it difficult to see a substantive, value-driven justification for cryptocurrency’s exorbitant market cap ($100B+). Weigh all the evidence carefully for yourself and see if this is something in which you want to get involved.

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