Who’s really profiting from crypto?

So I’m continuing to explore cryptocurrencies and specifically why anyone would want to buy them. One obvious reason is greed. While returns on most cryptocurrencies is marginal or negative, as pretty much anyone with a computer can make their own cryptocurrency, the big name cryptocurrencies tend to appreciate exceedingly well. They get a buzz, so that alone makes people want to buy them. It’s gotten to where I can buy Bitcoin at a kiosk at our local grocery store.

In the last five years, one BitCoin appreciated 4075%. You won’t get that return in an index fund. In 2017, Ethereum was virtually unknown and could be purchased at $9.59 each. It’s now worth $3232.61, so it’s up nearly 40,000%! (Technically, Ethereum is the platform, and Ether is the digital currency.)

There’s no way to know which of these coins will take off while the vast majority of them languish. It probably can’t hurt to buy at least some of these coins on the hopes that while most will languish a couple might take off and you could profit from those purchases. Even with established digital currencies though, there are major ups and downs. My BitCoin investment is worth a modest $140.59 at the moment, and my Ether is worth $90.89. A few months ago though my BitCoin was valued at closer to $200. I bought the Ether only recently, but at the moment I’m losing money on it as I spent the $100 in cash in my BlockFi account for it.

Obviously my investment is trivial, but it’s there mostly to get my head around this stuff. So far for me the return has been good but not great. Since it can all appreciate or depreciate very quickly, it doesn’t seem wise to invest too much. It’s clear in general though that digital currency millionaires are very few and that most of us who are late to the party will assume more of the risk because these coins cost more to buy.

I did watch a YouTube video on these currencies recently. It evolved into a discussion on what money is and talked about the gold standard. The U.S. dollar was once tied to the gold standard. What made the dollar valuable was that gold itself is time consuming to mine and process. The gold in our nation’s vaults was “proof of work”. The gold was valuable because it was hard to acquire, which made the dollar valuable because the number of dollars in circulation was (in theory anyhow) proportional to the amount of gold in our vaults.

Digital currencies are trying to create “proof of work”. “Mining” a BitCoin, for example, requires a lot of computing resources and energy use. The computers you use aren’t free and the electricity they use to create it is not free either. Maybe the algorithms used to create the currencies are free but if you manage to mine a new BitCoin (it’s becoming computationally prohibitive) you will sure expend a lot of treasure to do so. This in theory makes the coin worth money.

What makes it valuable though appears to be that buyers reward BitCoin sellers for the hassle it took them to create the coin. The energy and computer resources it took to make the coin can’t be recovered. Gold though is different. It’s a physical thing, although it is expensive to store because it has value and it’s not easy to use it to pay for things as it is, in effect, too precious to be used for routine financial transactions.

But inarguably the existence of these coins proves “proof of worth” because creating these coins is hard to do. If you don’t believe me, try creating one yourself with some spare PCs. For me the question then becomes, “Yeah, so what?” I can dig a hole ten feet deep in my backyard. The fact that I dug it indicates proof of work, but is it valuable? Maybe it would be if I turned it into a root cellar. Building a root cellar is probably cheaper than building an extension to my house for this purpose. With digital currencies though, the fact that you own some part of a virtual coin that was hard to create doesn’t mean much unless you can do something with the coin.

And with most of these coins, their primary value is not to buy stuff with them, at least not directly for most coins, but that they can be traded. Unlike U.S. currency, a digital coin is infinitely splitable. I own 0.00298038 of a BitCoin. I don’t prove ownership of it by pulling it out of my pocket, or from a piece of paper properly notarized saying I do. I own it because a record exists in multiple BitCoin blockchains stored on publicly accessible servers worldwide. I’m pretty sure it’s not directly tied to my name and address, but indirectly with my email address. I can verify my ownership if needed with the private key in my digital wallet or on the BlockFi digital exchange if I exchange it for something else, such as U.S. dollars.

It turns out though that there are other ways these coins generate “proof of work”: the hassle of creating records that show the transfer of these coins from one person to another. These blockchain servers don’t work for free: you have to compensate them for the hassle it takes to make these trades, generally in a percentage of the coin you are trading. If you have a digital coin broker, you compensate them, who probably become the entity to ultimately compensate those who place the transaction on multiple registers. For example, you can see the fees BlockFi charges here. You can think of these fees as similar to interest charges on your credit card or the fees that Visa or Mastercard charge businesses to manage credit card transactions, costs which are largely passed onto you in the form of higher prices.

So in effect these are like taxes, which means that digital coins aren’t quite coins and their price is a bit inflated to cover the cost of using them. If I use some coins to buy a pack of gum at the drug store I may pay a sales tax, but the store won’t have to pay Visa or Mastercard for the privilege of taking my real coins.

If your head is spinning, I’m not surprised. None of this is obvious to most people when they buy digital currencies, but you will be charged coming and going into this market. The profits go to those that “mine” the coin and the brokers that let you trade the coin. They also go to you if you exchange the coin for more than you paid for it after factoring in these fees. But the risk is on you. You will be charged to get into the market, and if you decide to cash in your chips, unlike the casino, you’ll be charged on the way out too.

I suspect except for a few lucky millionaires the real winners are the miners and the brokers managing all this technology, and it won’t be you.

Speculations on the future of digital “currencies”

So my $88.31 or so that I was paid in BitCoin on July 1st is now valued at $174.20, according to BlockFi, where it still sits because I’ve been too lazy to sell it and turn it into U.S. dollars. Looks like my natural lethargy worked in my favor as if I had sold it for on August 2nd, when I last blogged on this topic, it was worth $109.71. I’d be out the $64.49 in extra value it has accumulated since then. If the “currency” continues to rise as it has since I acquired it on July 1st, I’ll get a 666% return on investment and it will be worth $587.95 on July 1st, 2022.

The people who study this stuff think that maybe one BitCoin will hit $100,000 soon, perhaps because it looks like a BitCoin futures electronic trading fund (ETF) will soon be approved by regulators. Anyhow, the guys I follow on YouTube are still all agog on digital currencies. Graham Stephan is upping it to five percent of his portfolio.

Should I do the same? With our portfolio hovering close to $2M, that would be $100,000. No, I don’t think so. But since I have only $174 of digital currency at risk, I see no harm in keeping the BitCoin I have to see how it does as a speculative asset. It will be interesting to track it at yearly intervals.

These digital “currencies” are clearly becoming a new market, like it or not. Lots of people like me continue to feel largely baffled by these virtual currencies. It’s easier to get behind them though when you consider that most currencies are like BitCoin: virtual. That’s true of the U.S. dollar because it’s a fiat currency.

In my last post on this topic, I lamented that there were no assets behind these “currencies”, unless you count the value of the electricity that it took to “mine” one of these “coins”. The U.S. is now the largest miner of digital currencies, and most of it is occurring in Texas where electricity is cheap, at least until there is another winter storm that knocks out most of its power grid. Since most of this power comes from non-renewable sources, owning currencies that are energy intensive to mine, like BitCoin, should come with a carbon tax. Maybe that would deflate its surreal valuation.

Its value is based purely on supply and demand. Which makes me wonder if these currencies are the latest version of a Ponzi scheme and I now own a tiny fraction of an electronic tulip. If it’s a Ponzi scheme, you want to sell your crypto before the market collapses.

What perhaps can be said is that this new “market” is still getting established and time will tell if it’s got legs. But on the other hand, BitCoin has been around since 2009. It’s hard to see it collapsing altogether, if only because so many people have vested wealth in it, and won’t want to lose their investment in it. These “currencies” though are so easy to create that clearly not all them will survive.

I do think that these “currencies” that more closely imitate real currencies are likelier to survive. A lot of work is going into creating versions of these “currencies” that act as currencies. For example, you can buy so-called stable coins whose value is tied to currencies like the U.S. dollar.

These stable coins are generally underwritten by private insurers. Governments are thinking of putting banking-like regulations on companies offering these stable coins, emulating FDIC-like protections. It will be interesting and confidence building if governments but their good faith and credit behind these stable coins by essentially underwriting them. By doing so though they tend to undermine the foundation by which digital currencies were unleashed: to detach themselves from the shackles of traditional currencies. It’s unclear why these “currencies” based on stable coins should be preferred to currencies already in circulation.

I wonder if there will be a Black Tuesday for these currencies. Black Tuesday was the event that kicked off the Great Depression. One of the lessons from Black Tuesday was we needed to keep banks from collapsing, so we formed the FDIC. Because of their decentralized nature though, there’s nothing to prevent a Black Tuesday for crypto, and no organization to prevent it or from happening again.

What’s more likely in my mind is that the block-chain technology rather than these “currencies” will prove to be where its true value lies. Nonfungible tokens, for example, offer proof of ownership and transfer, and work on block-chain technology pioneered by “currencies” like BitCoin. If the goal is to do away with traditional banking, these miners may be onto something. I’m much more skeptical that they can succeed in creating currencies that will be as ubiquitous and fluid as traditional currencies like the dollar.

Sorry, digital currencies aren’t actual currencies

It’s hard to go a month now without a post from me on cryptocurrencies. I dabbled into this market on July 1st when a client paid me in BitCoin, which worked out to $88.31 at the time of the exchange. Since then its price has increased at a much greater rate than the market in general.

Yesterday I moved it from my digital wallet to BlockFi, a crypto exchange, and it was worth $109.47. So over just one month, I made a 24% return. If I could do this for a whole year, the return would be 288% and it would be worth $254.33. It’s safe to say that there is no other asset that I own that would reap that sort of return.

I can’t see eleven months into the future. You will get a million different opinions about where BitCoin’s value will be going. What I can say is that it fluctuates a lot. Since yesterday, its value dropped to $103.71. Volatility comes with the digital currencies territory.

What doesn’t change that much is the value of the U.S. dollar on a given day. Right now there are innumerable news stories because inflation in the last twelve months has been running in the 5-6 percent range. But if I had planned to spend my BitCoin today on something tangible, I’d be paying 5.26% more for it than yesterday. So in a way my BitCoin inflation rate was 5.26% and this occurred over just one day. Wow! But no one seems to be holding BitCoin to the same inflation standard as the U.S. dollar.

Why is this? To paraphrase The Grinch Who Stole Christmas, I puzzled over this until my puzzler was sore. Both are currencies, right? Well, no. BitCoin, Ethereum, Dogecoin and the rest are not actual currencies. Just because someone slaps a label to it, doesn’t make it an actual currency.

Okay, it is a currency in the sense that you can trade it for things of value, like until recently a Tesla. Right now at least though you can’t buy most things in these “currencies”. In my case, I buy them in U.S. dollars. Given that you can’t buy much with them, they are only currencies in a very limited sense. If you really want to buy something with your BitCoins, you are probably going to sell it to someone who will give you a local currency like the U.S. dollar in exchange for it. That’s what I aim to do with my BitCoin. It will feel real when its value in U.S. dollars hits one of my accounts denominated in U.S. dollars. Until then, it’s funny money. But actually, it’s not money.

So the fundamental premise behind “digital currencies” is false, as except in some very limited cases you can’t use these as money. That could and maybe will change over time, but right now for most practical purposes, they’re not currencies. They are not money.

So what are they? Some call them assets. For me, calling them assets fails the smoke test too. An asset is something you own, and it amounts to something tangible and real. These assets are often denominated in shares, so in that sense they are somewhat virtual. As an ex federal employee, I’m still in its Thrift Savings Plan (TSP), their fancy name for 401K/IRA. I have, for example, 2686.0352 shares in the TSP C Fund, which is a basket of funds. It’s likely that some part of its current value of approximately $203,000 is invested in IBM, so I own part of that company along with lots of others. I can claim my share its capital gains and dividends, at least when I sell them — it’s a tax-advantaged account. I own some part of the buildings that IBM owns and the computers and equipment inside them and in its warehouses.

What can I say about the assets behind my BitCoin? Well, I can say there are no assets. That’s not to say it doesn’t have value. If I can convince someone else to buy my BitCoin and give me U.S. dollars, I can take and spend those U.S. dollars pretty much universally. There is no BitCoin headquarters to go to if the currency goes bankrupt. If it does, I’ve lost the value of my BitCoin. Its value lies merely in its perception.

The same is true with U.S. dollars, of course. Dollars are perceived to have value because the U.S. government stands behind them. You aren’t entitled to your share of the gold in Fort Knox if the U.S. government collapses, but we do know there is an institution, a lot of smart people, and the full faith and credit of the government supporting it. If my bank account is FDIC insured and my bank goes belly up, the government will give me the value of my account in U.S dollars, up to $250,000.

If for some reason you have an incompetent government, then a currency can collapse too. Venezuela’s currency is just one of many recent examples. So I have plenty of incentive to keep the U.S. government functional. No wonder I obsess over whether certain radicals might succeed in doing away with our democracy and setting up an autocracy. If nothing else, the value of my U.S. dollars would get very iffy.

Those into “digital currencies” are placing faith in them too, mainly that they can’t be hacked or undermined. That’s pretty dubious to my way of thinking. One thing is clear is that they are subject to the laws of supply and demand. If demand ceases because they aren’t trusted, they become effectively worthless. Just like Venezuela’s currency.

These “digital currencies” are actually speculative assets where the asset is basically the successfully operation of an advanced computer algorithm (which spits out a “coin”) and the faith that blockchain-powered servers will be around to certify transactions in these assets. All of them share one fundamental weakness: they require the Internet. Some share another weakness: they depend on governments to allow their use. It’s hard to transact these “currencies” in China because for the most part its government won’t allow it.

Currencies facilitate the exchange of value. But they have one other important asset: they hold their value within a reasonable range of inflation over a long period of time. If they don’t, this money will move toward other currencies that do a better job of retaining their value. In short, they facilitate savings so that their value can be quickly and conveniently spent.

Digital currencies currently do not excel in either easily exchanging value or as a reliable source of savings. To my mind, this tells me they are not a currency.

So don’t treat them as such. With time, it’s likely the U.S. and other governments will create their own digital currencies. The blockchain technology that is the foundation of these “digital currencies” is something of value. It will be leveraged by other more stable entities like the U.S. government to more conveniently, securely, cheaply and transparently exchange value.

It’s hard for me to see a business case for “digital currencies” once governments start issuing their own.

Cryptocurrencies and true financial value

Until recently you could buy a Tesla with BitCoin. Elon Musk though recently changed his mind because it was an environmentally unfriendly currency, since newer mined BitCoins are mined using tons of servers, many of which use electricity generated by fossil fuels. So Musk is going toward more environmentally benign cryptocurrencies. There’s a lot of them out there and anyone with the right software and hardware can create their own. To use a cryptocurrency though you have to convince others to buy, use and accept them.

To say the least, cryptocurrencies are highly speculative. Coins most often mentioned in the media seem to do the best, and these include BitCoin, Ethereum and a literal joke currency, Dogecoin. With Elon Musk going all in for cryptocurrencies, the rest of us are left scratching our heads wondering if we’re missing something. Maybe we need to start buying cryptocurrencies too.

I had a customer recently who wanted to pay me in BitCoin. I told him no thanks, but he thought I was foolish because BitCoin’s price was likely to keep going higher. Maybe he’s right. All fiat currencies are speculative too. The U.S. dollar depends on the full faith and credit of the U.S. government and nothing else. Given how fragile our democracy is at the moment, maybe I should be trading dollars for BitCoin, Ethereum and Dogecoin.

Governments seem to be accepting the inevitable. I noticed on my tax return I had to answer some questions about cryptocurrencies, to make sure they were appropriately taxed. Cryptocurrencies seem to be settling in as a thing.

With the exception of real coins, all money is an abstraction and a shared delusion. It solved the messy problem of exchanging goods and services conveniently. BitCoin is not convenient, given the time and hassle it takes to exchange them, although it is getting easier. Others may be more convenient for transacting business where they are accepted, but the general market remains a long way from generally embracing cryptocurrencies.

The faith in most cryptocurrencies is that they are either hard to manufacture or that their block chain technology helps instill some sense of trust. Dogecoins are relatively easy to create, but they sure don’t look like a hedge against inflation. Five billion new Dogecoins are created annually, which means 2.7 million new Dogecoins go into circulation every day. It hardly looks like a precious asset, but where they are accepted at least they should be easy to spend. You shouldn’t have to worry about running out of them. The U.S. dollar is backed up by the U.S. government. The U.S. government at least has people overseeing the management and distribution of dollars. The same can’t be said about many cryptocurrencies.

I notice that those most into cryptocurrencies tend to be those who are libertarian, at least in spirit. They want the best of both worlds: a currency that retains its worth over time but also has the advantage that money provides: an easy exchange of value. It’s highly debatable though whether a cryptocurrency can hold its value. The run up in cryptocurrency prices seems due to supply and demand: more people are buying into the idea/hype of cryptocurrencies, which drives up their prices. Cryptocurrencies strike me as speculative investments without any firm moorings. Much like the Dutch tulip mania of 1637 demonstrated, these currencies hold value as long as we agree with the illusion/delusion that they have value.

I can see investing in cryptocurrencies as a highly speculative way of reaping short term profits. If I believe that there are many more enthusiasts of cryptocurrencies out there to be persuaded, buying some of these and hoping their prices go up, then selling them when they reap a handsome profit, makes a certain amount of sense. I would look at any money invested this way as money I could live without if the tables on cryptocurrencies I bought turned. I would not bet the house on cryptocurrencies appreciating. I would view it more like going to Las Vegas and gambling $1000, but no more than $1000, just for the fun of it. I strongly suspect though that having this approach does not make me a good candidate for investing in cryptocurrencies. I suspect most of these investors are looking to become millionaires through this sort of investing. People like me don’t rush in where angels fear to tread.

As an asset though, I consider these decentralized cryptocurrencies fool’s gold. In that sense I think Elon Musk is being foolish, but as the world’s richest person he can afford to be foolish on a grand scale. That said, over time it may be that we will have no choice. Cryptocurrencies may gain such traction that they can’t be ignored. There may come a time when going to a foreign country might require buying a cryptocurrency, because it and the local currency will be the only currencies accepted.

If that happens though we may be in for a world of trouble. The U.S. dollar’s value is based on the full faith and credit of its government. But nothing is forever. The U.S. is likely not forever as well, so having most cash parked in U.S. dollars could be foolish if our government ultimately collapses. It’s just a safer best than most other non-cryptocurrencies out there, and that it is the de-facto cryptocurrency of the world makes it a reasonably safe harbor … for now.

Real assets though is tangible stuff you own. You don’t own your savings account. It seems like we do, but its value is wholly dependent on the institutions that oversee it. With cryptocurrencies there are generally no people regulating it. If there are, it doesn’t amount to the investment in people and resources that countries give to managing their own currencies. Inflation may be the penalty we pay to make sure our currency doesn’t collapse altogether, because if the U.S. dollar weren’t overseen and regulated, it would probably collapse pretty quickly.

The deed to my house and cars, the portions of my portfolio that represent a percent of ownership in various stocks and funds, these are real assets because they have true value. All forms of money have some risk associated with them. I think many drawn to cryptocurrencies are suffering from a shared delusion that they can take the risk out of money through computer algorithms. I think they are likely to be disappointed in time. I’d rather own currencies that are managed by people because as flawed as we are I trust economists managing currencies more than I trust a computer algorithm.