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 ensured 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.

Bitcoin reevaluated

In December 2013 I looked at Bitcoin and called it libertarian bit nonsense. Like most pundits, I’m not good at admitting I was wrong. But I was wrong about Bitcoin. In December 2013 a Bitcoin was worth about $716. As of today one Bitcoin is worth about $3250. (See this index chart.) So if bought a Bitcoin in December 2013 and traded it today for U.S. dollars, your return on investment would be 354%. That’s an annual return of 96%. You are not going to get that sort of return from an S&P 500 index fund.

The dates I picked were random so coins bought at other times might have lost money. In truth if you had bought a Bitcoin in December 2013 you would have to have waited until November 2016 to see a positive return on your investment. For the last year or so though Bitcoin appears to be picking up real traction, taking the new currency to surreal highs.

One reason I was wrong in 2013 is that back then I did not anticipate its major use. Back then it was used for shady transactions but existed on the fringes of this world. Bitcoin seems to have found its niche as a method for facilitating ransomware. Illicit hackers are using it to get money from you when they do things like hijack your computer and won’t let you access key parts of it until you pay them sufficient Bitcoins. (Even then it works only about half the time.) If they asked for dollars or yen then hiding their tracks would be much harder. Making you go out and buy Bitcoins and then sending it to them though makes anonymous electronic thievery much more possible and practical. While each transaction is recorded in the Bitcoin itself, there is no mechanism in the transaction to positively identify the buyer and seller. Thus it’s much harder to catch electronic thieves at work.

I doubt these thieves hang onto their Bitcoins. Bitcoins are still a hassle to trade. Bitcoin exchanges are few and their trustworthiness not to mention solvency are problematic. Thieves probably don’t see the Bitcoins they collect as investment since they are hard to spend on real world goods and services. Most likely they are quickly converted into a local currency where they are then used to buy goods and services.

As a libertarian currency, Bitcoin is having some success. It is theoretically money that can be stored and used independent of taxation, although legitimate sellers that accept Bitcoins probably have to charge taxes on Bitcoin transactions. The percent of sellers that accept Bitcoins though is still tiny, which provides evidence that their value comes from being able to transmit value relatively free from prying eyes. This is one aspect of cash that allows it to endure into the 21st century.

So while Bitcoins may appeal to the libertarians among us, its primary usage is probably to facilitate crime, thus its value and surging price. The harder it becomes to trade illicit money with conventional currencies, the more valuable Bitcoins become, since there are a finite number of Bitcoins out there. Most governments are getting quite good at monitoring transactions of conventional currency. Transactions that are too large result in inquiries that may slow down or stop the transfer of money. With Bitcoins this is currently not much of an issue. Governments are getting better at regulating these transactions. At one time China blocked Bitcoin transactions altogether. They are accepted on certain Chinese exchanges now, but China is proposing to make Bitcoin exchanges subject to money laundering laws and to collect information verifying the identity of buyers and sellers exchanging Bitcoins.

As I noted in 2013, the more a Bitcoin is traded, the larger its digital fingerprint becomes. Some of these coins are becoming so digitally huge that they are inefficient to verify it is a legitimate coin. This is frustrating to many in this community, which is causing other more practical digital currencies to emerge like Ethereum. Currencies like Ethereum try to address issues like the huge blockchains in many Bitcoins and to build in features like identifying buyers and sellers and a limited blockchain ledger. If they gain traction then this undercuts Bitcoin’s ability to keep these transactions confidential.

Whether Bitcoin or some other form of digital currency, all such currencies that rely on blockchain technology are inherently risky, for the same reason that I noted in 2013: they are potentially hackable because they are encrypted. So far to our knowledge no one has successfully hacked into a Bitcoin. If it happens though that a hacking algorithm or a quantum leap in computing power reveals an easy way to mine new Bitcoins then the coin should drop in value precipitously and become essentially worthless. However, if a coin can be “minted” by a provable and legitimate source, say a country’s equivalent of a Federal Reserve, then such digital currency should hold value. This could be done by such organizations holding a registrar of coins it has “minted” that are publicly electronically available.

If that happens though then the onus for having a Bitcoin also goes away, as its value is in its surreptitiousness. Electronic coins that only go through legitimate exchanges and follow policies for tracking and handling illicit uses become essentially legitimate currencies because they are issued and accepted by trusted institutions.

So there are likely to be many more digital coins in our future. Bitcoin’s future as an electronic currency though is likely coming to an end as it becomes computationally inefficient to record transactions with Bitcoins and as advancements in computers, like potential quantum computing potentially render obsolete our current methods of encrypting data, making the encryption keys faster to crack.

Bitcoin’s time has arrived but with its success it is also likely quickly passing into obsolescence. What comes next is unknown but any permanent way of electronically storing untraceable electronic value was probably always myth.