Cryptocurrencies: The Rise of Decentralized Money
This article is the first installment in the Cryptocurrencies series exploring the nature of cryptocurrencies and their economic significance going forward. Future editions will examine blockchain technology and initial coin offerings (ICOs), among other topics.
Cryptocurrencies are unique instruments in the investing world. They share many characteristics of traditional currencies but can also serve as platforms for more sophisticated financial products.
Judging by their price history alone, cryptocurrencies are easy to dismiss as a bubble. And, indeed, the crypto space is filled with questionable offerings.
However, a discerning look reveals a new financial technology with the capacity to fundamentally change the global economic landscape.
A Short History
The cryptocurrency phenomenon traces its roots back to 2009, when someone writing under the pseudonym Satoshi Nakamoto laid out its theoretical framework in “Bitcoin: A Peer-to-Peer Electronic Cash System.”
While the idea of electronic cash wasn’t new, it had never attracted wide acceptance. One important roadblock was the “forgeability” of electronic information: It meant that bad actors could potentially create money out of thin air. Earlier systems relied on centrally managed servers that “held” electronic cash. Their vulnerability to cyberattacks also posed a serious problem.
Nakamoto’s paper addressed forgery and security concerns. By cryptographically chain-linking transaction records and placing them on a decentralized network, Nakamoto created an immutable, self-propagating ledger. It allowed users to store, spend, and transfer value. This network effectively functioned as a bank, except it had two other groundbreaking properties.
It was impractical to (a) hack or to shut down and (b) it eliminated the need to trust a third party to hold value/verify transactions. The bitcoin network was the proof-of-concept for creating and managing money outside the control of any single entity.
Since then, the cryptocurrency space has come a long way. There are now many new cryptocurrencies that seek to address bitcoin’s shortcomings — its transaction time, transaction throughput, scalability, and resource-friendliness — one way or another. The technology is developing fast and the best types and use cases of cryptocurrencies are yet to come.
Cryptocurrencies: What Are They?
The media has covered cryptocurrencies for a few years now. Despite these efforts, the true nature of cryptocurrencies remains somewhat murky and undefined. At the moment, cryptocurrencies represent different things to regulators, bankers, and to the general public.
The US Internal Revenue Service (IRS) classifies cryptocurrencies as property, the US judiciary system considers them a commodity, and bankers see them as competition. Individuals, on the other hand, tend to view them as investments.
While the battle over the regulatory status of cryptocurrencies continues, those who are interested in their practical application need to ask themselves three fundamental questions:
1. What is money?
Economists define money in terms of its properties. According to their definition, money is anything that can serve as a:
- Store of value: It can be saved and used later.
- Unit of account: It can be used to quote prices.
- Medium of exchange: It can be used in to buy and sell goods and services.
In the United States, money is also recognized as legal tender by the government. Its worth noting that the US definition of legal tender does not seem to preclude private businesses from accepting other forms of payment, including cryptocurrencies, though this may not be the case in other jurisdictions.
This means that government is not an essential component of money’s general definition, although it plays an important role in creating and circulating fiat money.
2. Are cryptocurrencies money?
We tend to think about money in physical terms, but anyone with a bank account and internet access can experience its abstract nature firsthand. Jack Weatherford — an anthropologist and author of The History of Money, among other books — notes the evolution of money from a commoditized representation, in the form of stones, salt, tobacco, dried fish, rice, cloth, etc., to a tokenized one, in the form of coins and paper money, to the more abstract form — the digital money.
In its essence, money is an abstraction with a set of fundamental properties that justify its use.
Within this context, cryptocurrencies are money. They mark the continuation of the larger historical trend of money moving from the concrete to the abstract. They possess the three properties ascribed to money by economists. Last but not least, they are gaining wider global recognition. If anything, cryptocurrencies represent the next stage in money’s evolution, one that does not rely on a central authority for governance.
In that regard, cryptocurrencies are the first independent global currency since gold and silver.
At the moment, decentralized cryptocurrencies have relatively low transaction throughput, which limits their use. For example, the bitcoin network is designed to processes five to seven transactions per second. This is nowhere near the throughput of Visa or Mastercard, which process thousands of transactions per second. It is also one of the main reasons bitcoin has struggled to gain acceptance as an everyday currency.
While important, this limitation needs to be analyzed in the context of the network’s other important features, among them transaction time, transaction throughput, and network decentralization, or security. They are interdependent.
Improvements in transaction time and throughput come at the expense of decentralization. Second-generation cryptocurrencies such as Ripple and Stellar have built their networks on the idea of relaxing the decentralization parameter. Their throughput capability is comparable to that of Visa and Mastercard. However, they are not as decentralized and hence probably not as secure as bitcoin.
In their current incarnation, cryptocurrencies are imperfect. But the problems they face are not unsolvable, and the crypto space is continually engaged in finding workable solutions.
One third-generation cryptocurrency — Cardano — seeks to combine formal scientific methods in cryptography with the tenets of game theory to build a cryptocurrency platform that offers high levels of throughput and interoperability with traditional financial systems, including compliance. It proposes to accomplish this without compromising on network security, customer privacy, or energy resources.
These are lofty goals and much of the mainstream adoption in this space depends on the success of Cardano and similar ventures.
3. What is the economic significance of cryptocurrencies?
Apart from their obvious use case as money, cryptocurrencies can play a significant role in increasing global economic participation and protecting against government overreach.
Globally, there are some two billion people without bank accounts, many of whom do not have the money to open or maintain an account. Cryptocurrencies have low adoption costs, are divisible into small fractions, and have practically no minimum account requirements. This means anyone with a phone or an internet connection can access the equivalent of a bank account and participate in the global economy.
This application isn’t limited to the developing world. The United States has a sizeable unbanked cohort as well. Cryptocurrencies could help integrate the unbanked into the financial system, creating synergies across the economy and generating additional tax revenues.
The decentralized nature of cryptocurrencies is equally important. It provides an alternative avenue to traditional financial systems to preserve, transfer, and manage wealth. Cryptocurrencies offer protection against unlawful government seizures and can mitigate the political risk that could lead to systemic financial calamities.
Conclusion
By seeking to provide a secure, fast, and frictionless means to store, spend, and move value, cryptocurrencies are challenging the traditional pillars of the financial system. Despite their seemingly ethereal nature, they have attracted talent and enough monetary momentum to change the way we transact, raise capital, and organize ourselves to create economic value.
Cryptocurrencies mark the ascent of independent, decentralized, “government-free” global money into the world economic order.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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It was high time that CFA Institute addressed cryptos in some way. Reading this blog was reassuring. I am Level 3 candidate from India, and have been involved with blockchain technology for some time now.
Few of many facinating facets of this tech that excited me-
— ICOs have paved way to raise capital from global audience removing many barriers.
— Ease of transaction has attracted thousands of millennials. That can be a glance into future vis-a-vis blockchain becoming mainstream.
— Like any other new asset class, cryptos have garnered significant curiousity.
— Blockchain is witnessing participation of people from varied backgrounds.
— And, every other project is working to be the next generation of ‘ Good Old Bitcoin’.
— Just like primitive internet, blockchains will lead to many expected and unexpected use cases.
Calling cryptos ‘bubble’ may be justified in that the numbers of projects mushrooming across the globe. However, there will be survivors with best use cases. And those survivors may well alter the financial and other sectors fundamentally.
Blockchain technology has a promising future, but it will never be allowed as a mainstream currency because of three powerful headwinds: governments, banks, and environmentalists. Governments would have to give up their power to tax and control capital. Good luck trying to circumvent that central entity. But, good concept and the technology will definetly have a future.
CFA Society Boston has been running programs on Crypto/Blockchain since 2014.
I think there’s a bit of sleight of hand in this article.
Let’s objectively consider whether cryptocurrencies really meet the 3-part definition-of-money test:
– Store of value: Not really – values are subject to wild gyrations and lack the stability and resiliency of the most important currencies they seek to substitute: USD, EUR, GPB, YEN.
– Unit of account: Not really – sure you can quote prices in cryptocurrency, but have another look at prices a month later and chances are they’ve changed. The real price quotation occurs in a stable currency that is simply convertible to cryptocurrency, the crypto-quotation itself is derivative.
– Medium of exchange: Not really – the number of merchants and service providers that accept payment in cryptos is still exceedingly small and very far from reaching anything near a critical mass.
Some of these points may be debatable, but I think it would be very difficult to seriously argue that cryptocurrencies, in their current form, meet all three conditions of the 3-part test. Therefore, by the author’s own selected standard, cryptocurrencies fail to meet the definition of money.
The point that the author was making has to do with the fundamental capacity of crypto to be classified as currency.
You CAN store it, you can exchange it for goods and services and you can quote prices in it.
Adoption and price gyrations, while important, are exogenous to the issue of classification and largely depend on your base currency willingness of the government to accept crypto (with Japan being the most advanced in this realm).
Note that by your standards the more volatile currencies (e.g. Veneselan bolivar) aren’t really money…
Compared to the bolivar Bitcoin is a pretty stable and easily accessible alternative.
Myself truly want to know about
Sharjah Coin
When will Deribit-Bitcoin start trading the options in demo
Also is it possible for me to attempt CPA from Australia.
For a currency to be embraced and work you need price stability. Imagine borrowing money in Bitcoin at $100 and paying it back at $20,000. ou also need trust. What happens if your bitcoin gets hacked? There are no barriers to entry? Dogecoin etc.. It is unregulated. It’s not a store of value either.. buying Bitcoin at $20,000 and selling at $7,000? As an investment it has no intrinsic value and no margin of safety. Yes it is finite .. but so could the currency of a small emerging nation who legislated not to print anymore money, what would that be worth? No doubt cryptocurrencies will emerge but I think more likely backed by central banks or large international banks. Maybe worth listening to Munger, Buffett, Druckenmiller, Gundlach, Dalio etc…
There are a lot of misconceptions around bitcoin and the blockchain technology. Bitcoin network can’t be hacked. Your credit card is more likely to get hacked than bitcoin network.
About Buffet and Munger: they may be out of their depth on this one. Incidentally, Buffet admitted they missed the boat with google and amazon because they didn’t believe in “mumbo-jumbo” business model of high tech industry.
I understand the concept is new to a lot of people. Those who understand crypto sometimes feel like people who invented cars… that they have to confront people who argue how cars make terrible horses. The argument isn’t false, but the fundamental premise is misguided especially if your final goal is to get from point A to B.
If you like to follow big guys, see how Soros and Rockefellers are moving into cryptocurrencies. Here is the link: https://www.zerohedge.com/news/2018-04-08/rockefeller-familys-3bn-vc-fund-unveils-plans-invest-crypto
Who decides whether a currency is considered legal tender? Who gets circumvented by cryptocurrency? Answer to both questions: government.
Definition of legal tender: https://en.wikipedia.org/wiki/Legal_tender
Example of a state government recognizing bitcoin as legal tender: http://fortune.com/2018/02/10/arizona-bitcoin-taxes/
I know the definition of legal tender and I know that most governments allow it right now. So, you are telling me that crytocurrencies wont be regulated in the future and will stay out of the reach of govt. They will loose their attractiveness once they are more strictly regulated. Then you are left with just another volatile currency. But, to each your own, go ahead and load up, in going to hold off.
google and amazon aren’t crypto currencies .. they are real business. Yes Buffet/Munger missed them as they couldn’t be sure they were sustainable – most things aren’t. But munger and buffett well understood their potential attractive characteristics as investments – of which crypto-currencies have none.
Yes cars changed the world .. but people who invested in the 100’s of early car companies mostly ended with nothing – most failed
soros is a trader – he’ll trade anything .. maybe he wants to go short.
rockefeller .. I don’t think he belongs in the same club .. John D is long gone..
yes the function of money will change over time .. all things do.. but in its current form I’d say buying cryptocurrencies thinking they are money is a very dangerous strategy and I’d be careful advocating as much
Crypto is not acceptable from AML point of view – end of story! This is a real test for CFA Institute and local Societies i.e. do we still stick to our core values (Code of Ethics and Standards of Professional Conduct). Do we?
Marko,
Are you suggesting CFA somehow betrays its core values by covering an emerging asset class/technology? Way to be dramatic and/or conflate the issues! Clearly you didn’t read the article till the end…
“All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.”
On a less dramatic note: I suggest you buy a coin on a cryprocurrency exchange (Coinbase is a legitimate business in the US) to experience AML/KYC at work.
Since we are talking about standards here: the CFA institute Standard V-A requires having a reasonable basis. Comments like yours, i would argue, would not pass it. They are certainly not helpful in building awareness about new a new technology that is most likely redefine the financial space.
What you believe is entirely your choice, but dragging the CFA institute into this is not a move a true professional would make.
As a reminder: public blockchains are a boon for law enforcement because every transaction in them is imprinted for eternity… but of course you didn’t know that!
How’s the Crypto investments going?
We are doing pretty well. How’s that investment in negative yielding bonds?
Cryptocurrencies mark the ascent of independent, decentralized, “government-free” global money into the world economic order.
attempts to buy ethereum have failed
no info is prpvided on how to buy ethereum
I have done all I could to buy ethereum which has failed
all I got was people trying to defraud me
all attempts to buy ethereum have failed
you sould have a more simple way for people to buy ethereum
all attempts failed
i got comments from all oiver the world from people trying to defraud me
yoiu should ghave made it simpler for people to buy etherereum
all instructions were followed but all I got was peo[le all over the world trying to defraud me
never will I attempt to be involved in crypto again
as they say it is a fraud
Dla osób znających język polski przygotowałem kurs w którym omawiam zagadnienie pieniądza oraz technologii blockchain:
https://helion.pl/ksiazki/blockchain-kurs-video-cyfrowa-ewolucja-w-swiecie-finansow-tomasz-waszczyk,vwszdf.htm#
Z pozdrowieniami,
Tomasz Waszczyk
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