On Purpose #4: Is cryptocurrency, you know...currency?

A few thoughts on the current state of crypto

Disclaimer: My investment firm, Sovereign’s Capital, does not currently directly invest in cryptocurrencies. I own several in my personal account, including Bitcoin and Ether, which are mentioned in this piece and my firm may hold interest in funds or companies that either hold cryptocurrencies or adjacent enabling technologies. This newsletter is not an endorsement of crypto investments generally or investments in any particular coin, fund, or technology. Nothing here is investment advice and you should consult your financial advisor making any personal decisions about your holdings.

There are now more than 15,000 different cryptocurrencies. The global crypto market cap is more than $2 trillion, with Bitcoin alone at nearly $1 trillion as of this writing. The price of Bitcoin in October of 2013 was $196. Today, it’s more than $40,000, and many coins have experienced similar increases in value. Athletes, celebrities, and corporations alike have begun to dabble in cryptocurrencies…yet to most people, the cryptocurrency market itself remains a mystery.

So, what are cryptocurrencies like Bitcoin and Ether? For those brand new to—and mystified by—crypto, I’ll offer a few thoughts below, starting with what I think is the key question of the cryptocurrency market: Are Bitcoin and related cryptocurrencies actually currencies or money?

I think that’s the oft overlooked but central question with regards to the crypto ecosystem. The promise of cryptocurrency broadly is that some will become competitors to national currencies like the USD. Advocates of these coins would argue, perhaps, that they are more focused on decentralized finance, tokenization, and smart contracts than currency (more on that later). But at some point, you will have to believe that if you buy a crypto coin today you will have to be able to use it readily to buy something you want tomorrow at a roughly stable value.

If that never happens—or if people lose faith that it will—a core premise of the industry and the trust on which it relies will be called into question, as will the value of the thousands of coins in market. With nation-states now launching their own “crypto” currencies (Central Bank Digital Currencies), I believe it’s important to consider the question.

What is money?

In his book, The Ascent of Money, historian Niall Ferguson described money as “trust inscribed.” While currencies may have, at one point, held some real values—salt, for example, which was used as a type of currency in some parts of the ancient world—all money today is fiat, meaning that it has no real value except that people trust it will be accepted by others for goods and services.

So, what are the essential characteristics of money? Economists broadly agree on three primary characteristics:

• Unit of Account: To be “money,” something must serve commonly as the standard by which other things are measured. For example, USD is money because in the U.S., almost any item’s value can be quantified in dollars. Lots of things are “worth” something, but are not really a unit of account. My Delta airline miles, for example, have some real monetary value, but no one thinks about the price of a piano in Skymiles.

• Store of Value: Money must be relatively good at retaining its value. No money is perfect—a good currency, for example, will often lose 2-3% of its value each year through inflation and all currencies fluctuate relative to one another unless formally pegged. But if people lose trust that a currency will be worth approximately what they exchanged for it in the future (e.g., through high or hyperinflation) that currency will cease to be money.

• Medium of exchange: This is money’s function as currency—you have to be able to use it to buy stuff pretty readily. Here economists often propose a variety of standards for what constitutes a medium of exchange. It must be stable, recognizable, durable, portable, and fungible for example. But you know it when you see it. Good money is readily accepted where you need it to purchase goods and services directly. As with the Delta example above, my Skymiles are reasonably useful for purchasing Delta flights but not very useful for purchasing ham sandwiches.

In that way, the U.S. dollar is an excellent example of money. It’s a great unit of account—coming in a variety of precise denominations. It’s historically been a strong store of value, with low inflation and predictable pricing relative to other strong currencies. And it’s perhaps the world’s best medium of exchange, accepted universally in the United States as well as in most international markets.

Are cryptocurrencies money?

Obviously, there are thousands of cryptocurrencies, but for our purposes we’ll choose the most widely held—Bitcoin—to evaluate whether that coin, the world’s strongest and one developed explicitly to be a currency, passes muster as money. If it doesn’t, almost certainly the others (whether stable coins or other) do not outside of their narrower closed ecosystems. Spoiler alert: It’s currently pretty borderline, particularly for Americans.

• Is Bitcoin a unit of account? Bitcoin and other cryptocurrencies are partially interesting because they are easily divisible (right now, Bitcoin can be divided into 100,000,000 “satoshis” with the smallest denomination currently <$0.01). And it’s certainly possible to price things in cryptocurrencies like Bitcoin. For some things its even the default. If you want an NFT from Bored Ape Yacht Club for example you *must* use Ether (Ether is kind of designed to be the money solution for the Ethereum ecosystem). And some countries, like El Salvador, have introduced Bitcoin as a national currency alongside the USD or their local currency. But there is currently no country or jurisdiction I know of where the *primary* unit of account is a cryptocurrency like Bitcoin. It’s still the exception not the rule, which makes the case for crypto as a unit of account currently uncertain.

• Is Bitcoin a store of value? Lately, Bitcoin and other cryptocurrencies haven’t just been a store of value but a massive wealth creation tool for those who have purchased them. A Bitcoin cost $196 in October 2013, for example, but is now worth more than $40,000. Other coins have appreciated at different rates (and some have depreciated) but overall cryptocurrencies have exploded as a source of wealth. That doesn’t, however, mean they are necessarily a great store of value because they are currently still so volatile. Volatility itself weakens the case for crypto as a store of value because when I place $1 in Bitcoin in January, I have no idea if by end of year that share of Bitcoin will be worth $0.10 or $10. The same could be said of the Euro, for example, but the fluctuations in value between the USD and other major currencies globally tend to be more modest which allows for things like more predictable trading.

• Is Bitcoin a medium of exchange? Here, the case is perhaps the weakest. Bitcoin and other cryptocurrencies are gaining increasing adoption. There are even countries like El Salvador mentioned above adopting it as an official currency. And I see “Bitcoin” ATMs all over Atlanta these days. But it is still hard to use Bitcoin as your primary way of purchasing goods and services right now as many people and organizations simply won’t accept it. As long as Bitcoin must primarily be converted to a currency like the Euro or the USD to buy most things, I think it will remain questionable whether it is money. The case is much stronger for it as an asset that can be converted to money (like gold) than money itself. And again, with notable exceptions for certain markets (like needing Ether to acquire certain NFTs), I don’t currently see any cryptocurrency that broadly functions as a currency in a major jurisdiction. As countries now pursue central bank digital currencies (CBDCs) it could be even less likely in the future.

I personally think the case for Bitcoin as money is borderline, particularly for Americans. It certainly doesn’t measure up to the Euro or the USD at this time, but it’s undeniably a better currency than the Venezuelan Bolivar, for example, so long as you can find a way to convert it into a local currency when you need it. And it certainly seems poised to function as a major world currency someday if current trends hold. It’s is already the 14th largest currency in the world, just behind the Swiss Franc and ahead of the Russian Ruble (so there’s ample argument contrary to my statements above). And I could easily foresee a future in which a few coins are, in fact, major international currencies operating alongside CBDCs.

But in the meantime, most of the 15,000+ coins in circulation, including Bitcoin, do serve other purposes. What are those?

What other uses make cryptocurrencies attractive?

The space is complex and rapidly evolving, I couldn’t hope to account for all the potential uses of all the potential cryptocurrencies, but a few primary functions come to mind:

• An (often speculative) investment: Most obviously, crypto can serve as a speculative investment. That’s basically the way the U.S. government treats cryptocurrencies today, taxing them like a speculative asset subject to short and long-term capital gains. That’s also, quite frankly, the way most people use cryptocurrency today—with individuals and a variety of crypto investment funds speculating on appreciation in thousands of new and existing digital coins every day. Most of the 15,000 coins out there exist not because they serve any meaningful useful function but because people want to bet on them (and betting is what it is given that most if not all have no fundamental value).

• A store of value in times of uncertainty: In certain contexts, crypto can be a better store of value than local currency. I first realized this hearing an expert from Argentina discuss Bitcoin in 2016, articulating that Americans (who have benefited from a stable currency for some time now) can’t possibly understand crypto as a stable store of value relative to the USD; but those in developing markets subject to capital controls (e.g., China) or hyperinflation (e.g., Venezuela or Zimbabwe) may see something like Bitcoin as infinitely safer and more stable than their local currency. That’s why many of the most crypto friendly countries are in the developing world. Even Americans, now experiencing inflation approaching double digits, may soon see the value in some cryptocurrencies as an inflation hedge in the same way we use gold.

• A way to ensure privacy and protect holdings from a government or institution: Many users of cryptocurrency are looking to operate, for good or ill, outside of the standard financial system and regulatory infrastructure. To be sure, many modern crypto exchanges are very transparent to regulatory bodies, and in some ways blockchain based coins are much more traceable than cash. But there are also ways in which to hold crypto which are private from other users and from governments. This can be a bad thing for those looking to evade regulators for nefarious reasons. But it can also be a very positive thing for those operating under oppressive and restrictive regimes. Stablecoins are one group of cryptocurrencies seemingly most amenable to this function, though they have been the subject of controversy.

• An anchor to a broader blockchain technology: Some cryptocurrencies are really designed mostly to enable broader blockchain ecosystems. Ethereum, for example, is an entire blockchain ecosystem that uses Ether as “fuel” or its form of money. And these larger ecosystems can enable the development, expansion, and refinement of blockchain technologies to develop everything from trading platforms to NFT marketplaces. Many coins will aspire not to displace the USD but to enable a profitable smart contract or token ecosystem.

• Tokens: Some of the other entities in market are not actually pure “coins” (digital money) but instead tokens that offer ownership in some real underlying asset. These are, of course, meaningfully different than coins with no underlying assets attached. They are not and do not aspire to ever serve as money, and they have a bright future as a way to more readily divide and offer ownership of assets from real estate to holdings in companies.

In parallel to these use cases, there are many things that make crypto unattractive. Many of the coins are remarkably environmentally destructive (though some have debated the reality of this destructiveness with regards to Bitcoin and many other coins are legitimately environmentally friendly). Some coins have been unethical schemes and the marketplace broadly is one bad actors use to commit fraud. And almost all coins have been subject to very high volatility. Of the coins in circulation, many are likely doomed to pass away.

But despite those challenges, it seems almost certain that we are living through what will be remembered as only the beginning of the cryptocurrency or decentralized finance era. Learning more about the technology will enable us all to navigate it more effectively. And I personally believe that several of these coins will likely evolve into competitors to national currencies (which themselves, will increasingly evolve to be digital currencies).

So, how should you think about holding crypto?

The decision of whether to purchase a cryptocurrency is a personal one. I’m not offering investment advice in this newsletter, and you should speak to your financial advisory before you make any decisions. But I think about crypto in the following ways:

1. In the U.S. at least, it’s not a substitute for cash. It’s too volatile and doesn’t truly function as a currency. The only places I’d consider it a substitute for local currency are those at risk of substantial inflation/deflation, political instability, or government oppression.

2. It can be an alternative investment. People have made a lot of money in crypto, but it remains a highly speculative, volatile asset class. For most people, that means it should only occupy a portion of their investment portfolio they can afford to lose and should not be leveraged.

3. If you’re going to invest, you either need to learn a lot or stick with the major coins on mainstream exchanges. 5-10 of the coins make up the majority of crypto assets and often (though not always) rest on more tested underlying technologies. Sticking with those as and trading through major platforms with good security protocols is probably best unless you are devoting a lot of time to understanding the space.

4. It can be an essential part of participating in the broader blockchain and NFT ecosystems. Visit opensea.io and you’ll see the beginnings of how crypto can be an essential currency within a closed ecosystem of blockchain technology. And for some coins, that—more than being a broad-based currency like the USD—may be the goal in its entirety.

And again, always consult your financial advisor to address your unique financial situation. For those interested in deepening their understanding of the technology, I’d offer a few resources below. And as always, I’d welcome your feedback as I learn more and potentially follow-up on this post in the future. I’m conscious that many people reading this newsletter will have a deeper understanding of these topics than I do and will hold competing views.

In the meantime, if you want to learn more, here are a few of the resources that have been suggested to me:

1. a16z seems to have the most comprehensive introductory set of readings out there.

2. Several people have recommended to me Ben Yu’s (very long) “Cryptocurrency 101”

3. Jesse Frederik’s very long and very skeptical post on Blockchain

4. Jerry Brito’s and Andrea Castillo’s 2016 Bitcoin Primer for Policymakers

5. Bankless: A Substack newsletter on Bitcoin, Ethereum, DeFi, and NFTs

6. On the Brink podcast from Castle Island

7. The Bitcoin Audible podcast

8. Tangents from Coincenter

9. These newsletters from CoinDesk

10. Crypto newsletters from Bloomberg