Is Bitcoin a currency ?

Or for that matter, is any other cryptocurrency a currency ?

This is a question that is often asked. And the answer that is often given is that just like any other currency, they allow for the transfer and store of value. By using a shared ledger that is distributed among users of a cryptocurrency like Bitcoin, their creators ensured that any transaction can be recorded, and is verifiable without a central authority like a bank. But then, the question that comes next to mind is that besides the technology, are there any economic principles behind the design and operation of a cryptocurrency ?

Most of the economic thinking by cryptocurrency creators and platforms have been on around how to make it cost prohibitive for anyone to overwrite a shared ledger of transactions and manipulating transactions to work in their favour, such as making transactions credit value to a hacker. Hence, while cryptocurrency creators and their developer communities focus on all sorts of game theoretic strategies, are cryptocurrencies even doing what they were designed to do — that is, used as a medium for quick, cost effective payment transactions ?

The answer is ‘No’.

Bitcoin and other cryptocurrencies are today traded and held more like assets. Like any asset, the price of Bitcoin goes up or down every day. It is not like other regular fiat currencies we hold that we use primarily for transactions. Most of us do not hold fiat currencies because their prices go up and down ! Why Bitcoin and other cryptocurrencies are not being used mostly as a way to make payments could be due to factors such as acceptance by merchant businesses, the actual speed and cost of transactions, or the ease of making such payments.

However, there is one very important difference between a fiat currency and a cryptocurrency today that might be one more important reason why cryptocurrencies are not accepted widely — that is, holding a fiat currency in an account in a bank returns an interest income, no matter how small, while holding a cryptocurrency in a wallet does not return an income. This is the ‘Opportunity cost’ of holding a cryptocurrency.

The opportunity cost is simply the income we forego by holding a cryptocurrency. And it perhaps holds a clue about another factor that makes a cryptocurrency risky to use in real life transactions — its volatility. But first let’s look at a scenario where the holder of a cryptocurrency is compensated to offset the opportunity cost of holding it.

Cost vs Returns of holding a cryptocurrency

The illustration above shows a simple demand and supply function where the supply curve for the cryptocurrency is vertical which reflects that supply is more or less inelastic during the term in consideration. The demand curve slopes downwards to the right and intersects the supply curve at a point Cx$, which is the opportunity cost of holding the cryptocurrency with respect to a fiat currency, let’s assume the US dollar for our example. The sloping demand curve implies that if the return on holding the cryptocurrency is brought down, its demand also comes down, and vice versa. Now, if there is a way to compensate the holder of this cryptocurrency with a return indicated here by iff, would the holder be indifferent to having this cryptocurrency in a wallet vis a vis having fiat currency in a bank account ?

If your answer is a ‘yes’ to the above question, it means that the cryptocurrency certainly becomes more acceptable and therefore, usable for payments. But then, how can anyone determine the return that a cryptocurrency should have ?

Year 2016 figures

The illustration above shows the great variation in yields of government securities across the world. These yields reflect the opportunity cost (Cx) of holding a cryptocurrency in these countries.

If the funds rate in a country on fiat money is 3%, the holder of a cryptocurrency would require a 3% return on its cryptocurrency holdings to offset the opportunity cost of not holding fiat money. However, they are just one component of the total opportunity cost.

The second component is the return a holder of a cryptocurrency will make by lending it to someone in another country. So, if the cost of borrowing or the lending rate is 3.5%, anyone holding cryptocurrency would need to earn at least 3.5% on loans given out in a cryptocurrency to borrowers of such a cryptocurrency residing in another country.

And by corollary, the third component is the benefit that a borrower gets by borrowing cheaply from a country with low rates. After all, someone in a country with high interest rates has the incentive to borrow from a country with low interest rates. So, if this holder in a country with a 3% funds rate gets a borrowing rate of 1.5% from the holder of the cryptocurrency in another country, it makes sense to borrow instead of buying the cryptocurrency with local fiat currency and thereby, make a net benefit of 1.5% since the local fiat currency would still make a 3% if it is not converted into the cryptocurrency.

The effective return that the holder of a cryptocurrency would then make is

iff = the funds rate on fiat currency + the lending rate on fiat currency + (funds rate on fiat currency - borrowing rates on cryptocurrency).

What this means is that if the return on holding the cryptocurrency, iff is at least equal to Cx or the opportunity cost of holding the cryptocurrency, there is a business case for using the cryptocurrency. If iff is more than Cx, the demand for cryptocurrency will go up and will push up its price or, in other words, it will appreciate against the local fiat currency, and vice versa.

Considering the opportunity cost of cryptocurrencies therefore opens up interesting possibilities of making cryptocurrencies more acceptable and usable. Of course, mechanisms of administering factors that assure such returns on holdings of cryptocurrency, and devising mechanisms to stabilize returns with respect to costs are interesting challenges.

Disclosure : I am working on the design and implementation of a digital currency protocol at Verified AG called the Via that imbibes some of these ideas in the article. The Via is a fiat collateralized digital currency that is designed for transferring value between applications running on different blockchain platforms, hence the name Via. Please feel free to connect with me on twitter and subscribe to developments on Via.