John Lewis

Will people in 2030 buy goods, get mortgages or hold their pension pots in bitcoin, ethereum or ripple rather than central bank issued currencies? I doubt it. Existing private cryptocurrencies do not seriously threaten traditional monies because they are afflicted by multiple internal contradictions. They are hard to scale, are expensive to store, cumbersome to maintain, tricky for holders to liquidate, almost worthless in theory, and boxed in by their anonymity. And if newer cryptocurrencies ever emerge to solve these problems, that’s additional downside news for the value of existing ones.

The congestion paradox

For a conventional medium of exchange, the more people who use it, the better. Like in telecoms or social media networks, network externalities mean that the more users one has, the more attractive it is for others to sign up. Additionally, most conventional platforms benefit from economies of scale: because their costs are largely fixed, spreading them over more transactions lowers average costs.

But cryptocurrency platforms are different. Their costs are largely variable, their capacity is largely fixed. Like the London Underground in rush hour, crypto platforms are vulnerable to congestion: more patrons makes them *less* attractive. Some (but not all) have very limited capacity: Bitcoin has an estimated maximum of 7 transactions per second vs 24,000 for visa. More transactions competing to get processed creates logjams and delays. Transaction fees have to rise in order to eliminate the excess demand. So Bitcoin’s high transaction cost problem gets worse, not better, as transaction demand expands.

The storage paradox

Ironically, virtual cryptocurrencies relying on a distributed ledger may be vulnerable to a crippling diseconomy of scale through system-wide digital storage costs. Each user has to maintain their own copy of the entire transactions history, so an N-fold increase in users and transactions, means an N-squared fold increase in aggregate storage needs. The BIS have crunched the numbers for a hypothetical distributed ledger of all US retail transactions, and reckon that storage demands would grow to over 100 gigabytes per user within two and half years.

The mining paradox

Rewarding “miners” with new units of currency for processing transactions leads to a tension between users and miners. This crystalises in Bitcoin’s conflict over how many transactions can be processed in a block. Miners want this kept small: keeping the currency illiquid, creating more congestion and raising transaction fees – thus increasing rewards for miners facing ever more energy intensive transaction verification. But users want the exact opposite: higher capacity, lower transactions costs and more liquidity, and so favour larger block sizes.

Izabella Kaminska points out this tradeoff has been *temporarily* masked by capital inflows creating subsidies via the mining rewards system. Newly min(t)ed bitcoins are purchased by incoming investors who just want to hold them long term. Investors cross-subsidise the payment infrastructure, because they are willing to buy the bitcoin created as a block reward for processing payments. But when those buy-to-hoard inflows stop so does the cross-subsidy, and the tradeoff re-appears with a vengeance.

A private cryptocurrency must continually attract more capital inflows to mask the transactions costs ( a staggering ≈1.6% of system payment volume) . By contrast, most traditional mediums of exchange don’t require such sizeable capital inflows to maintain their transactions infrastructure.

The next two paradoxes relate to currencies’ use as a store of value:

The concentration paradox

Despite proponents talk of decentralisation, disintermediation and democratisation most cryptocurrencies exhibit an extraordinarily high concentration of ownership – often in the hands of miners and/or “Hodlers”. 97% of bitcoin is estimated to be held by just 4% of addresses, and inequality rises with each block. Concentrated investor appetite and polarised sentiment makes it hard for big players to cash out, because the very act of selling up may cause prices to plummet…

An asset is valued by the market price at which it changes hands. Only a fraction of the stock is actually traded at any point in time. So the price reflects the views of the marginal market participant. You can raise the value of an asset you own by buying even more of it, as your purchases push the market price up. But realising that gain requires selling- which makes someone else the marginal buyer and thus pushes the market price downwards.

For many assets these liquidation effects are small. But for cryptos they are much larger because i) Exchanges are illiquid, ii) Some players are vast relative to the market iii) There isn’t a natural balance of buyers and sellers iv) opinion is more volatile and polarised. High prices reflect cornering the market and hoarding, rather than ability to readily sell to a host of willing buyers. For some assets with concentrated ownership, investors sometimes fear dominant players selling up. Relative to say, China’s share of US treasuries (≈5%), or central bank holdings of gold (≈20%), the concentration of ownership in cryptocurrencies– and risk of redemption induced crash- is way higher.

The valuation paradox

The puzzle in economic theory is why private cryptocurrencies have any value at all. The discounted cashflow model of asset pricing says value comes from (risk-adjusted, net present discounted) future income flows. For a government bonds it’s the interest plus principal repayment, for a share it’s dividends, for housing it’s rental payments. The algebra of pricing these income flows can get complicated, but for cryptocurrencies with no yield the maths is easy: Zero income means zero value.

A second source is “intrinsic value”. Gold pays no dividend but has value as a commodity for making jewelry, or industrial uses. Cigarettes circulated in prisoner of war camps as commodity money because they had consumption value. But cryptocurrency has no instrinsic value.

Some argue that the breakeven energy cost of mining provides a floor for cryptocurrency prices. But, in Jon Danielsson’s words: “the costs of mining are sunk costs, not a promise of future income”. If I waste £150 on employing labourers to find and exhume the buried remains of my childhood pet tortoise from my parents garden’, those costs don’t make the skeleton worth £150 to an investor.

What other sources of value are there? The mere expectation that in future cryptocurrencies will be worth more than they are today and so can be flipped for a profit? The problem is that if, as Paul Krugman argues their “value depends entirely on self fulfilling expectations”, that is a textbook definition of a bubble.

The anonymity paradox

The (greater) anonymity which cryptocurrencies offer is generally a weakness not a strength. True, it creates a core transactions demand from money launderers, tax evaders and purveyors of illicit goods because they make funds and transactors hard to trace. But for the (much bigger) range of legal financial transactions, it is a drawback.

It makes detecting nefarious behaviour harder, and limits what remedial/enforcement actions can be taken. Whilst blockchains can verify a payment has been received and prevent double spending (albeit imperfectly), many other problems are unsolved.

First, there’s the increased risk of market manipulation or outright fraud when trades and holdings can’t be traced back to named parties .

Second, most financial transactions involve an intertemporal element (a loan, futures contract, deposit of funds with interest). With anonymity, the person who hands over the money “up front” has no easy redress against the other party subsequently reneging on their side of the deal. This severely limits the scope for these transactions, unless there is 100% pre-funding: which is usually prohibitively expensive in terms of tied up capital, and/or obviates the need for the transaction (if I could 100% pre-fund a mortgage, I wouldn’t need one…).

Auer and Claessens demonstrate e mpirically that developments which help establish legal frameworks for cryptocurrencies increase their value. Keep a cryptocurrency far from regulated institutions and you reduce its value, because it drastically restricts the pool of willing transactors and transactions. Bring it closer to the realm of regulated financial institutions and it increases in value.

The innovation paradox

Perhaps the biggest irony of all is that the more optimistic you are about tomorrow’s cryptocurrencies, the more pessimistic you must be about the value of today’s.

Suppose bitcoin, ethereum, ripple et al are just the early flawed manifestations of an emergent disruptive technology. Perhaps new and better cryptocurrencies will arise to overcome all of the intrinsic problems of today’s. After all, early mobile phones were cumbersome and the first cars moved at jogging pace, but subsequent versions transformed the world.

Whereas goods derive worth from their value when consumed, currency derives worth from the belief that it will be accepted as for payment and/or hold its value *in the future*. Expect it to be worthless in the future, and it becomes worthless now. If new cryptocurrencies emerge to resolve the problems of the current crop, then today’s will get displaced and be rendered worthless. Unless of course, existing ones can adopt whatever new features the newbies come up with. But because the previous six paradoxes are so intrinsic to existing private cryptocurrencies, I just don’t think they can.

John Lewis works in the Bank’s Research Hub.

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