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Thursday, May 13, 2021

Cryptocurrency Short Comment

Although I had written a couple of theoretical articles some time ago, I have largely ignored cryptocurrencies. However, there has been enough newsflow about them that I decided I could do a drive-by comment. In case one wants an investment recommendation, all I can say is that the underlying problems they face are straightforward, I have no way of knowing the timing.

The thing I find most interesting is that attention has switched to Dogecoin, which is a meme coin. The reason why this has happened is solely based on the fact that its price rose by more than Bitcoin. This deflates much of the propaganda being emitted by Bitcoin enthusiasts, who insist that Bitcoin will replace fiat currencies and lead to a libertarian economic utopia. Instead, most people are buying it because the price went up. The doggy coin price went up? Well, buy that one.

(Note: I wrote this article before Elon Musk did a tweet on Wednesday that apparently blew up Bitcoin. I doubt that this really matters much in the long run, since something else equally stupid will happen relatively soon. Nevertheless, this sort of shenanigans help explain why I do not take Bitcoin seriously as a currency.)

Historically, bubbles burst when the asset gets distributed into the hands of those least capable of understanding the risk. This is normally money market investors. I do not see that happening any time soon, which means that there is no obvious end game based on that metric.

Fundamentals

From a fundamental perspective, we need to look at cryptocurrencies as systems. The system faces a fiat currency cash flow drain, as the miners need to pay for electricity and their hardware. Meanwhile, people working in the area of cryptocurrency need fiat to keep up their lifestyles. This implies a need for fiat currency inflows.

If we put speculative demand for the cryptocurrencies aside, the only source of fiat cash inflows are those needed to pay the transaction fees for whatever transaction flow they support. (The fee is normally denominated in the cryptocurrency, which needs to be purchased with fiat.) This is a subset of total transaction fees being charged, as speculative demand for the cryptocurrency also generates transactions. If the speculative interest reverses, so will transaction fees.

I find it rather hard to believe that non-speculative transaction fees are large enough to pay the wages, electricity and hardware bills for the entire system. So we have a situation that is entirely predictable from Minsky's writings about the business cycle: the belief in future appreciation of the asset drives fixed investment and speculative inflows into the asset.

Timing - Who Knows?

The earliest history of cryptos involved them mainly being held by technology investors. Technology investors have plenty of practice generating squeezes in speculative assets and ramping up their price. Since none of the cryptocurrencies have inherent value, there is no particular valuation metric they need to revert to.

However, cryptocurrencies are increasingly held by financial market participants. They buy the line when it goes up -- and sells when it goes down. Although they have an incentive to ramp the price, at the same time, they will keep their eyes on the exit door (which true believers will not). 

That said, I do not see any reason to expect a collapse -- that might only happen if the authorities decide to stop the inflows from the financial markets. A much more plausible outcome is a wide trading range, with waxing/waning levels of enthusiasm. The technology industry spawns enough new believers over time that they will put their income into the asset, ultimately filling demand holes.

In other words, crypto is just an outlet for gambling-like behaviour. Other than helping push along global warming and creating an extreme annoyance for anyone who wants to upgrade their computer's graphics card. it is a zero sum game that has little macroeconomic import for the large countries. (A small country that is a mining hub will feel the effects.)

(c) Brian Romanchuk 2021

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