Guidebolt

Cryptocurrency Economics

2017.12.10

Introduce me to the economics behind cryptocurrencies like Bitcoin.

Sure. To keep things familiar, we’ll compare Bitcoin (BTC, the top cryptocurrency) against the US Dollar (USD, the top national currency). Let’s start by acknowledging that we are looking at currencies. All currencies are judged on the same metrics of usefulness. First and foremost, a currency must be protected against unauthorized duplication such as counterfeiting and double-spending. Second, a currency must be easy to use and safe to handle. Third, a currency must be fast, cheap, and accurate to send or receive. Fourth, a currency must have appropriate supply control, value anchors, and other stabilizing mechanisms so as to prevent damage to an economy that relies on it.

BTC and USD both rank fairly well across most metrics. BTC double-spending is prevented by its distributed ledger; USD duplication is prevented by advanced minting techniques and heavily regulated banks. BTC is is a pure digital currency that is less flexible to handle and more prone to costly mistakes, but generally more convenient for international transfers; USD is a hybrid currency with convenient cash exchange and somewhat troublesome digital transfers. The most significant differences between BTC and USD deal with the simplicity of digital transfers, anonymity of transactions, and stability of trade value.

BTC and USD have a fundamental divide. As money transfer technology matures, the ease of sending money becomes comparable across these currencies. For instance, USD could integrate its own blockchain for simpler cross-border transactions. Now the primary difference is clear. BTC’s fundamental trajectory is anonymous transactions. USD’s fundamental trajectory is stable value.

What are the implications of this divide between anonymity versus stability?

Anonymity is good for the black market. It enables illegal purchases, money laundering, terrorist financing, tax evasion, unregulated wealth stashing, and circumvention of cross-border capital controls. Stability is good for the normal market. It eases the burden of debt, incentivizes spending, reduces the need to adjust prices, and anchors the value of currency across independent businesses and government services.

If stability is so good, why are people buying Bitcoin and able to make so much money?

Simply put, the black market is huge. From illegal drugs and weapons dealing to human trafficking and the laundering of ill-gotten wealth, its participants have a vested interest in anonymous transactions to subvert the law. They also make so much money that they don’t mind taking a 20% loss to clean their gains. Also, a great number of speculators are engaging in market arbitrage to buy low and sell high to such price-insensitive black market buyers. Moreover, BTC and other modern cryptocurrencies have a fixed supply design that produces a deflationary funnel, increasing the price of BTC as holders and speculators choke its transactions. Today, BTC is mostly a black market currency, an enormous money laundering operation, and a speculation bubble.

What is the future of Bitcoin and other cryptocurrencies?

Two questions of interest are most notable, assuming that cryptocurrencies remain free of major bugs, vulnerabilities, and hash-power attacks into the foreseeable future. The energy cost, technical speed limit, and fees of each BTC transaction are also relevant issues, but let's assume they get solved as well.

First is the question of compatibility between BTC and governments, especially in the wake of people skirting taxes and regulations. The greater the country's legal backlash, the sharper BTC shrinks to the shadows of the black market. Otherwise, BTC does have some potential to penetrate the normal market, albeit with new point-of-sale devices, legally compliant payment processing, and safety technologies for low-risk handling (ex. automatic, low-value secondary wallets to prevent costly mistakes).

Second is the question of value stability between BTC and the economy. The fixed supply is a real problem. Deflation rewards speculation and causes a host of aforementioned problems as well as disincentives for investment, lending, and entrepreneurship. The more speculators buy in at high prices, the harder they hold to justify their position. The buy-up creates a cascade of entrenched BTC that simply waits for the price to go higher while the BTC in circulation diminishes. This phenomenon is the speculation funnel. As the price of BTC rises through the funnel, the higher the sunk cost per unit for speculators and the higher the market impact from large quantity sell orders. In light of BTC's precarious path of price volatility and market manipulation, sellers are incentivized to accept more stable currencies. Here the undercurrent of a currency switch begins.

The more often that major sellers accept non-BTC currencies, the more likely the next drop in BTC price persists into the long-term. The trade value of a currency without intrinsic value is overwhelmingly determined by the sellers of goods and services. Thus, the crucial trial for BTC is the risk of a black market switch. BTC has no government or normal businesses that anchor value through independently offered prices with long-term expectations. Because most BTC transactions are filtered by its USD exchange rate, BTC does not even have room for price recovery through commodity arbitrage that normally stabilizes national fiat currencies.

Fundamentally, buyers need a good reason to choose BTC over other currencies accepted in the market. Once the speculation exhausts itself on high prices, many BTC owners will remain with a layer of significant sunk cost. As money transfer technology matures, those who bought BTC for easy long-distance transfers will switch back to stable national currencies. As BTC price becomes more precarious, even black market merchants may consider switching to or at least accepting alternative currencies with comparable or better anonymity. At this point, BTC risks falling into obscurity across the whole market.

Currency is a tool, and people decide to use different currencies for different purposes. With respect to common uses, purchasing power stability is significant, while decentralized counterfeit protection is not, at least presently. New forms of regulated cryptocurrency with flexible supply and fiat tethering are more likely to penetrate the mainstream market, rendering today's cryptocurrencies obsolete to either crash, phase away, or simply maintain anchors with niche and black markets based on the demands of its sellers. For the average person, it just seems sensible to either stick with normal national currency or shift only to a government-backed cryptocurrency that offers stability and scalability in addition to the standard benefits of the blockchain.