Guidebolt

Cryptocurrency Economics

2017.09.25

Unique certification is the design by which every unit of currency is protected from duplication. Fiat has complex minting for printed cash and strict laws for bank account management; crypto has the blockchain, a log of all transactions held by everyone on the cryptocurrency network. Fiat is vulnerable to counterfeiting and bank fraud; crypto is vulnerable to 51% attacks and unsecure core code. Unique certification is not a significant economic factor past a certain threshold of difficulty. Today we seem to be already past that threshold for both fiat and crypto.

Supply control is the design by which every unit of currency is created and cycled throughout the economy. Fiat such as the USD involves printing cash and loaning money to banks, who loan out to businesses and pay back with interest to the Federal Reserve, who buys assets from the economy in order to solve the cascading debt money supply problem. Crypto such as Bitcoin involves solving progressively harder computational problems and posting new solutions to the blockchain to receive coins; existing coins are then simply transferred from wallet to wallet. Supply control is a significant economic factor for managing the velocity of money during periods of growth and contractions. Fiat has flexible control over the money supply, primarily through the interest rate and expenditure rate of the central bank. Supply control of modern crypto is limited by computational power, oriented to growth only, and capped at a fixed coin maximum. Fiat-style flexible supply control is more resilient as it provides more defensive options against market manipulation, deflationary spirals, dead money, and recessions.

Transactional ease is the difficulty of trying to use a currency to purchase something. Fiat has minted cash for in-person transactions and bank-associated accounts for digital transfers. Crypto only supports digital transfers. While cash is convenient for small amounts and local transactions, larger transfers in fiat and crypto have a learning curve, especially with fiat for international transfers. Generally, fiat transfers take more time and are more secure against fraud, while crypto transfers are faster, sometimes cheaper, but irreversible and more vulnerable to costly human error. While the current banking system supports credit and prepaid cards in fiat, it is technically possible to do the same for cryptocurrency. While fiat works fine for day-to-day use, transactional ease remains a significant economic factor for under-served types of transfers where cryptocurrency finds marginal value.

Value anchoring is the process by which a currency develops entrenched trade value, such as by the growth of direct pricing and absolute demand based in that currency. Unbacked cryptocurrencies have no intrinsic value, just like modern fiat currencies. Yet when the United States dropped the gold standard during the Great Depression, the US dollar survived. Instrumentally, businesses decided to keep their USD prices in light of the chaos risk of pursuing an alternative to the entrenched USD system. Such price continuity maintained order in the economy and preserved the trade value of the US dollar. After all, if every dollar still buys the same amount of food at the grocery store, then it's as if nothing changed for the average person. Value anchoring is the central economic factor of all non-backed currencies.

Direct prices, such as 4 dollars for a jar of milk, are significant because they anchor specific values to a specific product from a specific business, helping establish a stable purchasing power per unit of currency offered independently across multiple businesses. Absolute demand such as government taxes and fees, or products only traded in particular currencies, amplify direct price anchoring effects. Conversely, indirect prices, such as exchange-derived prices, do not anchor at all because the purchasing power is tied to the exchange rate and the value of the basis currency. Exchange rates with other currencies are weak point-in-time anchors subject to speculative fluctuations and single-party manipulation, distinct from the decentralized mechanics exhibited in direct price anchors.

Historically, value anchoring has enabled all modern fiat currencies, stabilizing their purchasing power and producing exchange rates representative of the demand to live in or buy from the issuing country. The strength of the anchoring matters, evident from the many non-backed currencies that have failed in the past. In general, weakly anchored currencies are mostly speculation-driven, with no sensibility in deriving a minimum or maximum or appropriate trade value. Modern cryptocurrencies are no exception, but come with unique properties.

Modern cryptocurrencies have functional properties that ease high-value, international, fast, and anonymous transfers. Accordingly, they have anchors in the money transfer market as well as the black market, which does not mind currency volatility given their high profit margins. Additionally, modern crypto's fixed supply nature, historically low market cap, and high sub-unit breakability have produced massive opportunities for market manipulation.

Whereas fiat anchoring came pre-installed from paper notes backed by real precious metals, cryptocurrency was born as digital coins with an exchange rate propped up by experimental buyers. For today's cryptocurrencies, the path to anchoring poses a unique challenge, requiring a market bandwagon effect for per-unit purchasing power in addition to a cascade of direct pricing or trustworthy backing. Critically, the fixed supply nature of modern cryptocurrencies produces strong deflationary forces and stifles the velocity of money, jeopardizing mainstream potential. Such deflation would increase the burden of debt, reduce average salaries, and disincentivize spending as well as investment, lending, and borrowing.

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 certification is not. New forms of regulated, blockchain-certified 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. For the average person it seems only sensible to shift to a new cryptocurrency that offers centrally backed price stability and supply scalability on top of the decentralized blockchain and normal transfer benefits.