Saturday, June 3, 2017

Stores of Value

Lately, I’ve been asked several times about what I think is the underlying value of cryptocurrencies. With their increased popularity, it is a rather pressing question.

Although I am not an economist, or a financial engineer, or even particularly knowledgeable, I have managed to glom onto little bits and pieces of knowledge about money that are floating about. Although these ideas all appear to fit together, I reserve the right to change my mind as time progresses and I learn more.

In a world without money -- if all other things were equal -- getting paid would be a bit problematic.

I might, for instance, go to work and in exchange for my efforts to receive a chair as payment. I could roll that chair over to the local supermarket and exchange it for some groceries, and possibly a grocery cart as change. Once I returned to my house, I would have to take all of the tangible items I had received during the day and store them in various rooms, hopefully, to be available for rainy days. My retirement savings would require a whole warehouse.

Of course, that would be a massive pain and completely impractical. The size of the house I would need would be enormous and the bartered goods would get gradually covered with dust, or decay, or entropy would find some other sneaky way of breaking them down.

Quite obviously, someone would come along and provide a service to allow me to drop off my items, in exchange for keeping them clean and safe. However, they would have considerable incentives to not just waste storage space either. They might then trade my newly gotten chair back to the same company that I work for, and that could actually form my payment for my next day's effort. In fact, I might end up getting the same chair, over and over, stacking it up in my inventory count until I’d have to withdraw, say, a sofa to get some plumbing fixed in the kitchen.

Clearly, that would be a rather insane society, so it is little surprise that we stepped up from bartering to having a means of keeping an abstract count. We don’t need to pass around physical items, just a “metric” that relates them all to each other. In that sense, money is a store of work, of the effort that I have put in, but it is not quite that simple.

The banks act much like that barter storage service, but they are regulated to only have the means to multiple money at some fixed percentage. That is, they can loan out the same chair, again and again, but they are ultimately restricted on how many times they can do that because they always need to keep a minimum number of chairs in storage. Given their multiplicative effect (and others), money is more realistically a small percentage of the work, not 100%. For argument's sake, let's just say that it is 20%.

Now, we use money internally in a country to provide daily interactions, but we also use it externally between countries. In order to minimize any internal disruptions, the sovereign central banks are allowed to play with the underlying percentages. So they might reduce that 20% underlying value down to say 15% because they want their country's stored values to be more competitive in the world markets.

It is of course considerably more complicated than that, but this perspective helps to illustrate that there is a ‘relative’ internal value to money, as well as a more ‘absolute’ external one and that much of what governments are doing is manipulating the underlying value to help the internal economies remain stable.

There is often talk of the world’s economies moving away from the gold standard as being dangerous or reckless, but a close friend of mine pointed out that it actually stabilized the system. Although money is a partial store of work, we like to peg it to something tangible to make it easy to compare different values. Gold emerged as this anchor, but it actually has a significant problem. The world’s supply of gold is not constant. Some of it might get used up for jewelry or industrial efforts, and there is always the potential for new, large mines to get discovered and flood the market. By pegging against a moving target, we introduce unwanted behaviors.

Since money is more or less a store of work, and we have issues with needing to interchange between nations, it seems most reasonable to just assume that the underlying value is essentially a country's GDP. That is, money is really backed by all of the products and services produced by a country. Watered down to be sure, but still anchored by something tangible. Except for wars and other catastrophic economic events, the amount of work produced changes slowly for most countries. The economies grow and shrink, but they don’t usually get spikes.

With that oversimplified introduction in place, we can almost talk about cryptocurrencies, but I still have one more tangent that is necessary first.

When it was first discovered, researchers found that they could quite easily create electricity in their science labs. This was long before our modern electrical appliances; it was what was essentially a steam-punk era. From their perspective, electricity was most likely just a curiosity. Essentially worthless. They would create it in small amounts and play with it. It was just some sort of parlor trick.

A modern electrical plant can generate a huge amount of electricity, sending it over the wires to the millions of potential consumers. It has a significant value. As we create more devices like light bulbs and radios that need power, electricity changed from being worthless to having a very strong underlying value. But without electrical devices to consume it, there is no value.

We couldn’t live without electricity now, and there are, no doubt, plenty of people that made their fortunes by supplying it to us. It’s a strong utility that drives our economies.

This shows quite clearly that value can be driven only by demand; that something with no value can, in fact, be quite valuable if there are consumers. Keeping electricity in mind while discussing the current worth of cryptocurrencies is useful.

So with all of that in mind, we can finally get to cryptocurrencies.

It is somewhat obvious from the last analogy about electricity that if you produce something, to gain value there needs to be demand. For Bitcoin, it seemed like the first few years the demand was driven by curiosity or even entertainment. There were no real “electrical appliances” just interested people playing with it. So there was some value there, but it was tiny.

As different segments of the various markets came in and found uses for Bitcoin, the underlying value slowly increased.

The addition of other competitive cryptocurrencies like Ethereum appears to have strengthened Bitcoin’s value, rather than hurt it.

A good indication that there is something tangible below is that both Bitcoin and Ethereum have weathered rather nasty storms: Mt. Gox for one and The DAO for the other. If they were just 100% pure speculation, people would have walked away from them, but instead although they took significant hits, they recovered. Fads and Ponzi schemes don’t weather storms, they are just get forgotten.

As the cryptocurrencies break into new markets and there becomes more and more options for spending them, their underlying value increases. What drives them underneath is how flexible they are to use. If there are lots of places to use these currencies, and it is easy to switch back and forth, then as the roadblocks come down, the underlying value increases. So there is some intrinsic underlying value and it is increasing, probably quite rapidly at this point.

A hot topic these days is whether or not countries are for or against cryptocurrencies. Popular sentiment ascribes the motivations behind central banks as a means to control the masses, but I’ve never really seen it in that draconian light. Countries control their currency in order to try and stabilize their economies and to control their debts to other nations. They’re probably not too worried about individual spending habits. Most countries want their citizens to be successful.

They do need, however, to collect their ‘cut’ of commerce as it flows; that is how they exist. Cryptocurrencies don’t have to mess with this mechanics at all. That is, a country can still strengthen or weaken their money supply, and the fiat currency is still the final arbitrator of worth within the borders and between other nations.

Any deal with the Canadian government, for example, would be denominated in Canadian dollars. That won’t change even if all of the citizens used Bitcoin for their daily transactions. The dollar would still be in the underlying measure.

Cryptocurrencies being global offer citizens a way to essentially hedge their funds externally as well. Now that was always there, you can easily hold a US dollar bank account in Canada and then you can use it when you travel abroad, for example. Doing so eliminates any FX risk from travel expenses, and if you restock the account during periods of better exchange rates, it boosts the spending power of the money by a small amount.

If it works for a Canadian with US dollars, then there is essentially no difference in doing it with Bitcoin when we are talking about external transactions.

The funny part though is what happens if all of the citizens pay for their daily goods with Bitcoins. When it happens with internal transactions, does that somehow diminish the government's ability to heat or cool down the economy?

There would obviously be some effect. If Bitcoins were the better deal people would switch to using them. If they crashed, they would all return to Canadian dollars. That really feels like it is an asymmetric hedging effect. The underlying transactions would shift towards the best currency. But it is worth noting that all of the taxes would still have to be paid in the fiat currency and the people and vendors would likely try to naturally avoid currency risk and bad exchange rates when collecting these amounts. Canadian dollars would still be preferred.

Thus a fiat currency anchors the underlying value, and it wouldn’t surprise me the least if as the cryptocurrencies became more popular; that they had somewhat different valuations in each different region. That is, the country's own financial constraints will come to bear on the cryptocurrencies as well, and the central banks will lose only a small amount of control over the value. People would then try to arbitrage on the regional differences, but the summation of these effects would likely tie all of the fiat currencies closer together. They would collectively become more stable. More intertwined.

Realistically this has been happening for at least thirty years now. Globalization has been making it easier for currencies, and people, to flow. That relaxation of restrictions on the movement of cash naturally draws all of the players closer together. That, of course, means that one country's fate is more dependent on the others, but it also true that bigger organizations are intrinsically more stable. They move slower, but that is sometimes an advantage in a volatile world.

The cryptocurrencies are just going to increase that trend, to allow it to become more fine-grained and to get ingrained into the masses. Thus, they likely are in line with the financial trends in the 21st century, maybe speeding up the effect somewhat but definitely not changing the dynamics.

All of this gets me back to the real underlying question, which is what are the cryptocurrencies ultimately worth today. If we compare them back to fiat currencies we can start by looking at all of the work going into to produce them: the hardware, network connections, operations, and electricity. That output is analogous to the GDP of a nation and it provides a definitive underlying value, but we also need to consider the analogy to electricity.

The base work of maintaining the Bitcoin infrastructure is contingent on there being demand. That is, as the end-points -- the various uses of the cryptocurrencies -- increase they supply underlying value to the effort of keeping the coins running. The two grow hand in hand. As more electrical appliances found their way into common usage, the value of electricity increased.

But it also worth noting that particularly for Bitcoin, the underlying market is in an expansion phase. It is rapidly growing to meet brand new needs, it is nowhere near saturation. This seemingly unlimited growth, as it is fed by more and new types of demand is in itself a temporary value. Being ‘expandable’ is a strong quality because it provides optimism for the future, which while intangible is still a driving force.

On the other hand, there are intrinsic fixed technical limitations to the cryptocurrencies, and to those that are bound to high costs of PoW (proof-of-work) in particular.

No technology is infinitely scalable, the physical universe always imposes limits, and these technical limitations, rather than the full potential of the market itself, are where the saturation points arise. Thus the market will grow as large and as strong as the technology allows, not the current potential of the markets for the entire planet. That makes the issues about transaction speeds and backlogs far more pressing since they seem to imply that the saturation point is coming far sooner than expected.

All told, we seem to have at least four distinct parts to the valuation of cryptocurrencies. There is obviously some element of speculation, there is an underlying value to maintaining the infrastructure, there is the ability to expand and finally, there is increasing demand. We could likely model these as essentially separate curves over time, based on the historic data, and use that to attribute their various effects on the prices. It would be trickier in that some of the issues actually span multiple cryptocurrencies, and the underlying base is somewhat volatile right now, as different actors switch between the competing technologies.

Still, it says that it certainly isn’t 100% speculative right now and that the coins should be moving towards some specific value. The rate of return is driven way up by possibilities of expansion, but that will eventually converge on what is essentially the collective changes in the GDP for the planet.

Is that higher or lower than today’s current price? That would take a huge amount of analysis, and likely a large number of lucky guesses, but it does seem that much like electricity, cryptocurrencies will eventually become a normal utility for our societies and that collectively they are undervalued right now.

Any individual coin though might be overvalued, specifically because of its technical limitations, but those are also subject to change as we increase our knowledge about how to build and deploy these types of systems.

So it appears very unlikely to me that the cryptocurrencies will just blow up one day and hit a valuation of 0. They’re not a Ponzi scheme, but rather a fundamental change to our financial infrastructure. If a total crash could happen, there have already been plenty of chances for it to occur already. There is real value underneath, and it is really growing.

But caution is still required for any given currency, and it seems that spreading the risk across multiple ones is not only wiser but also in line with the observation that they seem to be stronger together, than individually. The situation, however, is rapidly changing, and it will likely take at least a decade or two before it settles down.

Cryptocurrencies are here to stay, but there is still a long road to go before they settle into their utility state. And it’s no doubt quite a rocky road.