Distrust of financial institutions and central bankers has renewed speculative interest in cryptocurrencies as stores of value and gateways to frictionless peer-to-peer transactions. But not every crypto has the same chance of success at one or both of these conflated objectives. Bitcoin may be a better store of value, while Ethereum may offer more practical functionality for now.
Cryptocurrencies’ success is not guaranteed when it comes to either objective. There are obstacles to cryptos’ mainstream use in transactions and, as Beanie Babies have demonstrated, value can be erratic, fleeting and in the eye of the beholder. Franciscus Accursius, a 13th-century Italian legal scholar, got it right when he wrote “A thing is worth only what it can be sold for.”
Store of value
Separate surveys show that 14% of Americans owned crypto at the beginning of 2021 — more than the proportion who owned gold (about 11%). Popularity alone does not validate crypto as anything other than a collectible, but its rapid uptake is noteworthy.
Fiscal spending has seen U.S. debt to GDP double from 62.9% in 2007 to 127.5% in the first quarter of this year. Unprecedented monetary expansion has seen total Bank of Canada liabilities explode from $120 billion to $575 billion over the one year ending March 2021. Successive rounds of quantitative easing and government spending are fuelling fears of inflation and even accelerated currency debasement, as growth in money supply without economic benefit erodes buying power.
This environment is leading some investors to ask if Bitcoin is digital gold. Both asset classes are “mined” with limited supply and are therefore scarce; both are portable and divisible; both are fungible, if one ignores criminal links that may restrict Bitcoin’s acceptance; and both attract zealous support as stores of value and hedges against inflation.
But Bitcoin, which has only been around since 2009, lacks meaningful history, and gold’s inflation-hedging properties are not settled law. Note the divergence between inflation and gold after 2008 in Chart 1, below.
Chart 1: Annual consumer price index change versus gold (USD), 1969–2020 (Source: Federal Reserve Bank of St. Louis)
Unlike Bitcoin, gold’s value is based on average annual net demand: 34% from jewelry, 7% from technology, 17% from central banks, and 42% from investment or speculation, according to Metals Focus, Refinitiv GFMS and the World Gold Council. Bitcoin demand seems to be driven entirely by speculation (illicit activity accounted for only 0.34% of all crypto transactions last year, according to a report from Chainalysis). The correlation between gold and Bitcoin prices was between -0.5 to +0.5 on a 90-day basis between July 2016 and January 2021, suggesting the relationship is not as strong as some believe.
Bitcoin’s limited supply (a maximum of 21 million coins), which is a benefit as a collectible, detracts from its efficacy as a money supply substitute. Without flexibility and controls for money supply, the number and amplitude of business cycle booms and busts would likely increase.
Cheap and hassle-free transactions that avoid banks, credit card companies, brokers and regulators are a fintech objective but a threat to the status quo. Third parties still provide the trust required for most transactions. Despite blockchain-generated “proof of work” and “proof of ownership” — which are cryptos’ substitutes for trust — extreme price volatility limits cryptos’ practical use as a currency. Weekly Bitcoin volatility (9.9%) was three times that of the Nasdaq (3.2%) and 4.5 times that of the S&P 500 (2.2%) over the 10 years ending January 2021, according to Bloomberg and the ICE Benchmark Administration.
To reduce volatility, an array of so-called stablecoins have launched that are pegged to other assets or currencies, including the U.S. dollar and even gold. Stabilizing mechanisms resemble central bank currency management under fixed exchange rates. Revenue generation via decentralized finance (DeFi), akin to securities lending, allows crypto owners to lodge their coins with a decentralized protocol like Uniswap that provides liquidity for traders, giving coin owners a share of lending fees and commissions (Uniswap charges 0.30%), which are collectively known as “gas.” High returns from “yield farming” (30% to 200% annualized) have been reported, but there is little certainty and less confidence in the revenue stream’s sustainability.
Acceptance of crypto for goods and services is essential for medium-of-exchange acceptance, as the market reaction to Elon Musk’s on-again off-again endorsement shows. Starbucks and Home Depot have joined Overstock and Microsoft in Bitcoin acceptance in the U.S. In Canada, Dominos Pizza and Shopify head a shorter list. Walmart is looking to launch its own coin (USD). The alternative is for crypto owners to convert to fiat (dollars) through a Bitcoin layer like Lightning or analog exchanges like Coinbase or Coinsquare that are slow and expensive.
Ethereum has an edge over Bitcoin as a transaction medium because it can be used for digital and blockchain projects like DeFi.
Investing or speculation?
Cryptos pay no dividend or interest, so they have no expected return. Serious portfolio construction can’t handle them. Nevertheless, their high historical returns and low correlation with other assets have some suggesting that including cryptos in portfolios improves Sharpe ratios. But high returns may have a disproportionate impact on this decision. How many portfolios can withstand a 50% decline in price regardless of asynchronous volatility? Like gold and fiat currencies, cryptos are speculation, not investments.
Without broad vendor acceptance and scalability — Bitcoin can guarantee 4.6 transactions per second versus 1,700 for Visa — crypto as a medium of exchange is going nowhere. While cryptos’ popularity imbues them with a sense of legitimacy, without trust and price stability peer-to-peer smart contracts may not always be fully embraced.
Are cryptocurrencies the future of the banking system? Maybe. Falling use of cash for retail purchases and rising digital transaction demands have accelerated research into central bank digital currencies. Broad access will come with digital identification and related security concerns. Still, the offered range for a “brand new” Valentino the Bear Beanie Baby is $1.22 to $23,000 on eBay, reminding us that reality is the last bid, shipping extra.