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What Drives the Value of Cryptocurrencies?

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Portfolio managers seek investments that promise high returns and for the past few years, cryptocurrencies have demonstrated this better than other assets such as U.S equities, U.S. bonds, gold, U.S. real estate, oil, and emerging market currencies. While investors have noticed this trend, there is still skepticism about where this value is coming from.

Some say the benefit of cryptocurrency is that it allows for cross-border payments, asset tracking, and getting ahead of inflation. However, crypotcurrency may also be considered a digital monetary commodity, which is part of a larger currency story.

What are monetary commodities?

Monetary commodities are any currencies with monetary value. In the past, those have ranged from everything from cowry shells to beaver pelts to metal to paper. Anthropologists have said that the form a currency takes is related to the environment in which it is formed. For example, a tribe which lives by the beach might sell shells and one from the open wild might sell animal hides.

Gold is considered to be a currency with one of the most desirable qualities among all currencies, including scarcity, fungibility, divisibility, transferability, and durability. It is because of these qualities that gold emerged as one the most highly-regarded commodities.

Gold’s feature as a rare commodity limited by the physical world leads people to give it a monetary value, a value which is different from gold or aluminum. Moreover, gold has led to a hoarding mentality, which has led to its global market of $7 trillion.

Can there really be a new form of money?

Many people may find it a stretch to imagine a new form of currency coming out to the market. However, history has shown that the value of money flows from the meaning people give to it. Like anthropologist David Graeber said, money flows from “human meaning-making which far exceeds rationalist/reductive economist paradigms.” For example, a piece of paper, or an animal skin, or a shell, or the more than 150 cryptocurrenices on the market exceeding $1 million, are only money because they have been defined that way, by the stories that are told about them.

How to create currencies

Fiat

Fiat money is a currency without intrinsic value which has been established as money by government regulation or law and with fiat, creation is a political tool as it gives a country control over its monetary supply, as a way to finance wars or control business cycles.

Dollars and other print currencies

The creation of print money, like dollars, is a poor store of value, as it loses a few percentages of its purchase power every year. Moreover, printing too much money is also an issue.

Bitcoin

Before 2009, no one knew how to create decentralized digital tokens with scarcity, however, bitcoin showed how it could be done, which lead to the creation of digital monetary commodities.

Now, the supply of bitcoin is steadily increasing and is slowly approaching 21,000,000 coins. The curve is unlikely to change as it is in the DNA of bitcoin. Even if miners were to change this 21,000,000 limit the community would likely restore ‘bitcoin classic’ with the original supply. Moreover, many people see immense value in money like bitcoin that cannot be inflated or debased.

How to transfer

In terms of ease of transfer, cryptocurrency has the lead. Gold must be handed over physically and fiat currencies are limited by regulatory issues. With crypto, however, transfers are unblockable, happen instantly across the globe, and have virtually zero cost. The power of cryptocurrency becomes even more valuable as the flow of money becomes restricted across the globe.

Ease of use

Crypto currencies although easy to transfer, are more challenging to use in the mainstream. Much of the difficulty stems from their regulatory constraints and the need in some cases to convert them to fiat or another currency before they can be spent. The more crypto grows, the more economic activity is needed to convert it to fiat, which will reduce this burden. Another challenge with cryptocurrency is the private key management which is needed to keep coins secure. This challenge may be overcome by improved technology and a greater understanding of cryptocurrency concepts.

Familiarity

Monetary value follows from belief, and it’s harder to believe in something new. For example, everything in this essay about the utility of bitcoin was true 7 years ago. But bitcoin was so new then that 10,000 of them were traded for two pizzas. $100 invested in bitcoin in May 2011 would be worth $20 million today.

However, every day that crypto currencies exist is one more day of familiarity. Our model of the world goes back only as far as our memories. When the children of today become investors, bitcoin will be as familiar as gold.

Programmable

Cryptocurrencies also introduce a new concept of programmable currency which is being used by companies that want to raise money. For example, instead of registering as a Delaware C Corp, and restricting fundraising to domestic accredited investors, companies can issue and sell bitcoin tokens with a few lines of code. Most of these tokens run on Ethereum, which is the leading programmable crypto currency (far more so than bitcoin).

Programmable money can allow business processes to be encoded in the blockchain, with fully-transparent prices and contract rules. By reducing the costs associated with a transaction and contract negotiation, programmable money can also reduce firm size, and lead to more efficiency for businesses.

Belief feedback cycle

In some ways, cryptographic tokens have more ideal monetary properties than any previous forms of money. Since humans commonly give tokens monetary value through belief by connecting these two, we create a feedback cycle. Considering George Soros’ Theory of Reflexivity, as monetary commodities rise, the utility of the commodity increases, thereby increasing demand for the commodity, creating what’s called a positive feedback loop.

In one sense, one might call this feedback loop a bubble that never pops. That is, individual currencies can pop, but the value in the concept of money will stay the same.

The Future

No one can predict whether crypto currencies will get through the obstacles of unfamiliarity and regulatory pressures to create feedback loop of positive belief and value. But as a digital monetary commodity they are a form of money that is functionally superior to gold, as gold was to shells, and hides and other currencies that came before it.They are also native to the internet, which is increasingly becoming the environment for our economic activity. And since the total market cap of all crypto currencies is about 0.3% of that of gold, that points to a high potential.

 

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