Cryptocurrencies are unique instruments in the investing world. They share many characteristics of traditional currencies but can also serve as platforms for more sophisticated financial products.
Judging by their price history alone, cryptocurrencies are easy to dismiss as a bubble. And, indeed, the crypto space is filled with questionable offerings.
However, a discerning look reveals a new financial technology with the capacity to fundamentally change the global economic landscape.
A Short History
The cryptocurrency phenomenon traces its roots back to 2009, when someone writing under the pseudonym Satoshi Nakamoto laid out its theoretical framework in “Bitcoin: A Peer-to-Peer Electronic Cash System.”
While the idea of electronic cash wasn’t new, it had never attracted wide acceptance. One important roadblock was the “forgeability” of electronic information: It meant that bad actors could potentially create money out of thin air. Earlier systems relied on centrally managed servers that “held” electronic cash. Their vulnerability to cyberattacks also posed a serious problem.
Since then, the cryptocurrency space has come a long way. There are now many new cryptocurrencies that seek to address bitcoin’s shortcomings — its transaction time, transaction throughput, scalability, and resource-friendliness — one way or another. The technology is developing fast and the best types and use cases of cryptocurrencies are yet to come.
Cryptocurrencies: What Are They?
The US Internal Revenue Service (IRS) classifies cryptocurrencies as property, the US judiciary system considers them a commodity, and bankers see them as competition. Individuals, on the other hand, tend to view them as investments.
While the battle over the regulatory status of cryptocurrencies continues, those who are interested in their practical application need to ask themselves three fundamental questions:
1.What is money?
Economists define money in terms of its properties. According to their definition, money is anything that can serve as a:
- Store of value: It can be saved and used later.
- Unit of account: It can be used to quote prices.
- Medium of exchange: It can be used in to buy and sell goods and services.
2. Are cryptocurrencies money?
We tend to think about money in physical terms, but anyone with a bank account and internet access can experience its abstract nature first-hand. In its essence, money is an abstraction with a set of fundamental properties that justify its use. Historians and anthropologists note the evolution of money from a commoditized representation, in the form of stones, salt, tobacco, dried fish, rice, cloth, etc., to a tokenized one, in the form of coins and paper money, to the more abstract form — the digital money.
Within this context, cryptocurrencies are money. They mark the continuation of the larger historical trend of money moving from the concrete to the abstract.
In that regard, cryptocurrencies are the first independent global currency since gold and silver.
At the moment, decentralised cryptocurrencies have relatively low transaction throughput, which limits their use. For example, the bitcoin network is designed to process five to seven transactions per second. This is nowhere near the throughput of Visa or Mastercard, which process thousands of transactions per second. It is also one of the main reasons bitcoin has struggled to gain acceptance as an everyday currency.
In their current incarnation, cryptocurrencies are imperfect. But the problems they face are not unsolvable, and the crypto space is continually engaged in finding workable solutions.
3. What is the economic significance of cryptocurrencies?
Apart from their obvious use as money, cryptocurrencies can play a significant role in increasing global economic participation and protecting against government overreach.
Globally, there are some two billion people without bank accounts, many of whom do not have the money to open or maintain an account. Cryptocurrencies have low adoption costs, are divisible into small fractions, and have practically no minimum account requirements. This means anyone with a phone or an internet connection can access the equivalent of a bank account and participate in the global economy.
The decentralised nature of cryptocurrencies is equally important. It provides an alternative avenue to traditional financial systems to preserve, transfer, and manage wealth. Cryptocurrencies offer protection against unlawful government seizures and can mitigate the political risk that could lead to systemic financial calamities.
By seeking to provide a secure, fast, and frictionless means to store, spend, and move value, cryptocurrencies are challenging the traditional pillars of the financial system. Despite their seemingly ethereal nature, they have attracted talent and enough monetary momentum to change the way we transact, raise capital, and organize ourselves to create economic value.
Cryptocurrencies mark the ascent of independent, decentralised, “government-free” global money into the world economic order.
A longer version of this article was first published on Enterprising Investor, a CFA Institute blog.