The crypto future

If cryptocurrencies are a bubble then they are up there with the greatest episodes of mass delusion in the history of finance. John Law, Charles Ponzi, Ivar Kreuger and all the great financial swindlers of history, eat your hearts out – if only any of you could have conjured up this one. And, in which case, all those little punters need to be warned and warned again; not that they’ll take much notice until it’s too late. If, however, cryptos are the future, then that’s sort of important, too. We need to prepare for the day when notes and coin are peripheral and central banks are shoved towards the margins as well. Trouble is, of course, no one knows which of these futures is more likely to transpire; not that it prevents many from having the strongest of opinions.

Consequently, every morning my inbox is stuffed with junk financial PR about cryptos. Take this morning, the Borse Stuttgart Digital Exchange tells me it has launched a mobile app for trading bitcoin, ethereum and some other cryptos. Simultaneously, a UK firm of financial advisers is offering clients a one-year bond that tracks bitcoin futures on the Chicago Mercantile Exchange and somehow it wraps that into a product offering high income. Don’t ask how. It doesn’t say and I really don’t want to know.

But here’s another that’s really fun. The head of a London-based trading platform says unequivocally: “It would be more risky to bet against bitcoin now than it would have been to bet against Amazon (US:AMZN) 23 years ago.” There’s confidence for you. Back in June 1998 Amazon shares traded at $7.38. With today’s price at $3,203, the stock’s value has grown by 30 per cent a year.

Are we really saying bitcoin can do the same? That would mean that B1.0, currently worth $38,142, would be worth $15.9m by mid-2044. Intuition recoils against that price. It can’t happen. It’s impossible. Except it did in the case of Amazon and there have been others.

However, adding a bit of plausibility onto a quantitative framework casts doubt onto the scenario. First, assume that by 2044 the theoretical maximum number of bitcoin – that’s 21m – have been mined; though, in passing, we might question whether there will be enough electricity in the world capable of powering the computers to do the mining. Anyway, the total value of bitcoin outstanding would then be $334 trillion.

So here’s the difficulty – currently, annual global output (GDP) is about $90 trillion. Assume GDP expands by 4 per cent a year until 2044 then the global total will still only be $222 trillion by that year. In other words, there will be quite a lot of left over bitcoin sloshing around, doing nothing much at all except, perhaps, driving some excess inflation. For the maximum number of bitcoin to be put to productive use, GDP would have to grow by almost 6 per cent a year; not out of the question but unlikely given the progress of the past – rather good – 20 years or so. Another problem with this scenario is that bitcoin becomes the sole global currency; no room for crypto rivals, stodgy old central-bank currencies or anything in between. Is that feasible? Put it this way, can you really see the USA and China sharing a common currency any time soon?

Details such as those mean nothing to our man from the trading platform. His justification for concluding that bitcoin is no more risky now than Amazon was in 1998? “The distinct similarity of bitcoin’s 13-year price history versus Amazon’s 23 years with the multiple double-digit corrections along the path.”

But that statement carries a basic syllogistical error. Amazon’s price history was volatile but its outcome was wonderfully successful is the first part. Therefore, runs the second part of the syllogism, because bitcoin’s price history is at least equally volatile, its outcome must be wonderful too.

Such logic is obviously suspect. We might just as reasonably take any number of highly rated technology hopefuls as the comparator. So draw a line between bitcoin and the share-price decline of, say, Yahoo! over the period covering the dotcom bust and the inference for the crypto-currency would be completely different.

It is true, as the chart shows, that the returns of both bitcoin and Amazon have been stomach-churning. The raw material is the weekly price returns for Amazon in its first 350 weeks as a public-traded company from mid-1997. The comparison is with 350 weeks for bitcoin starting in September 2014. So the effect is to compare two assets when they were young and their futures the most uncertain. Thus valuing them would be especially difficult and consequently their prices especially volatile.

Which is what the chart shows and the table quantifies. They point to bitcoin being a bit more volatile. The ratio of its high price to its low over the 350 weeks is 286 times, while Amazon’s is ‘only’ 72. Similarly, its ratio of maximum to minimum volatility – where volatility is the standard deviation of six-week price changes annualised – is 19 times to Amazon’s 10.

Spot the bipolar security
  Bitcoin Amazon
Price ($)
High 60,205 106.7
Low 210 1.5
High/low ratio 286.2 71.6
Volatility (% annualised)
Maximum 174.5 201.8
Minimum 9.4 20.0
Max/min ratio 18.6 10.1
Source: FactSet, Yahoo Finance  

If these findings don’t actually undermine bitcoin’s credentials, they don’t help them. After all, the whole point of currencies is that their value should be fairly stable otherwise people won’t use them as a means of exchange. True, there is a simple response to that – we are still in a period of discovery when bitcoin’s value as an established medium of exchange many years into the future has to be estimated and discounted to its present value. It does not matter how much mathematical overlay you use to give that process the appearance of order, basically it is guesswork and not even very glorified at that. Hence the volatility. And, of course, we see much the same in the process of valuing a company’s shares. Amazon’s share price has been especially volatile because, back in the early years of the century, it was a guessing game to estimate what sort of company Jeff Bezos’s creation would turn out to be. It could have ended up as just another online bookseller. Meanwhile, the notion of Amazon becoming an all-purpose web-based trading platform wasn’t even in the mix of expectations because that idea was only dimly perceived back then.

My response to cryptocurrency fun and games is to seek enlightenment from history; in particular, history as told by JK Galbraith, that great populariser of economics. “There is much in the history of money that is fascinating,” he wrote in the mid 1970s, adding that “there is more that richly illuminates human behaviour and human folly”.

Take John Law, the aforementioned Scottish economist in whose tale of folly Galbraith delights. Law revolutionised finance in the early 18th century by, in effect, introducing the world to securitisation. Law eased the burden on the French government by securitising its excessive debt and the securities so issued became money. It was a great success. So much so that “it is possible that no man, having made such a promising start, could have stopped”, warned Galbraith. So it proved. Law’s bright idea morphed into a scam that wrecked the French economy via the Mississippi Company, which issued massive amounts of securities against the fictional collateral of gold waiting to be dug from the subsoil of far-away Louisiana.

It does not take a genius to imagine that something similar is happening with cryptocurrencies. Substitute make-believe mining in Louisiana with virtual mining on a million computers, most of them located in Russia and China, and you have bitcoin. But this is one of the problems with all types of money. As Galbraith also notes, creating it is just ridiculously easy and all of it, even the state-authorised stuff, depends on the illusion of acceptance.

So, with cryptocurrencies, the question is not whether they will be useful; the question is whether the future of cryptocurrencies includes the likes of bitcoin, or whether it lies exclusively with the state-backed versions?

Recall that central banks only got interested in cryptos when Facebook (US:FB) in 2019 announced its intention to launch its own crypto, Libra, which has since become Diem. The concern was not cryptos per se, but the danger hidden within them when a quasi-state such as Facebook decided it could extract a little more rent by pricing transactions in its own currency. With 2.9bn active users, Facebook has much more purchase with its users than the average high-street bank has with its customers. And where Facebook leads Amazon’s wallet and PayPal could easily follow. Central banks cannot stand by and see that happen. No state wants to surrender control of its currency; the implications are just too important as, in a very different context, Greece found out during the financial crisis of 2008-09.

So, which would you prefer, a cryptocurrency controlled by legitimate state authorities or one in effect controlled by Russian mobsters or state goons in China? I know which one I would opt for. Oh, and don’t kid yourself that bitcoin has any special merit by capping the amount of currency that can be created. The history of money is littered with promises such as that – all broken.

bearbull@ft.com

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