What Kind of Assets are Cryptocurrencies?

cryptocurrencies

In the previous post I claimed that cryptocurrencies, at least most of them (including bitcoin), are not currencies although they are assets. Therefore, from now on I will stop referring to them as cryptocurrencies and call them cryptotokens, since I think the word token describes better not only their utility but also their properties as an asset class and does not exclude other projects that can actually perform as currrency.

Many people have pointed out how bitcoin, ethereum, ripple, etc. have equity like properties. For example, if bitcoin gains mass adoption, the price is expected to go up to match the price required to satisfy its utility with its user base. This is analogous to the price of a stock going up as a company’s earnings increase which usually require an increase in their customer base. However, the flaw in this analogy is that ownership of a cryptotoken does not provide any of the legal rights that are often afforded to the owners of equity in a company. To make matters worse for investors concerned on the legal ramifications of their investments, cryptotokens exist outside of any regulatory environment. While there have been efforts by several countries to pass laws to limit their citizens’ use of cryptotokens to avoid currency controls, such as in China, the fact that there is no actual legal entity standing behind cryptotokens other than the entire user base makes cryptotokens impossible to regulate without the state cracking down on its population in a manner reminiscent of a dystopian novel. While an argument can be made for the development teams behind a project as holding legal accountability for investors in their projects, once the project is live and the cryptotokens are being traded, the development team is not as relevant anymore, a different development team can fork the project and take the development of the cryptotoken in a different direction as it happened with Bitcoin Unlimited and Ethereum Classic. It is really up to the user base to decide which blockchain they will support. Therefore, the user base is the ultimate holder of leverage in the life of a cryptotoken and for that reason the user base is the ultimate holder of legal accountability regarding the value of a cryptotoken. Although, there may be in the future regulations introduced that afford some legal rights to owners of cryptotokens issued by a company where such company exists outside of the blockchain where the cryptotoken exists and those rights make the company legally accountable for the investments of cryptotoken owners thereby turning said cryptotokens into securities, until then most cryptotokens in existence are not securities and for that reason cannot be considered equity.

Detractors of cryptotokens have often pointed out the fact that cryptotokens lack legal backing despite performing like equity in a company as evidence that they are a scam since as the user base grows they become more valuable solely for the sake that there are more users. However, this type of thinking is due to a failure to understand what cryptotokens really are and the utility they provide. A better description of what cryptotokens represent are rewards points like those issued by credit cards or the loyalty programs of some businesses that can be used to pay for products or services offered by a business. In the case of cryptotokens however the business is not a brick and mortar entity but the network on which the cryptotokens exist whose service is provided through the algorithm within its blockchain. This company does not have any legal persons working in it and therefore it is considered a Decentralized Autonomous Corporation/Organization (DAC or DAO for short). The value of the service that this DAO provides to the public is measured in the value of its cryptotokens which go up in value as its services become more valuable to the public at large since you need the cryptotokens to access the DAO’s services just like rewards points offered by a small business would also become more valuable if the value of their services increases in US dollar terms but not in terms of their rewards points. Therefore, according to this terminology Bitcoin is the first DAO ever created with its service being the most basic of services possible with a blockchain, that is transferring information securely and with guarantees that it is not forged without the need of a middleman. Effectively solving the Byzantine’s General Problem.

While blockchain technology can be used to represent national currencies, or other well known assets like stocks, real estate, commodities, etc. it is currently being used to represent rewards points used to purchase the services of DAOs which are not much different than using rewards points to purchase products or services at your favorite shop. As a matter of fact rewards points of existing companies themselves are arising as a new asset class independently of the advances of blockchain technology with an expected value of $500 billion by 2019. There are even institutional investors such as hedge funds seeking exposure to them through new exchanges like the Affinity Capital Exchange (ACE). ACE is even planning to use blockchain technology to trade the products listed in its exchange. However, the difference between the majority of cryptotokens such as Ethereum or Bitcoin and the rewards points of loyalty programs of existing companies is that the companies behind the majority of cryptotokens are supranational decentralized entities called DAOs, that are virtually impossible to regulate. Therefore if one wants to classify cryptotokens as an investment vehicle, that investment vehicle is rewards points which has been in existence prior to the invention of Bitcoin, although not previously available to retail investors. However, the technology behind cryptotokens has actually created a new asset class, the DAO. One can seek exposure to DAOs, through cryptotokens that function as loyalty programs or mining equipment that verifies transactions in a DAO’s network, the latter being similar to fixed income products like preferred shares that pay out in the loyalty program tokens of the DAO while given the owner control over the network proportional to his ability to verify transactions.

Therefore, despite there being new blockchain projects every day, it is important to distinguish whether the cryptotoken being offered is giving exposure to a new DAO or the services of an existing physical company or companies (i.e. potcoin), because the latter would just offer exposure to loyalty programs of old fashioned companies, an asset that has already been in existence, whereas the former is giving exposure to a completely new asset class that has only been possible thanks to the internet.

Cryptocurrencies are not Currencies they are Something Else

cryptocurrencies

Back in 2013 when I first started investing in bitcoin and other blockchain projects many people including myself referred to all blockchain projects as cryptocurrencies. However, most blockchain projects that are referred to as cryptocurrencies (including Bitcoin) are not currencies. Most of them perform a terrible job as currencies, even the ones that are actually meant to work as currency such as Bitcoin. An agreed upon definition of currency by most economists is an object that is fungible (all unites of the currency are the same), transferable (can be easily interchanged), can serve as a unit of account (you can price goods and services with it), and serve as a store of value (the price tomorrow relative to everything else will be about the same as today). Unfortunately for most supporters of Bitcoin and other projects as a replacement of national currencies, Bitcoin and most similar projects fail to have all of these four properties of currency. Although Bitcoin and its brethren are fungible and divisible that they can be used as a unit of account they are as volatile as a penny stock, being subject to massive spikes and crashes sometimes simply due to unfounded rumors.

However, that doesn’t mean that all blockchain projects cannot function as currency. There’s a project called Tether which has tethered the price of the USD and EUR to its token by backing it with actual USD and EUR deposits. That project and similar others like Gatehub USD and Bitstamp USD which exist within the Ripple network deserve the term cryptocurrency since they are actually performing the job of currency by fulfilling the requirement of day to day price stability. However, they do not exist as separate from the national currencies they represent, and they are still not completely safe forms of currency as they are very dependent on the credit of the organizations supporting the tokens with USD and EUR funds as has been seen at times when insolvency rumors in the Bitstamp exchange or Tether affect the price of their respective currency tokens. Although the frequency of such rumors is rare and the price volatility of such tokens is small compared to those of Bitcoin and other blockchain projects.

If most cryptocurrencies are not currencies then what are they? It has been noted that the price variation of bitcoin and similar projects is similar to those of commodities. In the commodities world, sudden changes in demand due to weather or geopolitical events significantly affect the price of commodities due to their finite supply. With bitcoin and its brethren sudden changes in demand from speculators is often responsible for the sudden significant changes in prices due to the scarcity ingrained in the algorithm of most of these projects. The proof of speculators being responsible for the sudden spectacular price movements in bitcoin and its brethren can be seen in the fact that average transaction rates in their respective networks have been growing at a steady rate, signifying a steady rate of adoption due to its discovered utility among the people transacting in them, while the actual price has often been spiking multiple 1000% in short periods of time with massive volume and crashing down soon afterwards. Therefore, since bitcoin and its brethren have utility to the people that use it, as is evident by the steady growth of average transaction rates in their respective networks, they can definitely be categorized, just like natural commodities, as assets, as has been the position of the Internal Revenue Service in the United States, that is subject to significant spikes in volatility due to perceived scarcity among speculators.

A better and more important question that is yet to be answered is what kind of asset is Bitcoin and its brethren?