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What the proponents say:
Bitcoin's proponents primarily argue that bitcoin is a decentralized currency, one that is the next generation or iteration of money. It is argued that central banks (CBs) manipulate the money supply to achieve objectives that may not be favorable for those holding the currencies issued by these entities. For example, as in 2020-2021, central banks can increase the money supply to stimulate the economy in a recessionary period or make the exports of their economy more attractive through a currency devaluation (sterilized, unsterilized intervention), etc.
However, the primary concern that proponents of decentralized currencies present is that such manipulations are primarily a tax, especially on savers. As more wealth is held by older citizens in major economies, it is argued that such manipulations are an additional, unreasonable tax on older & affluent citizens.
The currency devaluations/manipulations, done for whatever reason, diminishes the purchasing power of those citizens whose savings and retirement depend on the primary CB issued currency; therefore, it is argued, a decentralized currency that cannot be manipulated, or devalued, through a government implemented seigniorage, protects holders of that currency. It is also argued that, as in the past, CBs would continue to devalue their currencies, and such a move would favor cryptocurrencies.
Of course, there are other 'advantages' of cryptocurrencies, such as a secure ledger system (blockchain) and relative ease of transactions; these benefits, nonetheless, only sweeten the deal and aren't the primary factor instigating demand, arguably; the primary causes of demand are capital appreciation and protection from currency devaluation, debatably.
What the skeptics say:
Many renowned academics, practitioners, and institutes have argued that bitcoin & crypto aren't a currency at all.
For example, Nassim Taleb (2021) argues that bitcoin cannot satisfy the fundamentals of a currency and that it has not been a currency at all. He argues against bitcoin being a safe haven asset, an inflation hedge, or a shield against adverse events.
Research from Wharton school of business states that BTC faces many transactional problems and fails to meet the criterion of 'unit of account,' a fundamental quality required in a currency.
A store of value cannot be so volatile to have a monthly standard deviation of 53%, with a 10% probability of losing 70+% of its value in one month; it can also not be considered a safe-haven asset as its price volatility is a staggering ten times higher than that of gold, which is widely considered the premier safe-haven asset (RC. 2021).
Similarly, other issues exist with crypto as a medium of exchange. For example, the transaction costs of BTC have risen above $55 multiple times. If BTC is adapted as a global 'shadow currency,' the transaction costs could rise exponentially; thus, as per its nature, the premier crypto cannot become a global currency of choice, as envisioned by proponents.
The primary argument of proponents regarding bitcoin shielding against inflation also does not seem rational. Buying crypto to lower the risk of inflation can be explicated as an imbecilic, 'out of the frying pan into the fire' strategy. If an investor is trying to safeguard her wealth from, say, a 10% rise in inflation, she would exponentially increase her risk exposure by acquiring Bitcoin.
Let's assume there is a 10% risk of inflation rising; does that make BTC a good alternative to hedge against that risk? Absolutely not! As stated above, as per the value at risk (VaR analysis), BTC has a 10% probability of losing 73% of its market value in one month. Therefore, acquiring BTC as an inflation hedge would be a foolish tactic by the investor to protect against a 10% inflation risk, and she should explore other assets with lower risks that are inversely correlated with inflation (RC, 2021) (see report for VaR analysis and further in-depth points).
Thus, we see that all mainstream arguments for crypto do not adhere to strict principles of validity. However, we are still short of a logical explanation for the meteoric rise of cryptocurrencies that we have seen in recent years. To make sense of the rise of crypto, the simplest explanation provided by skeptics is that we are experiencing a bubble, one that has ballooned due to greed and irrationality of the participants in this space, and self-enriching opportunism of the price manipulators.
Can it be a bubble?
Tulip mania lasted for about four years (1634 -1637); the South Seas bubble lasted for about nine years (1711 – 1720). If we look at the five most prominent bubbles in history, the aforementioned, plus Japan's Real Estate and Stock Market Bubble, the dotcom bubble, and the U.S. Housing Bubble, stand out. It is worth noting that none of these bubbles had a significant life over a decade, arguably. BTC, nonetheless, created in January 2009, turned ten years old in January 2019.
We still can't rule out the possibility that it may very well be a bubble, as price movement in the space does have signatures of irrational, emotional trading, primarily driven by greed. However, as more time passes, the concerns regarding high crypto prices being irrationally inflated will diminish, yet we would still need to rationalize the price of this 'entity' with no intrinsic value.
If prices do stay elevated long-term, and we have to assume that market participants in the space are acting rationally, we would be left with a conundrum that this report aims to tackle. If BTC isn't a currency or an asset, neither a bubble, then what is it, for goodness sake!
What is the only rational explanation?
"When you have eliminated the impossible, whatever remains, however improbable, must be the truth." - Sir Arthur Conan Doyle.
We are still missing with a logical explanation for the meteoric rise of BTC. Interest from institutional investors, and construction of securitized products such as BTCC ETF in Canada, etc., increase the demand for an explanation regarding the nature of cryptocurrencies.
So, what can it logically be?
After exploration of various asset classes and failing in trying to match the attributes of crypto: the only logical explanation that remains is the following:
Bitcoin and other prominent cryptocurrencies are a put option on the U.S. dollar, with a perpetual date, one that is divisible in smaller parts known as 'Satoshis.'
As the risk associated with the USD and the underlying system supported by the USD increases, BTC, as a put option on the USD, rises in value. However, if the risk associated with the same decreases in the future, prominent cryptos should decline in value.
We can think of crypto as an option without a single counterparty—or as having an emergent counterparty made up of micro-commitments by individuals, a form of peer-to-peer risk exchange instruments that is not reliant on a single entity; thus, more secure than an option issued by a specific option issuer that may be expose an investor to counterparty risk, in a catastrophic episode.
An option of this specific nature did not exist before. While BTC may not have been created for this purpose, as the creator of BTC expressed his agenda was to create a type of peer-to-peer electronic payment system ('Nakamoto,' 2009), the market, nonetheless, appears to be utilizing it as an option, i.e., its utility and fundamental value is, arguably, easiest explained by considering it an option, as described above.
An apt explanation:
In the 2008 financial crisis, many financial entities had transferred significant amounts of their risk to insurers such as AIG (American International Group Inc, NYSE: AIG), and it, along with a few other names, was considered a 'pillar of American capitalism.'
However, due to its exposure to credit default swaps of collateralized debt obligations (CDOs), of unjustifiable magnitude, during the 2008 financial crisis, AIG ended with losses of more than $25 billion. The company was in a serious risk of bankruptcy, and as other major financial entities in the economy, such as investment banks, related parties, and their investors, etc., were reliant on AIG for their risk mitigation, the entire system financial system in the developed world, in a way, was exposed to a risk of collapse. The Federal Reserve (FED) had to bail out the company with more than $150 billion through an exchange of about 80% of the company's equity via the Troubled Asset Relief Program (TARP) (McDonald & Paulson, 2015).
The Fed acted as an insurer of the insurers. . .
Nonetheless, if we consider a catastrophic episode in which the very purchasing power or the value of the USD is diminished, the FED wouldn't be able to bail out any 'too big to fail player' as the stabilizing power of the only product of the FED, the USD, may be diminished. For example, if AIG received 150 billion Zimbabwean dollars or 150 trillion Zimbabwean dollars during the financial crisis period, would such an inflow have stabilized it? Of course not, as ZWD lost all fundamental value, and due to being practically worthless, would have provided no stability to the system.
Due to what some call 'imprudent utilization of the U.S. money supply,' and continually ballooning national debt, some financial analysts argue that there is a serious risk that the USD may lose its fundamental value &, hence, its power to stabilize the economy it there is a severe crisis.
BTC can essentially be considered an instrument that the market views as a hedge against the above-expounded possibilities; a put option against the USD and the USD-dependent financial system (a put on the FED in a sense). In the above-explained scenario, holders of cryptos expect that their coins/tokens would rise exponentially in real value and hedge them against such an episode. As risks or micro risks associated with the USD and the USD dependent system rise, so should prominent cryptocurrencies; if the risks dissipated, the value of cryptos should decline.
Significance of this viewpoint
This viewpoint helps investors understand the very nature of cryptos, and by doing so, they should be in a better position to understand the fundamental or intrinsic value of cryptocurrencies.
All investors who can do so would be better positioned to identify when these instruments deviate from their fundamental value, enabling efficient trading positions for superior profits.
Lastly, it is also important to note that decentralized cryptocurrencies may not exist long-term due to government intervention, etc. (See report of in-depth exploration of this point), and we may have to rethink our expectations regarding them.
While further intellectual work can be done to explore their nature, the most logical and applicable explanation of their nature is provided in this report.
Reference
Knowledge@Wharton. Why Bitcoin Is Not a Viable Currency Option.
McDonald, Robert, and Anna Paulson. 2015. "AIG in Hindsight." Journal of Economic Perspectives, 29 (2): 81-106. DOI: 10.1257/jep.29.2.81
Risk Concern (2021). Endgame of Bitcoin and Crypto: What Is Likely to Happen With Cryptocurrencies in the Long Run?
Nakamoto, S. (2008). Bitcoin: A peer-to-peer electronic cash system. Decentralized Business Review, 21260.
Taleb, N. N., & Investments, U. Bitcoin, Currencies, and Fragility.
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