Is Bitcoin a crypto-currency?

Everybody refers to Bitcoin (and for that matter Ethereum, Litecoin and other blockchain based tokens) as “crypto-currencies”. This is only natural, as Satoshi Nakamoto first described Bitcoin as a “purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution” in his original white paper of 2008.

However, Bitcoin has been a victim of its own success, which has resulted in a spectacular price appreciation, from barely a few cents to over $8,000 in 2017. Therefore its transaction costs have also appreciated. It doesn’t make sense to use Bitcoin for micro-payments any more, as the fee may be higher than the actual payment.

To be sure, Bitcoin shares many of the characteristics of money (medium of exchange, store of value, unit of account, divisible, portable, durable, fungible and accepted). Paradoxically, the reason why Bitcoin may never be used as currency is that it is a very good currency. Meaning that it is scarce; its supply is limited. This makes it different from fiat currencies whose central banks can decide to print more dollars, euros or yen. Bitcoin, by contrast, has it built in its protocol a limited number of coins. 21 million to be exact.

This is where Gresham’s Law kicks in. This is a principle of finance according to which “bad money drives out good”. The better quality currency tends to be hoarded, as it is scarce and hence it’s a good store of value. Yet for that same reason, it has a tendency to disappear from circulation.

Because of Gresham’s Law, it is highly likely that, even if Bitcoin becomes mainstream, it will be used as a store of value, not as a medium of exchange.

Perhaps another crypto-token might be used as an electronic cash system, as Satoshi originally envisioned. But maybe a little bit of inflation is needed for a crypto-currency to become a widely used medium of exchange. In fact, traditional currencies including silver, gold and even shells and cocoa beans have experienced a low, though — on average — fairly constant rate of inflation. For gold, the inflation rate (i.e. the rate of growth in its supply) has averaged around 1% annually throughout history. Of course at times gold suffers wild supply & demand gyrations. But in the long-run, supply & demand even out.

So if Bitcoin is not a crypto-currency, what is it?

Probably the best answer is that Bitcoin has become a crypto-asset. And this is principally because of its scarcity and strong network effects.