Daniel Gorfine, Chief Innovation Officer and Director, LabCFTC
U.S. Commodity Futures Trading Commission (CFTC)
March 26, 2019
Note: This essay solely reflects the views of the author and does not reflect the opinions or views of the Chairman, Commissioners, or the CFTC.
Invariably, people who follow cryptocurrency debates have heard the following — quite sensible sounding — statement more than a few times: “As the network gains adoption, demand for the limited supply of cryptocurrency will increase and so the price of the coin or token will rise.” Indeed, this statement is the predicate for why some people may seek to create and sell, or acquire, a coin or token.
But while the basic notion of price being the meeting point of supply and demand is sound, is this the full story when considering cryptocurrency valuation and the value proposition of cryptocurrency in the first place?
Despite the original case made for the economic value of Bitcoin being tied to its use as a medium of exchange and a store of value, somewhere along the line many people began thinking about cryptocurrencies — especially those offered as part of the development of new digital networks or economies — as akin to traditional equity securities that would appreciate along with the success of its related project. This view was reinforced by the period of Bitcoin’s meteoric rise through 2017 and seems to suggest that a cryptocurrency might appreciate in perpetuity given the success of a network, as might the value of your shares in a company.
Yet is this how we should think about cryptocurrencies from a valuation perspective (separate from legal classification), especially when such instruments do not include the typical rights of a security, including ownership and entitlement to future profits of the enterprise?
To answer this question, one useful approach is to instead think about valuations from the standpoint of traditional currencies — an exercise that could help advance discussion and debate regarding economic expectations and the nature of cryptocurrencies.
But before delving in, it is important to underscore a few key points. First, this essay will discuss the valuation of a cryptocurrency as a medium of exchange and thus will assume that there is at least some baseline value to cryptocurrencies relative to traditional fiat currencies given, for example, their ability to power micro-transactions, decentralized exchange, or access to unique goods and services. This assumption, of course, still needs to prove out in the marketplace and is subject to substantial technological and economic barriers. Future digital fiat currencies or stable coins, for example, might seek to solve for crypto price volatility risk, and it is possible that the benefits of scale and adoption around one or just a few cryptocurrencies will mean there is little space for hundreds of independent coins and tokens all seeking to act as a medium of exchange.
Next, this essay is focused solely on the economic value of cryptocurrencies and not proper legal classification — indeed, the sale of crypto coins or tokens as part of traditional capital raising activity is likely, for example, to be subject to securities laws.
Let’s now consider the factors that typically underpin global currency valuations and apply them to the crypto realm, namely focusing on the role of economic competitiveness (often connected to a nation’s current account balance), but also considering interest rates, money supply, inflation, and expectations. It’s worth noting at the outset that we typically think about valuation of global currencies in a relative manner — meaning that the US Dollar, for example, appreciates or depreciates relative to other global currencies. Similarly, we might express cryptocurrency value in the same way — and we do — by pricing them relative to fiat currency (e.g. 1 Bitcoin to $3,500 USD).
First, we know that all things being equal, global currencies usually appreciate when the home country of the currency sees a rise in interest rates. This appreciation is the result of investors who will buy that currency in order to enjoy higher returns on deposited cash. To date, I am not aware of a cryptocurrency ecosystem or economy that systematically offers interest payments on deposits, but if a cryptocurrency were to function more like a currency, markets for borrowing and lending could arise.
Second, a global currency might appreciate relative to others if inflation remains low in the home country. This appreciation is the result of investors seeking the currency as a safe haven store of value that will not be inflated away by a central bank. This factor would support appreciation of many cryptocurrencies with a finite (or controlled) supply since there is little risk of inflation diminishing value. And, in fact, this attribute is one of the key reasons some have viewed Bitcoin as akin to gold and a natural hedge against the long-term relative depreciation of fiat currencies.
Third — and most interesting to this analysis — a global currency might appreciate relative to others if there is increased competitiveness/demand for that economy’s goods and services. This appreciation is the result of people who hold a different currency needing to exchange into the domestic economy’s currency in order to purchase the desired good or service. And when applied to cryptocurrencies it is precisely this dynamic that drives the view that a particular crypto coin or token will appreciate if people greatly desire to procure a good or service that is sufficiently unique and can only be procured within that network — essentially creating a “network effect.”
But, here is where we should pause and assess conventional thinking that might assume a cryptocurrency could appreciate as might an equity security — perhaps substantially — into perpetuity (let’s call this the “to the moon!” assumption). To the contrary, there are dynamics that might eventually cap, or at least curtail, a cryptocurrency’s appreciation if it is largely being acquired to serve as a medium of exchange in order to secure the sufficiently unique and desired good or service.
You can think of a crypto network’s sale of goods and services as analogous to a country’s exports to consumers in other countries. If the domestic country’s currency appreciates dramatically, the cost of exports rises along with the strength of that currency; eventually demand for that country’s goods and services will fall. We see this dynamic regularly play out in the global economy, and the result is typically that consumers will shift purchases to another producer in another country or the original producer might consider ways to make the product available in other currencies, less costly, or relocate production.
In the context of crypto networks or economies, appreciation could have a similar impact, making goods denominated in the currency more expensive. Against this backdrop, producers of goods and services denominated in the appreciating currency might choose from a few options to remain competitive. One option is to begin accepting payment in other currencies, whether fiat or crypto. This would result in a decrease in demand for the original cryptocurrency (since it is no longer the required medium of exchange), which should drive some level of depreciation relative to other currencies.
Yet another possibility is that the producers of the goods or services would decrease how much they charge for the good or service as denoted in the designated cryptocurrency unit, which would result in a decrease in demand for that particular coin or token amongst consumers since you don’t need as many to buy the good or service — again exerting downward pressure on the cryptocurrency. For those economically-inclined, this dynamic may remind you of the Purchasing Power Parity (PPP) theory, which proposes that two currencies are in equilibrium when a basket of goods costs the same amount in the two countries given the current exchange rate.
A final outcome would be for other competitors to begin offering the good or service denominated in another currency, which is similar to the dynamic of another country offering goods that become competitive as a result of exchange rate dynamics. Indeed, because the Internet has very low barriers to entry and creating competing crypto networks based on copying open source code is relatively easy, this result is likely to occur if the original cryptocurrency appreciates to the point that access to the network (and hence the goods or services) becomes too expensive and the offered goods, services, and/or network are not sufficiently unique.
Another way to think about the above dynamics is that the expensive conversion to the cryptocurrency becomes a source of friction and akin to an onerous membership fee. Would anyone, for example, buy a single token required to access a social networking platform if the price of that token had risen to $20,000? Not likely — and, accordingly, the social networking platform would either begin accepting other currencies, “print” more coins or tokens, decrease the price of network admission to, say, 1/100 of a coin or token, or face competition from a competing social network that utilizes a different currency. All of these options should exert downward pressure on the price of the original cryptocurrency and underscores a critical distinction between the long-run economics of a currency verse equity security.
A final factor that drives currency valuation is people’s expectations for future appreciation. If people expect low inflation, strong economic growth, economic stability, and/or interest rate increases they will typically increase demand for that economy’s currency. Without a doubt, expectations for future appreciation have played a large role in cryptocurrency market activity, and speculation that a particular crypto network and currency will become ubiquitous through mainstream adoption helps to explain activity we have observed in the market. But, importantly, as the discussion of factor three above makes clear, these expectations regarding the long-run economics of a cryptocurrency should at the least take into account the fact that a medium of exchange is subject to market forces that may counteract its rise or drive a point of exchange rate equilibrium.
Having analyzed the valuation of cryptocurrencies through the lens of traditional currencies, two key takeaways emerge.
The first is that the store of value attribute of a cryptocurrency may over the long-term prove to be the most sound basis for believing the coin or token may continue to appreciate relative to fiat currencies facing inflationary pressures. Essentially this is equivalent to arguing that a cryptocurrency is today’s digital gold.
That said, the second takeaway is that to the extent that the cryptocurrency serves as a medium of exchange to procure certain goods or services (which, notably, is what consumption or utility coins are intended to do), it may be helpful to think about the economics in two distinct phases. The initial “emerging crypto” phase, which begins at zero and runs through mainstream adoption, could witness equity-like appreciation, assuming steady adoption of the coin or token and real-world interest in the unique goods or services to be offered. A subsequent “mature crypto” phase, however, may introduce a longer-term steady or equilibrium state where significant and continuous appreciation is less likely given some of the exchange rate dynamics described above. How long the emerging crypto phase lasts relative to the mature stage remains, however, an open question.
It may be helpful to conclude by again analogizing the “emerging crypto” phase of a coin or token to a newly created country that has issued a domestic currency but still has much work to do in building a viable economy with proper infrastructure and commerce. Investing in that economy’s currency would involve substantial risk, but it could generate returns if the economy evolves to be robust and competitive. Assuming that broad adoption of the currency occurs, however, over time market forces or competitive pressures will demand relative stability of the mature cryptocurrency vis-a-vis other fiat currencies.
This is all not to say that cryptocurrencies will not have value — either monetarily or in terms of advancing innovation — but it does mean that further public discussion regarding expectations and the long-term economics of a cryptocurrency may be beneficial.
This article was first published on Tuesday, March 26, 2019, on FinTechPolicy.org, a FinTech resource center for collating and analyzing global regulatory developments in financial technology. [Retrieved from https://fintechpolicy.org/2019/03/26/valuing-cryptocurrencies-as-currencies/]
Cryptocurrency clip art sourced from iStock Photo.