The Three Main Hurdles for Cryptocurrencies Becoming Money
Could any of the current or future cryptocurrencies of the world become a successful money?
(We are only considering privately created permissionless cryptocurrencies, i.e. cryptocurrencies not created by states whose ledger is able to be maintained by anyone)
We need to consider what our standard of success is but defining what money is inherently problematic. There is a sliding scale of “moneyness” instead of a discrete division between money and non-money. For instance, diamond jewellery can have money like properties because it is liquid, so people can accept it as a means of payment and easily convert it into cash.
The rough standard of success that we’re considering for this article is on the level of national currencies. This is the ambition that many in the cryptocurrency community hold for the future of crypto.
In order to understand the basic requirements of money, let’s firstly go over the standard criteria given for money:
- Store of Value: This is the expectation that my money will be able to buy roughly the same amount of goods and services in the future i.e. that it retains its purchasing power.
- Medium of Exchange: Money can be used to facilitate trade between two parties. Without money as a medium of exchange people would have to trade an exact amount of goods for another exact amount of goods, requiring what economists call “a double coincidence of wants”.
- Unit of Account: This refers to the fact that we can have a numerical yardstick by using money. For instance, we price everything in terms of £s (or whatever other currency), this includes goods, services, company accounts and debts. Money is the unit that we use in our economies.
Now with these essential criteria in mind we can look to the main hurdles that cryptocurrencies face now and in the future to become successful currencies.
The main challenges that cryptocurrencies will be faced with in the future for becoming successful as money are:
- Competing against incumbent money’s network effects
We’ll go through each of these issues in turn, and look at why they are a significant challenge and what can and cannot be done to overcome these challenges.
1. The Volatility Hurdle
This is one of the most talked about issues with cryptocurrencies.
High volatility is bad because it prevents a cryptocurrency from being a good unit of account or store of value.
The store of value feature of money is compromised by definition from high volatility. This is bad because if the volatility of a money is very high then the agent who accepts this money as payment runs substantial financial risk from the volatility, this overall makes the money in question far less appealing for real world agents.
The unit of account feature of money is compromised by high volatility because the price levels of everything denominated in such a cryptocurrency would have to alter at an impractically high rate. For the few websites on the internet that do accept payment in Bitcoin or other cryptocurrencies, the unit of account is hardly ever these cryptocurrencies. Instead, the unit of account will be in the $ if it is an American company and a ~10 minute updating Bitcoin price will be provided on the website by looking at the most up to date $ to Bitcoin conversion and multiplying this by the price in dollars.
For example, a clothes website wants to sell a dress on its website to make sufficient profit. It knows that this is $20, but it does not know the amount of bitcoin it should be due to the high volatility of bitcoin. Hence, if someone wants to buy the dress with bitcoin, the website will use the most up to date $ to bitcoin conversion to charge the right amount of bitcoin. This means that Bitcoin operating on such a website is relying on the unit of account of the $ as it is unable to be an effective unit of account itself.
This reliance on using another currency for the unit of account and then purchasing in a cryptocurrency relegates the cryptocurrency into a payment rail, that some people refer to as a payment cryptoasset. Payment cryptoassets, are a different kettle of fish cryptocurrency, their attractiveness would be in providing lower fees and faster transactions than the likes of Mastercard or Visa, and volatility wouldn’t be that relevant as you don’t hold the payment cryptoasset for a long period of time.
What are solutions to this volatility issue?
One potential solution is the hope that as cryptocurrencies become mainstream and secure user adoption, they will become stable in the markets themselves.
Another solution is the creation of stablecoins, cryptocurrencies that have volatility reducing design structure built into them.
The first proposed solution we will call the “maturity dampening effect”. The argument often given for this thesis is as follows:
Cryptocurrencies are still infant technologies. There is high uncertainty about their future use and adoption, hence, high volatility is entirely natural because small updates in market information will cause large shifts in market expectation. Once the dominant cryptocurrencies emerge and become adopted by all those who will use them, they will reach a saturation point which will make their price become more stable.
There is some encouraging trajectory in the volatility of bitcoin. We can see something of a decline in volatility over time from the following graph:
One problem with the maturity dampening argument is that for a cryptocurrency to start being used by an increasing number of people as a currency/means of exchange, it must already have low volatility, but in order to have low volatility — it must gain greater acceptance. This seems like an intractable circle to overcome.
In a best case scenario, cryptocurrencies which are designed to have a fixed predictable supply (such as Bitcoin and Bitcoin forks), we can hope for a level of price stability similar to that of fixed supply commodities, such as, gold or oil. However, as Koning¹ and Sams² point out gold and oil will probably have a higher degree of price stability because there are feedback mechanisms in the market that react to changes in prices. For instance, if the price of gold rises, more effort will be put into the excavation of gold and thereby the supply increase by a greater amount, which has the effect of dampening down the price increase. Such a mechanism is not in place in bitcoin and therefore, volatility may be doomed to be even higher than that of fixed supply commodities like gold or oil.
Stablecoins may then be the best hope at overcoming the volatility problem. So far however, the history of stablecoins has been mixed, generally there is a fair amount of oscillation around a target price of 1:1 with the USD normally.
People are also not filled with trust from many of these stablecoins and there are concerns about the incentive compatibility of these systems.
It will take many years for future or current iterations of stablecoins to emerge that then go on to establish themselves as reliably stable such that they become attractive enough for people to use.
Note however, that stablecoins that seek to establish themselves as stable through a 1:1 parity with the USD are giving up on having their own unit of account. They are tying themselves to the USD, and relegating themselves to a type of e-money, like the money you have in a PayPal account. If the USD succumbs to hyperinflation the stablecoin will have a stable relationship to the USD, but not stable to the rest of the goods in the economy.
A stablecoin that relies on using USD or another currency as its unit of account would be a far less revolutionary outcome than that of a real independent cryptocurrency.
2. The Scalability Hurdle
At the moment all decentralised cryptocurrencies cannot scale effectively because of the current technology limitations. By scale effectively we mean increase the amount of transactions by a large magnitude with negligible effect on speed of transaction and cost of transaction.
The difficulty in large part comes from the cryptocurrencies who choose to stand by the commitment to decentralisation of the network with a permissionless blockchain (as we said at the beginning, these are the only cryptocurrencies that we are considering here). Many cryptocurrencies such as XRP have managed to scale effectively, however, this comes at the cost of a centralised network.
Let’s take bitcoin as an example to understand more generally the problem of scalability. Bitcoin has the problem that if there is congestion on the network it cannot handle effectively with the amount of transactions trying to pass onto the blockchain. This creates two problems:
a. It creates high transaction fees. This is because those who want to make their transactions go onto the blockchain have to incentivise miners of the network to include their transaction on the next block over the list of other transactions also vying for a place on the blockchain. (These can become very high when the network is highly congested)
b. It means that transactions take too long to go through and therefore it is impractical to use. You have to wait too long when completing the sale or the purchase of something.
There are generally two solutions to this, one is increasing the blocksize (although this is not without costs), the other is 2nd layer solutions.
The best hope for bitcoin and other similar cryptocurrencies is 2nd layer technologies such as lightning network for Bitcoin, and the raidon network for Ethereum. In simple terms, the 2nd layer allows for some transactions to be done off the blockchain of the cryptocurrency. For instance, if Alice and Bob transact with each other four times a day on the blockchain, they could instead choose to settle the net amount that one owed the other at the end of the day. This then eases up the congestion of the network as they are only using it once a day rather than four. This is a cartoon version of what 2nd layer solutions involve, but captures the spirit of the solution.
The effectiveness of 2nd layer solutions are yet to be clearly determined, we are in the early days of implementation and hence we cannot clearly evaluate whether these will solve the problems of scalability without sacrificing safety and decentralisation.
Another separate concern of scalability is the size in GBs of a potential successful cryptocurrency network. If the same number of transactions of a national currency were carried out on the blockchain then the file size of the cryptocurrency would rapidly balloon. The bank for international settlements (BIS) have written about this issue³.
The graph below shows the hypothetical ledger size assuming that all non-cash retail transactions of either China, Europe area or United States are processed via cryptocurrency. It is assumed that each transaction adds 250 bytes to the ledger.
Such a large size of blockchain ledger might have the effect of making it impractical to be maintained by nodes exceeding the size of server memory capacity within a number of months. Also, the size of the incoming transactions may be too large to cope with at this order of magnitude.
3. Competing against the Network Effects of Incumbent Money
Money is only useful if enough other people accept and use it. It is one of the most classical examples of network effects — the greater the number of participants the more valuable the network (normally increasing in a non-linear fashion).
We’ll first look at how different moneys in the past have established their networks and try and draw inference to how cryptocurrencies of the future could do this.
So, how have different moneys over the course of history established themselves?
There are a number of schools of thought.
One is the commodity theory of money, that is people sought out commonly demanded commodities such as wheat, barley, gold or silver and transacted in these. The fact that these things had value by themselves, enables them to be used as a form of money without issues of trust. However, for a long time we have not relied on commodities underlying the value of our money, we now use fiat currency. And cryptocurrencies are not analogous to commodity money as cryptocurrencies are not inherently valuable, nor are they a claim on a commodity that is. Therefore, this theory does not help us.
Another is Chartalism / the state theory of money⁴ this points to the coercive power of the state as the most decisive factor in determining what money is. The argument is as follows:
States have the power to determine the currency in which taxes and other debts to the state must/can be paid in. It also imposes legal tender laws so that members of the country must accept the payment of this currency for debt amongst themselves. This decree by states creates a constant and general demand for a particular kind of money in the economy, since most people will eventually need some of this money to pay their taxes. So once this particular currency is defined as the unit of account by a state, it naturally follows that it starts being used more generally as a medium of exchange and a store of value in the wider economy.
If this theory of the origins of money as we know today is accurate, then it highlights what may be a huge challenge for cryptocurrencies. The acceptance of the £ by the UK Government, gives the £ money some future guaranteed utility value, and bootstraps it to be the major currency of a country’s economy.
If cryptocurrencies can’t appeal to the underlying intrinsic value of its token (it isn’t based on a commodity), nor the official acceptance of it by governments (this would be turkey’s voting for Christmas), how can cryptocurrencies hope to compete with the network effects of current monies?
One answer is that it will be a gradualist approach, whereby more and more people come to use cryptocurrency X, and thereby network effects accrue gradually over time. However, people generally only use one currency at a time, if people get paid in £s, pay their taxes in £s and buy things in £s, why would they use a subsidiary currency which had less network utility?
A cryptocurrency overcoming this would be something akin to starting a rival social network that ends up displacing facebook. The network effects of facebook give it a monumental advantage. They are not impossible to overcome but the odds are certainly low given the incumbent’s network effects, this analogously applies to new money.
One way that a cryptocurrency could have a sudden surge in use could be the failure of a country’s currency. The hope would be that a cryptocurrency would replace that failed currency thereby a natural opening to large scale adoption being given.
However, in such scenarios it is not evident that bitcoin or an equivalent would be the first port of call — why not something like the USD which has high trust, acceptability, internationally than the likes of Bitcoin. This point is made by Broadbent⁵.
One reason why a cryptocurrency might be used instead of something like the dollar, is if there was a large scale financial crisis. For instance, if the dollar itself was called into question because of large government debt, then there may be a wide enough fear of national fiat that cryptocurrencies are turned to as alternatives. However, this would be then leaving the hope of powerful network effects to be established by apocalyptic events.
Another reason for higher adoption might be from an ideologically motivated reason whereby people feel cheated by the current system and seek to try and opt out of it by using cryptocurrencies. However, the practical cost of such an ideological position will be significant, buying groceries, getting paid all become much harder.
Aside from this, the other option for cryptocurrencies might be to offer money for specific use cases, such as being used for the internet of things, or as an alternative to remittances rather than the all encompassing use cases that current currencies have.
Some of these 3 challenges for current and future cryptocurrencies feed into each other. The uncertainty of any one cryptocurrency’s acceptance in the future makes it hard to gain a large network, and this in turn makes it more volatile.
The technical issues of scalability may reasonably be overcome. However, without the power of a government to help create a monopoly which is how most of money over time has been created, some of these challenges may prove to be insurmountable.
¹Koning, J.P.,(2016). Fedcoin: A Central Bank-Issued Cryptocurrency
²Sams, Robert, (2014). A Note on Cryptocurrency Stabilisation: Seigniorage Shares
³BIS Annual Economic Report (2018). Cryptocurrencies: looking beyond the hype (91–114)
³Knapp, G.F., (1924). The State Theory of Money.
⁴Broadbent, B., (2016), Central Banks and Digital Currencies