The Alchemy of Cryptocurrencies — A Primer

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LAPOBlockchain

9 min readMay 21, 2019

By Athanasios Ladopoulos, Chief Investment Officer of LAPO Blockchain.

The notion of Cryptocurrencies is based on the creation of a peer-to-peer electronic form of money that enables online payments among the participants while keeping out traditional financial institutions. In other words, a decentralized and thus non-controlled financial system.

Several factors play a role in forming Cryptocurrencies economic behavior. Those factors may also inhibit their acceptance as currencies while assigning to them properties of more speculative assets. Evidence of such unintended transformation is, for example, Bitcoin’s behavior with price swings that have exceeded 80% — i.e. from $259 on April 10, 2013, down to $45 within 3 days, an 83% decline!

I am singling out some of those characteristics that I consider most important in forming the economic personalities of Cryptocurrencies, such as:

Scarcity of supply

There is a widespread belief that scarcity of supply is a characteristic that reinforces the notion of “currencies”. Hence, the great majority of Cryptocurrencies, with Bitcoin as their prime candidate, boost a finite supply of their coins. However, this assumption expressed as the above association is somehow misleading. In the conventional world, the fiat currency is indirectly “linked” with the production capacity of the economy of the nation it represents (even if the supply purposely far exceeds that, through i.e. Quantitative Easing) and “reflects” on the trading dynamics between the source country and its trading partners.

As fiat money is not commodity-backed, the above links represent the faith and trust we place in the governments that declare them as legal tender of a country for all debts, public and private. In a digital world where currencies are decentralized, Cryptocurrencies lack such dynamic links as there is no universal currency yet to represent the world’s current economic output; the result is expressed as excessive price volatility. Their true values, many times misrepresented by their prices, are not revealed while their prices become subjected to mood swings and crowd behavior.

There is also another interesting observation worth mentioning. As the number of minted coins decreases, the incentive of miners is also shifting from mining the coin to an income generated from using the coin — i.e. transaction fees. This is a peculiar shift as it represents a form of tax and assumes a wide adoption of such Cryptocurrencies within the wider fabric of our society far beyond the trading exchanges. Some Cryptocurrencies though, have decided to impose artificial methods to control the supply of their coins. They appear as Stablecoins, utilizing several techniques including:

Pegging their value to USD or other national (GBP) or perceived stable currencies (CHF)
A basket of currencies
Commodities
Indexes
Baskets of other Cryptocurrencies
Trading algorithms or hybrid forms of those mentioned

While most of them still pose limited supply of coins they use, one or many of the above-mentioned mechanisms reduce volatility and thus promote wider adoption among the public. Currently, though, Bitcoin, which price is dictated by supply and demand (and lacks any stabilization mechanism), holds the lion share of the Cryptocurrency markets. This is predominately due to first mover advantage and the perceived monetary gains it can bring to its holders. Unfortunately, such expectations hummer its use as a currency and transforms it into a speculative asset, accessible to many but possibly understood only by those with the experience in trading.

Store of value

In the conventional world, money, as we mentioned above, expressed by trading instruments (currencies) represent individual or group economies. Thus, money/currencies maintain indirect “links” to real economies and production capacities albeit much of their value also rests on the faith which participants place on their economies, administrations, and political and socio-economic systems. Regardless, the huge divergence between real and perceived value (the link between the money and the production capacity through trust and faith to the governments issuing them) contributes in the creation of bubbles, inflation, deflation, and even stagflation. In some cases like the US, oversupply of USD is possible as1) it represents the currency to pay for the consumption that drives this huge economy 2) it is the reserve currency used as a trading and a hedging instrument and 3) it is the currency that fuels the world’s growth in terms of energy consumption (petrodollar). A currency missing any or all those points while maintaining an oversupply would have resulted in very unfortunate results for the people using it in everyday life.

Hence, the notion of Store of Value in the world of Cryptocurrencies once more is distilled down to their prices and not to any linkage with economic value creation. If a Cryptocurrency was adopted in daily life and used to pay for goods and services, for the production of food and food products, salaries and raw materials as well as for the import and export of these products, etc., then a link to economic value as well as a wider network value could have been established. Lacking such a link, we left with assuming Store of Value is the perceived price at the exchange board.

Without a centralized mechanism to intervene in order to stabilize its “value”, a Cryptocurrency i.e Bitcoin, is exposed to “fear and greed”. For example, while Bitcoin’s coin inflation is fixed to the number of coins minted per year, there is no central authority to back it if fear (another form of “inflation” causing accelerated sales depresses the price, triggering more sales, depressing the price even further and thus eroding the “Store of Value” assumption) takes over and there is a continues wave of coin sales. In an extreme scenario, the price and value of Bitcoin can go to “0”.

Alternatively, if greed takes over and enough people are happy to buy a Cryptocurrency at any price, given its limited supply, its value could appreciate to infinity (theoretically). Notably, this faith and trust could be self-generating within an ever-expanding network where the power of the network expressed through network economics, despite been decentralized, collectively forms a common belief and re-enforces a common trust; “If all of us believe it then it has to be it”.

Medium of exchange and unit of account

Cryptocurrencies represent both mediums of exchange and units of account albeit the use as a medium of exchange is greatly restricted between its users, which currently represent stakeholders with the intention to attain appreciation gains rather than utility usage. To serve as a true medium of exchange, Cryptocurrencies must be widely accepted as a method of payment in the markets for goods, labor, and financial capital.

They act as a common denominator to perform transactions and thus represent a unit of account and measurement of relative value (utility). Even though much of it is still within the confinement of exchanges, they could easily be converted to fiat money and reverted to use within the conventional world.

A standard of Deferred Payment

Usually missing from articles that talk about Cryptocurrencies. The assumption behind this criterion is that if money can be used to purchase goods and services today, money should also be good to make these purchases today under the assumption that will be paid in the future. Loans (housing, education, consumer, business, etc.), insurances (life, fire, pensions) and future agreements (derivatives) are all expressed in clear monetary terms. Similarly, all have deferred or spread-out payments that allow us to buy goods and services today, then pay in the future or assume that payments today will maintain the same purchasing power sometime in the future. Due to the lack of a wide adoption within our society, as well as by the banking and financial industries, Cryptocurrencies do not serve this purpose well. To become a “Standard of Deferred Payment”, there needs to be accepted as a general form of payment which inspires trust and exhibits an acceptable degree of price stability. Thus, value preservation is prerequisite.

It is evident that non-stable, non-collateralized Cryptocurrencies will continue to struggle meeting the above criteria that set out the behavior of currencies. Thus, we can say that any serious attempt to establish a widely acceptable Cryptocurrency would imply that a stabilization mechanism is in place. Setting out what the business model of each viable alternative is, could be a good starting point for further investigation.

1. Fiat-backed Stablecoins

Revenue source: Issuance/redemption fees, market making, short-term lending
Drivers: In/out of smart contracts, bid/ask spread and trading volume, reserve ratio, and interest rates
Considerations: A stability mechanism will reduce revenues as the spread between the Stablecoin’s price and the price of the underlying collateral must be greater than any fees to create arbitrage opportunities for traders
There is a need for market depth, volume, velocity, magnitude, and frequency all of which are usually found in larger and more mature markets, to assure an efficient and frictionless market trading environment
Lending might require investing a portion of the collateral in short-term Treasuries and money market funds and interest rates might be driven by the size of the collateral base and the required reserve ratio

2. Crypto-backed Stablecoins

Revenue source: Rights to transactions fees and interest on collateral, claims on collateral and governance rights (non-revenue generating)
Drivers: On-chain transactions, interest rates, appreciation of collateral’s value
Considerations: Transaction fees can be a detriment to widespread adoption and if “fat” they can attract immediate competition
Collateral requirements might be onerous, requiring the owner to put a large collateral upfront, sometimes several times greater than the “Crypto” they wish to borrow while no stability guarantee can be in place when another Cryptocurrency is used as collateral
Opportunities might exist for tokenized assets to be used as collateral
Voting on key risk parameters that affect the solvency of the system as well as i.e. protocol updates

3. Commodity and real asset-backed Stablecoins

Revenue source: Rights to transactions fees and interest on collateral, claims on collateral
Drivers: On-chain transactions, appreciation of collateral’s value
Considerations: Transaction fees can be a detriment to widespread adoption and if “fat” they can attract immediate competition
Collateral price fluctuations and volatility might affect income streams
Opportunities might exist for tokenized assets to be used as collateral while risks might exist associated with the commodity’s market cycle and perceived volatility

We have purposely excluded non-collateralized “black box” Stablecoins that employ purely a monetary policy, “approximating” the role of “algorithmic Central Banks”. Such Cryptocurrencies opt to increase/decrease the coin’s supply to create a sense of stability through pure monetary intervention but without anything to back it up. Contrary to such models, Central Banks do hold reserves and their role extends beyond controlling money supply to ensure stability in the system, into printing money, lending to retail banks, becoming the regulator and authority in banking and of monetary policies, and implementing specific goals to achieve low inflation and full employment.

Commodity-backed Cryptos

Commodity-backed money; they carry a value of use, which goes beyond that of the conventional fiat money. Gold and to some extent, silver (Figure 1) are two examples of commodity money. Gold, for example, has been used as a form of money for thousands of years while derives added value for other attributes. It is a good conductor of electricity and thus is used in the electronics, aerospace industry, manufacturing of energy efficient reflective glass for skyscrapers and in the medical industry as well. Furthermore, it has some extra attributes other commodities do not have; beauty and malleability as jewelry.

Figure 1. A Silver Certificate and a Modern U.S. Bill. Until 1958, silver certificates were commodity-backed money — backed by silver, as indicated by the words “Silver Certificate” printed on the bill. Today, U.S. bills are backed by the Federal Reserve, but as fiat money. (Credit: “The.Comedian”/Flickr Creative Commons)

Thus, gold has historically served its purpose as a medium of exchange, a store of value, and as a unit of account and a standard for deferred payment. Gold-backed Cryptocurrencies stand to enjoy those attributes by association and thus may provide a better alternative to other forms of Cryptocurrencies.

Conclusion

Money is most commonly used to complete a transaction that involves a financial element i.e to pay for purchasing and to receive for selling goods and services. It serves as a medium of exchange, a store of value, a unit of account, and a standard of deferred payment. In our conventional world, there are two types of money: commodity money — with added value from its use as something other than money; and fiat money — which has no intrinsic value but is declared by a government to be the legal tender of a country.

Cryptocurrencies are the evolutionary step of money. As we move into the Fourth Industrial Revolution that includes amongst other things mobile supercomputing, intelligent robots, self-driving cars, and neuro-technological brain enhancements, it is unrealistic to remain fixated on fiat money. Hence, digital money will come to serve digital needs and desires expressed in forms of monetary value transactions between humans-to-humans, humans-to-machines, and machines-to-machines.