Vitia in Numeris

The Case for Enhanced Skepticism

I was surprised to read that David Swensen, CIO of the Yale University endowment, creator of the endowment model of investing, and one of my investing heroes, had allocated some portion of the Yale endowment to at least two different Blockchain/Cryptocurrency investment funds. If so, it is a significant vote of confidence in the emergent technology, if not in the value of cryptocurrencies themselves.


A bit of background: a cryptocurrency is a means of transacting digitally, and a distributed ledger of such digital transactions. Bitcoin was the first and is still the most widely used cryptocurrency. It derives its name from the cryptography used to encode individual transactions and to ensure the digital security of the specie (to abuse the term.) The quantity of Bitcoin in circulation is algorithmically determined and controlled, and the identities of its holders are by design anonymous. For these reasons it has captured the imagination of goldbugs, anarchists, libertarians, and parallel market participants alike--but it is its ten years of life and meteoric rise in value that has made it a topic of fascination among observers of the financial markets.


We first began telling people not to buy Bitcoin when it was trading at about 1 BTC to 200 USD, so well after the party was already in swing. (Its subsequent 20,000% run hasn't mitigated our lack of enthusiasm for the invention, as there have been many opportunities to lose one's entire principal over the course of that time.) We felt then that it was definitionally not a currency, as it failed to meet two of the three criteria that make something a currency: a) a unit of account, b) a medium of exchange, and c) a store of value. First, you have to be able to count it, and cryptocurrencies can be counted. A medium of exchange is something that can be used to buy stuff. For example, I can take a dollar to a store and buy a cup of coffee, but I can't take a koala to a store and expect to be able to tender it for a cup of joe. Lastly, a dollar today should generally be worth a dollar tomorrow, subject to the rules of price theory and the time value of money. This is the criterion that most typically fails to appertain in hyperinflationary environments.


Since that time, BTC can still be counted, and I can buy some Microsoft services and potentially a Tesla using BTC, but Starbucks won't take my BTC for a cup of coffee, and annualized volatility in the exchange rate of BTC/USD is so high as to be disorienting. Therefore, it continues to fail to fulfill the criteria for consideration as a currency. Furthermore, it fundamentally cannot replace current forms of money in use because of the Bitcoin scalability problem: its very architecture prohibits the recording of very large numbers of transactions. Add to the social bad of its additional energy expenditure its facilitation of parallel (black) market transactions, as well as its contribution to financial instability, it's unclear to us that its social benefits outweigh its social costs.


The other day I did see cryptocurrency referred to as an asset, which got me to thinking about whether the term is justified. Certainly, if I had 1 BTC in my digital wallet, and I was putting together my economic balance sheet, it would contribute about $44,000 to the asset side. But, like gold, it doesn't have any industrial use (contrary to the opinion of the lesser informed, very little gold goes into the manufacture of electronics,) and it doesn't generate cashflows. Unlike gold, you can't melt it to mold into pretty shapes to adorn your neck and fingers, so it has no use except in recording digital transactions, and if a nuclear bomb detonates over the cities of earth and the electromagnetic pulse fries all electronics, you won't be able to use it to buy four AR-15s and several boxes of 5.56 mm ammunition as you prepare for post-apocalyptic life.* It is an asset, but one with severely limited value in use--and one whose value violently fluctuates.


There are certainly enough people in the world who have need of a means to transact online and anonymously, so I don't think BTC or other other alt-currencies with sufficient adoption will go to zero. They are almost certainly not fairly valued at present, and their value is likely entirely speculative, i.e., due primarily to greater-fool dynamics, the idea that something will go up in value as long as the buyer thinks that she can sell it on in future for a higher price. This is how speculative manias provide the fuel for their own fire, the definition of a self-reinforcing positive feedback loop.


It is as a gold-like asset that we categorize crypto-assets: primarily interesting not for their intrinsic value (for they have none,) but rather for their extrinsic value. Their value is inversely correlated to society's faith in its financial system. Since the last twenty years have seen an increase in both the frequency and magnitude of financial crises, society's faith in the authority of its financial institutions has been further and further eroded. Coupled with a general anti-institutional animus, the rise in the value of crypto-assets comes as no surprise. We therefore treat Bitcoin and its larger substitutes as a barometer of society's faith in its systems. Its constant march uphill should be unsettling.


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*For the avoidance of all doubt, goodstead does not recommend or condone the holding of assault weapons as an effective hedge against financial catastrophe in the event of apocalypse, nuclear or zombie.

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