Cryptocurrencies: The Rise of Decentralized Money

This article is the first installment in the Cryptocurrencies series exploring the nature of cryptocurrencies and their economic significance going forward. Future editions will examine blockchain technology and initial coin offerings (ICOs), among other topics.

Cryptocurrencies are unique instruments in the investing world. They share many characteristics of traditional currencies but can also serve as platforms for more sophisticated financial products.

Judging by their price history alone, cryptocurrencies are easy to dismiss as a bubble. And, indeed, the crypto space is filled with questionable offerings.

However, a discerning look reveals a new financial technology with the capacity to fundamentally change the global economic landscape.

The cryptocurrency phenomenon traces its roots back to 2009, when someone writing under the pseudonym Satoshi Nakamoto laid out its theoretical framework in “Bitcoin: A Peer-to-Peer Electronic Cash System.”

While the idea of electronic cash wasn’t new, it had never attracted wide acceptance. One important roadblock was the “forgeability” of electronic information: It meant that bad actors could potentially create money out of thin air. Earlier systems relied on centrally managed servers that “held” electronic cash. Their vulnerability to cyberattacks also posed a serious problem.

Nakamoto’s paper addressed forgery and security concerns. By cryptographically chain-linking transaction records and placing them on a decentralized network, Nakamoto created an immutable, self-propagating ledger. It allowed users to store, spend, and transfer value. This network effectively functioned as a bank, except it had two other groundbreaking properties.

It was impractical to (a) hack or to shut down and (b) it eliminated the need to trust a third party to hold value/verify transactions. The bitcoin network was the proof-of-concept for creating and managing money outside the control of any single entity.

Since then, the cryptocurrency space has come a long way. There are now many new cryptocurrencies that seek to address bitcoin’s shortcomings — its transaction time, transaction throughput, scalability, and resource-friendliness — one way or another. The technology is developing fast and the best types and use cases of cryptocurrencies are yet to come.

The media has covered cryptocurrencies for a few years now. Despite these efforts, the true nature of cryptocurrencies remains somewhat murky and undefined. At the moment, cryptocurrencies represent different things to regulators, bankers, and to the general public.

The US Internal Revenue Service (IRS) classifies cryptocurrencies as property, the US judiciary system considers them a commodity, and bankers see them as competition. Individuals, on the other hand, tend to view them as investments.

While the battle over the regulatory status of cryptocurrencies continues, those who are interested in their practical application need to ask themselves three fundamental questions:

Economists define money in terms of its properties. According to their definition, money is anything that can serve as a:

• Store of value: It can be saved and used later.
• Unit of account: It can be used to quote prices.
• Medium of exchange: It can be used in to buy and sell goods and services.

In the United States, money is also recognized as legal tender by the government. Its worth noting that the US definition of legal tender does not seem to preclude private businesses from accepting other forms of payment, including cryptocurrencies, though this may not be the case in other jurisdictions.

This means that government is not an essential component of money’s general definition, although it plays an important role in creating and circulating fiat money.

We tend to think about money in physical terms, but anyone with a bank account and internet access can experience its abstract nature firsthand. Jack Weatherford — an anthropologist and author of The History of Money, among other books — notes the evolution of money from a commoditized representation, in the form of stones, salt, tobacco, dried fish, rice, cloth, etc., to a tokenized one, in the form of coins and paper money, to the more abstract form — the digital money.

In its essence, money is an abstraction with a set of fundamental properties that justify its use.

Within this context, cryptocurrencies are money. They mark the continuation of the larger historical trend of money moving from the concrete to the abstract. They possess the three properties ascribed to money by economists. Last but not least, they are gaining wider global recognition. If anything, cryptocurrencies represent the next stage in money’s evolution, one that does not rely on a central authority for governance.

In that regard, cryptocurrencies are the first independent global currency since gold and silver.

At the moment, decentralized cryptocurrencies have relatively low transaction throughput, which limits their use. For example, the bitcoin network is designed to processes five to seven transactions per second. This is nowhere near the throughput of Visa or Mastercard, which process thousands of transactions per second. It is also one of the main reasons bitcoin has struggled to gain acceptance as an everyday currency.

While important, this limitation needs to be analyzed in the context of the network’s other important features, among them transaction time, transaction throughput, and network decentralization, or security. They are interdependent.

Improvements in transaction time and throughput come at the expense of decentralization. Second-generation cryptocurrencies such as Ripple and Stellar have built their networks on the idea of relaxing the decentralization parameter. Their throughput capability is comparable to that of Visa and Mastercard. However, they are not as decentralized and hence probably not as secure as bitcoin.

In their current incarnation, cryptocurrencies are imperfect. But the problems they face are not unsolvable, and the crypto space is continually engaged in finding workable solutions.

One third-generation cryptocurrency — Cardano — seeks to combine formal scientific methods in cryptography with the tenets of game theory to build a cryptocurrency platform that offers high levels of throughput and interoperability with traditional financial systems, including compliance. It proposes to accomplish this without compromising on network security, customer privacy, or energy resources.

These are lofty goals and much of the mainstream adoption in this space depends on the success of Cardano and similar ventures.

Apart from their obvious use case as money, cryptocurrencies can play a significant role in increasing global economic participation and protecting against government overreach.

Globally, there are some two billion people without bank accounts, many of whom do not have the money to open or maintain an account. Cryptocurrencies have low adoption costs, are divisible into small fractions, and have practically no minimum account requirements. This means anyone with a phone or an internet connection can access the equivalent of a bank account and participate in the global economy.

This application isn’t limited to the developing world. The United States has a sizeable unbanked cohort as well. Cryptocurrencies could help integrate the unbanked into the financial system, creating synergies across the economy and generating additional tax revenues.

The decentralized nature of cryptocurrencies is equally important. It provides an alternative avenue to traditional financial systems to preserve, transfer, and manage wealth. Cryptocurrencies offer protection against unlawful government seizures and can mitigate the political risk that could lead to systemic financial calamities.

By seeking to provide a secure, fast, and frictionless means to store, spend, and move value, cryptocurrencies are challenging the traditional pillars of the financial system. Despite their seemingly ethereal nature, they have attracted talent and enough monetary momentum to change the way we transact, raise capital, and organize ourselves to create economic value.

Cryptocurrencies mark the ascent of independent, decentralized, “government-free” global money into the world economic order.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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