Is Cryptocurrency a Good Investment?

With the total value of bitcoin hitting US$1 trillion this month (greater than the annual nominal GDP of The Netherlands, or the value of Facebook) cryptocurrency is an economic phenomenon to be reckoned with. But size isn’t everything and cryptocurrency’s popularity is not necessarily indicative of its long term profitability.

To try and answer the question if cryptocurrency is a good investment, it’s relevant to first clear up what cryptocurrency is? Is it Money? And if yes, what kind of money?

Cryptocurrency as Money

Money, according to economists, is a store of value and a medium of exchange. Money can be a dollar, ringgit, yen, rupiah. But it can also be sea shells during the stone age or cigarettes in prison. Money is useful because it is fungible: it can quickly be converted into something that you want or need. For money to become fungible it needs to have a community of users who agree on its value and are therefore willing to accept it as payment. The value of money is what you can buy with it, after all.

The community around money is typically the nation state. The nation state issues currency via a central bank or currency board and then proceeds to spend, issue debt and tax its citizens in that currency. In most cases this is enough to persuade the vast majority of people in the country to start using government-issued money, especially if the value of that money is relatively stable. Countries which cannot manage the stability of their own currency might use another country’s “hard” currency. Think of how some countries also use US dollars, euro, pound sterling or Indian rupee alongside, or instead of, a local currency.

Aside from this government centric view of currency, a currency can also be used because it lowers transaction costs. A prime example of this is the US dollar: when a Malaysian trades with someone from Vietnam, they will usually not deal in ringgit or dong, but in a third currency like the US dollar. This is not because the ringgit or dong are crackpot currencies, they are highly fungible in their domestic economies, but because in the foreign exchange market the US dollar has huge volumes and a low spread. There are huge volumes of US dollar-dong and US dollar-ringgit transactions daily, whereas direct ringgit-dong transactions are very rare. Therefore a transaction that converts ringgit to US dollars to dong will typically offer the lowest transaction cost.

So where does this leave cryptocurrency? Does cryptocurrency have a ‘captive’ community that accepts it as payment? Or can a cryptocurrency be used in an international setting, like the US dollar, connecting different currency communities?

Welcome to Cryptoland

Although cryptocurrencies like bitcoin are not backed by any national governments (this is part of their attraction) there are communities in which cryptocurrencies are being used.

Especially in situations involving online transactions that safeguard privacy and don’t involve any paperwork, anonymous cryptocurrency like bitcoin can be very useful. This partly explains the popularity of cryptocurrency in crime: hiring an assassin, buying weapons or drugs, paying for hacked personal data, running a ransomware business, etc. The privacy that cryptocurrencies can provide seems ideal for any situation where one wants to economically subvert a government. Its anonymity should help with tax evasion or to circumvent capital controls. While there are also legitimate uses of cryptocurrency, its a bit like offshore financial centers: an anonymous offshore company in an opaque jurisdiction is exceptionally useful if you’re engaged in tax evasion, corruption or money laundering.

Nevertheless, we have to admit that there is a large and presumably thriving Cryptoland where cryptocurrency is fungible and widely accepted in transactions. How big is the economy of Cryptoland? It’s estimated that crime accounts for about 3.6% of global GDP. If we assume global GDP of US$90 trillion, that means Cryptoland’s economy has a GDP of US$3 trillion and possibly more, depending on the real size of the grey and black online economy.

Yet its use in the shadow economy will likely harm cryptocurrency’s long-term prospects as governments will either ban it or seek to closely regulate it in ways that makes it less attractive for the seedier denizens of Cryptoland, who are presumably its main users now. In terms of transactions Cryptocurrency could have a cost advantage when compared to credit cards, but many countries also have very competitively priced domestic payment systems. In Malaysia online bank transfers cost around 10 sen (around 2 US cents and often waived for consumers), which is an amount that’s not easy to undercut for a cryptocurrency. Of course other payment services like credit card, QR codes, etc. are more expensive, but ultimately payment processing seems unlikely to be cryptocurrency’s long-term competitive edge.

Bye Dollar, Hello Crypto?

If wide adoption of cryptocurrency beyond the shady shores of Cryptoland seems unlikely, is it possible that cryptocurrency will serve as a connector of national currencies, much like the US dollar is today? Especially in international transactions banking fees tend to be much higher and the opaque, old, unsafe and inefficient system of correspondent banks and SWIFT seems ripe for disruption.

This is an area where an electronic currency, something like a cryptocurrency, could offer an advantage. But the question then quickly becomes: which cryptocurrency would one use? Many of the fiat cryptocurrencies like bitcoin, ethereum or dogecoin, are not backed by any assets and they tend to be highly volatile. This means that for practical transactions like from ringgit to dong, a cryptocurrency instead of the US dollar might not be the safest or smartest option.

A more popular alternative will likely be a crypto token backed by something else: say gold, silver, crude oil, palm oil or currencies like the US dollar, euro or yuan, which has a relatively stable price. If transactions in such a cryptocurrency are cheaper and easier than current cross-border transaction systems, this is probably a more viable future for cryptocurrency.

The above analysis suggests that, outside of Cryptoland, cryptocurrencies are not viable as money. But perhaps that’s not the insurmountable barrier that it seems to be. After all, gold used to be the world’s money, and although that role has largely come to an end, gold is still being held as an asset mainly in gold bars or as jewellery (its industrial use is quite limited)

Crypto as the New Gold?

Viewing cryptocurrency as a new gold rush arguably makes the most sense: fortunes are being made and lost, its highly volatile, there are robbers waiting to pounce… and the people who are getting rich seem to be the equipment suppliers (NVIDIA) and the cryptocurrency dealers (Coinbase), perhaps less so the miners themselves.

The value of gold is purely based on social perception: it is valuable because people have always thought that it is valuable. Cryptocurrency seems to have a similar sociology behind it, whereby most buyers buy because they want to be owners of Cryptocurrency, the idea that investment is consumption. Obviously the ownership of gold is more institutionalized and has a much longer history, but it also has a similar investment as consumption sociology.

So does it make a lot of sense to own cryptocurrency if it is like gold? Consider these two observations:

  • Gold is not a great long-term investment over the very long term. Stocks have historically had better returns (dividends included), although there have been periods where gold did out-perform stocks. If you do invest short-term, are you confident that you will make a profit and not lose your shirt in a very volatile and unregulated market?
  • There’s not one cryptocurrency in fact there are hundreds of cryptocurrencies. So it’s possible that you won’t buy the winner, perhaps because the winner hasn’t been launched yet. Before Google, Facebook and Amazon, there were hot internet services like Netscape, Compuserve, ICQ, Lycos and Friendster. “Whatever happened to them?” you may wonder. The same may apply to your cryptocurrency investment.

So as a serious investment, to which you may wish to divert a substantial part of your savings, cryptocurrency does not seem to fit the bill. But if you have money lying around that you would otherwise have just blown at the casino… then perhaps its not the worst idea. At least it will give you something to talk about at parties.