The first wave of the Internet era was all about connecting people. We had e-mail, followed by social media, e-retail, cloud computing, and big data. Throughout it all, the Internet has proliferated, reducing the cost of access.
Today, we are living through a third wave. The financial crash of 2008 brought about never-before-seen levels of mistrust because of information asymmetries. This led to the emergence of Bitcoin, a peer-to-peer electronic cryptographic currency. Bitcoin’s system of rules differs from traditional fiat currencies as it functions on distributed computations. This means that the technology underlying Bitcoin, called blockchain, allows data to be exchanged without a trusted intermediary, positing, for the first time, an ‘Internet of Value’, much like an immutable database that could be a repertoire of value. Internet 3.0 based on blockchain could be the transactional platform that could jumpstart, say industrial automation and self-driving vehicles, with even social media being powered by a distributed ledger.
While blockchain is being embraced by the stodgy banking and financial industry, it does see Bitcoin as ‘competition’. Veterans such as Jamie Dimon, the president, chairman and chief executive of banking firm JP Morgan Chase, has denounced Bitcoin. However, without Bitcoin (or other cryptocurrencies for that matter), there is no independent blockchain. Bitcoin, or the other cryptocurrencies, is what incentivises and keeps blockchain networks well-oiled. Traditional banks are embracing blockchain in a way which maintains the status quo and where they have complete control. Alas, while the world requires a stable global financial system, the distrust of central banks and the entire financial industry has only increased. ‘Trustless’ cryptocurrencies, especially Bitcoin, are emerging as a store of value, like gold.
Cryptocurrencies can function as a unit of account which could be used to transact, unless regulators decide to stomp the parade, and therefore, they act as a store of value; however, one which is subject to future regulations. Ether, introduced in 2015, has been the second-most successful cryptocurrency till date. Its validation is proof that the time for cryptocurrencies is now. However, cryptocurrencies cannot exist by themselves. The widespread adoption of blockchain technology has driven up its price.
With regard to pricing, we must ask ourselves whether we can trust central bankers. More importantly, are certain central bankers more trustworthy than others? Are programmable algorithms more trustworthy than central bankers? These questions highlight the fact that although we are gradually starting to trust computer-generated algorithms, we are still years away from completely relying on them. Thus, it’s safe to say that cryptocurrencies will not replace fiat ones anytime soon, and neither do they need to.
“A big differentiator of currencies of any financial asset is its valuation. Currencies are priced relative to other currencies, but they cannot be valued. When speaking of government-backed currencies, i.e. fiat currencies, the relative price of, say, the rupee in terms of the US dollar will be determined by the prevailing exchange rate. The intrinsic value of any asset is a function of its expected cash flows, risk, and growth rate,” Aswath Damodaran, professor of finance at the Stern School of Business at New York University, has said.
The problem lies in our inability to explain the value of Bitcoins through our current paradigms. It can, however, be priced. The ‘money view to finance’ offers new perspectives.
At the same time, the mining of cryptocurrencies through concepts of Proof of Work or Proof of Stake are new and different from what other currencies are based on.
Monetary systems are always hierarchical. Money as a means of settlement can be distinguished from credit, which is a promise to pay money, thereby delaying final settlement.
Fiat currencies are issued by a sovereign, and central banks are willing to be intermediaries as the ultimate back-stopper or to function as lenders of last resort (LOLR) in case of a currency run. With commodities, like gold, the restraint is usually a physical one. This is why Bitcoin is similar to gold, in a way.
The numbers say it all. The price of Bitcoin has risen in the last 12 months from $755 on 5 December 2016 to $11,333 – an increase of about 15x.
What characterises asset bubbles is exuberance, usually signing off as an ex-ante risky investment. Such exuberance also causes anguish to other market participants, and, more often than not, experiences have shown that ideations perfected by crowds may also fail. Behavioural finance ascribes bubbles to irrational investing. Faith in numbers leads to a herd mentality. When prices go up, people start to speculate an even further rise.
Is there a bubble?
Israeli behavioural economists Daniel Kahneman and Amos Tversky speak with vigour about ‘optimism bias’. According to Kahneman, “[this] may well be the most significant of the cognitive biases.” This would induce false notions of optimism and an illusion of control (one might argue that some people investing in cryptocurrencies think their investments/speculative behaviour are immune to regulatory risk). Further, WYSIATI (What You See, Is All There Is) leads people to believe in the accuracy of their predictions and further drives them into a herd mentality. This optimism can also be gauged by the fact that the current price of Bitcoin has had a high correlation with ‘bitcoin’ being a dominant subject of Google search. The success of Bitcoin has therefore led to its price surge. This has made it an even more appealing prospect for investors and speculators. People tend to search to know more about it, only because they hear about it.
However, both blockchain technology and Bitcoin are in their nascent years of application. There is bound to be euphoria. We do see the potential of this technology to change and re-organise our daily affairs in currently unimaginable ways. While Bitcoin is the dominant cryptocurrency, there are others like Ethereum, Ripple, Dash, etc. which are also gaining ground.
As the euphoria continues and new investors join the party, the cryptocurrency asset class will continue to grow. A relatively small shift in asset allocation towards cryptocurrencies has the potential to positively impact cryptocurrency prices.
For the smart investor with a risk appetite, it might make sense to diversify and hold a bouquet of cryptocurrencies. Not many of them may survive or flourish, but the ones which do can outperform any other asset class.
What’s next? Bitcoin at $100,000 or a collapse? Only time will tell. Until then, I leave you with a thought by American economist and Nobel Laureate Milton Friedman, who with considerable foresight, said, “The one thing that’s missing, but that will soon be developed, is reliable e-cash, a method whereby on the Internet you can transfer funds from A to B without A knowing B or B knowing A – the way I can take a $20 bill, hand it over to you, and then there’s no record of where it came from.” Today, we are at that juncture where we ought to believe and ask instead, “Think Different!”
Bitcoin and blockchain can create an entirely new financial and transactional system which also has the potential to re-organise how our society functions.
Tapas Sarkar is executive director and partner at investment banking firm 7i Advisors.
*The article earlier erroneously referred to Milton Friedman as Thomas Friedman. This has been corrected. The error is regretted.