Cryptocurrency is moving into the mainstream but valuations look much too high

This post sets out our thinking on cryptocurrencies. It’s a lot longer than normal because the topic is such a large one. Here are the key points:

• The technology behind cryptocurrencies is still immature, but will allow the development of highly robust and secure systems to perform simple financial and non-financial transactions.
• This will make it much easier for small organisations to compete with big organisations in fields like payment systems, and should put a cap on the amount value that can be extracted by financial network operators. This is part of the broader theme of fintech disruption. But while the technology can remove many operational risks it cannot remove credit risk and all the other uncertainties that financial organisations face — don’t believe (all) the hype about disruption.
• Regulators around the world are rapidly bringing cryptocurrencies into the fold of financial services regulations. While they won’t be able to completely control all illegal activity facilitated by the technology, the financial system is not going to be radically upended and replaced by ungovernable systems controlled by no one.
• Most practical applications require much lower transaction costs and higher transaction speeds than the leading cryptocurrencies today, but these are available and being introduced. This brings with it reduced energy costs.
• The current valuation of the major cryptocurrencies is extremely high given the lack of current practical uses and the ease of creating new currencies. While it’s possible that, like gold or diamonds, people decide to hold Bitcoin as a store of value despite its limited usefulness, gems and precious metals have thousands of years of history as status symbols and Bitcoin does not.
• Cryptocurrencies should become like commodities: their value should be around the cost of producing more, which is a lot lower than where most of them are now, and they’ll be used to connect the activity of the network operating the blockchain to the end users of that blockchain.

We’d think of cryptocurrencies as being like websites in the late 1990s. While it was pretty clear then that the technology of the world wide web was important, that didn’t mean that every website, internet service provider and domain name was a priceless asset that would be worth vast sums of money in future.

Definitions

Cryptocurrencies are a vast topic. There are at least 6500 currencies on offer and they have many different features and characteristics.

But in general, for each one we’re talking about a database that is distributed over many computers. The database, or blockchain, records ownership of individual “coins” of the currency (and potentially lot of other things as well) in digital form.

Transactions in the blockchain are secured by strong cryptography and the computers that run it are rewarded for their work by being given additional coins.

The systems are carefully designed so that there is no need for centralised control, and in most cases a bad actor would need to gain control of more than half the total computing power of the entire chain in order to subvert it.

To add to the complexity, it is possible (and increasingly common) to run a digital currency on top of the blockchain that is powered by a different currency. So you can have a currency that depends on another currency to function.

There are many other uses of blockchain and cryptography, but for our purposes we’re thinking about only systems that could be seen as a currency of their own without centralised control, rather than application of the technology that is controlled by an organisation.

Also, for this note we’re only thinking about the cryptocurrencies themselves, not the companies that surround them or work on them. And as much as possible we’re going to talk in generalities about types of currencies.

As they evolve so quickly we want to lay out a set of principles for analysing them, rather than get into the merits of one coin relative to its 6499 competitors.

Framework

Normally, when assessing investments, we think about the income they produce and the earnings growth they can expect, and offset that against the risks that their value falls. In the case of cryptocurrencies, they produce no income.

Immediately that tells us that we should look at them not as investments, but as commodities whose value is determined by supply and demand.

Demand drivers

Let’s start by looking at the factors that could influence demand for the currencies. The first question here is “what are they for?”

We can divide the uses that have been suggested for cryptocurrencies into three groups:

1. Store of value
2. Medium of exchange
3. Distributed platform for computation.

The use of the currency is critical for determining the characteristics that are important for its demand.

As a store of value (like gold, silver, diamonds, art or antiques) the cryptocurrency needs broad acceptance as being valuable: a sizeable proportion of the population need to recognise it as being valuable for its own sake.

It does not necessarily have to do anything, but it should also not have legal and regulatory hurdles to ownership and it should be able to be held securely.

As a medium of exchange, like electronic payments or funds transfer, speed of transactions and low cost is the key.

Distributed computation is a third use which is less prominent in the popular press but a huge focus of the crypto development community.

Transaction costs and speed is very important for this use, as is a broad ecosystem of developers and service providers to make the system functional for a wide range of uses.

Transaction costs and speeds

Most cryptocurrencies in use today have significant transaction costs. They vary with the popularity of the coin and its design, but typical costs to transact with the major coins Bitcoin and Ethereum are US$1 to US$5, spiking to over US$50 when the coin is very popular. This is not an accident.

The high transaction cost is an important feature of the original Bitcoin specification that designed the validation of blocks of transactions to require significant computation and includes a mechanism to adjust the transaction cost and keep it high over time.

The idea is essentially that if you make it too easy to validate blocks on the network someone could marshal a vast pool of computers, jump in and take over the network.

An unintended consequence of this is that the energy consumption of these cryptocurrencies is huge. The Cambridge Bitcoin Electricity Consumption Index estimates that (at time of writing) Bitcoin’s operations are consuming 13 gigawatts of electricity and total consumption to date has been 279 terawatt hours.

To make matters worse, the transactions are also slow. Transactions can take a few seconds to several minutes to be confirmed (ie, to have been copied to enough places in the blockchain to be part of the consensus record).

And the total rate at which blockchains can add transactions is well below traditional payment platforms: Bitcoin is processing about three transactions per second for all users worldwide, whereas Ethereum can process around 14.

These costs and speeds make cryptocurrencies almost useless as a medium of exchange or distributed computing environment.

More recently some cryptocurrencies have been created that allocate power to validate blocks of transactions based not on ability to do complicated maths problems but on the amount of the currency that the validator holds. (In the jargon this is called “proof of stake” as opposed to “proof of work”.)

Theoretically, this means that someone who could control more than 50% of the currency could validate bad transactions, but this is considered unlikely and anyone with such a large stake in the network would have little incentive to damage its integrity and (presumably) reduce its value.

Cryptocurrencies designed with this type of system and other technical improvements should offer greater transaction speeds and lower costs.

One of them, Solana, estimates that they process 2600 transactions per second at an average cost of $0.00025. For comparison, Visa processes around 1700 transactions per second in the US.

This level of responsiveness and low cost would allow practical use as an exchange or distributed computing.

Ethereum is transitioning to this new model. When combined with some technical enhancements, it will be considerably faster and cheaper than it is now.

Distributed computation platform

Cryptocurrencies are usually though of in terms of digital, internet-based currency. But fundamentally they operate as distributed databases and can be used to store other things apart from an account balance.

One use that has gained a lot of press attention is “non fungible tokens” which are usually small pieces of digital art that can be traded between users. Other, more practical, uses proposed include tracking the location of shipping containers, or a digital land registry.

Many of them, most notably Ethereum, can also store and run small computer programs. Known as “smart contracts” these programs allow third parties to write software that then lives on the blockchain alongside the currency records.

These smart contracts can process other information when users pay the computers that run the blockchain to run them. And they pay for it with some of the blockchain’s cryptocurrency.

This is an interesting development because it allows small organisations to create systems that are guaranteed to have the same scale and security as the cryptocurrency without investing a large amount of money setting up IT systems of their own and having them audited by experts.

It also means that there would be a market for the cryptocurrency: people wanting to use these systems would purchase the cryptocurrency with real money so that their transactions will be processed by the computers running the blockchain.

The smart contracts were originally thought of as a way of automatically mediating exchanges that are defined in legal contracts.

The challenge is that most of these exchanges require something to happen outside the blockchain too, like an external price, so there needs to be a system to put the relevant information on to the blockchain before the contract can operate. So while the exchange itself is secure, you still need to trust the process that provides the information in the first place.

Also, smart contracts work automatically without human oversight. If there’s a coding error or an external situation that designer didn’t anticipate, the results may be technically correct but not desirable.

We’d expect as smart contracts become used for important purposes that standard forms of contracts and some sort of override clause will become more common.

The costs of blockchain computing should remain higher than traditional systems on average, because there’s additional computational and storage overhead to manage.

But the distributed nature of the system and public auditability of the processes will enable small players to deliver trusted services much more cost effectively.

Regulatory issues

After a long period of not really responding to cryptocurrencies, regulators around the world are releasing rules and incorporating cryptocurrencies into their frameworks.

Looking particularly at the Australian regulations from ASIC, much of it is simply saying that the normal rules apply to cryptocurrencies – if you are effectively selling shares in a company calling it an “initial coin offering” does not remove all the obligations of the Corporations Act.

Anecdotally, crypto developers have told us that a lot of the legal work with new products is trying to design them so that they sound enough like a currency or financial product to attract investors without meeting enough of the legal definitions of financial products to make them regulated.

Anonymity

One particular aspect where regulation will change cryptocurrencies is privacy. Many cryptocurrencies are considered anonymous, although it would be more accurate to consider them pseudonymous because the cryptographic identifiers of the owner are associated with each transaction, even if the real identity of the owner is not.

But almost every country now has strong rules on identifying the entity associated with financial transactions (these include “know your client”, anti-money laundering, counter terrorism financing, source of wealth, suspect transactions reporting and financial sanctions rules).

These rules are often depicted as helping limit organised crime and terrorism, but they enjoy wide support from governments because they help reduce tax evasion.

With the introduction of regulated exchanges and mainstream platforms we’d expect that regulators mandate that the real identities customers be collected and linked to the crypto identifiers so that transactions can be tracked.

There are some cryptocurrencies that are designed to be truly anonymous. Regulators will probably attempt to supress these by restricting the connection between them and the legitimate financial system.

Institutional grade?

ASIC’s guidance on cryptocurrency ETFs gives a good insight into what would be needed to treat cryptocurrency as an asset of sufficient quality to be the basis of a mainstream investment product. ASIC Information Sheet 230 provides the following explanation.

• There is a high level of institutional support and acceptance of the crypto-asset being used for investment purposes
  
• Reputable and experienced service providers (including custodians, fund administrators, market makers and index providers) are available and willing to support ETPs that invest in, or provide exposure to, the crypto-asset
  
• There is a mature spot market for the crypto-asset
  
• There is a regulated futures market for trading derivatives linked to the crypto-asset, and
  
• Robust and transparent pricing mechanisms for the crypto-asset are available, both throughout the trading day and to strike a NAV price."
  

We’d say that for the more mature cryptocurrencies like Bitcoin and Ethereum, there is enough of a market to attract support from service providers and investors to satisfy these criteria, but not for most others at the moment. But given the potential sums of money involved, service providers will come to the party quickly if a new cryptocurrency becomes popular.

ASIC is also at pains to point out the need for the highest levels of security around the cryptographic keys that give access to the fund’s coins.

While one of the attractions of cryptocurrencies is the lack of a central authority to manage things, that means that if you lose the keys or have them stolen, there’s no way to get back your currency (unless you can convince a majority of the community who operate the currency to change the rules to give you your currency back).

That is, while there’s no single point of failure, there’s also no single point of repair if things go wrong. Notwithstanding this risk, high security is a strength of the cryptocurrency model in general.

Supply drivers

Turning to the supply side of the equation, what can we say about the ability to create more currency?

At a system level, this is easy: supply is effectively infinite. The fact that thousands of cryptocurrencies have been created shows that there are essentially no barriers to entry.

All the code required to operate the major cryptocurrencies is public, and anyone can take a copy of the code, modify it and release it. If you can convince enough people to run your code on their computers, you’ve got a new cryptocurrency.

Many individual currencies have limits on the amount of coins of that currency that can be created. But most do not.

Technology change

The technology behind cryptocurrencies is still in development. There have been some high profile coding mistakes associated with cryptoassets and the technology and many more operational and security failures in service providers that surround them.

But the main evidence that the technology is not stable is that new platforms, algorithms and systems are being developed and launched continuously.

It’s also worth noting that the technology for a currency can change if the community that runs it collectively decides to operate a different way.

Examples include the change in Ethereum from proof of work to proof of stake mentioned above, and the “hard fork” of Bitcoin into Bitcoin Cash, where some users created a new copy of Bitcoin with some technical differences to improve liquidity, and in the process gave every Bitcoin holder an equivalent amount of Bitcoin Cash.

Network effects

With currencies and other platforms there are network effects: the more people who use it, the more attractive it becomes to potential new users.

We see in many new technologies that the first version of the technology that is “good enough” to be adopted by a significant user base tends to dominate the field even if technically better options come along shortly after.

We can already see evidence of this: despite (in our view) many technical deficiencies compared to its descendants, the original Bitcoin has a far greater market value than other currency.

We’d say its too early to crown a winner for the currencies that are best for transfer of value or distributed computation, but we’d expect that the transition will come in the next few years.

Value

The market value of cryptocurrencies is stupendous. At time of writing, it’s estimated at US$2.9 trillion. Of this, US$1.3 trillion is in Bitcoin, US$571 billion in Ethereum, US$108 billion in Binance Coin, US$74 billion in Solano, US$73 billion in Tether, US$72 billion in Cardano and a long tail of thousands of others. There are over 100 currencies with a notional market value of over US$1 billion.

Most of these are wildly speculative: given that lots of new coins can be created and the practical uses are limited, it’s hard to justify these valuations.

Even if distributed computing becomes a major factor, there’s no good reason why a very large value should be attached to coins that are the product of computation that has already happened. It would make more sense for people to buy coins from systems that are much more efficient.

Tether is an exception. Each unit of Tether entitles the holder to claim US$1 from the corporation Tether Limited, which is fully backed by reserves. (Ironically, Tether won’t redeem tokens for US persons, due to regulatory issues.)

Understandably the value of Tether trades very closely to the USD and has not experienced any price appreciation like the other currencies.

Conclusions

The most interesting aspects of cryptocurrencies are the potential as a platform for highly secure, rules-based exchanges that require very little setup cost.

However, if this practical use of cryptocurrencies becomes mainstream, it will be with efficient systems that can operate at low cost and whose currencies trade at around the cost of production.

It’s hard to believe cryptocurrencies will become recognised as a store of value for their own sake. Precious metals and gems have thousands of years of history behind them, and Bitcoin does not. We would regard the current valuations as far too high to be sustained.