Early in my career one of my mentors gave me one of the best pieces of common sense advice on trading that I ever received. Never buy financial products you don’t understand. And in today’s market there’s one very pathological psuedo-asset class, that despite all the sound and fury, I dare say nobody fully understands: crypto assets.
Tis a very strange phenomenon that we as a civilization are allocating so much time, effort, energy and CO2 emissions towards an initiative seemingly backed only by a set of loosely-overlapping narratives that nobody can agree on. The value of everyday things like wheat, metals, semiconductors, and even synthetic products like stocks, interest rate swaps and bonds are well understood. We have rational valuation models for these products and there’s a market that purchases these products because of their intrinsic value or exposure they bring to collective human economic activity. Crypto on the other hand is a seemingly intellectually circular product that cannot justify its existence in terms of anything but appeals to the political. Crypto seemingly exists simply to trade more crypto on purely ideological purposes attached only to several seemingly incoherent stories. The multibillion dollar question right now is what type of asset should crypto tokens be considered as. There are four competing narratives on this subject we will discuss.
There’s the claim the crypto assets are monetary instruments or currencies as their colloquial namesake implies. However as a currency these tokens fail most of the classic economic definitions of money and consequently we see effectively nobody attempting to use crypto tokens as money outside of a small set of vanity projects done purely for political spectacle. Curiously the crypto faithful view the fixed supply of tokens like bitcoin as a desirable feature of a currency since in the Austrian and monetarist dogma they see intervention and inflation as an undesirable feature and quote the Friedman doctrine of “inflation is always and everywhere a monetary phenomenon”.
However this is one of those “feature vs bug” misreadings of basic economics. The actual desirable property of a currency is one with a variable supply which a central bank can control to target a specific low inflation rate by measuring the purchasing power of the currency with respective to the domestic costs of goods. A controlled inflationary currency with interventionist monetary controls encourages economic growth and stability over time. It remains stable and can be used to collect taxes and reliably value long-term cashflows on products like decade-long mortgages. A national currency’s value is derived from the requirement to pay taxes in the currency, the monopoly on the government’s ability to issue the currency, and the recognition of the courts that it can be used to settle public and private debts with the law stepping in to settle disputes denominated in the currency.
However deflationary currencies do nothing but encourage hording and without centralised inflation targeting are untethered to the cost of goods and swing around violently. As we see in crypto, they exhibit extremely volatility since no economic activity can be denominated in terms of them. One could never price a thirty year mortgage in bitcoin because its volatility makes it completely unpredictable and no sensible bank could calculate the risk of covering that debt. A world in which Elon Musk can tweet two emojis and your home depreciates 80% in value is a dystopia. Cryptoassets aren’t currencies, because by design they lack the centralised monetary controls to make them stable to use as a medium of exchange for goods and services. There can be no separation of money and state, because the state is the only party that could issue money almost by definition.
Then there’s the claim crypto assets are commodities. Commodities are interchangeable goods used as inputs in the production of other goods or services based on their intrinsic value. Unlike a gallon of petrol which can be burned for energy, or a kilo of wheat which can be made into bread, or a ounce of gold which can made into jewelery, there is no intrinsic use of a bitcoin. There is nothing inside of a bitcoin that can be used for anything other than to offload it on someone else who will buy it for more than what you paid for it. It is nothing more than a pure greater fool-seeking asset. These kind of products do occur in markets, but always as part of a market manias where the underlying unit is untethered to any intrinsic value and simply becomes a vehicle for speculation and price appreciation detached from the underlying object. Things like beanie babies, Pokemon cards, and tulip bulbs have historically exhibited this property until the pool of fools dries up and they collapse or revert back to their fundamentals. Zinc is a commodity because it’s a stable element at room temperature with 30 electrons and it’s shell configuration makes it useful in tools and conducting electricity, as a commodity it does not depend on a narrative or shared collective delusion to give rise to this utility.
Additionally there is the thesis that crypto assets are securities contracts. This notion is the most coherent story as most crypto assets meet both the philosophical and legal definition (called the Howey Test) of other comparable investments. Securities are effectively a collective fiction, they’re a financial product that exists within a legal framework about a contract that gives buyers and sellers legal rights to cashflows of a common enterprise. Crypto tokens most resemble equities, they’re an investment in a joint venture of a set of software developers and entrepreneurs who raise money from the public for a proportional stake in a common enterprise of launching the token. Investors expect a return from the efforts of the entrepreneurs to recruit more and more buyers to purchase the token in the future and thus generating them a return.
Crypto tokens are not all that dissimilar from equity investments in companies, except the underlying company has no business. This is strictly inferior than assets like stocks which either pay dividends from their revenue, buy back their own stock, or have mergers and acquisition events which introduce new cash in the system to reward investors for holding their stock. There are no fundamentals to any crypto token and it’s discounted future cashflows are all strictly zero and thus its present value must be strictly zero. It does not sell or do anything to bring in external revenue, it exists purely to grow the pool of greater fools to buy the token so that early token holders can be paid out by later token holders. There are no underlying cashflows in the enterprise by which to value the token. It’s effectively as if a penny stock company existed solely to pump, sell, and dump its own penny stock.
And finally there’s the claim that crypto assets are like art. Essentially Satoshi’s whitepaper is a piece of performance art split into 21 million pieces as a parody of hypercapitalism or to make a political statement about anarcho-capitalism. It wouldn’t be the first time in history that someone had done this kind of stunt, see Marcel Duchamp’s Monte Carlo Bonds conceptual art. This model has the curious property of being unfalsifiable because who’s to say what is and isn’t art, or what a specific piece of art should or shouldn’t be worth. Economics doesn’t have an answer to what a Van Gogh or a Picasso should be worth, and will never have an answer because it’s a question rooted in the humanities and aesthetics. What is curious is that if crypto tokens are art they aren’t being discussed or valued in terms of this model, and the “performance” part of the piece seems to be in presenting the art as a simulacrum of traditional financial asset classes. Which is quite curious because deception and incoherence would then be the message of the piece.
Setting all these models aside, there are two far more coherent perspectives on the crypto assets that have far more explanatory power for the behavior we see. Crypto assets are the synthesis of a speculative mania and a financial scam built around an opaque technology, phoney populism, with a tolerance for intellectual incoherence at its core. And it is a novel type of a scam, one that we don’t have a precise term of art for. They share the obscured and circular payouts of Ponzi schemes, the cult-like recruiting of multilevel marketing schemes, the ephemeral nature of high-yield investment fraud, and payout mechanics of pyramid schemes but strictly speaking they aren’t exactly like any of the classical scams. They’re something entirely new that we don’t have a word for yet. Some people have cleverly suggested we adapt the German compound word schneeballsystem or snowball scheme to refer to this new type of scam.
However there is a simple inescapable truth behind these schemes. These schemes around crypto tokens cannot create or destroy actual dollars, they can only shift them around. If you sell your crypto and make a profit in dollars, it’s only because someone else bought it at a higher price than you did. And then they expect to do the same and so on and so on ad infinitum. Every dollar that comes out of cryptocurrency needs to come from a later investor putting a dollar in. Crypto investments cannot be anything but a zero sum game, and many are actually massively negative sum. In order to presume a crypto investments functions as a store of value we simultaneously need to suppose an infinite chain of greater fools who keep buying these assets at any irrational price and into the future forever.
This is where these financial instruments leave the realm of reason and enter the cult-like world of MLMs and quasi-religious movements. Arguments for the non-zero valuation of crypto assets are all predicated on belief in infinities, circular logic, or faith in invisible hand of future forces yet unknown. Faith is the substance of things hoped for, the evidence of things not seen, but does not make for an intellectually coherent valuation model for an asset class.
As we know from the history of every other speculative mania, popular delusions based on the madness of crowds cannot sustain themselves indefinitely. These investments are effectively a game of libertarian musical chairs where participants gamble on timing the market hoping not to be left holding the bag when the music stops. The only novel element is that our new media landscape has effectively distorted the public’s sense of epistemology so drastically that they’re willing to convince themselves of the emperor’s luxurious clothing far longer than they would have in the past. Eventually though, reality always has a way of asserting itself since madness is not a stable state of being.