Ask Forstrong:

The Cryptocurrency Bug: Catch Me If You Can

April 27, 2021

Ask Forstrong: What are your thoughts on cryptocurrencies?

Speed Read:

  • The crypto boom has tapped into many of our modern discontents — a mistrust of policymakers, disruptive technology, rising populism and general post-crisis pessimism.

  • Paradoxically, the more attention crypto gets, the more oversight from regulators and central banks. This is a huge hurdle to clear for crypto.

  • Crypto’s captivating hold on humanity masks a larger trend underway: the move away from a unipolar currency world led by America to a tri-polar world with the euro and especially the renminbi becoming more important stores of value.

Experience has taught us that it is best to leave the room after making any comments on cryptocurrencies. Toss the grenade and walk away. This is especially true in the current climate. Crypto prices have soared this year, widening the gap in public opinion and, would you believe, lathering up the crypto bulls even further.

Still, let’s indulge the topic and have at it. Where to start? At its core, crypto evangelists invite us to imagine a world where our currencies are decentralized — free from the heavy hand of government intervention and untouched by their modern tools of negative interest rates, quantitative easing and, lately, unchecked fiscal stimulus. Underpinning it all is blockchain technology which promises to offer anonymity, eliminate middlemen, transcend national borders, carry almost frictionless costs and, here’s the ace: enforce a finite supply.

Much of this resonates deeply with this author. We, too, like our fees low and privacy heavily guarded. And, it is no surprise that, with recent government actions, alternative mediums to fiat currencies are surfacing. Bitcoin, in the words of one analyst, may just be the “last functioning fire alarm”.

Recent figures from the IMF sharpen the point. The leaders of planet earth (i.e. the G20) have increased spending or cut taxes by USD 11.7 trillion since the onset of the pandemic — some 12% of 2020’s global gross domestic product. For comparison, after the 2008 global financial crisis, and after months of bickering, the G20 grudgingly agreed to stimulus worth just 2% of global GDP. In terms of fiscal expansion, this time really is different.

All of this government abundance stands in stark contrast to crypto’s proposed scarcity. But crypto’s rise is also a symptom of a longer-running trend: the increasing instability of the US dollar. Since WWII, the currency has been the de facto global reserve currency. For a time, the arrangement worked well for the world monetary order. Aside from its raw power, America’s greatest asset was always its consistency. Allies could plan accordingly. Cross-border payments settled seamlessly. And the world was moored to a stable anchor.

But the above assumed a high level of trust in America. This has clearly diminished of late. In fact, the pattern in recent years has been one of abrupt swings not just in policy but in worldviews from president to president. As it is, America’s predictability is now manifestly in decline (see our recent piece, “America Tests Positive For Political Dysfunction”). Importantly, the country’s volatility clearly curbs its ability to anchor the world system. A capricious Washington cannot lead. It is no surprise that the private sector has stepped in with digital currency initiatives.

What is money?

All that said, believing in the kind of monetary nirvana proposed by the crypto community requires an extraordinary leap of faith. Does the future they describe have a chance of success? To answer that, we must first understand money. What is it really? Webster’s defines it as something accepted as a medium of exchange. But it also must be stable, portable and, importantly, widely used. The last feature is crucial. After all, both fiat currencies and crypto cannot be consumed and do not produce anything. In fact, they completely depend on a collective confidence that they actually have value — even if that conviction is a “consensual delusion”, as some claim. Put plainly, their entire value is derived from its use, or potential use, as a medium of exchange.

The path to crypto’s widespread use is littered with risks, including a few existential landmines. Even ignoring their enormous volatility (Bitcoin’s price has had 6 peak-to-trough declines of more than 70% since inception), investors cannot forget that cryptocurrencies rely on decentralized software. As recently as 2018, a bug in the Bitcoin code was discovered which could have led to unlimited inflation ¹. And now we get news last week that a coal mine flood in China’s Xinjiang region shut down 35% of Bitcoin’s global mining power.

Now, to be fair, all of this may be just growing pains. Crypto is a nascent industry and, unsurprisingly, no stranger to scandal, technical bugs and the like. But the biggest threats come from the regulatory and competitive side. The reality is that anyone can issue money. The problem is getting people to accept it.

Here, cryptocurrencies face a serious competitor. They are called the government. And, they are no longer standing still with crypto oversight. If this author has learned anything after two decades in finance, it is this: policymakers are control freaks. Eventually, they will demand their slice of the spoils (raising taxes) or regulate something (increasing costs for the private sector). To paraphrase former US president, Ronald Reagan, the government’s view of things can be summed up as “if it moves, tax it and if it keeps moving it, regulate it”.  

Regulatory efforts are now swiftly underway. Most of these largely focus on AML (anti-money laundering) issues but there is a long list of other initiatives including prosecuting people for not reporting their crypto gains². You can bet capital gains taxes are not far behind.

All this matters because, if enacted, regulations add risks and potential costs for those who transact against the law. And, increased regulations would systematically remove the original benefits the cryptocurrencies claim to bring. Less anonymity, more intermediaries and greater surveillance was not part of the plan. This signals that the state, not crypto, is winning in terms of control of the monetary system.

Systemic Risks Rising

The larger risk than regulation, however, is competition. Never mind the more than 4,000 cryptocurrencies that exist today (so much for fixed supply). Enter the central bank digital currency (CBDC), a digital form of a country’s fiat currency that is also a claim on the central bank. Instead of printing money, the central bank issues electronic coins or account backed by the full faith and credit of the government.

This is the future folks. Over time, CBDCs can integrate with all types of applications and digital initiatives that the private sectors has built up. Cryptos have spawned an entire ecosystem, including tokens, listed securities and exchanges to trade cryptocurrencies. Many of these efforts need not be wasted.

Most major governments already have CBDC initiatives well under way, including China’s lead with its digital yuan (with the main goals of improving on physical cash, controlling financial crime and the explicit discouragement of crypto use). Agustín Carstens, former governor of the Bank of Mexico, current general manager of the Bank for International Settlements (BIS), and evidently an all-around Bitcoin hater, dumped this bucket of cold water on crypto in a recent speech ³:

First, should digital currencies rely on a central authority or a decentralised governance system? Second, should access be based on verification of identity, or purely on cryptography? The answer is that if digital currencies are needed, central banks should be the issuers and they should grant access based on identification.

Clearly, a wet blanket for the crypto crowd. “My message to young people is this: stop trying to create money,” Carstens goes on. “Money has become established. Young people should use their many talents and skills for innovation, not reinventing money.” He then went onto attack the side effects of Bitcoin’s monstrous electricity usage, which he claims is higher than Switzerland’s (where the BIS is based). Ouch.

Carstens is not alone in his views. In fact, most of the world’s lead policymakers, including Treasury Secretary Yellen and Fed chair Powell have declared their intention to regulate and compete with crypto. We are only in the foothills of a long digital journey for the world’s central banks. Paradoxically, the more attention crypto gets, the more hostility from regulators and central banks. And, rightly or wrongly, governments do have the distinct advantage of insisting that people use their money — and insisting that people do not use Bitcoin. This is a huge hurdle to clear for crypto.

Speculation or Investment?

Where does all that leave us? Let’s call crypto what it is: a speculation on a lofty yet uncertain future with enormous risks. Serious investing starts with an understanding of present and future value. Conversely, speculation begins with a premise that others will pay more for it in the future, with no regard for intrinsic value.

But admittedly not everyone is a long term investor. Which begs the question: despite all the risks, can crypto still function as a good hedge against economic crisis and inflation, a kind of digital gold? Here, we can monitor market developments to determine the answer. Yes, crypto has done well throughout the pandemic. But crypto land is also clearly a hotbed of wild, and at times, random crowd-funded speculation.

To illustrate the point, consider the cryptocurrency that was originally created as a joke: Dogecoin, “dowzh-koyn” — best pronounced with a heavy English accent (trust me, try it). If the name itself initially suggested rich comedic pickings, it really undersold what was to come. Most cryptos have some moral mission — taking on the Fed, promoting economic liberty, restoring the value of money, etc.

Dogecoin claims none of these. It does, however, have a phenomenal track record, handily beating out Bitcoin since its 2013 inception and now sports a market capitalization of over USD 70 billion (at least, as of the last hour it did).

But if Dogecoin has no intended use as a medium of exchange then this is simply a classic case of the greater fool theory. Dogecoin investors are buying, not because they think it has any intrinsic value, but with the hope that others will pile in, push the price up and then they can sell to make a quick profit. We all know what this is called: it is a Ponzi scheme and it is impossible to know when it implodes.

Dogecoin aside, if crypto generally is more of an object of speculation rather than a market hedge, then its prices should increasingly correlate with the overall levels of speculation in the marketplace. This is exactly what has happened. All of Bitcoin’s major losses have coincided with market declines — in 2012, 2015 and 2018. Even more worrying is that crypto correlations with the NASDAQ (a proxy for risk appetite and generally a similar pool of investors) have moved steadily higher over the last few years. Investors should not expect crypto to hedge the next bear market.

 

Investment Implications

Every generation gets its gold rush. The crypto boom successfully tapped into many of our modern discontents — a mistrust of policymakers, disruptive technology, rising populism and general post-crisis pessimism. We are sympathetic with all of these and the overall view, especially among young people, that the rules of the game keep changing. Since as far back as 2008, the world has witnessed rolling crises, stagnant wages, raging asset prices and government policy that is best described as experimental.

But the odds are heavily stacked against decentralized digital currencies. It is far more likely that we remain stuck in an imperfect world of fiat currencies.

Crypto’s captivating hold on humanity also masks a larger trend underway: the move away from a unipolar currency world led by America to a tri-polar world with the euro and especially the renminbi becoming more important stores of value. The digitization of money only accelerates these trends. Over the long-term, there are plenty of profits to be made for the globally intrepid investor.

We wish the crypto community much success. But count us in the non-believer camp. Now if you will excuse us, we will politely leave the room.

 

¹ If the above discussion may as well have been Greek to you, we recommend starting with a report by the bright mind of Matt Hougan, a 64-page tour de force of the crypto world. https://www.cfainstitute.org/-/media/documents/article/rf-brief/rfbr-cryptoassets.ashx

² https://www.bis.org/fsi/publ/insights31.pdf

³ https://www.bis.org/speeches/sp210127.pdf

TYler MORDY

Chief Executive Officer & Chief Investment Officer

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