Cryptocurrency musings

I’m tempted to buy some Bitcoin this week, after its “value” dropped 30%. It would be a highly speculative investment, as the future of Bitcoin and all cryptocurrency ranges from world-changing boom to spectacular bust. I tell anyone who asks me about investing in Bitcoin to be ready to lose it all, fast. Or you could make a million. It’s that volatile and uncertain.

I’ve been conflicted about the whole cryptocurrency phenomenon for a couple of years. I understand the basic technology underneath cryptocurrency – blockchain – and it’s a solid technical foundation. Blockchain is a useful, provable foundation for distributed data – it works.

Most cryptocurrencies, including the most famous, Bitcoin, are based on blockchain. So that’s not the part that conflicts me. Much more complex is how value is ascribed to a coin. This leads us into the very hard to grasp territory of nation states versus corporations, exchange rates, national economies and fiat currencies.

Bitcoin and the US dollar have one big thing in common – they are both fiat currencies. That is, their value is based on faith in their issuer – faith that the coin or dollar will always be honored as a way to buy things, and that the issuer will always be around to back the transaction. Fiat currencies have no hard basis behind them, such as a guaranteed amount of gold for all the currency in circulation – the “gold standard” which the US removed in 1971.

So why is a paper dollar worth anything? Only because the holders – buyers and sellers of physical goods – are sure that the US is going to be around a while and that the US economy is strong enough to keep the value of that dollar stable. And that enough people and companies share that belief to make the dollar very liquid – it has value in almost any financial transaction. That’s it – belief and faith give the dollar value, stability and liquidity.

With Bitcoin, the answer is the same – sort of. There is no government, no nation-state, that issues a Bitcoin. A mysterious group of technologists created Bitcoin in 2008 as an alternative currency based on blockchain. Over the past 13 years enough people have “invested” in Bitcoin to create a measure of liquidity – there are enough buyers and sellers to create a market. Also, in the last 3-4 years, issuers of traditional nation-state currencies (like the USD) have established exchange rates for Bitcoin, allowing BTC investors to exchange their coins for dollars.

This is when I began to take Bitcoin a lot more seriously. If I can exchange one fiat currency for another, that’s real liquidity. At this point, the only difference between the USD and BTC is volatility, or stability. The USD’s value is relatively stable, whereas BTC is wildly volatile.

Remember, for both currencies, value is based on faith. Faith that the issuer will continue to exist and continue to honor transactions involving the currency.

So how much faith do I have that the open-market, decentralized “issuer” of Bitcoins – the online distributed blockchain itself – will retain the characteristics of stability and liquidity? The answer is some faith in the short term and little to no faith in the long term. My best bet is that the technology behind BTC will be adopted and subsumed by nation states, and fiat currencies issued by nations will continue to have the most stability and liquidity. That some nation’s currency – ours, China’s, Europe’s, etc. – will continue to be the baseline currency for world markets and that cryptocurrencies will be adopted by marginal groups performing transactions they would like to keep secret (e.g. criminals, secret societies, gangs, some corporations) and then converting (laundering) their crypto holdings by exchanging it for traditional nation-state currency at convenient times.

Nation-states will carefully manage and regulate the exchange rates between their currency and cryptocurrencies. The hope (faith) of current BTC advocates is that Bitcoin can replace the USD as the international currency baseline, but my bet is on the nation-states. Crypto will remain a volatile, second-tier currency with a useful (though probably distasteful) role in economies.

In the meantime, I’m watching the value of BTC closely. If it takes another short term dip, I’ll buy a little. It’s a bit like making a bet on a decent poker hand. Your short term odds of making some money are good, but you have to know when to cash out your chips (BTCs) and walk away with some dollars.

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