The Curious Case of Cryptocurrencies: Part I

[Pranav Tolani is associated with a corporate law firm in Mumbai and can be reached [email protected]]

Cryptocurrencies have made waves in financial markets around the globe. According to leading cryptocurrency exchanges, the August 2018 global cryptocurrency market capitalisation is somewhere short of USD 400 billion – less than half of what it was in December 2017 (on the back of Bitcoin’s exponential rise and rise of around 2000% in a year). While the number is insignificant in front of the USD 80 trillion global stock market, it is big enough to pose significant systemic risk to monetary policies across jurisdictions and tempting enough to invite ever-increasing attention and participation.

Cryptocurrencies, hence, pose major concerns for financial regulators around the globe because (i) the cryptocurrency market in most jurisdictions function in a legal grey area – from cryptocurrency exchanges to their public offers (called initial coin offerings), the industry is largely unregulated; (ii) a major part of cryptocurrency user base comprises unsophisticated retail participants; and (iii) there seems to be no convincing driving factor behind the bullish trend (or bearish, now) except uninformed and speculative mass public investments.

In view of the aggressive regulatory stance to curb cryptocurrency use in India (one amongst many jurisdictions), it would be opportune to consider the curious case of cryptocurrencies and their position in the larger scheme of things.

A Brief Background

Cryptocurrencies, simply stated, are cryptographically secure digital tokens which can be used as mediums of exchange like regular currencies. They differ from traditional fiat currencies (like the Indian Rupee, US Dollar etc.) in two fundamental ways (other than being virtual, of course) – first, they are not issued by a statutorily empowered central or reserve bank; and second, instead of utilising traditional banking channels, cryptocurrency payment systems use Blockchain for enabling, recording and authenticating transactions.

While digital currencies (cryptographic, or not) in one form or the other have been in existence for quite some time (e-Gold, for example, was used widely between 1996 and 2007), they suffered from logistical issues and had severely limited uses – for example, most of them were close-ended and could work only within a particular infrastructure; while some others needed asset backing (like the Bretton-Woods era currencies). Further, since the ideal was to have a decentralised system, issues of over-spending and double-spending made ledgering and accounting of transactions extremely difficult in the absence of third-party intermediaries (like banks, who do the same for a fee).

The challenges above were solved only when the Blockchain was conceptualised and used for the first time in the Bitcoin – in the aftermath of the 2008 financial crisis. Since then, there has been no looking back. As on date, there are more than 1600 (and growing by the hour) cryptocurrencies in circulation – however, only a few have any significant user base or market capitalisation.

Open Questions

Even as cryptocurrencies have presented themselves as a creature at the cusp of cutting edge technology and finance – they leave some fundamental questions unanswered.

Are cryptocurrencies currencies?

While cryptocurrencies contain the eponymous suffix – are they really currencies in the correct sense of the word at all or not? An identifying feature of any ‘currency’ is that it is a generally accepted token which is readily exchangeable with products and services (a feature known as liquidity) and has a commonly accepted value – which, in most cases, is strongly protected against volatility by a statutorily empowered central or reserve bank. Since they are completely decentralised, cryptocurrencies have no such price anchor. As a result, the price of a cryptocurrency is directly tethered to uncontrolled fluctuations in its demand and supply.

For example, Bitcoin, which was exchangeable for around USD 1000 per token at the start of last fiscal year, closed the year at almost USD 20,000, before falling to and reaching a plateau at around USD 6000 since March 2018. In a centrally issued currency like INR, volatility in exchange rate (for example, against the USD) is countered by the Reserve Bank of India by buying or selling USD in the international forex markets – in an act known as ‘intervention’. Without a central regulator, Bitcoin functions in a free-float and its price can skyrocket (and equally likely, crash) depending upon its demand (discussed below) in the market.

Hence, while cryptocurrencies demonstrate certain characteristics of currencies – like being a store of value, having easy liquidity, demonstrating usability as medium of exchange – they lack many others. For one, the unchecked volatility and lack of recognition as legal tender continually prevent users from undertaking any serious mercantile activity through cryptocurrencies. Second, cryptocurrencies do not seem to be able to inspire people to use them as ‘money’. In fact, it is ironic that cryptocurrencies have gained mainstream global attention not as intermediary-free alternatives to traditional currencies (which is what they were anticipated to be used as) but as speculative too-good-to-miss kind-of investment opportunities.

For the above reasons, it can be argued that cryptocurrencies are not currencies (or money). In fact, most global regulators tend to treat cryptocurrencies as commodities. For example, the USA, Hong Kong, Canada, Finland,Indonesia and various other jurisdictions have, in one way or the other, allowed trading of cryptocurrencies on their respective commodities exchanges or informal OTC commodities markets.

Why are cryptocurrencies so volatile?

Regardless of the above, currencies, commodities, stocks or bonds, depending upon regulatory flexibility (in descending order of appearance, here) allow scope for long and short-term investments and trading-for-profits. As mentioned already, cryptocurrencies have been used primarily as investment vehicles. An interesting consideration is that cryptocurrencies do not demonstrate features of a good investment-class asset as well. While traditional currencies (forex) fare on an economy’s performance, good stocks and bonds are backed by the issuing company’s performance, or by dividends, or by their credit rating. Further, companies provide metrics like balance sheets, income statements, earnings, management reports etc. to assess if the price being asked is justified. Commodities (like precious metals) are subject to well-understood market factors (like forex or stock market performance, their availability and scarcity etc.).

Cryptocurrencies do not provide any of the above and, in the absence of these parameters, not only is it extremely difficult (or improbable) to predict cryptocurrency price movements (leave alone formulating investment strategies), even the current price dynamics seem motivated only by speculative as opposed to informed, rational and calculated investment decisions (of course, by casual, and not institutional investors).

Then why are they so much in demand? Demand – the power to make a single tulip bulb in Netherlands sell for more than 10 times the annual income of a skilled workman, and to make the NASDAQ Composite Index in the USA grow by over 400% in a span of 4 years on the back of an IT industry boom. Demand is a creature of human sentiment and can be easily influenced – at times, artificially. As keen readers would have pointed out by now – both above are speculative economic bubbles of their time. First, the Tulip Mania of the 17thcentury; second, the Dot-com bubble of the 21stcentury. Economic bubbles are identified by a ‘boom’ period where an asset trades at values highly disproportionate to its intrinsic value, thereby creating an economic bubble; and a ‘burst’ period during which the market crashes – both boom and bust caused by uninformed and irrational positive feedback (or something commonly known as the ‘herd mentality’) that drives demand. In the above cases, the respective tulip bulbs and IT company stocks were selling at highly inflated prices, and when the respective bursts were triggered, a single tulip bulb could not retain even 10% of its face value, while on the NASDAQ almost USD 5 trillion in market capitalisation was lost in the blink of an eye. Cryptocurrency market-cap graphs have increasingly shown similarities with historic asset bubbles.

For cryptocurrencies (more particularly Bitcoin), the boom took place between the months of July and December 2017 when prices skyrocketed without any rational explanation. Similarly, the drop since then can possibly be due to frenzied investors shorting their positions, whether as a commercial call, or due to bad publicity and regulatory clamp-downs in various jurisdictions. As can be seen, since there are no real parameters to understand the market and take an informed call, both investments and exits are a result of a herd mentality (which is again, an identifying feature of a speculative bubble).

Also, while the lack of performance parameters and irrational demand point to why cryptocurrency prices are volatile – there are several other contributing factors as well. For example, the cryptocurrency demographic is very skewed, with some investors holding a lot, and some holding few – leading to market being indirectly under control of a small number of participants.  

Can the volatility be tamed?

In most jurisdictions, financial markets wherein speculative and manipulative activity is plausible are strongly regulated by a securities markets regulator (Securities and Exchange Board of India, for example). The regulator prescribes (at times, in meticulous detail) regulations for everything – from functions of participants like stock exchanges, brokers etc. to even the time between which trading is allowed. In a typical stock market, fluctuations in price will prompt a circuit filter to trigger and trading in the volatile stock will be halted, while manipulative activities like circular trading, front running etc. are considered as penal offences (more detailed reports on control measures can be read here and here). Cryptocurrencies, however, trade on completely unregulated stock exchanges which hardly have any control over trading activity. In fact, most of them are even prone to security breaches due to lack of infrastructure – South Korea and Japan both have been victims of stock exchange hacks, for example.

[To be continued]

Pranav Tolani

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