Financial Evolution, Cryptocurrency Edition

Highlights

• The cryptocurrency market capitalization has increased dramatically by 970% since January 1, 2020.
• The next stage of money transformation is into a cryptocurrency that has a decentralized character.

Finance is the circulatory system of an economy, where the value of goods and services moves from one economic agent to another through money transactions. The requirement for money depends on the economic environment – the more complex the economic system becomes, the higher the requirements for money. 

At the current stage of economic development, government money takes the dominant position in the financial system, which allows a government to manage an economy through monetary policy, but this was not always the case. Initially, anything could play the role of money, such as cowrie shells or beads; then precious metals, paper, and electronic money. The existence of different kinds of money at different stages of human history depends on the level of economic and technological development of a society.

This transformation process can take a long time with its ups and downs. We can turn to the gold standard history and see the stages which had been passed through by a financial system before it turned into a system whose principles are intuitively clear to us today. In today’s realities, gold continues to function as money as a historical artifact but not because it is the best financial instrument to store value. Gold was a natural choice for investors as a hedge against accelerating inflation in the mid-20th century, as major currencies were pegged to gold through the US dollar under the Bretton Woods system. But the official link between the dollar and the gold was severed in August 1971 when the conversion of the dollar to gold was abolished.

Currently, thanks to technological development, we can observe the next stage of money transformation into a cryptocurrency that has a decentralized character.

Cryptocurrency and blockchain technologies have been actively developing over the past ten years, becoming a part of the global financial system. According to Statista, the number of cryptocurrencies has increased from 66 to 10,397 since 2013, which indicates the massive introduction of cryptocurrencies into the global financial system.

At the moment, the cryptocurrency market has  wide geographical coverage. According to Triple-A, a company specializing in providing payment transactions in cryptocurrency, in 2021 there were around 300 million cryptocurrency users in 139 countries around the world, and about 18 thousand enterprises accepted payments for their services in cryptocurrency. The top 5 countries in terms of the number of cryptocurrency users are: India – 100,740 million people, the USA – 27,492 million people, Russia – 17,379 million people, Nigeria – 13,016 million people, Brazil – 10,373 million people. At the same time, as a percentage of the current population, Ukraine and Russia took the first two positions at 12.73% and 11.91%, respectively in 2021.

The Cryptocurrency Market in the Pandemic Time

Macroeconomic shocks and financial crises reveal imbalances in the economic system which are very difficult to recognize in normal times. According to TradingView, the cryptocurrency market capitalization as of May 3, 2022, is $,1712 billion, while capitalization as of January 1, 2020, was $185.105 billion, demonstrating growth of 825%. We can identify two factors of such growth during the pandemic, which are closely intertwined with each other: 1. Cryptocurrency as a tool to store value; 2. Speculation.

One of the tasks that should be solved within the framework of the decentralized finance paradigm is canceling (or minimizing) a government monopoly on money emission in order to prevent inflation due to the monetary factor. The process of developing the cryptocurrency market towards a store of value since the beginning of the pandemic is directly related to government support of national economies and the growth of the monetary base. Thus, according to the Federal Reserve Bank of St. Louis, the M2 money supply aggregator increased by 42% from February 2020 to March 2022. This increase in the money supply is not comparable either with the increase caused by the 2008 crisis (when the monetary aggregator increased by 13.7% in 2008–2009) or with the inflationary growth in the money supply in the 1970s. Therefore, the government monetary policy to support the economy during the pandemic has activated the function of storing value for cryptocurrency assets, as protection against an expectation of monetary inflation of national currencies.

The speculative factor is associated with the identification of trends in the financial market and further trading in the direction of this trend. In my opinion, the speculative factor has a tight connection with the idea of the “safe haven” for cryptocurrencies in order to store value in a period of high macroeconomic uncertainty.  Ideologically, cryptocurrency, as an element of decentralized finance, is a financial asset that can ensure the store of value and a high level of liquidity during the period of lockdowns of international economies and the growth of the monetary base, due to the fact that cryptocurrency mining is not directly related to the economic directives of the Governments and the monetary policy of Central Banks.

I suppose that the current situation with the determination of the value of cryptocurrency is similar to the situation with technology stocks that ended with the Dotcom crisis in 2000. Barton Biggs, in his book “Hedgehogging”, describes in detail the atmosphere around technology stocks as the stocks of “the New Economy” before the Dotcom crisis, and the existence of widespread opinion at that time, that traditional methods of valuation could not correctly evaluate technology stocks. In the context of cryptocurrency, we also had a bubble at the end of 2017 when Bitcoin had a price of $19.497,40 on December 16, 2017, and later Bitcoin was able to reach this price in the pandemic time on May 2020.

Therefore, the increased price trend for cryptocurrencies at the beginning of the pandemic was based on the demand for an asset that was not associated with the government monetary policy, and it was further supported by a speculative component, which accelerated the growth of prices and volatility in the cryptocurrency market.

What Is the Current Status of Cryptocurrency as a Financial Asset?

Wide social acceptance is an integral part of a financial asset that plays the role of money. At the same time, it is important that the financial system has an asset that can play the role of money which is not issued by a sovereign government, and this asset should also reflect the current features of the functioning of society.

At the current stage of globalization, a significant part of social interaction and trade takes place via the Internet, which provokes interest in the function of a digital decentralized monetary asset. At the same time, the sharp increase in public interest in modern information technologies, provoked by the pandemic, has significantly expanded the social acceptance of blockchain technology, which is the basis for cryptocurrency assets. Currently, various applications and platforms have been developing based on blockchain technologies. For example, a blockchain algorithm makes it possible to develop a mechanism for conducting financial transactions which does not require the presence of a third party who would confirm the correctness of this transaction, as soon as the algorithm itself generates the proof of transaction correctness. Thus, the growth of economic activity is associated with the technological development of a blockchain network, which, consequently, forms the value of a cryptocurrency.

It should be noted that at this stage of financial and technological development, it is not entirely correct to call cryptocurrencies “currencies” and compare them with traditional national currencies.  A currency must have the following characteristics: a unit of account, a means of payment, a stable store of value, and act as a single numeraire. If we look at Bitcoin as the main widespread cryptocurrency, we can see that Bitcoin does not fully match any of these criteria:

1. Bitcoin is not fully a unit of account, since nothing is priced in Bitcoin
2. Bitcoin is not a scalable means of payment, as Bitcoin is unable to process thousands of transactions per second like traditional payment systems
3. It is not a stable store of value for goods and services due to its high volatility
4. The lack of a single numeraire system in which prices of various items could be expressed, due to the presence of thousands of crypto tokens and hundreds of cryptocurrency exchanges at the moment, which reduce price transparency.

Despite the fact that we previously pointed out that cryptocurrencies have the function of value store during the pandemic due to the growth of inflationary expectations, this does not mean that this function will remain inherent in them in the future when the inflation rate drops to the pre-pandemic level. From a portfolio management standpoint, the high volatility of cryptocurrencies means that cryptocurrency assets should take a small share in the portfolio structure.

We must take into account that at the moment cryptocurrencies are in the infancy stage. The historically high volatility of cryptocurrencies can be explained by competition between them and determining which of them will eventually be accepted in society as non-sovereign money.  A slight change in the probability of a particular cryptocurrency achieving its goals leads to a significant change in its price. We can think of this in terms of startups, where several hundred startups develop the same technology, and only some of the first ones will eventually be able to monetize it bringing the final profit to their investors.

At the same time, we see active development across various areas. One of the key areas for the introduction of cryptocurrencies into everyday life, in the future, is the development of the function as a means of payment. Thus, Bitcoin, which is the flagship of the cryptocurrency market, concentrates only on the function of storing value and is not intended to fully act as a means of payment, since the Bitcoin blockchain technology is not configured to efficiently process thousands of transactions per second. However, this transactional inefficiency is expected to be overcome on the basis of alternative blockchain technologies which are a basis for other cryptocurrencies. For example, the Ethereum blockchain seems to be effective for solving this problem (we discuss Ethereum in this article).

Also, in addition to further technological development, the cryptocurrency market needs to go the way to obtaining a full legal status in the global world and fully integrate into the budget and tax systems of the countries of the world. The regulatory factor also has a big impact on volatility. According to Statista, cryptocurrencies have a green light in most countries now. But possible changes in regulations in the future create additional risks. Currently, cryptocurrencies are banned in China, which ban was introduced little by little starting in 2013 and no doubt had an impact on “the bubble burst” in 2018. Individual countries with their regulatory bans on the use of cryptocurrencies such as China can generate additional risk for cryptocurrencies.