Rethinking cryptocurrencies

By Dr Simon Trimborn

Dr Simon Trimborn Assistant Professor of Business Statistics in the Department of Management Sciences, argues that cryptocurrencies, and Bitcoin in particular, have strayed far from their initially conceived role as digital payment systems and that market participants are constantly re-inventing their use. This article is based on various articles and projects, most notably Trimborn, Simon; Li, Mingyang; Härdle, Wolfgang Karl / Investing with Cryptocurrencies – a Liquidity Constrained Investment Approach, published in the Journal of Financial Econometrics, 2020.

The Bitcoin project sparked the emergence of numerous companies working on or around the new asset.

The launch of Bitcoin in 2009 marked the beginning of a radical realignment in the digital economy. The idea of having a medium for transactions without the need for a designated intermediary, such as a bank or Swift, attracted a fairly high amount of interest from people all over the world. Within a few years, the Bitcoin project had sparked the emergence of numerous companies working on or around the new asset. A combination of approaches from cryptography, computer science and economics created this new system. Please note, I say "without the need for a designated intermediary," an intermediary was still needed to process the transaction. However, the system ensured that no single entity had control of the system.

Going beyond the processing of payments

As original as the idea behind Bitcoin was, the system was not without flaws.

As original as the idea behind Bitcoin was, the system was not without flaws. As with any system, its properties are only present under certain conditions which means that the Bitcoin system could be attacked. To be clear, I am not referring to the blockchain. The Bitcoin blockchain works perfectly fine as it is, though its role is only to record transactions. Only in combination with other approaches does the Bitcoin system materialise. I will briefly mention three notable features here. Please note, this list is not exhaustive. These have been selected as features of Bitcoin which have triggered tremendous research activity to overcome the ensuing flaws.

Firstly, as mentioned, the Bitcoin system has no designated intermediary. Instead, the decision on the payment processor for the next block of transactions is conducted via a trial-and-error search for a cryptographic string, called Proof-of-Work. Since this is a competitive process, there is an incentive to utilise ever more computational power to find the said string and win the reward associated with it (winning Bitcoin). This leads to huge power consumption for the processing of Bitcoin transactions which is often criticised. (Note that other Proofof-... concepts were introduced and are used in other cryptocurrencies which require significantly less power.)

A second notable feature of Bitcoin is its limited supply. Unless the Bitcoin community decides to change this feature, there will be a maximum of 21 million Bitcoin available. This is part of the Bitcoin system to counter inflation, though some see it as a limitation which has in turn led to some other cryptocurrencies having an infinite supply.

A third feature of Bitcoin is its privacy. Even though the transactions are recorded publicly on the blockchain, the identity of the parties involved is unknown. However, this only holds as long as the users follow rules such as using a new transaction signature, or "address," for each new transaction. Frequently such rules, are not applied by users and, as a result, Bitcoin users became traceable to some extent via their transactions. Other approaches were developed and are used in other cryptocurrencies which introduced privacy-focused systems to ensure a higher degree of anonymity than Bitcoin can offer.

In the early days, most of the alternative cryptocurrencies were merely copy-cats and attempted only to solve minor limitations of Bitcoin. Over time, however, new cryptocurrencies went well beyond the processing of payments. The market for cryptocurrencies has evolved in many different directions since 2009, and this calls for a fundamental rethink into their nature and use.

The coffee gets cold

The very name "cryptocurrencies" suggests that all of these tokens are primarily deployed as currencies. However, this is not the case.

The very name "cryptocurrencies" suggests that all of these tokens are primarily deployed as currencies.

However, this is not the case. Many constitute tokens with very different purposes, and even the ones which were originally intended as currencies like Bitcoin, barely qualify for a widespread use as a medium of exchange. Bitcoin transactions are posted every 10 minutes onto the public blockchain. Proof-of-Work decides who is the current designated payment processor via the search for a cryptographic string. It is possible that more than one entity finds this string at almost the same moment and then more than one person will post the transactions. In this case, over time the users will agree on whose block of transactions to use which will cause the other persons' blocks, and the subsequent blocks attached to those sidechains, to be invalid.

These payment processors may not post identical transactions to the blockchain. They have a choice on which transactions to include into their block of transactions, which means that one's transaction may not be posted to the blockchain by every payment processor. If your transaction is in an invalid block, then it will not be on the blockchain. The problem is: you will only know with time if a block, and therefore the transactions included, are valid or not. Usually, it is agreed that for Bitcoin it takes six new blocks until a block can be considered as highly likely to be valid. This means, if you were to try to pay for a coffeeto- go in a store with Bitcoin, you would have to wait until six blocks were posted to the blockchain. Only then would the Barista accept the payment. Given each block is posted only at a 10-minute interval, you would have to wait about one hour in the store until you could enjoy the coffee. Besides the coffee getting cold, the delay is a systemic problem impairing the widespread use of Bitcoin as a payment system.

Cryptocurrencies as a speculative asset

This limitation as a medium of exchange is widely acknowledged and in reality, Bitcoin, as well as many other cryptocurrencies, are typically used in very different ways. The most popular is as a speculative asset class. Due to exorbitant returns, cryptocurrencies and Bitcoin in particular have received strong attention, and their prices often move from one all-time-high to the next. However, frequently they go in the opposite direction and whoever buys shortly before a price crash, loses a substantial amount or even all of their previous investment.

A perfect "add-on" to an investment portfolio?

Cryptocurrencies possess a diversification effect with regards to assets from traditional financial markets.

High returns are not the only attraction. Financial econometricians have analysed the actual properties of cryptocurrencies and found that they possess a diversification effect with regards to assets from traditional financial markets. They are said to be a perfect "add-on" to an investment portfolio, given their low correlation with traditional assets. However, there are other factors to consider. Investing in cryptocurrencies is illegal in some jurisdictions, which has to be taken into consideration when making investment decisions. For the jurisdictions where it is legal, the question remains whether one can actually leverage on the diversification effect. Studies have shown that many cryptocurrencies feature too low-a-liquidity for an actual investment into them. An investor who buys too many tokens of a particular cryptocurrency would disrupt the price on the market or even buy off the entire supply. An investment amount of 1,000 USDollars would already be too high for some illiquid cryptocurrencies.

A store of value better than gold?

Certainly, one is not interested in storing valuables in an asset which is prone to large losses.

Another popular claim is that Bitcoin is a store of value similar to, or even better than gold. Defining an asset as a store of value implies that one is interested in preserving its value, otherwise it would be a speculative asset. Certainly, one is not interested in storing valuables in an asset which is prone to large losses. However, Bitcoin as well as other cryptocurrencies are exposed to strong changes in their market value. The volatility is exorbitantly high compared to gold, and has been the basis for a number of studies in financial econometrics. Of course, this does not mean that Bitcoin won't be able to act as a store of value in the future by establishing a more stable time series. However, gold still has one advantage over Bitcoin which it will never lose: it is a commodity used in manufacturing. This ensures that its price is much less likely to drop to zero.

Searching for a role: ICOs, smart contracts, decentralised finance

Initial Coin Offerings (ICOs) are another innovative idea. In an ICO a start-up sells the tokens of its newly founded cryptocurrency which often entitles the holder to participation in the success, or downfall, of the start-up. The founders of the startup then use the allocated funds to finance operations. The concept is akin to Initial Public Offerings where a start-up sells shares of its company to finance future operations. Note, however, that in practice many ICOs have proven to be scams, and funds have been embezzled.

At about the same time the idea of smart contracts grew. These are programmes which are linked to a cryptocurrency and the clauses of the contract cause transactions on the blockchain. In this way, the specifics of a contract are publicly recorded and visible to whoever shall stay updated on the ownership of an asset. This could include information on ownership of a house, or obligations resulting from a contract.

A further recent trend in the cryptocurrency market is Decentralised Finance (DeFi). These are programmes constructed on top of a blockchain which offer financial services. Different to finance apps offered by financial institutions or other companies, DeFi apps store the information on a blockchain and function via smart contracts. All these applications have moved far away from the original notion of payment services, and are more in the area of investments.

Constant reinvention

It is not clear which – if any – of the current uses will prevail or if a new use opportunity will arise which will constitute a long-term application.

As we have seen, the actual use of "cryptocurrencies" has diverged far from their initially intended use in 2009: payment systems. The very term stems from the initial project description for Bitcoin. Within the community, various claims have since been made for crypto properties, such as "digital gold," intended to be a digital store of value. However, the actual market performance of Bitcoin does not support this claim, with strong market fluctuations disqualifying it as a payment system.

To counter this, some cryptocurrencies were introduced as "stablecoins," intended to pave the way towards use as currency. Commonly the stable price is achieved by backing with another fiat asset or currency with stable market performance, such as the USDollar, or by backing them with a basket of non-stable cryptocurrencies which are hedged against one another to achieve a stable price formation of the baskets value. In practice some stablecoins have not been able to hold their peg and were exposed to volatility after all. The vast majority of cryptocurrencies are nonstablecoins which are primarily used for investment, implying speculation on their future performance.

Throughout their history, market participants have constantly reinvented the role of cryptocurrencies. So far it is not clear which – if any – of the current uses will prevail or if a new use opportunity will arise which will constitute a long-term application. Only the future will tell. In the meantime, it will be certainly interesting to follow the ongoing developments in the cryptocurrency space.

Dr Simon Trimborn
Assistant Professor
Department of Management Sciences