Bitcoin’s 1,600% rise this year and its recent wild value fluctuations have both excited investors and led critics to predict its demise, some with apparent glee.
The currency’s detractors point to the price run up as nothing more than a bubble that will surely burst. They also say that as a cryptocurrency where users can sometimes hide their identities, its use facilitates illicit transactions, leading governments such as China to declare all such currencies as illegal.
But these views miss an important reality: Cryptocurrencies operate according to a different set of fundamentals than do fiat currencies, such as the U.S. dollar and the Euro. These differences give cryptocurrencies a useful place in the economy.
The value of any currency – whether it be fiat or crypto – is determined by supply and demand. For a government-backed currency, supply is politically driven, basically reflecting the government’s desire to print money. Demand is determined by people’s desire to use the currency for current and future transactions.
Cryptocurrencies are different. Several factors drive their supply, none of which are political. Tech-savvy startup companies often create new cryptocurrencies to fund their businesses. Over 1000 new currencies were created in 2017, valued in the billions of U.S. dollars. The launch of a new currency is called an initial coin offering (ICO). Entrepreneurs often prefer ICOs to more traditional sources of startup capital, such as venture capitalists, because the ICO process can be more flexible and less costly, and it provides access to a wider range of funders.
To be sure ICOs might bypass traditional safeguards that reduce financiers’ exposure to risks typical to funding startups, such as conducting due diligence on the entrepreneurs’ talents and trustworthiness, but the funders seem to be willing to take those risks.
ICOs have implications for Bitcoin. Bitcoin competes with new cryptocurrencies and benefits from them. It competes with other cryptocurrencies in providing the privacy and low transaction costs that these new tokens represent. But an ICO might increase the demand for Bitcoin if the ICO buyers seek to manage their risks by exchanging their new tokens for Bitcoin.
So-called miners largely drive Bitcoin’s supply. Miners are the entities that use massive amounts of computing power to solve mathematical puzzles, whose keys include current and past Bitcoin transactions. A miner effectively validates new transactions when it solves a puzzle and ensures that no one has altered the transaction histories. This protects Bitcoin’s legitimacy. Miners are rewarded for their work in Bitcoin.
Several factors drive the demand for cryptocurrencies. In addition to having a transaction value similar to that of fiat currencies, cryptocurrencies are valuable because they provide greater anonymity. This greater privacy is attractive to persons suspicious of government or bank oversight, but it also facilitates illicit transactions, such as drug trade.
Lower transaction costs and faster confirmations relative to fiat currencies also drive demand. Using cryptocurrencies can avoid bank and credit card fees. And the money received can be available for use within minutes rather than the hours, or days that may be required with banks and fiat currencies. As indicated earlier, ICOs can also drive demand for more widely recognized tokens like Bitcoin and Ethereum.
But there are reasons for concern. In addition to the problem of facilitating illegal activity and the threat of governments shutting down the currencies, there are fragilities built into the Bitcoin system itself.
Market power amongst miners has emerged. This has been beaten back so far, but if it re-emerges some miners could control the system, diminishing Bitcoin’s trustworthiness.
Also, the system depends on the participation of miners. If their computing and energy costs exceed the prospective value of their Bitcoin rewards, miners would cease to operate, causing a breakdown of the entire system.
And Bitcoin supply is driven by a miner reward system that does not try to align the growth of supply with changes in demand for transactions. This is a major source of price volatility.
But these challenges are fixable: Cryptocurrencies could be divided into classes according to their privacy types. And a more economically rational supply management could be created. Given that cryptocurrencies can improve the efficiency of legitimate financial transactions and allow some proper businesses to flourish that otherwise might not, the fixing appears worthwhile.
Mark A. Jamison is a Senior Lecturer at the Warrington College of Business and the Director of the Public Utility Research Center at the University of Florida. He is concurrently a Visiting Fellow at the American Enterprise Institute. Palveshey Weber is an entrepreneur and a student of finance at both Harvard University and the University of Florida.