The Digital Currency Charade

12/4/20

Like many others, I first heard about Bitcoins sometime around the end of 2013. I wasn’t impressed. In fact, I was critical. Bitcoins is a particular brand of cryptocurrency or digital currency, which is promoted as a payment mechanism whose value can’t be manipulated by regulations or actions of central banks. This attribute derives largely from the capacity to buy and sell cryptocurrencies anonymously. Some think of that feature as an advantage, but I don’t. It has long been clear to most observers that the primary use of a cryptocurrencies is to avoid taxes or otherwise engage in illegal transactions, such as those involving drugs deals or other illicit activities, where the perpetrators want to hide their identity. It’s not surprising that Bitcoin is the currency of choice for cybercriminals, of whom there is no shortage.

Think about the utility of receiving payment in a currency where you’ll have absolutely no certainty as to its future buying power. Ridiculous. Beyond using cryptocurrencies as a payment mechanism, they’re also promoted as investments. Holding such a currency as an asset class, however, is a pure speculation. It only works as long as there’s a bigger fool who’s willing to bear that risk after you. For this product to be promoted as either as a medium of exchange or as a store of value strains credulity — and yet people fall for it.

Since 2013, the market for cryptocurrencies has dramatically expanded. Today, it’s reported that in excess of 5,000 different cryptocurrency products can be traded, with the market value of the outstanding balances exceeding $370 billion. [Source: Nerdwallet]] Much of the recent interest in these products is due to the dramatic run up in their value over the last nine months. For instance, according to CoinDesk, Bitcoin — i.e., the brand of cryptocurrency that is the industry leader — traded below $4,000 in this past March, but by the end of November, its price was approaching $20,000. Given this extreme volatility and the identifiable positive direction of the price trend, it’s not surprising that representatives of the financial services industry have identified an opportunity and begun to offer products tied to these markets — not surprising but disturbing.

I have some personal history to share: Years ago, I was the Director of the New York Office for the Chicago Mercantile Exchange. Exchanges make money as a direct function of trading volume, and thus it’s understandable that they would want to expand their volumes by adding new contracts to their roster of offerings. One of the requirements for new listings was and is that the proposed contracts be approved by the Commodity Futures Trading Commission. I admit to objecting to this requirement. After all, the market would tell us if the product had value. If it had value, people would use it; otherwise, they wouldn’t. In my opinion, the role of the CFTC in this regard was superfluous and costly and it unnecessarily retarded innovation. Moreover, to my recollection, in the 16 years that I worked for the exchange, I don’t recall any application for a new contract having been denied.

Once cash cryptocurrency trading volumes hit some critical pace of trading, the idea of listing a related futures contract was a no-brainer. Of course, the CME Group did just that; and these days, trading volume frequently exceeds 10 thousand contracts a day, with each contract covering five Bitcoin. If ever there were a situation where the CFTC should have exercised its authority to deny approval for a contract, this was it. Whatever the purported benefits of these contracts may be, the fact that these alternative currencies are a lubricant that facilitates illegal or illicit commerce should be overriding.

The trading activity in these markets — cash and futures — probably shouldn’t bother me as much as it does. For the most part, this trading is a game where willing players are simply picking each other’s pockets. Only willing participants play the game, so why should I care? I suppose I’m bothered because I think it’s a stupid game with little or no socially redeeming qualities. In general, speculators play positive role in markets by adding liquidity and improving market efficiency — i.e., serving to reduce transaction costs from what they otherwise would be in the absence of speculators. In the case of cryptocurrencies, however, legitimate interests are few. Speculators would provide much greater societal value if they reserved their capital for use elsewhere.

It’s disappointing to me that seemingly respectable institutions are fostering an undeserved patina of legitimacy for cryptocurrencies. I’m well aware that some sophisticated hedge funds play in this playground, and that’s fine. For the most part, these players make their money by following disciplined trading rules that limit their losses with losing trades. They can enjoy attractive gains overall by making the correct directional bet only 50 percent of the time, as long as the gains on the 50 percent winning trades out-pace the losses on the 50 percent losing trades. It’s not rocket science. If they want to spend their time doing this, God bless them. On the other hand, non-professionals dabbling in these markets in the hopes of making a killing are being taken for a ride. Some, inevitably, will get lucky, but they’re being played.

I was a critic in 2013, and I’m a critic now. Cryptocurrencies do more harm than good.

Kawaller holds a Ph.D. in economics from Purdue University.