The Future of Cryptocurrencies

5/12/21

Largely fueled by explosive price appreciation, cryptocurrencies are getting a lot of attention these days, with a growing population of promoters joining the fray, including many who should know better. We now see a whole class of white-collar shills for this activity, trying to paint a patina of respectability on a product thats main function is to facilitate criminal activity or else enable speculators to pick each other’s pockets. Elon Musk, mugging on SNL, seemingly jokingly called cryptocurrencies a hustle. In fact, he got it right.

On the speculation issue: As one who has worked in financial markets for my professional career concentrating on derivative instruments, I’ve had the opportunity to view speculation close up, as speculation plays a critical role in those markets.

For the uninitiated, derivatives may seem like complex financial instruments; but generally, they’re not. Most derivatives are straightforward arrangements that generate payoffs that depend on changes of some external reference price or index. Typically, these (or very similar) economic outcomes could be arranged without derivatives, but derivatives often offer a more efficient and cost-effective way to realize desired results.

Irrespective of the particular design of any derivative, users fall under either of two categories. In the first instance, the user starts with no prior risk or exposure. In that case, entering into the derivative contract introduces a brand-new risk and exposure. Here, the user is using the derivative for speculative purposes. They would be positioning with the derivatives to reflect a view as to the direction of a coming price change for the derivative’s underlying reference price. If they’re correct in their view, they win; if they’re wrong they lose. This binary consequence is the nature of a speculation.

In the second instance, the user starts with some pre-existing risk or exposure, and the derivative position is used as an offset, intended to mitigate or cancel out the economic effects from a price change on their pre-existing exposure by having the derivative generate an offsetting gain or loss on a closely related (if not identical) reference price. The user expects to win on their exposure and lose on their derivative, or vice versa. This application is called hedging, and it should be clear that when using derivatives in this manner, the objective is to transfer an unwanted risk to an external party who is willing to bear that risk — and that counterparty would typically be a speculator.

In other words, speculators enable those who want to transfer their risk to be able to do so. Without speculators, there could be no hedging. Thus, while derivative speculators are motivated by trying to make money, in doing so, they’re providing a vital benefit to business managers who seek to manage risks relating to a wide range of exposures including interest rates, foreign exchange, and a host of commodity markets. In contrast to speculators who operate in derivatives market places, speculators in cryptocurrencies provide no social benefit beyond the immediate payoff of the bet.

To consider a position in a cryptocurrency an investment misuses the term. Nothing productive happens when two counterparties exchange ownership of cryptocurrencies. That said, I can’t deny that cryptocurrencies have created millionaires — even billionaires; but these gains could evaporate just as quickly as they came into being when animal spirits foster a change in expectations. When that happens, as it will, the race for the exits will likely take back much of the paper profits from the early cryptocurrency speculators, but plenty of late comers are sure to realize real losses.

On some level, one could take a laissez faire attitude and let willing partners do whatever they want; but when greed enters the mix, as it certainly does for many speculators, the prospect of systemic disruption looms. At a minimum, given the size of the market that’s already developed, we should expect an avalanche of lawsuits when the market for cryptocurrencies turns bearish and losses start to become widespread. Claims that people were inappropriately duped into playing in this playground are inevitable. Beyond that, the domino effect of large-scale bankruptcies, if they were to occur, is also a potential that warrants consideration. I just hope our legislators and regulators won’t be overly influenced by the growing cadre of lobbyist who are knocking on their doors pedaling their cryptocurrency snake oil.

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