Cryptocurrencies Are Tied to Nothing — That Doesn’t Mean They’re Worth Nothing

Singapore, SINGAPORE – When Jeremy Scott, then a 16-year-old student at Pomona High School in Colorado, tried to explain to his parents about the tremendous investment potential of a digital currency called Bitcoin in 2012, his father, a chartered accountant said with a deadpan expression,

“It’s backed by nothing and will come to nothing.”

But Scott junior, an avid CS:Go player (the massively popular multiplayer online game, Counter-Strike: Global Offensive) and self-professed computer nerd immediately saw the value in Bitcoin.

Scott had already been doing a brisk business, selling “skins” — customized digital renderings of weapons and outfits for CS:Go — and plowing the money he made back into his computer to improve its hardware.

And it was that investment in hardware that allowed Scott to start “mining” Bitcoin on his gaming rig’s GPU (Graphics Processing Unit).

What started out as a hobby, soon became an obsession, as Scott experimented with overclocking his GPU, improving the cooling in his machine and spending hours on online forums in an effort to optimize his Bitcoin mining efforts.

It wasn’t long before Scott’s father noticed an inexplicable spike in the power bills and after finally confronting his son about his computing activities, reminded him,

“It’s not money, it’s not backed by nothing, now if you don’t want to make nothing of your life, you’ll stop this.”

It’s not likely to be the first or the last time someone criticizes cryptocurrencies for being “nothing.”

Yet in the financial markets, there are also securities which are also rooted to “nothing” — instruments which are arguably as ethereal as Ethereum.

Consider zero coupon perpetual bonds — a debt instrument that is issued at a deep discount to its face value but pays no interest and never gets repaid — yet is widely accepted as a legitimate financial instrument.

The only exit from a perpetual bond is what someone else will pay for it.

What is the price of “hope”?

Cryptocurrencies may be based on “nothing” but it doesn’t follow that they’re worthless.

On the contrary, the value that cryptocurrencies may provide might actually depend upon them being linked to nothing.

And when considered from that perspective, cryptocurrencies keep company with a rather exclusive class of securities, including precious metals, collectibles and art.

Auto salon was drawing the crowds but bids were at a minimum.

By contrast, financial securities have constraints that can be used to model their risk and to define their value.

Bonds are issued by borrowers and differ in value and coupon rate depending on the creditworthiness of their issuers. Bonds also provide predictable cash flow and specified dates of maturity, when they can be surrendered for their face value.

Stocks on the other hand provide far less predictable cash flow (if at all) — dividends are discretionary. But stocks also provide (depending on how much stock one owns) voting rights on how a company is run.

Currencies then are anchored to their ability to be traded in for goods and services — a role that for now, cryptocurrencies have yet to assume.

Yet despite the volatility of the markets where bonds, stocks and currencies are traded — their “value” is ultimately determined by their characteristic constraints.

While very “risky” stocks may provide high returns, there is arguably something that anchors their worth — a growth story, a disruptive business model or a burgeoning industry.

Federal Reserve Chairman and man explaining to you what “assets” means, Jerome Powell.

And while bonds are somewhat predictable financial instruments, very rarely provide high returns except where obtained at deep discounts.

Currencies that actually function as means for the exchange of value tend to be tethered (no pun intended) to their own purchasing power, measured against a basket of goods and services available in an economy. Which is why your beads don’t tend to work outside of a Club Med.

But for cryptocurrencies, there are no such limitations to determine their value.

There are no discounted cash flow models, or estimated valuations. No comparable analysis, no meaningful precedent transaction approach or even a cost approach to determining the “worth” of cryptocurrency.

Yet if such valuation models existed (in a meaningful way), cryptocurrency would be a far less effective vehicle for speculation.

In its current form, cryptocurrencies are a rare example of unconstrained securites — valued as a pure projection of volatility by market participants.

Why buy an unconstrained security?

So why would anyone want to invest in an unconstrained security — precisely because it is unconstrained.

Because outsized value can be had from large windfalls.

Einstein had difficulty adjusting to time travel.

Think of it as a “gambler’s high” if you will, where the size of the wager is disproportionately small to the size of the payout — like buying a Powerball ticket.

Excessive returns are possible in unconstrained securities because there is no basis (as yet determined) for their value in the first place.

Whether it’s Beanie Babies or slot cars, the upper bound of these unconstrained securities is some unknown and unknowable quantification of avarice.

Are Cryptocurrencies Truly So Baseless?

To understand if it’s at all possible to anchor a value for cryptocurrencies, it’s important to understand among whom it is most valued.

Statistically, demand for cryptocurrency tends to be highest among young people living in urban centers with limited access to other financial securities and who often live paycheck to paycheck because of the high cost of living.

Now if such an individual had US$500 in spare cash for investing, the annual dividend returns from a blue chip stock or the coupon rate of a bond would be wiped out (almost immediately) by the need to pay for rent in a modern city.

Because of the tight cash flow constraints such individuals live under, the possibility to enjoy one of the most important elements of investing — the ability to compound investment gains — is limited.

And even if they made US$1,000 on their investment, the tendency to blow that amount is high, not necessarily due to the lack of financial discipline, but more because of the relative pricing of the cost of living, investing and salaries.

A thousand bucks may sound like a lot of money, but isn’t even a drop in the ocean when the price of real estate is disproportionate to the minimum wage and the prospect of obtaining a mortgage is slim.

“Damn it, I forgot to order milk again.”

Instead of despairing, it’s no wonder that cryptocurrencies become an attractive investment vehicle to the disaffected youth of the world.

True, cryptocurrencies may not make one rich today, but the mere prospect that it might, already adds value to one’s psyche, especially if one ekes out a feckless living, sustained by the largess of one’s fellowman or a minimum wage existence.

And for the millions of disaffected youth, left behind by a capitalist system that seems to disproportionately reward a perceived elite class, traditional securities and their sliver-thin returns seem to be an exercise in futility.

A bad sneeze and your couple of basis points are blown away.

Add to that the possibility that those generations who benefited most from global inflation and the rise in traditional asset values, fearing threats to their wealth, also invest in cryptocurrencies to diversify their asset base — and the value proposition for cryptocurrency investment becomes far more apparent.

But that doesn’t mean that cryptocurrencies will always exist as unconstrained securities.

There may yet come a day when cryptocurrencies can truly facilitate the frictionless transfer of value or become a globally recognized store of value.

Against that backdrop, cryptocurrencies will eventually become less “nothing” and far more “something” — something which will dampen their speculative value and erode their quality as unconstrained securities.

The writer is Patrick Tan, Partner and General Counsel for cryptocurrency quant trading firm Compton Hughes.