The cryptocurrency debate: Is it Tulip Mania 2.0?

By Indroneel Das

Very recently, the Chinese took the extremely sensible and requisite step of banning Initial Coin Offerings (ICO). Just like equity shares that are first floated to the public for subscription, based on a pre-decided value which is presumed to be the ‘fair value’ at that point of time, so are cryptocurrencies. In an ICO, anyone interested in buying a cryptocurrency that is being freshly issued to the public makes a certain investment based on the current valuation of the cryptocurrency. In return, he may be able to lay his hands on digital units of that cryptocurrency, which he will subsequently be able to use for online transactions, wherever cryptocurrencies are accepted as a mode of payment. Alternatively and much more importantly, the currency might appreciate in value and could be traded later for a much higher value than the original amount invested. The most famous cryptocurrency, Bitcoin, has been around for more than 8 years. And until recently, it was the single major cryptocurrency that existed in the world which also constituted the bulk of the transaction volumes of all existent cryptocurrencies.

Gradual changes

Over the last six months, the scenario has radically changed. New cryptocurrencies, such as Etherium and Ripple, have made their way to the market and as a result, the share of the good old Bitcoin’s market cap to the total market cap of all the cryptocurrencies has reduced from more than 90% to less than 50%. This may, to some people, seem like a coming of age. Of course, the sharp and constant increase in the value and volumes of these currencies does signal that more and more people are buying these currencies, and broad acceptability is also increasing, as a result. But none of the above indicates that cryptocurrencies are a good investment or will be a stable and well-accepted currency in the long run. In fact, the truth may be in stark contrast to what the current valuations and trading volumes would suggest about the future of cryptocurrencies

Looking for intrinsic value

Straight away, it can be said that cryptocurrencies do not even qualify as good assets or investments. This is because there are only two kinds of assets that should be bought into. One, those that have an intrinsic value which is fathomable and is not a figment of popular imagination. Second, those that come with the backing of a credible authority, even if they lack a tangible intrinsic value.

Let us understand why these two types of assets work. First, focus on assets with ‘intrinsic value’. Intrinsic value refers to the idea of the underlying holding some value based on one of two things- either the underlying finds some consumer use or industrial application, or there is visibility and a reasonable guarantee of incremental cash flows in the years to come. A digitally created currency doesn’t have any use to a consumer or to the industry, and neither does it guarantee any cash flow. Of course, if you possess it and sell it, it will generate cash flows for you. But the whole point is, investor or trader-created supply and demand should itself not completely decide the way the price behaves. There should some stability and some sanity checks that the price and value should be anchored to. Stock prices move up and down, sometimes rather sharply, based on supply and demand too, but there are limits to these price movements in a short time frame. Also, over a reasonably long period of time, stock prices have a solid correlation to the performance and earnings of the underlying movements. This is the sanity check, which, on an average, checks the price fluctuations.

A digitally created currency doesn’t have any use to a consumer or to the industry, and neither does it guarantee any cash flow. Of course, if you possess it and sell it, it will generate cash flows for you. But the whole point is, investor or trader-created supply and demand should itself not completely decide the way the price behaves. There should some stability and some sanity checks that the price and value should be anchored to. Stock prices move up and down, sometimes rather sharply, based on supply and demand too, but there are limits to these price movements in a short time frame. Also, over a reasonably long period of time, stock prices have a solid correlation to the performance and earnings of the underlying movements. This is the sanity check, which, on an average, checks the price fluctuations.

Absolute or relative?

There is no such underlying for cryptocurrency and therefore, nothing to suggest whether it is truly undervalued or overvalued. Because the question that should immediately follow is ‘relative to what?’ Then, there is nothing to suggest that there is an intrinsic value associated with cryptocurrencies. This brings the argument to the second kind of asset that can be bought into- ones with the backing of a credible authority. Whenever a central bank decides to print currency, it is a promise from the state to the holder of currency. The holder is therefore sure of the value of a note of Rs. 100. It will still be worth Rs. 100, even a decade from now. Of course, it may no longer be able to buy the same things that it can today, accounting for inflation. But that is the domain of purchasing power, it is not a part of this argument. Cryptocurrencies, on the other hand, fluctuate in terms of their absolute value every day.

Supply and demand dynamics and the importance of regulations

The objective of currency is that its presence or absence should impact the ability to buy and sell, and therefore impact supply and demand. Its own value should not be subject to supply and demand. Again, even the central bank-recognized currency of the nation fluctuates in the forex market. But to an Indian residing in India, the rupee is not going to fluctuate based on transaction volumes and amounts. However, the cryptocurrency will. The acceptability of cryptocurrency might be increasing, but it isn’t even close to competing with central bank issued currencies in terms of acceptability. This obviously means most people are buying and selling it to get rich. So its demand is not based on its fundamental characteristics, or its transactional value, but only on speculation.

Cryptocurrency is a rebellious idea that aims to decentralize currency and move everything to a digital platform. But then, do you know that all it takes to create units of cryptocurrency is a slightly expensive and capable PC, which runs for days after days and produces cryptocurrency in a process called ‘mining’. Cryptocurrency may not leave footprints, but that isn’t a pro. It’s a con. Who ensures that a unit of cryptocurrency is not just a figment of someone’s imagination or an image on your screen? You don’t even know who mined it, where it came from, and where it went. You also don’t know what it’ll be worth tomorrow and based on what factors.

Like the Dutch central banker, Nout Wellink said, ‘’it’s even worse than the tulip mania, at least you got a tulip then. You get nothing now’’.  Given that valuations are now sky high, many new players are joining the bandwagon. Some even claim to backed by real estate. Which, like everybody found out in 2008, is itself susceptible to bubbles. This is a rapidly mushrooming market where information is scarce and valuations are based on speculation. Exactly the kind of market which needs either regulation or complete banning. It is, therefore, high time that the GOI and the RBI step in and take corrective action on the lines of what the Chinese government recently did.

Featured Image Source: portalgda via Visualhunt.com / CC BY-NC-SA