What Is Cryptocurrency? Will Crypto Recover? Here’s What You Should Know.
I have recently had an opportunity to chat with a person about cryptocurrencies. Just to make sure, we do not provide advice on cryptocurrencies. It is not within our practice. However, it is one of the perspectives to observe the holistic shape of financial volatilities. So, an independent investment advisor like us has a professional responsibility to have original and accurate ideas on independent research.
Some say cryptocurrency is Web3 technology and quite promising as a highly distributed, decentralized, and disruptive technology. It is even compared to the internet and email in the mid-90s. Like legacy communication systems are displaced by internet-based technologies, cryptocurrency is expected to become the next-gen monetary system or new global currency replacing legacy money. Its backbone of blockchain has a quite unique rumored transformative potential.
While I understand many enthusiastic voices from liberal and aggressive innovators such as Elon Musk, the history tells that new technology applications to financial instruments have always been mixed.
Unlike general goods and services, financial transactions are uniquely different. Anyone on the earth probably cannot live without financial transactions in some form. But on the other hand, they are required to be secure and confidential, and at the same time, fraudulent transactions have to be detected. Those objectives and constraints have many challenging conflicts.
In essence, this is like a complex data-scientific optimization matrix of objectives and constraints to solve. Even the closest point of optimization result is not feasibly good enough to be used in real life. Moreover, optimizing many conflicts simultaneously often leads to an error of no answer.
The following is the list of unique fourteen aspects of cryptocurrency.
1. Lack of Value
There is no actual underlying entity of fundamentals, as physical or with financial return. Its actual value can be regarded as being without value. It is so unique. Cryptocurrency is not tied to physical goods such as gold, rare collectives, historical artworks, or vintage wines. It is not linked to non-physical financial returns such as dividends, free cash flow, or cash distributions. It is a significant disadvantage as an asset for people who decide on valuation because structurally, there is no way to find how much is over or undervalued against underlying value.
2. Unlimited Freedom of Pricing
This is another side of the above fact of the value as no-value. It may sound counter-intuitive, but its crucial functional and liberal advantage is made of the disadvantage of empty value, allowing ultimate limitless pricing on public exchanges.
This obviously looks like great news for profit-seeking traders; however, this uniqueness makes risk analysis extremely difficult. Any statistical modeling starts with estimating parameters of the true population, such as the probability distribution of the true population. For instance, who and how can say the true return population is normally distributed? What true population did subprime with CDS have? Statistical data from a small sample of limited and short history (but that is the best anyone can) could be missing large yet unobserved samples. Many are just dealing with naïve and false statistical judgment. Even AI and ML could easily falsely manipulate and develop the wrong network. There is always a risk in the case of new financial products with a short history and a tiny sample.
3. Misconception of Currency Foundation
It is surprising to hear many saying that any currency, including cryptocurrency, is based purely on trust or a sense of credibility. That is inappropriate, and each currency’s structural bottom stands primarily on foreign currency reserves through international trade. This economy-linked structure is crucial proof of value, while cryptocurrency has no such an economic basis as a foundation. A variable is only defined in a line of the new codes.
4. The Lack of Link with Value Distorting Senses of Investment and Valuation Discipline across Broad Assets
One of cryptocurrency’s most frequently asked questions is its impact on the broader market. People seem to be looking at a direct link via wealth effect, such as whether the decline of cryptocurrency’s market cap will raise risk toward public equity.
We think the answer is not zero but limited. For those wealth effect & contagion type risks to occur, a chain of duplication and multiplication of risks through leverage via derivatives and margin usually comes beforehand. However, cryptocurrency is traded on different exchanges. Leverage is not widely available, and its cost is high. Therefore, a derivative on cryptocurrency is not widely traded.
Our concern is an indirect and broad influence. As cryptocurrency is made from the distorted senses on pricing, i.e., confused valuation practice, market pricing psychology gets distorted.
We would like first to clarify what market pricing analysis and valuation mean. We think not many believe strongly that price and value are two completely different and distinct figures. Our definition is that market price is an immediate cash quote from the market participants. At the same time, value is not explicit information, estimated by each participant based on a forecasted future return such as cash flow from ownership. Each point of time in the future has a different intrinsic value because value grows over time.
So the estimates of value work as a system of implicit anchors of market prices. The problem with cryptocurrency is that it does not have such an anchor mechanism. On the contrary, it spreads the notion that valuation is unnecessary and quick pricing is sufficient, becoming a herding phenomenon of careless senses spilling over to other assets, short-sighted pricing analysis getting popular, and market volatility rising.
5. Guaranteed Relative Negative Yield
There is no yield returned as benefits owning the asset, no interest or dividend, or any reward to the owner. Instead, it is a guaranteed relative negative yielding asset. So capital gain on trading is the only path, structurally forcing cryptocurrencies to become price forecast-oriented trading tokens.
6. Opaque Actual Fees and Commissions
Cryptocurrency is unregulated. Its commission and fees are not transparent, and those rates tend to benefit the crypto exchanges and the owners of exchanges more favorably than regulated public risk assets. Related to the point above, as cryptocurrencies require trades for capital gains, they are guaranteed sources of income of trading commissions and fees from the perspectives of exchanges.
7. Black-boxed Order Matching Process and Unclear Bid-ask Spread
Moreover, the exchanges have a black box of trading processing to match bids and ask for trades. It is not impossible to do unregulated cross-exchange arbitrage of flash boys.
8. Mining Cost Structure Against the Global Energy Security Trend
Mining costs are tied to electricity and network infrastructure operation costs. We are facing significant energy supply issues requiring our society to prioritize using limited supply globally. It is significantly damaging to the whole society, causing inflation via energy consumption.
9. Extremely Easy Start and Unlimited Entry and Supply
Super easy entry. With a basic python and a week of $20 online lessons, you can start a new cryptocurrency of your own. Visit Udemy or YouTube or buy a book to become a disruptive and decentralized fintech CEO.
10. Similar Faces Active in Engineered Subprime Products
Often, those who were once active as exotic financial engineers and executives during the golden days of subprime products are now back as disruptive and innovative fintech executives or directors. The nature of profit and skills of marketing speculative products might need a match. They all are aware that ICO makes easy and huge profits instantly.
11. Market Size Getting Large to Ignore the Systemic Risk
The cryptocurrency market has grown large enough to trigger systemic risk to the financial and economic system. It is 1/2 of those whole US SM cap equities. Further growth would increase the chances of extensive regulation, and the risk-return profile is unfavorable. Stable coins are an extreme example. It does not have an upside as it is tied to USD but only a significant downside if there are any issues, so the expected return is structurally negative. It’s an enormous—high-risk negative return asset.
12. Justification of Cryptocurrency in Portfolio Solely on Quantitative Measures
There have been growing positive views on cryptocurrency as a tool to reduce portfolio total risk through diversification because it has negative correlations with many public market assets. This is a problem because
1) as noted above, the actual total population is not identified, and so the negative correlation cannot be proved from a strictly statistical point of view,
2) this approach only amplifies the widening gap between price and value as the approach completely overlooks value, forcing the process to get infected by the market herding phycology.
Using stats on herding activities as a guide for portfolio decisions is a self-defeating and reflective process just multiplying and enhancing the market herd bias leading to a more unstable and volatile market.
13. Blockchain Is Not Cryptocurrency
Blockchain is a distributed database technology with pros and cons. An application needs a suitable database, and no single database is versatile. There are various requirements from either infrastructure or application architecture. Blockchain happened to be the best for bitcoin, but it is not for high volume, high throughput, and rapid processing applications. It has a trade-off between performance/scalability and decentralization. So naïve and careless argument regarding cryptocurrency as blockchain is quite misleading with an intended purpose of dressing cryptocurrency up with a futuristic-looking word to boost group-herding.
14. Obscured Line between Financial Liberalism and Malicious Usage Intent
While many innovators and academics are excited about the potential as a disruptive tool to liberalize the financial system, the financial transactions structurally involve ill-willed cleansing and illegal intent. Regulations are made locally and not universal, and the small and less developed nations are used as locations of transactions. Cryptocurrencies are still in the early innings of the established regulatory framework across the globe, and malicious intent tends to explore and develop innovative ways to achieve its goal.
All those being said, I have a couple of things to add more color not to get biased in a misleading way.
First, there is a risk of shorting cryptocurrencies. As mentioned above, cryptocurrencies’ essence is that they are empty, like a balloon without weight. So all the price movement you see is like a random balloon in the air. As such, you cannot logically predict whether it will go up or down. Either way, it can move in a probability distribution with its shape still developing. Many are trying to build and train a neural network and ensemble trees to find an algorithm. However, I think those processes can be effective only under a specific controlled circumstance, such as a board game, and the nature of crypto trading will remain unknown. Real risk emerges when that learned network breaks, i.e., data science, will be, in aggregate, a self-defeating approach. As long as you do not touch it, you will not be in any trouble. Fine.
Second, there has been a trend in the industry toward the sales and marketing of packaged investment products. The packaged products were made of ETF, and targeted indexes were developed accordingly. Indexes apply specific rules of security characteristics, such as dividend yield, value or growth factor of a multi-factor model, country or industry or market cap, etc. This means that the package label has more important than its contents and ingredients for sales and marketing. As you see in buying packaged food, the brand and packages have become a crucial key to sales rather than its contents. Quantitative tools are excellent complements to it as they can dress up the labels by adding more information as if they are not only labels, although they have nothing to do with their underlying foundational value. Cryptocurrency is positioned as its extreme extension, as its contents are literally empty.
For most people, it is very challenging to understand the concept of two lines of price and value in the market. Likewise, it might not be so simple to comprehend what cryptocurrency is in nature. The investment side is looking at the long-term line of value, a line that exists separately from the price of the stock, which is not inherently a short-term trade. Sometimes the two lines are close, but most of the time, they are far apart. However, predicting when they will get closer is a secondary return for the investor because it is speculation in itself. But why forecasting their proximity is a secondary return for investment? It is because it creates its own infection that drags you into speculation.