Cryptocurrencies as money?

Accepted academic definition of money is that it needs to fulfil three functions:

A medium of exchange, a store of value, and a unit of account.

Medium of exchange means it is a payment mechanism – you can use it to pay someone for something, or to extinguish a debt or financial obligation. To be a good medium of exchange, it doesn’t need to be universally accepted, but it should be widely accepted in the particular context for which it is being used.

Store of value means that in the near term your money will be worth the same as it is today. To be a good store of value,you need to be reasonably confident that your money will buy you more or less the same amount of goods and services tomorrow, next month or next year. When this breaks down, money’s value is quickly eroded, a process often referred to as hyperinflation.

Unit of account means it is something that you can use to compare the value of two items, or to count up the total value of you assets. To be a good unit of account, the money needs to have a well-accepted or understood price against assets.

So is today’s money good money?

The dollar is generally acceptable for payment in US and other countries, so it is an excellent medium of exchange. And it is an excellent unit of account because many assets are priced in dollars, including global commodities such as crude oil and gold. However, given that purchasing power of the USD over time has decreased significantly,it has been a poor store of money.

We can predict, more or less, that the USD will lose its purchasing power by a few percentage points each year. This is known as price inflation. Price inflation is measured by Consumer Price Inflation – an index measuring the changes in th price of a theoretical basket of goods that are reportedly chosen to represent typical urban household spending.

Perhaps money fulfills one need – immediate settlement of obligations, whereas the longer term store of value need can be achieved through other assets such as land or housing.

How do cryptocurrencies fare against the standard definitions of money?

As a medium of exchange, Bitcoin has some interesting characteristics.

Bitcoin is the very first digital asset of value that can be transferred over the internet without any specific third party having to approve the transaction or being able to deny it.

We are able to make payments with bitcoins, it is faster than some traditional payment methods. It is widely accepted among its community. But by a global standard, no, it is not widely accepted.

What about merchant adoption? Well in reality, most company who say that they accept Bitcoin as payment don’t actually accept Bitcoin as payment. They use cryptocurrency payment processors that act as an intermediary by quoting a price to the customers in bitcoins, accepting the bitcoins from the customer, then writing an equivalent amount of conventional currency – the boring way into the merchant’s bank account.

How about Bitcoin as a store of value?

Bitcoin has certainly been a good investment, but its volatility makes it nauseating store of value.

Bitcoin do have the potential to keep value over the long term. According to its current protocol rules, bitcoins are created at a known rate (12.5 BTC every 10 minutes or so) – and that rate will decrease over time. So the supply of it is understood and predictable, capped to almost 21 million BTC and not subject to arbitrary creation, unlike fiat currencies. Limiting the supply of something van help maintain its value if demand is stable or increases, though the downside of a known, predictable and completely inelastic supply unrelated to fluctuating demand results in perpetual price volatility, which is not good if you are looking for price stability.

Now, what about Bitcoin as a unit of account?

As a unit of account, Bitcoin fails miserably, due to its price volatility against USD and everything else in the world.

Will the price volatility of Bitcoin decrease? It is anyone’s guess, but I personally doubt it. A price can be high, but if a market is illiquid, small amounts of money can still push the price around. Stability is determined by the liquidity of a market (how many people are willing to buy and sell at any price point), than the price of an asset. But even liquid markets can move quickly if the market’s participation of the value of asset changes suddenly.

Furthermore, as discussed earlier, Bitcoin’s supply is inelastic. If there is a spike in demand, there is no impact on the rate at which bitcoins are generated, unlike normal goods and services, so there is no dampening effect on the price, and this holds true for any price point – even if volatility decreased, traders may just take bigger bets, often with leverage, which would then move the price again.

Currently there is a quest for stable coins – cryptocurrencies whose prices are relatively stable compared to some other thing, for example a US dollars. Unless they are backed 1 to 1 with the relevant asset, stable coins are very hard to produce because essentially you are trying to peg the price of something dynamic to something else with a different dynamic.

There is one case where BTC may be used as a unit of account: when valuing baskets of other cryptocurrencies. This is a niche case.

So should we write off Bitcoin? Perhaps not.

The issue seems to be that people try to fit Bitcoin into an existing bucket (‘It is a currency/ asset/ property/ digital gold’), and when it exhibits some properties that do not match others in that bucket, it is declared as failure . Maybe the answer is to not try to fit it into any existing bucket, but to design or define a new bucket, and to judge Bitcoin and other cryptoassets on their own merits.

Source: Anthony Lewis’ Bitcoins and Blockchains

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