Drawing from city-level data spanning 2013 to 2020 in China, this study examines the economic outcomes of a digital currency pilot test policy. Through the application of a Difference-in-Differences (DID) model, the findings indicate areas promoting digital currencies are more inclined to draw businesses to establish and allocate investments into fixed assets, thereby fostering economic growth. Our empirical evidence also suggests that the robust adaptability of digital currencies across varied cultural contexts and geographical locations.
Cryptocurrencies’ market cap of over USD 1.7 trillion at the end of March 2021 make the category too big to ignore. While the category is small compared to, say, the global market value of real estate, bonds, stocks, or even gold, the market cap of Bitcoin is approximately USD 1 trillion, accounting for 60 percent of all cryptocurrencies. Although Bitcoins market cap value is greater than the total value of all outstanding JPY and over 900 percent of outstanding GBP, its liquidity is comparatively very low. The average number of bitcoins exchanged daily is equivalent to less than 0.05 percent of outstanding JPY and 0.06 percent of outstanding GBP. The other major cryptocurrencies, such as Ethereum (ETH), Cardano (ADA) and Polkadot (DOT), are even smaller and less liquid.
Considering their significant market cap and low liquidity levels, is it justifiable to consider cryptocurrencies a new and permanent assetclass? Greer defines an asset class as “a set of assets that bear some fundamental similarities to each other, and that have characteristics that make them distinct from other assets that are not part of the class.” There are three broad asset classes: capital assets, consumable/transformable assets, and store of value assets. Capital assets such as equities, bonds, and real estate typically generate an income stream for the owner. Consumable/transformable assets such as physical commodities and precious metals provide economic value to the owner when they are consumed or transformed into other assets. Store of value assets such as precious metals, currencies, and fine art store value for the owner over a longer period of time.
Currencies function as a medium of exchange, a unit of account, and a store of value asset. Despite their similar sounding name, there are several reasons why cryptocurrencies such as Bitcoin do not qualify as a currency. For one, they are not a viable medium of exchange because they are not a legal tender and are only accepted as payment by a small, albeit growing, number of merchants. Moreover, their historically high price volatility makes them ill-suited as a unit of account.
Since most cryptocurrency owners hold on to their holdings for a longer period, it could be argued that cryptocurrencies belong to the store of value asset class. However, some scholars argue that cryptocurrencies constitute a new asset class. Although they are similar to other asset classes, some scholars argue that cryptocurrencies have their own unique set of characteristics and features. There are four characteristics that distinguish cryptocurrencies from traditional asset classes: investability, politico-economic profile, correlation of returns, and risk-return trade-off profile.
Recall for a moment Keynes’ allegory in “The General Theory of Employment, Interest, and Money.” In Keynes’ beauty contest, judges are rewarded for selecting the faces most popular among all judges, rather than faces they personally like most. Keynes explains that winning this contest “is not a case of choosing those faces that, to the best of one’s judgement, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached a third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.” Keynes postulates that in the stock market, fundamental value matters less than what everybody else predicts the average assessment of value to be. In terms of cryptocurrency valuation, in the absence of a common valuation model, cryptocurrencies prices will follow expectations about how news will be interpreted by key stakeholders.
Most cryptocurrency valuation models rely on market cap and the long-term token supply schedule. Market cap is calculated by multiplying the unit price of a token by the supply of tokens in circulation. The market cap of Bitcoin on March 28, 2021, for example, is USD 56,000 multiplied with18.7 million Bitcoins in circulating supply, which equals USD 1 trillion market cap. The long-term token supply schedule tracks how many tokens will be created in what timeframe and how many are circulating in the secondary market. For example, the current circulating token supply of Bitcoin is approximately 15.2 million bitcoins (18.7 million minus 3.5 million due to lost keys), and its supply is capped at 21 million bitcoins. Some tokens like Ethereum (ETH) follow an inflationary model and do not cap total supply. Cryptocurrency supply can be reduced permanently through coin burns (sending coins to a known private key) or temporarily through lock-ups (such as through a smart contract) or buy-backs (repurchase of tokens by network). Cryptocurrency supply increases through “mining” or “minting” new coins.
Broadly speaking, there are six approaches to valuing cryptocurrencies, illustrated here using Bitcoin as an example:
1. The “store of value” framework assumes that Bitcoin will eventually replace other assets as a store of value. If Bitcoin were to replace all mined gold, with an estimated value of USD 10.6 trillion, each of the 21 million bitcoins would be worth over USD 500,000. Deducting the estimated 3.5 million lost Bitcoins would increase the value of each Bitcoin to over USD 605,000. If Bitcoin were to replace 20 percent of gold’s share as a store of value asset, the value of each Bitcoin would be approximately USD 100,000. Discounting could be introduced to reflect the uncertainty of reaching a 20 percent market share at a future date.
2. The “token velocity thesis” considers token transaction velocity a key driver of long-term token value. Transaction velocity is calculated based on the monetary equation of exchange M x V = P x Q, where M is the size of the asset base, V is the velocity of the asset, P is the price of the digital currency and Q is the (current) supply of the digital currency. The lower the velocity, i.e., the more people are holding a currency as a store of value, the higher the value of the currency. Staking features such as “proof-of-stake consensus mechanisms” reduce token velocity and support higher prices. The velocity of a currency is calculated by dividing a nation’s gross domestic product (GDP) by the total money supply. Since Bitcoin is not a currency, the rate of its exchange on the remittances market is a possible market substitute. Before the pandemic, remittances from high-income to low- and middle-income countries were valued at approximately USD 500 billion. If 20 percent of this market were to migrate from traditional cross-border payment channels such as Western Union or MoneyGram to the Bitcoin protocol, and assuming a Bitcoin circulation velocity of 5.48, in line with the velocity of the USD prior to the pandemic, each circulating bitcoin would have a value of approximately USD 1,000.
3. The “INET & crypto J-curve thesis” framework was developed to calculate the value of a fictitious coin INET. The framework has four parts:
This model is best suited for the valuation of so-called utility coins with real utility value, such as Filecoin (FIL), that give token holders the right to use a decentralized storage network.
4. The “network value to transaction (NVT) ratio” compares the relative use of the cryptocurrency network over time. NVT for a given time is calculated by dividing the network value, i.e., the market cap by the transaction volume, i.e., the daily monetary volume transmitted through the protocol. A higher NVT ratio suggests the network is overvalued, while a lower NVT ratio suggests it is undervalued. To improve this metric, the denominator is smoothed with the 30-, 60-, or 90-day moving average function. A limitation of the NVT ratio is the assumption that the value of the cryptocurrency is only derived from its function as a medium of exchange. A higher NVT ratio can also reflect a high number of people holding the cryptocurrency as a store of value. Bitcoin’s current NVT ratio ranges from 70 to 80, below the levels it had reached before the bursting of prior bubbles.
5. “Daily active addresses – DAA” is a metric for the number of users that employ the crypto network in transactions on a daily basis. Similar to the concept of daily active users (DAU) for platforms and applications, DAA can provide information about the activity level on the network as an approximation for network utility. It is often used as a complement to NVT and on-chain transaction volume. In the wake of Bitcoin’s price increase at the beginning of 2021, the number of DAA increased to over 1.3 million active wallet addresses. In January 2021, more than 22.3 million unique wallet addresses actively sent and/or received Bitcoins in the network.
6. “Stock-to-Flow ratio – SF-ratio” goes back to Nick Szabo´s insight, that “precious metals and collectibles have an unforgeable scarcity due to the costliness of their creation.” Bitcoin, for example, has “unforgeable costliness” because mining Bitcoins is very energy intensive. Gold has the highest SF-ratio of 62 as the supply grows on average 1.6 percent each year, and it would therefore take 62 years of production to get to the current stock of gold. With a current reward of 6.25 Bitcoins per block mined and a stock of 18.7 million coins, the Bitcoin SF-ratio is 57, very close to the level of gold and ahead of silver that has a SF-ratio of only 22. Statistical analysis indicates a strong relationship between SF-ratio and market value, suggesting further increases in the value of Bitcoin with future “halvings” of the mining rewards occurring every 210,000 blocks, i.e., every four years.
Other important aspects of cryptocurrency due diligence include the quality of the code across all layers, the size and level of activity of the developer community, consensus-mechanisms and governance, and incentive design.
Before buying and trading cryptocurrencies, investors must consider crypto custody. The fundamental principle of token ownership is “I know, and I own” rather than the “I am, and I own” principle governing bank and security accounts. Tokens are stored in e-wallets and exchanged by sending them from one wallet to another. Wallets are protected using public-private key encryption. In order to dispose of a token/coin the investor needs to know the private key of his or her wallet. If he or she loses the key or sends the token to the wrong address, the cryptocurrency is lost.
There are three types of storage technologies for private keys, depending on whether the wallets are connected to the internet. In cold storage, the private key is stored off-line as a hard copy or on an external electronic data storage device. Famously, the Winkelvoss Bitcoin billionaire twins distributed snippets of a printout of their private keys across multiple safe deposit boxes in the USA. Retrieving a key from cold storage takes time and can therefore slow trading, and the owner can lose the private key. In hot storage, the crypto wallet is run through a system connected to the Internet, such as in the cloud, on a mobile device or on a stand-alone computer. Most retail crypto exchanges hold a share of their cryptocurrencies in hot wallets. Warm storage is attractive to institutional investors for whom the lack of secure custody solutions for private key storage has been a barrier to investment. Military-grade “warm-storage” technological solutions, which rely on certified hardware security modules and allow withdrawal of tokens within seconds, have recently made crypto-custody more appealing to institutional investors. Together with regulated crypto-custody services and the increased availability of insurance for crypto-custody, “warm-storage” custody is paving the way for increased institutional cryptocurrency activity.
Some cryptoexchanges are centralized exchanges, such as Coinbase in the US, or Kraken and Bistamp in Europe, and decentralized exchanges, such as dYdX. Coinbase is regulated in the US and has a New York money transmitter license. It offers a smaller number of cryptocurrency coins than, for example, Binance, in order to avoid US securities laws infringement. Binance, as one of the largest exchanges worldwide, attempts to appear decentralized but in fact is a network of several legal entities in different jurisdictions each with their own regulatory regime. Binance offers its native token, the Binance Coin (BNB), which initially offered discounts on trading fees but has since developed into an entire ecosystem. Initially, Binance did not offer fiat on- and off-ramps, whereas Coinbase has developed extensive fiat payment options. In 2019, Binance launched Binance US, which supports deposits and purchasing via bank transfer, debit card, or wire transfer and withdrawals via bank transfer. dYdX is a new form of decentralized exchange. It is a permissionless platform powered by smart contracts that run on Ethereum supporting lending, borrowing, and most importantly, margin trading.
The large number of exchanges and the diversity of regulatory regimes for cryptocurrency trading are conducive to fraudulent trading activities such as “wash-trades” and “pump-and-dump” schemes. In addition, over the past few years, there have been several serious hacks of cryptocurrency exchange wallets, diverting significant amounts of cryptocurrencies, mostly Bitcoin and Ethereum, into hackers’ wallets. While public blockchain protocols make it easy to trace transfers into wallets, it is very difficult to link wallets with computer terminals or individuals across jurisdictions. In 2019, for example, hackers stole USD 40 million worth of bitcoins from Binance. In response, Binance suspended withdrawals and deposits for one week and drew on a secure asset fund based on allocations of ten percent of all client trading fees since 2014 to reimburse affected investors for their losses. Only if crypto-trading moves away from centralized exchanges that hold investors´ private keys and tokens in so called “hosted” wallets to fully decentralized, permissionless peer-to-peer exchanges can the concentration of digital wealth that has attracted hackers and bad actors be avoided.
For investors wishing to skirt the hazards of trading on crypto-exchanges, investment vehicles such as brokers, contracts for difference derivatives (CFDs), trusts, exchange traded notes and exchange traded funds offer viable alternatives:
