Michael J. Casey is the chairman of CoinDesk’s advisory board and a senior advisor for blockchain research at MIT’s Digital Currency Initiative.
In this opinion piece, one of a weekly series of columns, Casey argues that bitcoin’s appeal as an investment could diminish its effectiveness as a currency and calls for testing alternative cryptocurrency models.
Bitcoin traders like to say their best trading strategy is not to buy and hold, but to buy and “HODL” – hold on for dear life.
For the umpteenth time, it’s paying off. Bitcoin’s price has rebounded from a sharp drop in September, overcoming a bout of wild volatility that would scare off even the most seasoned Wall Street trader from other markets. Despite a slew of unambiguously negative news, from China shutting down bitcoin exchanges to a looming fork in the cryptocurrency’s code that threatens chaos and acrimony in the community, here we are again with a new all-time high of over $5,200 set today and quite possibly more ahead.
I see two core reasons why bitcoin commands such value – no doubt to the bafflement of people like JPMorgan Chase CEO Jamie Dimon.
One is somewhat tautological, and that is the fact that bitcoin exists at all, that it seemingly cannot die. As if to confirm the HODLers’ worldview, circumstances like those of the past two months tend to test, and ultimately prove, the contention that bitcoin’s decentralized design can resist any effort to shut it down, whether from outside or within its community of users.
That’s what’s valuable about it. The more bitcoin shrugs off attacks, the more it highlights its core value as an immutable currency of the people.
The second pillar beneath bitcoin’s value is its scarcity. Although bitcoin will keep generating new coins until its total supply reaches 21 million in 2140, the protocol has front-loaded that distribution such that 80 percent of those are already in users’ hands. That petered-out distribution function will keep bitcoin scarce into the future.
There is, however, a paradox here: this scarcity feature could actually undermine bitcoin’s appeal as a currency.
HODLing = hoarding
In its aspirations to fulfill the three functions of money – a store of value, a medium of exchange and a unit of account – bitcoin could be cursed by success. The built-in scarcity, up against expectations for growing demand for an immutable financial instrument, has created an awesome store of value for the decentralized, digital economy of the 21st century.
Bitcoin is in this narrow sense is a much better, highly liquid, digital version of gold. But so long as all these HODLers keep coins out of circulation, there won’t be enough of them around for people to use it to buy goods and services.
Yes, payment processor BitPay is reporting a surge in transactions, but such gains come off a very low base. The vast majority of bitcoin transactions aren’t commercial in nature, and a number of merchants that experimented with bitcoin in 2014 and 2015 have since stopped accepting it.
As a portion of global commerce, bitcoin is a pipsqueak.
This particular failure is likely to continue even if one or both of the two sides sparring over how to scale bitcoin’s transaction throughput succeed in their goal, whether through on- or off-chain solutions. Fast, low-fee transactions won’t entice people to part with their bitcoin if they perceive that it’s more valuable to hold it. In keeping with Gresham’s Law that “bad money drives out good,” they’ll instead transact in an inferior currency. Such as the dollar.
Of course, any decent, functioning currency must be somewhat scarce in order to hold its value; no one wants to accept Venezuelan bolivars right now. But as many economists often point out, neither should a currency be overly appealing as a store of value. If too many people hoard the currency, too little gets into circulation as a medium of exchange, which in turn makes it less likely to be quoted as a unit of account.
This theory suggests that an ideal monetary policy includes a small amount of inflationary expectation. It’s why most central banks formally target a 2 percent inflation rate, signaling that they intend to find a balance between too much and too little monetary expansion. The problem is that many of them fail to achieve that goal and end up debasing the currency, in the form of excessive inflation like Venezuela’s, or create harmful deflation, as with Argentina’s currency peg in 1991. Perhaps there’s a better, automated way to optimize monetary policy so that people both save and spend their currency – ideally with a cryptocurrency that no one can shut down.
Of course, it’s virtually impossible to imagine bitcoin’s algorithm ever being altered to increase its supply. Users, miners and businesses would never agree to such a diminishment in its value proposition.
It’s fair to say we’d never have bitcoin – and the broader field of cryptocurrencies and blockchain technology – if Satoshi Nakamoto hadn’t built in a scarcity feature to bootstrap demand for it. But now that the precedent has been set, developers of altcoins have an opportunity to experiment.
Experimenting with inflation
That’s what’s happening at the MIT Media Lab’s Digital Currency Initiative, where I am a senior advisor. The DCI has launched K320, an experimental cryptocurrency that’s the first application of the cryptokernel blockchain toolkit developed by researcher James Lovejoy.
K320 starts out with a bitcoin-like frontloaded release schedule for its first eight years, but then slots into a steady increase of 3.2 percent every year after that. It’s modeled on Milton Friedman’s “k-percent rule,” which posits that money supply should be increased by a fixed rate annually, regardless of the state of the economy.
The 3.2 percent number is a best-guess attempt to establish a rate of increase that’s high enough above the common 2 percent central bank inflation target to create sufficient expectations of depleting value for people to use the coin – but not so high that it encourages them to dump it.
But we can only know by testing it. It might be that a more dynamic model is needed, one in which, for instance, money supply is adjusted automatically, based on a digitally verifiable measure of the velocity of transactions. What’s needed is new field of crypto-economic experiments.
Whatever the results of these studies, I don’t think bitcoin investors have anything to fear. In the long run, bitcoin’s immutability, in-built scarcity and political neutrality give it the potential to become a kind of global reserve currency for the masses – a digitally native backstop that everyone owns, much as countries hold dollar reserves as a form of national insurance.
Still, the real promise of cryptocurrencies is that they let us overhaul our broken monetary and payment systems, making them less oppressive, more efficient and accessible to all. We need a unit of value that people will readily exchange with each other.
And for that, a heavily HODLed, deflationary asset just won’t cut it.
Rusty bitcoin image via Shutterstock