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How Supply Affects Crypto’s Value, Explained

Debate has been raging on whether cryptocurrencies with a fixed supply are good or bad. Do they increase prices and demand, or stymy spending?

So is crypto actually a currency?

This is open to interpretation.

While some crypto startups have sought to ensure that their tokens can be used to buy something specific — whether its collectible cats or stocks — others are creating assets with a deliberately limited supply to help crypto users store value and see it appreciate over time.

One example is Bitcoin Rhodium. Its commodity, XRC, has a total supply of 2.1 million tokens coded in the blockchain. Named after a rare precious metal, the new crypto asset argues that other solutions were not a tempting proposition for investors seeking a long-term investment in crypto securities. It describes itself as the final part of the “Crypto Trinity” — along with Bitcoin and Litecoin — which is designed to appeal to a broad spectrum of investors, many of whom have different needs and interests.

As well as bridging the gap between crypto and traditional investments by offering a  time-bound dividend, Bitcoin Rhodium also says it offers a decentralized peer-to-peer exchange between precious metal investors and users of XRC, BTC and LTC — efficiently matching supply and demand without the need for intermediaries.

What happens when there are no Bitcoins left to mine?

Firstly, it might not be something you need to worry about — it’s unlikely many of us will be around in 120 years.

As this Cointelegraph feature explains, miners will particularly feel an impact. They are currently rewarded when they mine a block, but these rewards are going to tumble over time and eventually disappear altogether when supplies are exhausted. Satoshi Nakamoto himself predicted that the onus would change from block rewards to transaction fees once this plateau is reached — after all, transactions will still need to be validated on the blockchain. This could mean consumers end up paying higher fees in order to ensure their transactions are processed quickly.

As the number of Bitcoins remains stagnant and prices fall, divisibility is going to prove to be a vital factor in keeping supply levels strong. This cryptocurrency has eight decimal places — and Nakamoto reasoned that this would ensure that small purchases could still continue to be made. Without this, you’d end up in a situation akin to paying for a $1.50 can of cola with a $5 note, and not getting any change.

Ethereum tokens are divisible to 18 decimal places — and as this article explains, this is important because it ensures that they can easily be exchanged for different crypto assets or fiat currencies with differentiating value.

Over time, divisibility could prove to be more important than you may think. By 2017 — more than a year ago — a report had suggested that 3.8 million Bitcoins have already been lost. That’s 18 percent of the overall supply. Loss, theft and destruction were all likely factors, and you can bet your bottom dollar this figure is higher now.

What are the downsides of deflation?

One of the main downsides is a concept known as a “deflation death spiral.”

Like with hyperinflation, this is where things go to extremes the other way. Demand decreases because fewer people are spending money — yet, at the same time, prices are tumbling. Because the number of consumers buying goods or services has reduced, wages are vulnerable to falling, and economic productivity tumbles with it. This can lead to companies going out of business altogether.

It’s almost like a staring contest, where companies and consumers are waiting to see who blinks first. Businesses keep cutting their prices in an attempt to woo customers, but the public is holding out because they expect prices to fall. Ultimately, there’s a risk it could all become a race to the bottom.

This goes back to the Austrian School of Economics’ perspective that people would still need to spend money for essentials. It also believes that, as long as a currency or economy isn’t built on foundations of debt, the levels of deflation would stabilize to prevent such a death spiral.

In a way, this leaves cryptocurrencies at an impasse. How can it be transacted in order to gain momentum and attract mainstream adoption without missing out on the fact that their assets could be worth more in the future? Some advocates, like this Medium blogger, argue that the best way to remedy this is to make purchases using crypto — and then instantly buy more of it using fiat. If small things like coffee and lunch are bought using crypto, it can help demonstrate its utility and boost demand, with more merchants accepting it as a method of payment.

How do deflationary, fixed-supply assets affect consumer behavior?

When done right, it can reduce consumption — in a good way.

Many economies around the world are driven by the principle that it’s better to spend money now before it devalues in the future because of inflation. Debts — in the form of loans and credit cards — are rampant, and this applies at a government level too.

Deflationary assets encourage consumers to spend their money wisely so they can see their remaining funds appreciate in the future. But as Jorg Guido Hulsmann from the Austrian School of Economics points out, this doesn’t necessarily mean that crypto holders wouldn’t end up spending anything at all. Consumers would still spend money on essentials — food, fuel and mortgage payments — fully acknowledging that it could be cheaper in the coming years, as urgency is a factor.

Also, in an economy with a deflationary currency, there would still be times where you want to treat yourself — going to a bar, having a nice meal out or going to the cinema. Hulsmann argues that such crypto assets don’t have to be the death knell for consumer spending altogether, but it would make someone think twice before buying something they don’t really need.

It could also change the public’s relationship with debt — and make them more reluctant to borrow money for flashy cars and big televisions when they know that their payments would be increasing in value with every monthly repayment that passes.

So, Bitcoin may be deflationary. Isn’t deflation a bad word?

Not necessarily — this can help the cryptocurrency remain valuable.

Deflation relates to a decrease in the price you pay for goods and services. It’s the opposite of inflation — a term you’ve probably heard of if you’ve ever wondered why prices keep rising in supermarkets. Although it is considered a bad thing in the traditional economy, it isn’t necessarily a bad thing in the crypto world.

Inflation is a problem because that $1,000 you store in a safe for a decade could end up buying you a lot less. Just look at the United States Inflation Calculator, which shows that a $1 item in 1913 would cost $25.43 today.

As Blockonomi’s Brian Curran explains, inflationary markets also lead to “rampant debt levels” and push economies to live beyond their means. It can also end up going to extremes — and in Zimbabwe, inflation rates soared from 59 percent in 2000 to 80,000,000,000 percent (yes, 80 billion) in 2008. This is hyperinflation, and it renders currencies unusable. Venezuela, a country suffering from extensive political instability, has become one of the world’s biggest crypto markets because of hyperinflation, with one trader saying: “Even though Bitcoin is volatile, it’s still safer than the national currency.”

Cryptocurrencies such as Bitcoin are finite — with some economists comparing them to “digital gold” as a result. As output rises, the prices of goods are going to fall, but crypto as a store of value could rise simultaneously. Advocates of deflation argue that this is far more stable than what we see in the global economy today.

Ethereum doesn’t have an overall cap, and instead, new crypto is injected into its ecosystem every year. Although this makes it inflationary, inflation rates are decreasing as more ETH enters circulation.

Are cryptocurrencies with fixed supplies a good thing or a bad thing?

This is a hot topic for debate, and crypto companies have taken different approaches when creating their own assets.

The world’s biggest cryptocurrency, Bitcoin, has a fixed supply of 21 million — and last April, it was confirmed that 80 percent of this total had already been mined. Although newly minted Bitcoins aren’t going to be around forever, as the number available is going to decrease over time, there’s still a long way to go before they will all enter circulation. In fact, as things stand, the supply of new coins won’t be fully exhausted until 2140.

Those in favor of fixed supplies, as seen in Bitcoin, say that this creates digital scarcity. Lower supply can mean higher demand, thereby increasing prices. They also say that this sets crypto aside from the global financial system, in which central banks can effectively print more money through a strategy known as quantitative easing, which can lead to inflation and mean the dollar in your pocket isn’t worth as much as it used to be.

But in terms of cryptocurrencies achieving mainstream adoption, some opponents argue that fixed supplies actually stop people from spending, meaning that digital assets are speculative investments that people hoard. As this Bloomberg article argues, depreciation is impossible when an asset is finite, and this creates the risk of crypto owners waiting to get their goods cheaper. When it comes to conventional currencies, inflation is something that disincentivizes consumers from holding onto their cash — the longer it’s in their wallet, the less purchasing power it has.

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What Would Happen to Crypto In a Global Market Meltdown?

Michael J. Casey is the chairman of CoinDesk’s advisory board and a senior advisor for blockchain research at MIT’s Digital Currency Initiative.

The following article originally appeared in CoinDesk Weekly, a custom-curated newsletter delivered every Sunday exclusively to our subscribers.


A common thought experiment in the crypto community is to ponder how cryptocurrencies would fare in the event of another global financial meltdown.

It is not an idle question. There is a host of troubling developments in the global economy: the threat of a trade war, jitters in Italian debt markets, problems at Deutsche Bank and new emerging market crises in Turkey and Argentina.

Meanwhile, central banks, led by the U.S. Federal Reserve, are tightening or signaling tighter monetary policy. That’s putting a brake on the huge gains that low interest rates and quantitative easing had bestowed on global markets in the eight years since the end of the last crisis.

With this combination of risk factors already in play, there’s always a chance that some unforeseen trigger could set off another terrified rush for the exits among global investors.

What would the impact be on bitcoin and other cryptocurrencies? Would their reputation as independent assets see them benefit from safe-haven inflows? Or would the market-wide reduction in risk appetite spread wide enough that crypto assets get caught up in the selloff?

Opposing scenarios

Some crypto hodlers salivate at the idea of market panic.

They contend that, unlike the 2008-2009 collapse, when Satoshi Nakamoto’s newly launched cryptocurrency was essentially out of sight and unavailable to the hordes seeking a haven from the fiat world’s chaos, bitcoin is now widely recognized as a more versatile alternative to traditional flight-to-safety assets such as gold.

In a crisis, they say, bitcoin could shine – as might other cryptocurrencies designed as alternatives to fiat cash such as monero and zcash. Unaffected by future monetary policy responses, immune from draconian interventions such as the Cypriot bank deposit freeze of 2013, and easily acquired, they could prove their value as digital havens for the digital age in such a moment. Accordingly, the bulls’ argument goes, their prices would surge.

On the other hand, if there’s enough of a market-wide departure from risky investments, it’s hard not to see this sector being swept up in it.

Just as the most extreme gains in crypto prices in the latter part of 2017 were inextricably linked to the rapid “risk on” uptrend seen in stocks, commodities and emerging-market assets, so too a major selloff could easily infect these new markets.

Cryptocurrencies and tokens are perceived by most ordinary investors as high-risk assets – you buy them with money you can afford to lose when you’re feeling upbeat about market prospects. When the mood sours, this class of investment is typically the first to be retrenched as investors scramble to get cash.

At $300 billion, according to Coinmarketcap’s undoubtedly inflated estimates, the market cap of the overall crypto token market is more than three times its value of a year ago (even though it’s down more than half from its peak in early January).

But it’s less than 1 percent of the end-2017 market cap of $54.8 trillion for the S&P Global Broad Market Index, which includes most stocks from 48 countries. If risk-hungry investors are panicking and looking for things to dump – or for that matter if they’re looking for something safe to buy – it won’t take much of their funds to move the crypto markets, one way or another.

Low correlations

Backing the bitcoin bulls’ argument is the fact that correlations between cryptocurrency and mainstream risk assets – the degree to which prices move in tandem with each other – are quite low.

A 90-day correlation matrix compiled by analytics firm Sifr put bitcoin’s correlation with the S&P 500 index of U.S. equities at minus-0.14. That’s a statistically neutral position since 1 represents a perfect positive correlation while -1 is a perfectly negative relationship.

But they say that in a crisis “all correlations go to 1.” The panicked state of the crowd, with investors selling whatever they can offload to cover debts and margin calls, means that everything could go out with the flood.

Intellectually, too, that sort of wholesale downturn would comfortably stand as a logical counterpoint to the conditions seen last year when market valuations reached excessive levels. We cannot separate the flood of money that flew into crypto at the end of the year from the fact that eight years of quantitative easing had driven a “hunt for yield” in once-obscure markets as the return shrank on now pricey mainstream investments such as corporate bonds.

With bond funds paying little more than, say, 2 percent for years, bitcoin looked attractive to mainstream investors. When that artificially-stoked liquidity disappears, the reverse could happen.

Despite all of this, I do believe a global financial crisis could be an important testing moment for crypto assets.

Perhaps there’ll be a two-phase effect. In the immediate aftermath of the panic, there would be a selloff as every market is hit by the liquidity squeeze.

But after things settle, one can imagine that the narrative around bitcoin’s uncorrelated returns and its status as a hedge against government and banking risk would gain more attention.

Just like the mid-2013 surge in bitcoin that accompanied the Cypriot crisis’ lesson that “they can come for your bank account but not for your private keys,” so too a wider financial crunch could spur conversation around bitcoin’s immutable, decentralized qualities and help build the case for buying it.

The wider point here is that, whether it’s as an aligned element that rises and falls in sync with the broader marketplace or as a contrasting alternative to it, cryptocurrencies can’t be viewed in isolation from the rest of the world.

Image via Shutterstock

The leader in blockchain news, CoinDesk is a media outlet that strives for the highest journalistic standards and abides by a strict set of editorial policies. CoinDesk is an independent operating subsidiary of Digital Currency Group, which invests in cryptocurrencies and blockchain startups.

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How To Diversify Away Risk In A Crypto Portfolio: Correlation And Variance

Disclaimer: This article does not contain investment advice or recommendations. Every investment and trading move involves risk, you should conduct your own research when making a decision.

Observations of the crypto market give impression that “when Bitcoin sneezes, the cryptocurrency market catches a cold”, – in traditional stock markets this would not be the case. Although there are public companies whose stock movements have strong correlations due to those doing similar work in the same industry – oil companies, for example – investors are still capable of diversifying away risk in an equally weighted portfolio by adding stocks with negative correlations to the portfolio.

Technically, diversifying away risk in a crypto-only portfolio could be difficult. Creating a two-asset portfolio with highly correlated stocks gives an investor a greater risk of losing more wealth. When two assets have a strong correlation coefficient they tend to move in the same direction. If  two assets in the same portfolio move in the same direction then your gains in wealth will be greater and your losses more severe. That could be the reason why investors try to create portfolios with negatively correlated stocks.

If one asset is declining in a portfolio consisting of two assets that are negatively correlated, then the other asset in the portfolio should be increasing. This should in effect diminish the maximum amount of wealth that can be lost in a portfolio.

Just from checking out the digital asset prices on a cryptocurrency exchange, one can see that they are highly correlated with one another.  If Bitcoin is in the red for the day, nearly every cryptocurrency on the homepage will be in the red, if Bitcoin is in the green, – so would be the others. That is why people say that “even the most unseaworthy boats will float when the tide rises”.  

Correlation of cryptocurrencies

Economic researcher Vasily Sumanov told Cointelegraph the cryptocurrency market is highly correlated because most altcoins are bonded to Bitcoin:

“The market is very small [market cap] and has low-liquidity, a majority of the trade volume is provided by algorithmic traders using bots. There are only a few exchanges who actually establish prices but prices at these exchanges are connected to arbitrage bots also. All digital assets are really bonded to the BTC market – besides stable coins like USDT – so every change in the market is immediately mimicked by other assets.

When BTC/USD is falling, all digital assets/USD are falling because the price of a majority of digital assets is being calculated via the USD/BTC price.  For example, when BTC is falling, traders could sell altcoins for BTC. Afterward they could immediately sell Bitcoin, and receive dollars and then buy back their BTC at a lower price. Then they could buy cheap altcoins with their Bitcoin.”

It could be well illustrated by this winter fall of the crypto market. Here is what it looked like, for example, on Feb. 2, 2018. While Bitcoin lost 15%, Ripple lost 30% –  XRP could have become cheaper due to the algorithm used by a majority of traders.

Image source: Coinmarketcap

In a correlation matrix created from the yearly returns of Bitcoin (BTC), Ethereum (ETH), Litecoin (LTC), and Ripple (XRP), there are seven out of ten digital asset pairs that are perfectly correlated; BTC-BTC, BTC-ETH, ETH-ETH, ETH-LTC, ETH-XRP, LTC-LTC, and XRP-XRP. The three other pairs still show strong correlation – anywhere between .7 and 1: BTC-LTC is correlated at  .934, BTC-XRP at .729, and LTC-XRP at .892.

BTC, ETH, LTC, XRP - MATRICES

Trading systems technology and operations consultant Tony Karim shared with Cointelegraph his opinion that digital assets are highly correlated due to investor sentiments and systematic risks:

“Mainstream crypto assets (not so much with newer altcoins) are closely correlated in their volatility due to the same catchment of underlying investors who are almost exclusively sentiment driven with similar trading motives without reviewing any of the drivers and flow of this market.”

“The recent devaluation has been due to fundamental activities and pressure be it regulators, thefts from exchanges and individuals, and other negative publicity. Therefore, when one crypto asset is impacted, this propagates to completely different cryptos using totally different technology on a bear or bull trend on the mainstream assets by market volume. Another fact is liquidity is in the hands of a few and based on the total number of crypto assets actively trading daily vs the number in circulation. There isn’t the same sense of liquidity that is present in other markets.”

If crypto-assets fall victim to high correlation coefficients, would it be possible to diversify away risk in an equally weighted cryptocurrency portfolio by adding more crypto-assets?  To answer this question we will analyse the expected returns and standard deviations (SD) from a series of portfolios constructed from Bitcoin, Ether, Litecoin, and Ripple.  All the data analyzed consists of yearly prices taken on Oct. 5, as the first day for the earliest year available.

Single asset portfolios

PRICES, VARIANCE AND STANDARD DEVIATION

Bitcoin

Bitcoin’s blockchain was launched on Jan. 3, 2009. Based on the yearly returns from 2010 to 2017, with a portfolio that consists of only Bitcoin, you can expect a 194.2 percent return on average. The standard deviation – the amount you can expect the returns to deviate from the average – associated with holding a portfolio of only Bitcoin is 168.8 percent. This means that the returns you can expect from Bitcoin could deviate 168.8 percent above or below the average return.

Ethereum

Ethereum was released on July 30, 2015 as a blockchain network that allows companies to create applications, contracts, or systems via programming on the Ethereum network. The data for Bitcoin and Ethereum in this article was pulled from 99Bitcoins.

If you hold a portfolio that consists of only Ethereum, you can expect a 307.29 percent return based on Ether’s yearly return data from 2015 to 2017. The standard deviation of an Ethereum only portfolio is 6.06 percent. This means that one can expect the yearly returns of Ethereum to be rather reliable and not stray too far from the average return of 307.29 percent. That being said, Ethereum has only existed for 3 years.  

Litecoin

Litecoin was released on Oct. 7, 2011, created from a fork in the Bitcoin Core blockchain. For that reason, Litecoin is very similar to Bitcoin, and that may be why Litecoin does not have its own white paper. Litecoin aims to solve some of the problems associated with Bitcoin such as network efficiency and transaction verification speed. The data for Litecoin in this article was pulled from Bitinfocharts.

Based on the yearly returns of Litecoin from 2013 to 2017, if you hold a Litecoin-only portfolio, you can expect a return of 136.1 percent with a standard deviation of about 163.6 percent.

Ripple

Ripple was released in 2012 as a cryptocurrency and global remittance service for banks to make nearly instantaneous cross border payments for an amount lower than traditional transaction fees. The data for Ripple in this article was pulled from Coinmarketcap.

Based on the yearly returns from 2014 to 2017, with a portfolio that only consists of Ripple, you can expect a 80.3 percent return on investment. A Ripple-only portfolio has a standard deviation of about 182.5 percent.

Two asset portfolio

In a two asset portfolio the expected returns will increase in respect to every single-asset portfolio except when comparing the Litecoin-only portfolio to the LTC-XRP portfolio, the Bitcoin-only portfolio to the BTC-LTC and BTC-XRP pairs, and the Ethereum-only portfolio to the ETH-LTC, ETH-XRP, and ETH-BTC pair.

TWO ASSET EQUALLY WEIGHTED PORTFOLIO

The expected return is the average of the returns from previous years. Because Bitcoin and Ethereum have relatively high expected returns in their single-asset portfolios, when you add either XRP or LTC to the Bitcoin or Ethereum-only portfolios, the lower expected return values of LTC and XRP drag down the overall expected return of the portfolio. For example: 2>1, 1+2=3, 3/2 = 1.5, 1.5 < 2.  

That is why the expected returns are lower for every two asset portfolio containing BTC, besides the BTC-ETH pair. In the BTC-ETH portfolio, Ethereum’s average return is higher than Bitcoin’s average return; so when the portfolio’s expected return is averaged, the expected return for the two-asset portfolio is higher than the expected return for the BTC-only portfolio – for example  2 >1, 1+2 =3, 3/2 =1.5, 1.5>1.

The standard deviation associated with a portfolio consisting of two assets is lower than the SD of every single asset portfolio (except when comparing the Ethereum-only portfolio to every other one containing Ethereum or the Litecoin-only portfolio to the LTC-XRP one).

The standard deviation of Ethereum is so low (6.05 percent) that when another asset is added to an Ether-only portfolio, the higher SD of the other asset raises that of the entire portfolio to a level higher than that of an Ethereum-only portfolio.

In the LTC-XRP portfolio, the standard deviation of the portfolio is 4.77 percent higher than SD of a Litecoin-only portfolio (163.6 percent). For most investors, this may be nothing to sneeze at, but it all depends on the level of risk that an investor is able to tolerate.

Three asset portfolio

In a three-asset crypto portfolio, the expected returns increase in comparison to every-two asset portfolio.

The standard deviation associated with holding a three-asset crypto portfolio will increase in comparison to every two-asset portfolio except those with LTC-XRP, BTC-XRP, and BTC-LTC, their SD will decrease when you add a third crypto-asset to the portfolio.

THREE ASSET EQUALLY WEIGHTED PORTFOLIO

Four asset portfolio

In an equally weighted crypto portfolio that consists of BTC, ETH, LTC, and XRP the expected returns would decrease compared to those of every three-asset portfolio. The maximum decrease in expected return is 232.225 percent and comes from the portfolio that adds Bitcoin to the  ETH, LTC, XRP portfolio, and the minimum decrease in expected return is 119.159 percent and comes from the portfolio that adds ETH to the BTC, LTC, XRP portfolio.

The standard deviation would increase in respect to three out of the four three-asset portfolios, with the only decrease in the SD being in reference to the BTC, LTC, XRP portfolio by 4.91 percent.

FOUR ASSET EQUALLY WEIGHTED PORTFOLIO

So how to diversify away risk in crypto portfolios?

Although digital assets are highly correlated, it is possible to diversify away risk in a crypto-only portfolio by adding more crypto assets to the portfolio. It is possible to diminish standard deviation when you move from a single-asset portfolio to a two-asset portfolio in 3 out of the 6 possible two-asset portfolios; from a two-asset portfolio to a three-asset portfolio – in respect to 3 out of 6 two-asset portfolios, and in a four-asset portfolio – in respect to 1 of the 4 three-asset portfolios.

The reason you are able to diversify away risk in a crypto-only portfolio even though the crypto-assets are highly correlated could be because there are different types of risk, as Sumanov said to Cointelegraph.

“Diversification in a crypto-only portfolio can help with the following:

  1. Single asset risks. Risks of project failing, delisting from exchanges, ban from government, problems with team etc. Huge dump due to a major holder deciding to sell all his holdings one day and many other risks, that are connected  with holding only a single asset. For example, TenX token (ticker PAY) declined a lot in price after Wirex Company declined their contract for cryptocurrency card issuing due to EU regulator.
  2. Connection of portfolio value to average industry growing. If you invest in just single or few assets, it is like playing the lottery. Your assets can perform differently – one could grow fast, and another could just make +10 percent  and that is all. So, portfolio diversification gives you the opportunity to receive profit from the whole market growing and not depend just on having faith in one coin.
  3. You can make different portfolios (for example high-risk, average, low risk) and receive profit that will be “averaged” on risk type.”

Even though digital assets are highly correlated, it is possible to mitigate the amount of risk you are exposed to by investing in multiple crypto assets instead of only one crypto-asset. This is reminiscent of the old adage “you should not put all your eggs in one basket”. By investing in multiple crypto-assets it is possible to spread out the amount of risk you are exposed to instead of having all of the volatility of the portfolio come from one asset. By spreading the risk over several assets, it could be also possible to increase the expected returns of a portfolio while diminishing the amount of standard deviation of the portfolio.

RETURNS OF BTC, ETH, LTC, XRP

When comparing all six two-asset portfolios to the four single asset portfolios, it is possible to increase expected returns in respect to at least one of the single-asset portfolio. Comparing the three-asset portfolios to the two asset portfolios, it is possible to increase expected returns in all four three-asset portfolios, and when comparing a four-asset portfolio to the three-asset portfolios, it seems not possible to increase expected returns in comparison to the three-asset portfolios.

The analysis shows that spreading wealth over a number of assets, instead of putting all into one, could diversify away the idiosyncratic risk that is unique to a particular digital asset, and the more risk one is able to diversify away, the better situated he could be to protect himself against losses in the cryptocurrency portfolio.

The views expressed here are the author’s own and do not necessarily represent the views of Cointelegraph.com

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Lightning Network May Not Solve Bitcoin's Scaling 'Trilemma'

Frances Coppola spent many years working in banks and IT, and now writes and speaks about finance, banking and economics.


Bitcoin has proven incapable of accommodating growing demand without deviating considerably from Satoshi Nakamoto’s original vision of a “peer-to-peer electronic cash system.”

It was intended to provide a fast, secure and inexpensive means of making payments without using the traditional financial system. Today it still only manages a tiny proportion of the traffic of, say, Visa or Mastercard, yet has become cripplingly slow and very expensive.

Solving bitcoin’s scaling problem has become a principal concern of developers. But the problem has proved intractable.

Now, making a virtue out of necessity, the buzz is that bitcoin is “digital gold.” Its built-in limit of 21 million bitcoins makes it an ideal anchor for a hard-money financial system similar to a strict gold standard. A new payment system could be built on top of it.

The problem is, it isn’t possible to have full decentralization, a fixed money supply and sufficient liquidity for an efficient payments system. This is bitcoin’s “trilemma.”

Immobile money

In the gold standards of old, there was no trilemma. They were always centralized.

For example, the “classical” gold standard of the 19th century was the heyday of the British Empire, which at that time covered a third of the globe. The pound was the currency of international trade, and it was backed by gold.

Countries in the empire were forced on to the gold standard by the British government; countries outside the empire joined the gold standard, or even adopted the pound as their currency, because it made trade much easier.

In the center of the web, the Bank of England managed both the price of gold and pound issuance. It was the most centralized financial system since the Roman Empire.

But for bitcoin, the fact that it is designed as a decentralized system means something else has to give. And the clue is its rapidly rising price.

Bitcoin is becoming illiquid.

Bitcoin’s growing illiquidity is due to a toxic combination of high demand, hoarding and designed-in scarcity. The rapid price rise indicates that purchases have increased much more than sales. More and more people are buying bitcoin in the hopes of cashing in as the price rises, while those who already own bitcoins are Holding On for Dear Life for the same reason.

People are also reluctant to spend their bitcoins, because that rapidly rising price means that they face huge opportunity costs.

And although bitcoins are still being mined, the rate at which they are mined is nowhere near enough to meet demand – and anyway, miners too can HODL their bitcoins.

Meanwhile, rising transaction volumes are causing network congestion. Bitcoin has no means of adjusting capacity other than rationing verification. Miners verify transactions with higher fees more quickly than those with lower fees. Those who want fast verification (which is nearly everyone, since bitcoin’s price is rising so fast) will pay higher fees. Those who don’t want to pay higher fees must wait longer for their transactions to settle.

Bitcoin’s popularity therefore means both higher transaction fees and slower settlement times. The design feature intended to prevent it coming to a hyperinflationary end is driving it towards deflationary gridlock. As Business Insider asked, what on earth is the point of money that you can’t spend and can’t convert to anything else?

But is there a way round this problem? The clever folks working on the Lightning Network think so. Their solution is to take most transactions off-chain, and to share liquidity across the network.

Supply shortfall

Lightning is a decentralized network of pre-funded, bilateral bitcoin payment channels off the bitcoin blockchain. Lighting transactions are typically small, and most are not broadcast to the blockchain. So they should be much faster and cheaper than on-chain bitcoin transactions.

Assuming enough people open Lightning payment channels, there will eventually be a sizable bitcoin liquidity pool distributed across the network. The question is, how to enable it to be shared.

Lightning developers are designing a routing facility that identifies which network nodes have sufficient funds to make a payment, calculates the shortest viable route to the payment destination across those nodes, and sends the payment. If this works, it would resolve the bitcoin trilemma.

But it is not certain that it will work. There are two potential problems.

The first is that Lightning’s pre-funded channels tie up funds that could be used for other purposes. Because of this, people may choose to keep very low balances in their Lightning channels, topping them up frequently rather than making infrequent balance adjustments.

And the second is that channel funding changes constantly. Typically, people would fund their channel, then pay the balance down gradually. Soon after funding, there could be quite a large balance, but only a few days later, the balance might have diminished considerably.

If a lot of people fund their channels at around the same time – for example, if people fund their channels on payday, then pay them down over the next month – liquidity across the network could vary considerably. This would mean that, at times, particularly for larger payments, it could be difficult or even impossible to find a payment route.

As it stands, therefore, Lightning could prove as illiquid as bitcoin.

Lightning’s illiquidity problem could be solved by creating large payment channels kept open and fully funded at all times, so that they were always available for payment routing. But this would mean Lightning was not fully decentralized.

Such “hub” channels would be more efficient for payments, but they would be a magnet for thieves and a point of weakness in the network. If one went down, an awful lot of payments could be disrupted.

The alternative would be to allow channels temporarily to go into deficit as a payment passes through. This would ensure that payments always settled.

But since it is effectively fractional reserve lending, it would breach the “gold standard” principle of bitcoin. If gold is needed to settle payments, and you haven’t got enough gold, you can’t settle payments. That’s how a gold standard works. It is also why it fails.

Lightning is still a work in progress, of course. But at present, it is hard to see how it can resolve bitcoin’s three-pronged problem.

Neptune and trident image via Shutterstock

The leader in blockchain news, CoinDesk strives to offer an open platform for dialogue and discussion on all things blockchain by encouraging contributed articles. As such, the opinions expressed in this article are the author’s own and do not necessarily reflect the view of CoinDesk.

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Why Bitcoin Needs Fiat (And This Won't Change in 2018)

Tim Swanson is the director of research at Post Oak Labs, a U.S.-based technology advisory firm, and the former director of research at distributed ledger technology consortium R3. 

The following article is an exclusive contribution to CoinDesk’s 2017 in Review series.



Imagine a parallel universe in which the U.S. economy could only grow at $50 every 10 minutes generating a mere $2.6 million of output per annum. That due to a hard-coded economic planning computer program, every four years the income its inhabitants collectively generated divided in half. Such that in year nine, its output shrank and was $12.50 every 10 minutes or $657,000 a year.

That is to say, irrespective of how productive and skilled the labor force became or how large the labor force grew, the productive output in the U.S remained fixed and static with the only change (downward in this case) occurring just once every four years.

How many people would volunteer to live and work in that “Upside Down” world?

This situation effectively mirrors the static, internal economy of bitcoin and many other cryptocurrencies.

For instance, with proof-of-work networks like bitcoin, the marginal productivity of labor is zero. It does not matter how many more units of labor are added to the income generation (mining) process as the network will always produce the same amount of economic output.

Today, after nearly nine years of operation, the bitcoin network – better referred to as Bitcoinland – generates 12.5 bitcoins roughly every 10 minutes. Irrespective of external economic conditions, of demand, the Bitcoinland economy will generate about 657,000 bitcoins per year in its third epoch.

While comparisons with aggregate measurements like GDP and money supplies may be an imperfect analogy, the fact that economic expansion as measured in output can – with the exception of a fork and rule change – never change in bitcoin due to its inelastic coin supply is arguably detrimental to its unit of account.

The purposefully planned sameness is often extolled as a “feature not a bug,” and many cryptocurrency enthusiasts like to daydream for when regulators and financial institutions of our own world disappear, eaten up by grey goo nanites funded by bitcoins.

But before bitcoiners can reach their Upside Down nirvana state, they need to resolve the underlying omnipresent economic calculation challenge facing their security system and labor force.

The phenomenon is simple to describe: virtually no participant in Bitcoinland conducts economic calculations (such as pricing) for any goods or services in cryptocurrencies such as bitcoin.  There are many reasons for this, including chronic volatility.

Courtesy of J.P. Koning

Or increasingly high ($10+) transaction fees that result in hemorrhaging of merchants (even their very own Cobra Commander acknowledges this issue).

But for this article, let’s put aside the typical discussion of payments and merchants and instead focus on labor.

Labor force

If Bitcoinland is viewed as its own sovereign (virtual) nation-state, the only wages any native participant receives in return for any kind of service rendered is what miners are paid to solve and “vote” on a benign problem about once every 10 minutes.

From the perspective of the network: developers, maintainers, administrators, enthusiasts, Twitter sock puppets, meme artisans, flame war veterans, self-appointed thought leaders, pumpers, hat wearers, etc., are all viewed as foreign third parties and can only receive bitcoins after they are first minted by the miners.

Much like multinational corporations (MNC) with large overseas operations, miners of cryptocurrency networks as a whole do not measure the income they receive in terms of bitcoins (or other discrete cryptocurrencies), but instead they measure their income in terms of “fiat” from foreign financial markets, specifically converting bitcoins into the local fiat currency where their mining operation physically resides.

However, unlike MNCs that eventually repatriate some or all of their capital back to their headquarters, aside from a recycling of coins into ICOs, most cryptocurrency-focused companies are still dependent on what amounts to foreign domestic income (FDI), regular injections of foreign capital from venture firms in order to grow or even measure enterprise valuations.

Miners do this because the unit of account for fiat currency is typically stable and liquid, such that they can pay wages to their employees, pay rent, electrical costs, property taxes, etc. There are exceptions to stability, such as planned economies of Venezuela and Zimbabwe which have suffered from years of political chaos, but in general, most developed countries and even developing countries have relatively stable domestic currencies relative to Bitcoinland.

And because bitcoin is still not used as a unit of account, its labor force (miners), rely on a third-party reference data in order to conduct all economic calculations.  That is to say, in order for Bob the miner to accurately calculate if he should increase or decrease consumption (and investment) of capital, or to measure whether his mining operation is profitable, Bob projects future revenue based on a unit of account that is stable, in this case, currency from foreign capital markets.

During the Cold War there was a joke in academia: that the Soviet Union would conquer the world with the exception of New Zealand (other versions used Switzerland as the cut-out). New Zealand would be left alone because the Politburo needed a functioning market so that the Soviets could know what the market prices were for goods and services.

While Bitcoinland may be attracting large sums of foreign capital, miners continually still need very liquid over-the-counter (OTC) and spot exchanges denominated in foreign currencies because it is with these foreign currencies that they pay their bills.

In this case, despite their own defects and problems, the U.S., eurozone, Japan, South Korea, China and several other countries effectively stand in for “New Zealand,” such that the national currencies and prices in these countries reflect dynamic economic conditions that bitcoin miners can use as reference rates in their capital consumption projections.

Final remarks

In 2018, just as the past nine years, miners will still depend on foreign financial markets for both stable pricing and liquidity. If the existing traditional financial markets became chaotic and unstable, miners would be unable to rationally plan and allocate for future investments.

For instance, the unseen costs of hash generation for a hypothetically stable $20,000 bitcoin would be about $13 billion in capital consumed by miners in their rent-seeking race.

And that is just one proof-of-work coin. If there were dramatic bouts of volatility, or even an extended bear market, this could result in bankruptcies like CoinTerra, HashFast or KnC previously went through, though that is beyond the speculation of this article.

Ironically, despite all the bluster, because cryptocurrency ecosystems lack a circular flow of income, they will still be dependent on the very financial system they vilify for daily support and stability.

And while there have been many “stablecoin” projects announced and launched over the past year, nearly all of them are not only dependent on commercial bank accounts, but also on the economic stability of a specific economic region they aim to serve. Guess what set of entities provides that type of relative stability?

Ideological enthusiasts will likely resort to whataboutisms and respond by bitcoinsplaining: how dirty filthy statists will censor your virtuous darknet market transactions and that maintaining proof-of-work networks is worth any cost to the environment! But again, that is for a snarky article on a different day.

Empirically with proof-of-work-based blockchains, the labor force and the liquidity providers all still depend on functional, mature foreign capital markets in order to convert their coins into real money. Perhaps this will change as more hedging products, courtesy again of foreign financial markets, are brought online.

While the traditional financial markets will continue to exist and grow without having to rely on cryptocurrencies for rationally pricing domestic economic activity, in 2018, as in years prior, Bitcoinland is still fully dependent on the stability of foreign economies providing liquidity and pricing data to the endogenous labor force of bitcoin.

Too much macroeconomics for you? CoinDesk is accepting submissions for its 2017 in Review series. Email news@coindesk.com to tell us your thoughts on the year ahead.

Upside Down world image via “Stranger Things” Facebook page.

The leader in blockchain news, CoinDesk strives to offer an open platform for dialogue and discussion on all things blockchain by encouraging contributed articles. As such, the opinions expressed in this article are the author’s own and do not necessarily reflect the view of CoinDesk.

For more details on how you can submit an opinion or analysis article, view our Editorial Collaboration Guide or email news@coindesk.com.

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'Wealth Effect' From Bitcoin Trading Could Boost Japan's GDP, Say Analysts

Analysts from Japanese financial holdings company Nomura have estimated that the rise in the value of bitcoin could boost Japan’s economic growth.

Analysts Yoshiyuki Suimon and Kazuki Miyamoto said on Friday that the “wealth effect” arising from the massive gains in the price of bitcoin could increase the country’s GDP by 0.3 percent, a Bloomberg report says.

According to the researchers’ prediction, gains from bitcoin trading by Japanese investors could see consumer spending increase in the range of 23.2 billion–96 billion Japanese yen ($206.5 million–$854.4 million).

A report published Friday by Yoshiyuki Suimon’s team noted:

“Moreover, the fact that the rise in bitcoin prices was concentrated in 2017 Q4 could result in the wealth effect materializing in 2018 Q1, and if that is the case, we estimate a potential boost to real GDP growth on an annualized quarter-on-quarter basis of up to about 0.3 percentage points.”

Describing the “wealth effect” as the increase in consumer spending resulting from a rise in asset values, the team further stated, “Although Japanese investors’ unrealized gains are unlikely to feed straight through to their patterns of consumption, it is common knowledge that personal consumption is bolstered as a result of increases in the value of asset holdings.”

According to a CNBC report, the Nomura team also acknowledged a statement from the governor of Bank of Japan, Haruhiko Kuroda, who said in late December that speculation has led to the rise in bitcoin price.

Nomura building image via Shutterstock

The leader in blockchain news, CoinDesk is an independent media outlet that strives for the highest journalistic standards and abides by a strict set of editorial policies. Have breaking news or a story tip to send to our journalists? Contact us at news@coindesk.com.

Disclaimer: This article should not be taken as, and is not intended to provide, investment advice. Please conduct your own thorough research before investing in any cryptocurrency.

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Bitcoin No Threat to Financial Stability, Say European Economists

A group of European economists believe bitcoin is no threat to the financial stability, although regulatory oversight needs to be increased, new research shows.

In a survey published yesterday by the U.K.-based Center for Macroeconomics, 100 prominent European university economists were asked for their thoughts regarding the recent market growth of bitcoin and cryptocurrencies.

According to the results from the 50 respondents – in response to the question “Do you agree that cryptocurrencies are currently a threat to the stability of the financial system, or can be expected to become a threat in the next couple of years?” – nearly 50 percent of the respondents said they “disagree,” while another 25 percent “strongly disagree.”

Some economist argued that, even with a near-$300 billion market capitalization, bitcoin is still trivial compared to the overall financial market.

For example, Michael McMahon, professor in economics from the University of Oxford, was quoted as saying:

“Cryptocurrencies are still too small and lacking in widespread ownership, especially among large investment groups, to be a serious risk to the overall financial system.”

Similarly, Ethan Ilzetzki, assistant professor from the Economics Department Centre for Macroeconomics at London School of Economics, called bitcoin and other cryptocurrencies “a toy for a very narrow segment of investors.” Further, they are “detached” from the financial system and the “real economy,” he said.

While not recognizing bitcoin as a threat, a majority of the respondents still expressed concerns around the role of bitcoin and its challenge to traditional central bank-issued currencies. In fact, 61 percent of the interviewees either “agree” or “strongly agree” that regulatory oversight of cryptocurrencies needs to be increased.

For instance, Sylvester Eijffinger, professor of financial economics at Tilburg University, argued that cryptocurrencies are “undermining the monopoly of money creation by the central banks and [leading to] the ineffectiveness of conventional and unconventional monetary policy.”

However, as recently reported, the European Central Bank takes a somewhat different view on bitcoin. Addressing the European Parliament late in November, the president of the ECB, Mario Draghi, stated that digital currencies are “not yet something that could constitute a risk for central banks.”

Stacks of coins image via Shutterstock

The leader in blockchain news, CoinDesk is an independent media outlet that strives for the highest journalistic standards and abides by a strict set of editorial policies. Have breaking news or a story tip to send to our journalists? Contact us at news@coindesk.com.

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Nobel Winner Robert Shiller: Bitcoin Is Too 'Ambiguous' to Value

Nobel Prize-winning economist Robert Shiller believes there’s no clear way to put a price on bitcoin.

“I think the value of bitcoin is exceptionally ambiguous,” he told CNBC today.

The comment is perhaps notable in that it comes from a legendary economist who gained long-term credibility following his work around the 1987 stock market crash and the housing bubble in 2008. He received the Nobel Prize in Economics in October 2013.

Yet speaking to the network, Shiller argued that it’s difficult to peg the fundamental price of bitcoin, remarking:

“You just put an upper bound on [bitcoin] with the value of the world’s money supply. But that upper bound is awfully big. So it can be anywhere between 0 and there.”

That same sentiment was reflected in Shiller’s recent op-ed article for The New York Times, in which he wrote: “How can we even start estimating the fundamental value of bitcoin, with its astonishing market value of more than $275 billion? Any attempt will soon sound silly.”

Bitcoin’s price has surged in value since the beginning the year, climbing from $800 last January to a new record of almost $20,000 this weekend, according to CoinDesk’s Bitcoin Price Index.

Shiller cited a phenomenon that may explain the reasons behind such a phenomenal market rally. According to neuroscientists, he said, our brains work differently when making choices in a stressful, ambiguous environment.

“You might think people who are educated will transform the decision problem into something precise … But it doesn’t seem like the brain is doing that,” Shiller told CNBC.

Robert Shiller image via WEF/Wikipedia

The leader in blockchain news, CoinDesk is an independent media outlet that strives for the highest journalistic standards and abides by a strict set of editorial policies. Have breaking news or a story tip to send to our journalists? Contact us at news@coindesk.com.

Disclaimer: This article should not be taken as, and is not intended to provide, investment advice. Please conduct your own thorough research before investing in any cryptocurrency.