Can cryptocurrencies fulfill the functions of money?

This article summary is part of my personal background research work. The top part of each post had a detailed summary of the article. Scroll farther down the page for the article's broader implications for Bitcoin.

Article Summary

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Keywords

• Cryptocurrency monetary functions
• Bitcoin supply growth
• Ethereum monetary policy
• Ripple centralization
• Litecoin vs. Bitcoin
• Store of value in digital currencies
• Gold vs. cryptocurrency
• Credibility in cryptocurrency issuance
• Stability of digital currencies
• Comparative analysis of cryptocurrencies

Short summary

This paper by Saifedean Ammous evaluates whether cryptocurrencies can fulfill the traditional functions of money: medium of exchange, store of value, and unit of account. The analysis focuses on five cryptocurrencies—Bitcoin, Ethereum, Litecoin, Ripple, and Steem—chosen for their market capitalization and distinct monetary properties. While all cryptocurrencies can theoretically serve as a medium of exchange, the paper argues that they generally fail as units of account due to their inherent instability. Bitcoin is highlighted as the only cryptocurrency with potential as a store of value, owing to its fixed supply growth and robust network security.

The paper contrasts the monetary policies of these cryptocurrencies with those of national currencies and gold, emphasizing that Bitcoin’s low supply growth and strong commitment to its issuance schedule make it a more credible alternative to traditional forms of money. However, the paper also points out that without a central authority to stabilize its value, Bitcoin and other cryptocurrencies are unlikely to offer stability or broad adoption as units of account. The paper concludes that while cryptocurrencies have made strides in certain areas, they still have significant hurdles to overcome before being considered viable forms of money.

Issues (Threats and Opportunities)

• Bitcoin's Supply Growth: Bitcoin’s predictable and low supply growth positions it as a credible store of value, especially in comparison to other cryptocurrencies. However, its lack of stability in purchasing power limits its broader adoption. The stability and credibility of Bitcoin's supply make it a strong candidate for long-term value storage, a key function of money.
• Ethereum’s Unpredictable Monetary Policy: Ethereum's monetary policy is less predictable, with plans to transition to a Proof-of-Stake model that could alter its issuance rate. This unpredictability undermines its credibility as a store of value. The lack of a clear, credible commitment to a fixed issuance schedule weakens Ethereum's appeal as a monetary asset.
• Ripple’s Centralization: Ripple’s centralized control and large initial supply distribution raise concerns about its ability to function as a stable monetary unit, given the potential for large-scale manipulation by its creators. The centralization of control in Ripple makes it vulnerable to trust issues, which is critical for monetary assets.
• Litecoin’s Security and Processing Power: Litecoin, despite similar monetary policies to Bitcoin, lacks the processing power and security that make Bitcoin credible, making it less attractive as a store of value. Security and network robustness are crucial for maintaining confidence in a cryptocurrency's value.
• Steem’s Issuance Model: Steem’s high issuance rate and complex, incentivized structure favor early adopters at the expense of new entrants, reducing its attractiveness as a monetary asset. The skewed reward system and high inflation in Steem undermine its potential for widespread adoption.
• Cryptocurrency Volatility: The inherent volatility of cryptocurrency prices, driven by fluctuating demand and fixed supply, prevents them from functioning effectively as units of account. Stability in value is essential for any currency to be widely accepted as a unit of account.
• Comparative Analysis with Gold: Bitcoin’s supply growth rate is projected to be lower than gold’s by the mid-2020s, positioning it as a potentially superior store of value. The comparison to gold strengthens Bitcoin’s case as a digital alternative for wealth preservation.
• Lack of Centralized Monetary Authority: The absence of a central authority in cryptocurrencies, while ensuring fixed supply, leads to significant price instability, undermining their utility as stable monetary units. The trade-off between decentralization and stability is a significant challenge for cryptocurrencies.
• Market Demand vs. Supply Predictability: While Bitcoin’s supply is predictable, its market demand fluctuates, leading to price volatility and limiting its use as a stable currency. The gap between predictable supply and unpredictable demand complicates Bitcoin's role as a reliable currency.
• Role of Cryptocurrencies in the Financial System: Cryptocurrencies' potential to serve as money depends on their ability to fulfill all three monetary functions; however, their current instability limits their broader adoption. The broader acceptance of cryptocurrencies as money hinges on their ability to achieve stability in value.

Methodology

The paper employs a comparative analysis methodology, examining five major cryptocurrencies—Bitcoin, Ethereum, Litecoin, Ripple, and Steem—against traditional monetary standards. It assesses these cryptocurrencies based on their monetary policies, supply growth, and network security. The analysis contrasts the design and economic features of these digital currencies with national currencies and gold, focusing on the ability of each to serve as a medium of exchange, store of value, and unit of account. The credibility of the monetary issuance schedule, security of the network, and the role of central authority (or lack thereof) are key factors in the evaluation.

Results

The study finds that while all five cryptocurrencies can serve as a medium of exchange, their ability to fulfill the other two functions of money—store of value and unit of account—is limited. Bitcoin emerges as the strongest candidate for a store of value, primarily due to its fixed supply growth and strong network security. The supply of Bitcoin is highly predictable, and its growth rate is projected to fall below that of gold by the mid-2020s, making it a potential digital alternative to gold for wealth preservation.

However, the paper also highlights significant challenges for Bitcoin and other cryptocurrencies. The absence of a central authority leads to price volatility, as demand for these currencies fluctuates while supply remains fixed. This volatility undermines their utility as a stable unit of account. Furthermore, the centralization in Ripple and the unpredictable monetary policies in Ethereum and Steem weaken their credibility as monetary assets. Overall, while cryptocurrencies show promise, they have considerable hurdles to overcome before being considered viable forms of money.

Implications

The findings of this paper have several implications for stakeholders in the financial and cryptocurrency sectors. For policymakers, the study suggests that while cryptocurrencies like Bitcoin may have potential as digital stores of value, their volatility and lack of stability make them unsuitable as units of account. This instability could pose challenges for integrating cryptocurrencies into the broader financial system without the support of a central authority to stabilize their value.

For investors, the analysis highlights Bitcoin’s potential as a long-term store of value, particularly as its supply growth rate becomes more predictable and decreases below that of traditional safe-haven assets like gold. However, the volatility associated with cryptocurrencies remains a significant risk factor that could affect their adoption as mainstream monetary units.

For developers and the technology community, the paper underscores the importance of network security and credible monetary policies in establishing the long-term viability of cryptocurrencies. The centralization issues identified in Ripple and Ethereum suggest that decentralized networks with strong security features are more likely to gain trust and adoption in the future.

Research Questions

Bitcoin's Supply Growth:

• How does the predictability of Bitcoin’s supply growth influence its long-term adoption as a store of value?
• What mechanisms can be implemented to mitigate Bitcoin’s price volatility without compromising its decentralized nature?

Ethereum’s Unpredictable Monetary Policy:

• How will the transition from Proof-of-Work to Proof-of-Stake in Ethereum impact its long-term monetary stability?
• What are the potential effects of Ethereum’s unpredictable monetary issuance on investor confidence and market behavior?

Ripple’s Centralization:

• To what extent does Ripple’s centralization pose a risk to its adoption as a global financial settlement currency?
• How can Ripple’s governance structure be adjusted to enhance trust and decentralization within its network?

Litecoin’s Security and Processing Power:

• What improvements in security and processing power would make Litecoin a more competitive alternative to Bitcoin?
• How does the disparity in processing power between Bitcoin and Litecoin affect the latter’s credibility as a store of value?

Steem’s Issuance Model:

• How does Steem’s high issuance rate impact the long-term sustainability and attractiveness of the currency for new users?
• What alternative models of reward distribution could make Steem more appealing to both early and late adopters?

Cryptocurrency Volatility:

• What factors contribute most significantly to the volatility of cryptocurrency prices, and how can they be mitigated?
• How does cryptocurrency volatility impact their utility as units of account in both personal and business transactions?

Comparative Analysis with Gold:

• How does Bitcoin’s projected supply growth compare to that of gold over the next 25 years in terms of attractiveness as a store of value?
• What role could Bitcoin play in diversifying portfolios traditionally composed of gold and other precious metals?

Lack of Centralized Monetary Authority:

• What are the potential risks and benefits of operating a currency without a centralized monetary authority?How can decentralized cryptocurrencies achieve greater price stability without compromising their core principles?

Market Demand vs. Supply Predictability:

• How does the gap between predictable supply and unpredictable demand affect Bitcoin’s long-term viability as a currency?
• What strategies can be implemented to better align Bitcoin’s supply mechanisms with market demand fluctuations?

Role of Cryptocurrencies in the Financial System:

• What regulatory frameworks are necessary to integrate cryptocurrencies into the existing financial system while preserving their decentralized nature?
• How can cryptocurrencies evolve to fulfill all three traditional functions of money more effectively?

Five Key Research Needs

1. What factors contribute most significantly to the volatility of cryptocurrency prices, and how can they be mitigated? Volatility is a critical barrier to the adoption of cryptocurrencies as units of account and as a stable store of value. Understanding and mitigating the causes of this volatility would significantly enhance the usability and credibility of cryptocurrencies in the financial system.
2. How will the transition from Proof-of-Work to Proof-of-Stake in Ethereum impact its long-term monetary stability? Ethereum's shift to Proof-of-Stake represents a major change in its monetary policy, with potential implications for its stability, security, and credibility. This research is crucial for understanding the long-term effects of such transitions on cryptocurrencies.
3. How does the gap between predictable supply and unpredictable demand affect Bitcoin’s long-term viability as a currency? The disconnection between Bitcoin’s fixed supply and its fluctuating demand is a fundamental challenge that impacts its stability and adoption. Researching ways to better align supply mechanisms with demand fluctuations would enhance Bitcoin's effectiveness as a currency.
4. To what extent does Ripple’s centralization pose a risk to its adoption as a global financial settlement currency? Ripple’s centralized structure is a major concern for its credibility and adoption. Investigating how this centralization impacts trust and exploring potential decentralization strategies would provide valuable insights into improving Ripple's adoption.
5. How does Bitcoin’s projected supply growth compare to that of gold over the next 25 years in terms of attractiveness as a store of value? As Bitcoin’s supply growth rate approaches that of gold, it becomes increasingly relevant to understand how these two assets compare as stores of value. This research would help investors and policymakers assess the role of Bitcoin in wealth preservation and diversification strategies.

Potential Implications for Bitcoin

Bitcoin’s Role as a Store of Value

Bitcoin's fixed supply growth and decentralized nature make it a strong candidate for long-term wealth preservation, similar to gold. This predictability in supply, coupled with a robust and secure network, enhances Bitcoin's credibility as a store of value. As the supply growth rate decreases over time, it is expected that Bitcoin will attract more investors looking for a hedge against inflation and traditional currency devaluation. This could lead to increased adoption, particularly in regions experiencing economic instability or where access to traditional banking services is limited.

Impacts on Bitcoin Mining

The paper’s emphasis on Bitcoin's security, driven by its vast processing power, highlights the importance of continued investment in mining infrastructure. As the reward for mining Bitcoin decreases due to the halving events, the profitability of mining will increasingly depend on transaction fees and the efficiency of mining operations. This might lead to further consolidation in the mining industry, with only the most efficient miners able to sustain operations. Additionally, the shift in energy sources towards more sustainable practices could become a significant focus, given the increasing scrutiny on the environmental impact of Bitcoin mining.

Volatility and Adoption Challenges

While Bitcoin is well-positioned as a store of value, its volatility remains a significant barrier to broader adoption as a medium of exchange or unit of account. Businesses and consumers may be hesitant to adopt Bitcoin for everyday transactions due to the potential for rapid changes in value. This volatility could also impact its use in international trade, where stability is crucial for pricing goods and services. However, the increasing adoption of Bitcoin in financial products, such as futures contracts and exchange-traded funds (ETFs), might help to mitigate some of this volatility by providing more mechanisms for hedging and risk management.

Regulatory Considerations

The lack of a centralized authority to stabilize Bitcoin’s value presents challenges for regulators who are concerned with protecting consumers and maintaining financial stability. As Bitcoin becomes more integrated into the financial system, regulatory frameworks will need to evolve to address these challenges while preserving the decentralized nature of the network. Governments might explore the development of complementary policies that encourage innovation in the cryptocurrency space while ensuring that the financial system remains stable and resilient.

Long-Term Adoption and Network Effects

Bitcoin’s growing network effects, driven by its increasing user base and recognition as a digital store of value, are likely to continue strengthening its position in the global financial system. As more people and institutions adopt Bitcoin, its liquidity and market depth will improve, potentially reducing volatility over time. This could pave the way for broader adoption in various sectors, including remittances, savings, and even as a reserve asset for governments and financial institutions.