Cryptocurrencies – Intrinsic Value & Practical Points
Bitcoin and other cryptocurrencies have an opportunity to completely transform the global monetary system, advancing the concept of money to new levels of innovation and transactional efficiency (along with other applications).
Below, I make the case that virtual currencies can have legitimate, inherent value precisely because enough people say they do. I also discuss a few practical limitations of virtual currencies, as they stand today (in early 2018). Specifically: volatility, mining and tax treatment.
Imbuing Value to Virtual Currencies
People frequently describe cryptocurrencies as “not real” and lacking intrinsic value. In other words, people feel the value is “just made up”. This, of course, is true. But it’s also true of all global currencies, including the U.S. dollar.
Traditional currencies in developed nations are primarily virtual currencies.
Currencies only hold value to the extent that we all agree that they hold value. This statement was less true historically, when the dollar held to the Gold Standard (that is, backed by actual gold reserves). But now, all global currencies have value simply because we agree upon it – just like a virtual currency. In fact, with technology, only ~10% of our money in the U.S. is in the form of physical bills and coins – known as the M0 money supply (and about 2/3 of the M0 is held overseas). The other ~90% is represented by virtual entries on bank ledgers.
One might counter that a key differentiator is that traditional currencies are fiat currencies. That is to say, they are backed by the assurances of the issuing governments. True. But this does not create the value. A government’s assurance simply reduces the risk that the currency implodes. The currency itself has value imbued upon it by a common belief of its value. On the flip side, there are also downsides to currencies tied to certain governments (think Kazakhstan or North Korea) and sometimes very little assurance provided by the backing government (i.e. Greece in recent history).
NOTE – While a full discussion of the evolution of money – from coin to gold standard to fiat currency – would more fully develop my argument, I’m afraid most people would stop reading if I tracked that far back at this juncture (discussed further below for those interested).
Practical Limitations of Virtual Currencies
Although there are some distinct benefits, virtual currencies still have some practical limitations in their current form.
Bitcoin, Ethereum, Litecoin (and others) are currently in a speculative bubble and are consequently too volatile to be practical
Most currencies trade freely in open markets to establish the relative values of each, as does Bitcoin and other virtual currencies. Consequently, a lot of people are buying and selling virtual currencies, particularly Bitcoins, speculating on the future value.
The problem isn’t with a lack of liquidity. Instead, the current problem is the lack of real-life adoption in using these new currencies as a means to pay for actual goods and services. I do not personally know anyone who has actually bought or sold something with Bitcoin. I know it happens in that I have read about it. But currently, it seems to be the rare exception rather than the rule. Further still, I have yet to see a product or service even priced in Bitcoin.
Until actual real-world adoption catches up, the cryptocurrencies are interesting, but not particularly useful. As such, their value is random and not tied to commerce, just trading. Once critical-mass adoption occurs, and I believe it will, the value of the cryptocurrencies should become more grounded and consistently valued. Less volatility will encourage more adoption and vice-versa until the cryptocurrencies reach a certain cultural momentum that creates stability.
If the volatility continues to swing wildly, cryptocurrencies cannot become viable for payment because the holding risk is too great, and the task of constantly re-pricing goods and services will be too onerous for vendors.
Mining for Bitcoin seems like a waste of resources, but I offer no better solution.
Bitcoin mining is akin to modern day minting. Neither are practical, but both are required.
Bitcoin mining serves several purposes.
- It validates blocks of transactions to ensure all the distributed ledgers are concurrently correct and in agreement.
- It compensates those contributing computing power (miners) to the ledger validation process by crediting them with associated service fees and by issuing them new coins (although it’s sort of a randomly awarded payment for service).
- It creates a mechanism to steadily release new coins to the virtual currency money supply.
Mining (or blockchain validation) is needed whether or not new coins are issued. It’s just that initially, the mining serves dual purposes (distributing new coins and validating transactions).
Once Bitcoin is fully minted (capped at 21 million Bitcoins), no new Bitcoins will be issued. At this stage, presumably miners will only want to validate Bitcoin transactions that have sufficient associated service fees (service fees are currently optional).
The IRS burdens (perhaps cripples) virtual currencies with an awkward tax treatment.
Virtual currencies will be cautiously adopted in the United States as long as the IRS continues to treat them as property (capital assets).
This unfortunate tax treatment effectively means that:
- You will need to establish and record a cost basis every time you receive virtual currency. Keeping track of this will be too cumbersome for most people to attempt.
- You could, and likely will, have a capital gain or loss every time you pay someone using a virtual currency. Keeping track of this would also be onerous. According to the IRS,
“If the fair market value of property received in exchange for virtual currency exceeds the taxpayer’s adjusted basis of the virtual currency, the taxpayer has taxable gain. The taxpayer has a loss if the fair market value of the property received is less than the adjusted basis of the virtual currency.”
I know, no one will really report the gain, especially if you have to calculate it on a FIFO basis, which is the default IRS treatment. This may be an acceptable level of tax evasion risk for some individuals dealing in small sums, but commercials vendors will not want to mess with it. It’s too arduous and increases the risk of a funky IRS audit. According to the IRS:
“A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property. For example, a person who in the course of a trade or business makes a payment of fixed and determinable income using virtual currency with a value of $600 or more to a U.S. non-exempt recipient in a taxable year is required to report the payment to the IRS and to the payee.”
Can you imagine the spreadsheets and paperwork?
Brief History of Money – likely boring for most
The invention of money revolutionized the ability to trade. No longer did people have to swap one good for another directly. In a barter economy, people had to connect with mutually desirable goods at the same time and in the same physical place. If the two parties did not have swappable goods, no trade was made until a third-party (or 4th) could complete the circle of trades-needed. The odds of this must have been as good as completing the IRS forms for reporting gains and losses on virtual currency transactions (discussed above)! Early marketplaces helped with this 3+ party trading conundrum, but it was still very cumbersome.
Most people do not think of money as an invention, but at one point it was. In fact, it was an incredible invention. With a proxy for value that one could easily carry, people could now hold this value until they met the right trading partners and then they could either swap goods or swap money for goods.
The reason this worked is that the proxy for value (the coin) was usually made of gold or silver and therefore had some intrinsic value itself. Fast-forward to paper bills and numbers recorded on a ledger at the bank. How could these still have value without being backed by a valuable substance, like silver or gold?
The Gold Standard
The U.S. dollar (and other currencies) were originally backed by gold. That is, the government would agree to convert paper money into a fixed amount of gold. Thereby giving the paper its value. Even this is a relatively new invention. England was the first country to officially adopt a gold standard in 1821.
With time, countries abandoned the gold standard and tied their currencies to the U.S. dollar. (The UK stopped holding to the gold standard in 1931.) As long as the U.S. dollar remained tied to gold, all other currencies locked to the dollar were tied to gold by extension. However, President Nixon severed the ability to convert U.S. dollars to gold the year I was born, 1971. Currently, no countries hold their currency to a gold standard. Consequently, the global system of currencies moved to fiat currencies. In fact, the Nordic countries are trying to move away completely from M0 money. If you go to a bank in Sweden, you can’t take out cash, because they have none on hand.
While traditional currencies have gone through a lengthy evolution from coinage to gold standards to fiat currencies that are now 90% electronic ledger entries, virtual currencies skipped straight to 100% virtual. Hence the name. This is why I argue that virtual currencies, if widely adopted, do not differ much from traditional currencies with regard to the acceptance of their inherent value.