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Crypto is not what you think it is
(Michael Hogue)
Is that a bird? Is it a plane? No, it is a series of numbers with a value in US dollars that was designed to be a currency, but is traded as a derivative.
Recent actions by the Securities and Exchange Commission and its apparent turf war with the other major currency regulatorthe Commodity Futures Trading Commission, sparked a debate: are cryptocurrencies securities or are they commodities?
I would argue that digital currencies like Bitcoin and Ethereum are neither of those things, but something entirely different. Or rather, two different things.
Firstly, as the name suggests, cryptocurrencies are currencies.
Take it from Lorenzo Di Mattia, a veteran hedge fund manager and founder of Sibilla Global Fund, who was once approached by an investor with a proposal to launch his own crypto fund.
“I don’t know what encryption is, haha,” wrote Di Mattia, via WhatsApp. “It is not a commodity. Maybe it’s a coin.”
The original intention was certainly to create an alternative to the US dollar, around which the US financial system is built. Generally, people in this country keep US dollars in traditional banks that have to keep some of their deposits in cash. The technical term is “fractional reserve” banking. Many of us now also transfer virtual versions of the same dollars from our accounts to, say, the plumber’s bank account.
Satoshi Nakamoto’s original white paper on bitcoin in 2009 described a method of disintermediating the banking system. As noted in this plan, people, especially tech-savvy people, were disillusioned with the fractional reserve system, which nearly collapsed due to the reckless and greedy behavior of some of the banks that were the cornerstone of the system.
Nakamoto’s solution was a purely digital currency, bitcoin, that could never be counterfeited and, most importantly, would not depend on Wall Street intermediaries. The currency would be minted with virtual watermarks created by high-powered computers. This is where cryptography comes in: Computer “miners” would solve complex formulas embedded in the unique number of each previous bitcoin and thus link the newly minted currency to the ledger or blockchain. Anyone with Internet access could view the blockchain, which, like a shared master bank account, recorded each of these verified coin creations.
Nakamoto did not design this system to be linked in any way to the dominant banking system, the US dollar or the financial markets – and not to the securities, commodities or derivatives markets. Bitcoin was intended to be an alternative to all of this.
Almost everyone who has studied this technology agrees: Bitcoin and the copycat digital currencies that followed it with similar cryptographic protocols, including Ethereum, Ripple and countless others, were a huge improvement over the US dollar, in theory.
In practice, as currencies and as a means of payment, cryptocurrencies are a miserable failure. More than a decade after the first pizza was sold via bitcoin (a single coin was worth a fraction of a cent at that stage, in 2010, and a pizza cost 10,000 bitcoins), approximately no one uses bitcoin to buy pizza. There are many explanations for this failure, but the main one is that it is simply too risky for traders doing business in dollars to accept volatile cryptocurrencies.
If not used as currency, will cryptocurrencies be used as securities? Only the smaller coins. There was a trend called initial coin offerings in the 2010s that attempted to marry stock offerings and cryptocurrencies.
A title is something that gives you a stake in a company or nation. Sometimes this bet requires “capital”. When you buy a share of Microsoft stock, you own a small piece of Microsoft, in exactly the same way that you would own half of, say, a mosquito spraying company if you bought half of it from a friend. Sometimes the bet takes the form of debt or “credit.” When you buy a U.S. Treasury bond, you are making a loan to the U.S. and you maintain a contract that guarantees repayment from the U.S. Treasury.
There are other types of titles, but they all give a person a contractual interest in something.
Gary Gensler, head of the SEC, wants his agency to oversee cryptocurrencies. He did not claim that Bitcoin, Ethereum or any of the better-known cryptocurrencies are securities. Instead, he notes that his agency has investigated some smaller coins that were created as bonds. Gensler proposes extending his authority over the entire crypto market because platforms like Coinbase and the bankrupt FTX will always host some of these coins that are technically securities:
“While the legal status of each token depends on its own facts and circumstances, given the commission’s experience with several tokens that are securities, and with so many token trades, the likelihood is quite remote that any one platform will have zero securities,” it is as Gensler presented the argument in 2022.
The main cryptocurrencies clearly do not offer participation in anything. This is why some insiders, like Joseph Lubin, the co-founder of Ethereum, insist that cryptocurrencies are commodities that, like copper, gold or oil, the person buying Ethereum does so because they believe in the “intrinsic” value of the asset. cryptocurrency.
Cryptocurrencies share this quality with commodities, but this is the only thing the two categories have in common. The basic definition of a basic material, or commodity, is, of course, that it is tangible. Gold attracts commodity investors because they can open the safe and hold it in their hands.
If they are not (effective) currencies, or bonds, or commodities, then how can we understand cryptography in the conventional financial framework?
Cryptocurrencies, as monitored on traders’ computer screens, are, I would say, derivatives. Yes, ironically, the crypto world has turned the very thing that Nakamoto and other economic libertarians were so repulsed by on Wall Street in the 2000s, a derivatives market. For much of that decade, America’s best and brightest used all their intelligence to endlessly transform useful financial products like home mortgages into unstable, highly volatile instruments through the accumulation of enormous side bets.
When they are traded for speculative purposes, which is how the vast majority of people who interact with cryptocurrencies do, cryptocurrencies become derivatives. Most Bitcoin and Ethereum holders only care about the currency’s price in US dollars, which is a derivative value.
When a speculator buys a bitcoin, which would currently cost about $60,000 each, he is essentially involved in a currency swap. In these derivative transactions, Goldman Sachs may lend JPMorgan $100 million and the rival bank lend Goldman €80 million, under a fixed-term swap contract. The value of the “swap contract” will fluctuate based on foreign exchange market fluctuations.
Just like buyers of dollar swaps, bitcoin holders do not want to own bitcoin at all. They are simply making a derivative bet on the dollar value of bitcoin.
The other argument for regulating bitcoin and cryptocurrencies as derivatives is that they behave like derivatives. In the most volatile two-year period in its history, the S&P 500 fluctuated 3% or more in a grand total of 35 sessions out of a total number of about 400 sessions, according to the research firm Red burn. Individual stocks, obviously, are much more volatile than that, but individual stocks as big as bitcoin – think Apple and Microsoft – are increasingly correlated to the S&P 500. Stock derivatives, the price of put options and call options tied to the S&P 500 or Apple or Microsoft, on the other hand, routinely swing 10% or more on a day-to-day basis. It’s hard to find a day on the bitcoin chart where the digital currency hasn’t moved more than 3%.
Warren Buffett famously and presciently derided derivatives as “financial weapons of mass destruction.” Nakamoto invented bitcoin as a safe alternative to a banking system that was overloaded with hundreds of trillions of dollars. Unfortunately, the gravitational pull of Wall Street’s money-centric banks has drawn in the crypto world, which is now a multi-million dollar derivatives market, in need of regulation to avoid another massively destructive collapse.
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