Cryptocurrencies: Questioning its need, limitations, and divergence from its core ideas.

My first introduction to cryptocurrencies was around 2017. Though I didn’t understand how it works at the time, the idea of utilizing your idle computing power to earn a valuable currency was captivating. Fast forward to 2021; I stumbled upon the original white paper, which made me realize how much the whole cryptocurrency ecosystem has evolved over the past years.

Cryptocurrencies are now far from being a ‘currency’ and are mostly treated as digital assets. And this has made cryptocurrencies a very controversial topic. So, perhaps it’s time we began to critically question its intrinsic value, use cases, and whether it delivers on its promise.

The market participants and the motivation for writing this post

Undoubtedly, Cryptocurrencies cater to the Millenials and the younger generation. While others might be skeptical or don’t understand how it works and think it’s best to stay away from it. Even among those who participate, the reasons may vary. You may be it for fun, want to enjoy the volatility, or seriously believe that you can make decent money out of it. And you probably can, but that’s not what this post is all about. By all means, go out there and start trading. It’s a free market.

The problem starts when the naive audiences are targeted aggressively. Cryptocurrency promotions are everywhere, be it ads, Youtube, Facebook, or Reddit. Genuine queries about cryptocurrencies on google will often land you on SEO-optimized pages of some websites that will provide a biased view about the subject. Even worse are the so-called ‘influencers’ involved in promoting some worthless tokens to their audience. These are essentially ‘pump and dump’ scams duping people out of their money. These people often portray cryptocurrencies as the future of our economic systems, fiat currencies as ‘just a worthless piece of paper’, governments and traditional financial institutions are ‘evil’, and ‘power-hungry capitalists’ going as far as tearing us dollars on live television. Anyone having a single ounce of common sense and basic understanding of economics will cringe at this point. But perhaps it is pointless arguing with smooth-brained apes (Yep!, that’s what they call themself on Reddit). You must realize that no one is your friend in the market, there is no charity, and these people are just trying to sell you something that benefits them.

What does Economics 101 tell us about cryptocurrencies?

Let us start with some basic economics which you must be familiar with before participating in any financial market.

Understanding currencies or, more broadly, money:

Money can be defined as anything that is accepted as a form of payment for goods and services. It serves three primary purposes:

Medium of exchange
Unit of account
Store of value

I am not elaborating on these as they are self-descriptive, and this post is not meant to be Econ 101.

Currencies consist of paper bills, and coins are a form of money. A legal tender is a form of money that is legally recognized as an acceptable form of payment. So fiat currency is not just a piece of paper. It derives its value by being a medium of exchange for all the goods and services produced within an economy.

Now ask yourself, where do cryptocurrencies stand according to this? Can I buy a milk carton using any cryptocurrency? How much do I pay for it? How much does a dozen eggs cost in a particular cryptocurrency? Can I be sure that it will cost more or less the same tomorrow? (In short, is my purchasing power over time stable?)

This doesn’t make cryptocurrencies very appealing as a currency. Does it? Sure it’s treated more like a digital asset, perhaps as an inflation hedge, which we will come back to later. Before that, let us clear some misconceptions and answer some questions.

The government can simply print money, eroding its value and leading to hyperinflation.

No, The government doesn’t simply print money. Saying so is reducing a complex process to an oversimplified statement that can be misleading. The central bank manages the monetary policy, and primary objectives include price stability and stable economic growth. It controls the supply of money in the economy. It enjoys a certain degree of freedom from the government. The fiscal policies, on the other hand, include decisions on taxation, government spending, etc. And it is usually determined by the elected government. So it isn’t a bunch of corrupt politicians mass printing money. Instead, it’s some of the best economists the country has to offer, ensuring that things go smoothly. Hyperinflation isn’t something you need to worry about in your day-to-day activities. And no one is incentivized to doom an economy. If it goes down, we all go down together. Unless you have hedged against inflation, and that’s where commodities like gold or even cryptocurrencies come in.

Inflation is terrible, and deflation is good as it will increase my purchasing power.

No, not necessarily. Infact, moderate inflation is considered good. Many countries target an inflation rate of 2% that is considered to be healthy. It encourages consumer spending and economic growth, and at the same time, doesn’t spiral off, leading to hyperinflation. Deflation, on the other hand, can be bad too. Why would you buy something today when you can purchase it at a lower price tomorrow? It reduces consumer spending, which also can spiral out of control, just like inflation. Hence it can be a sign of a weakening economy.

Now that we understand the basics. It should be clear why cryptocurrencies are not suited for the job. It has a fixed supply and inherent deflationary nature. Adopting cryptocurrencies as the primary legal tender will also mean forgoing monetary policies, which are absolutely essential to maintain a stable economy.

Even if it is not a currency, it still is a valuable asset. But why?

Now that we have identified problems with using cryptocurrencies as a ‘currency’, the next question that comes to mind is: Then why is it valuable? after all, it is not a productive asset. What other purpose does it serve? The answer is the same as for everything else. Its supply and demand determine its value. This is where people draw parallels to commodities like gold. And indeed, you can ask, why is gold valuable? What makes it a good investment? Some argue that it isn’t. See Warren Buffett on Gold. But unlike cryptocurrencies, gold is a tangible asset that actually has a limited supply. However, no one is stopping you from making your own cryptocurrency. In fact, it can have identical properties as any other crypto out there. At this point, this feels more like a Keynesian beauty contest. What is some piece of information stored in a distributed ledger with nothing tangible to back it worth?

Enough Economics. Let’s talk about the underlying technology.

If you ask anyone what’s so special about cryptocurrencies, the answer will be somewhere along the line of:

“It is a decentralized ledger that allows trustless execution of transactions without the need of a central authority. Thus being more secure, cost-efficient and democratic”. Now, this sounds good. After all, it is “giving back the power to people”. Someone might even pitch in about it being anonymous.

Is it anonymous?

Sure, as long as your public key is not associated with you. If it is, you might as well be living in a house made of glass since it is a public ledger.

Is it secure?

Who owns the keys, owns the wallet. Lost your keys or got infected by malware? Then it is time to say bye-bye to your wallet.

Is it a decentralized and trustless environment?

Sure, core blockchain technology enjoys a great degree of decentralization and trustlessness. But it isn’t true for the infrastructure that has been built around it. You will most probably trade cryptocurrencies on a centralized exchange. Every time you trade an actual currency for a cryptocurrency, you place your trust in a central authority (the exchange). Even decentralized currency exchange protocols such as uniswap rely on arbitrage opportunities created by external prices (aka centralized exchanges) for their pricing mechanism. Still, they suffer from problems such as price slippage.

Moreover, these exchanges may not be regulated to the same extent as traditional exchanges since the laws regarding cryptocurrencies may not be well defined. In fact, there has been a case of one such exchange just vanishing in thin air. These should be a cause of concern for everyone involved. Regulations are good. They are in place to protect the investors. On the other hand, asking for regulations (aka giving power to some central authority) is quite ironic. Watching the crypto nuts on Reddit asking the SEC to take action against Elon Musk was quite amusing.

Also, trust is critical. In the blockchain, you place your trust on the mechanism itself. In smart contracts, you also need to trust that the contract is secure and will function as desired. This has led to the formation of companies that ‘audit’ the smart contracts for bugs and security vulnerabilities. Again, here trust is involved.

Even after all these steps, for these smart contracts to be useful in the real world, they need to rely on ‘oracles’ that allow smart contracts to interact with the real world. After all, whatever happens in the blockchain remains on the blockchain. Thus oracles have a lot of power in smart contracts. So trust is unavoidable. Sure, smart contracts are not just about trust. They do provide an autonomous and secure way to execute contracts. Smart contracts are not the focus of the post. I am just pointing out the limitations.

Stablecoins: Hypocrisy reaches the moon

Stablecoins are cryptocurrencies pegged to another asset, including USD. The first time I heard about stable coins, I thought it was a joke. But they are indeed real. But if the underlying is not a token (say USD), the backing needs to happen off the chain by the issuing entity. So, in short, people who won’t trust a fiat currency would rather trust a private entity that a particular token can be redeemed for the same fiat currency. I wonder how Satoshi Nakamoto reacted when he heard about the concept.

DeFi & Liquidity Pools

Let’s take a look at another new buzzword, Decentralized Finance. Quoting from Wikipedia:

Decentralized finance (commonly referred to as DeFi) is a blockchain-based form of finance that does not rely on central financial intermediaries such as brokerages, exchanges, or banks to offer traditional financial instruments, and instead utilizes smart contracts on blockchains, the most common being Ethereum

I won’t go to lengths explaining Liquidity Pools. Essentially it is a pool of funds locked into a smart contract that provides liquidity for currency exchanges. In return, it pays the market makers a chunk of transaction fees. But they suffer from some drawbacks such as price slippage and impermanent loss (which, contrary to the name, can be pretty permanent). Read more on one such protocol uniswap here. As mentioned earlier, it still relies on arbitrage opportunities created by external prices (aka centralized exchanges) for its pricing mechanism.

Talking about finance, what about loans? Since there is no way to run a background check and enforce payments, you can only borrow loans on a blockchain by putting up more of another currency as collateral. The only option for uncollateralized loans is ‘flash loans’ which only last for a block and are usually used in arbitrage.

Do we really need a decentralized and trustless solution to currency and finance, and if so, at what cost?

It should be clear that decentralization and trustlessness are not binary states. And achieving them has several trade-offs and limitations. Now, It is time that you ask yourself some important questions:

How much decentralization and trustlessness do you need if any at all?
What real-life problems does it actually solve? Do alternative solutions exist?
Are you willing to give up simplicity, instantaneous transactions, and a lower transaction fee for the sake of decentralization?
In a decentralized environment, Who regulates the market and how? Who is accountable for what?

I simply fail to understand the intrinsic value of cryptocurrencies and the need of such complex solutions of DeFi built around it just to mimic a proportion of what we can do with traditional approaches. Especially when some of these solutions go against the core ideas that made cryptocurrency famous in the first place. The current hype and misinformation around cryptocurrencies, blockchain technology, and new sh*t-coins popping up every day don’t help either.

Sure, technologies built upon blockchain, like smart contracts, definitely have a lot of potential and use cases. Still, it is very easy to jump on the hype train. So it’s crucial to critically examine the need and actual use cases of these innovations. Not every piece of technology needs to be adopted. If the cost and benefits are not analyzed properly, you may end up with an over-engineered product with little to no use.