In the first part of this series I provided a background regarding the history of money and what cryptocurrency is. In this instalment I deal with the nature of the transition and answer some criticisms of cryptocurrency.

Crypto: The Big Picture - Part 2

A disruptive transition

Throughout history, technological developments have sometimes led to disruptive transitions which sweep away old established organisations and practices and usher in new ones. These disruptive technological changes often also alter our collective myths. In more recent decades the pace and frequency of such disruptive transitions has quickened. Indeed technologists such a Ray Kurzweil have argued that technological change is on an exponential curve, getting faster and faster all the time.

Natively digital money (cryptocurrency) will have an enormous disruptive impact on the banking and finance industries. It will be as great a disruption as digital music, photos video and websites have had on the arts, media and advertising industries. While these are important peripheral industries, banking and finance are at the heart of the world economy and thus the disruption and alteration of our collective myths will be far greater.

We are still in the relatively early stages of this disruptive transition. The current market value of all cryptocurrencies is around US$0.5 trillion. While large, this is still a tiny fraction of the amount of fiat currency on issue. US dollar money supply M2 alone is almost US$14 trillion US$ and global broad fiat money supply is around US$90 trillion.

Only perhaps 20-35 million of the world's 7.5 billion people are using cryptocurrency and a majority of people on the planet are unaware of its existence. It is roughly at the stage the internet was in the mid 1990s and the computer was in the mid 1980s.

Criticisms of Cryptocurrency

Many traditional financial experts posit criticisms such as:

• “Cryptocurrency has no underlying value”
• “Bitcoin is a classic bubble”
• “Crypto-currencies are too volatile to uses as money”
• “You can’t buy much with Bitcoin so its not really money”
• “Intial Coin Offerings (ICOs) are mainly scams”

While there is some truth to each of these statements, they miss the forest for the trees. Lets examine each of them in turn.

What is underlying value?

As noted in Part 1, neither national fiat currencies nor crypto-currencies are backed by any asset with underlying value such as gold. In the absence of hard asset backing, the underlying value of a currency is a simple function of supply and demand. Supply is about how much of the currency is on issue and demand is about how many people want to use it.

Unfortunately for the underlying value of fiat currencies, all the major central banks have massively increased the supply of their national fiat currencies over the last decade or more while population growth was flat or declining. In the fiat currency system there is no limit on how much and how fast a nation can increase the money supply and thus no certainty as to what future supply will be. Because of this fiat currency has ceased to be useful as a reliable store of value.

In contrast, for bitcoin and most other crypto-currencies, the basis upon which supply increases is fixed in the computer code and thus is certain and predictable. Most cryptocurrencies adopt a low or very low rate of increase in money supply, with Bitcoin taking the extreme approach of the rate of new currency issue decreasing over time towards a fixed 21 million bitcoin limit.

On the demand side, the working age population of the First and Second World is now entering a long period of decline and with it the number of people with economic capacity to use substantial amounts of fiat money. Conversely cryptocurrency demand is expanding from a very small base. Over time its expansion will further decrease demand for fiat currency.

Thus the critics have it upside down. Fiat currency has no underlying value because of massive actual and potential oversupply and decreasing demand while bitcoin and many other cryptocurrencies DO have underlying value because of their scarce supply and increasing demand.

When is a bubble not a bubble?

A classic investment bubble is when speculation, rapid price rises, herd mentality and fear of missing out pushes the price of an asset way beyond its underlying value. A some point smart money takes profits, the psychology reverses and the price collapses, eventually returning to something close to underlying value.

But classic bubbles are premised on the fact that the large numbers of new investors and large price increases characteristic of a bubble do not impact the underlying value of the asset. A tulip bulb does not become more economically productive just because everyone wants one. A company does not become more profitable just because investors rush its shares.

But with crypto-currencies the situation is different. The underlying value of a currency is related to how many people believe in and use one or more of its functionalities as a store of value, medium of change and/or unit of account versus its scarcity. Its about how many people believe in the collective myth.

Every new FOMO investor in the “bubble” is another actual user of crypto-currency as a store of value and a potential user of it as a medium of exchange and unit of account. A bubble investor who takes a little time to understand what they have bought and properly secure their investment in a software or hardware wallet becomes a person much more likely to accept crypto-currency in exchange for the goods or services they produce or other assets they wish to sell. Thus what might initially be herd mentality in a bubble, actually creates real value.

Secondly, the development of a huge range of new online services by thousands of startups in the crypto field is substantially funded by cryptocurrency holdings and issues. When the price goes up, these startups are much better able to afford the people and services they need to successfully implement their vision. This vastly increases the functionality and usability of a wide range of crypto based services which in turn drives crypto-currency adoption.

Thus both the increase in the number of people and the increase in price characteristic of a classic bubble have the effect of increasing the underlying value of the crypto-asset.

In the next instalment of this article, I'll deal with more criticisms of crypto-currency and talk about the impact of this disruptive transition on the established order in the tech and financial sector.