Achieving stability in cryptocurrency value

July 18, 2018
Chris Wheal

Volatility has been something of a black mark on cryptocurrency investment in the months following bitcoin’s tremendous tumble from near $20,000 a token to its current levels.

Barring financial crises, central bank intervention or geopolitical tensions, currencies traditionally do not rise or fall by more than a few tenths of a percent each day. This makes them ideal transmissions of value in the exchange of goods and services.

 

Price stability is an important factor when looking for a store of value

Periods of extreme inflation, or hyperinflation, are uncommon in developed economies and when they happen in developing countries – such as Zimbabwe between 2005 and 2009 – domestic currencies are often abandoned in favour of stable units such as the US dollar.

Price stability is important for those who see cryptocurrencies eventually replacing traditional fiat currencies as the main transmission of funds: indeed, this is the most important function of money – a medium of exchange.

Money as a store of value

The next most important function of money is as a store of value. Many would argue that to be an effective medium of exchange it must be able to hold its value over time.

Currencies may not even be the most effective store of value over time because it depreciates with inflation – look at this inflation calculator – and we see that $1m in 1970 would be worth $6.5m today. Even in living memory for most people reading this article, if you’d stored $1m under your bed in 2000, today you’d be $464,789 worse off, according to the calculator.

Collectibles such as art and rare stamps are better stores of value. Currencies have the advantage over them, however, by being highly liquid: you can spend currency immediately, while liquidating a painting into cash takes time and money.

This is one of the main arguments surrounding cryptocurrencies and their potential use in global payments systems: how effective are they as a store of value?

What undermines stability in value

Cryptocurrencies are relatively new as an investment sector so have little track record on which investors can base historical returns. They encompass technological engineering on a scale not seen in other sectors and are such a recent development that regulators are still unsure how they should be handled and governed.

To this end there are four main reasons why cryptocurrencies lack stability in value:

1. Poor liquidity

Liquidity is the relative ease by which an asset can be bought and sold and readily be converted into cash. Remember, however, if you want to sell an asset for cash, you first must find a buyer. A market is made when buyers are matched to sellers – at the right price. This can take time.

The longer the time taken to match buyers to sellers means that a bottleneck of unmatched sellers can build up. All this while, the value is sinking as those wishing to offload lower their prices to facilitate a quicker sale.

Government bonds and blue-chip equities are among the most liquid of assets. They are popular investments and there is always demand for them.

 

Gold and other precious metals can be quickly converted into cash

Commodities such as gold, silver and other precious metals are liquid because of strong demand, strong market participation and ease of conversion into cash. Oil and other bulk commodities are difficult to store and transport and so are not regarded as highly liquid in financial terms.

Cryptocurrencies suffer from low liquidity: buyers and sellers can be fairly-easily matched on exchanges, but there are a lot of exchanges and a lot (more than 1,500) of cryptocurrencies. Many of these exchanges do not offer transactions from crypto to fiat currency, merely between cryptocurrency pairs.

Furthermore, the relative newness of the asset class means that adoption rates remain low, and this contributes much to the lack of liquidity.

The massive rally in December 2017-January 2018 and subsequent crash had much to do with poor liquidity. As prices moved higher everyone wanted in on the action. Mining activity increased, producing more coins yet the supply was not capable of meeting demand.

Once prices had rocketed, investors could only realise profits by selling, and by this time everyone had the same idea: there were too many unmatched sellers.

2. Technical challenges

This is a matter of trust. To build up clients and investors – and, indeed, liquidity – a company or enterprise knows it must also develop strong levels of trust in its products, people and governance.

In the realm of crypto assets, investors need to know they can trust their digital exchanges, their wallet systems, the intentions of initial coin offerings and the blockchain network these ICOs support.

 

One of the biggest technical challenges is for exchanges to stay a step ahead of the hackers

This is a minefield: more than $1bn has been hacked from exchanges this year, largely from online – or hot – wallets, while fraudulent ICOs have been rife.

Cryptocurrency forks – the creation of new or parallel blockchain protocols as simultaneously-produced blocks compete for dominance – represent a further technical challenge to the issue of trust.

Investors in a world of digital assets need to know that their investment is safe from malicious actors who would seek to disinvest them of their holdings – or to make them worthless.

Forks are contentious: some of them are genuine and can – in rare cases such as bitcoin cash – represent a huge windfall, while many others are nothing more than scams. But they still uncover trust issues that the digital asset sector can do without if it is to gain wider acceptance.

3. Regulatory uncertainty

This has been one of the biggest factors behind recent cryptocurrency volatility and we have a separate article here [link to regulation article] on the differing regulatory approaches around the world.

From the outright banning of much cryptocurrency activity, as in China’s outlawing of ICOs and trading between fiat and crypto, to the full-on, tailor-made regulatory frameworks specifically designed to accommodate frictionless trade, as in Malta.

The uncertainty of trading on an exchange that one day may be outlawed by a stricter turn in a government’s approach to crypto regulation is a powerful disincentive.

Meanwhile, unfettered regulatory approval – such as in Malta – might attract more cyber crime: a crypto hub could also become a hacker’s hub.

Another factor in crypto volatility is regulatory arbitrage: large holders of digital assets can take advantage of these differing regulatory approaches for huge profits. Buying where fees and taxes are friendly and selling at a greater price into markets where regulations are such that they can charge higher fees for transactions.

4. Lack of centralized authority

A central bank’s primary aim is ensure price stability. Keeping inflation at a steady rate by use of monetary tools such as interest rates and government bond sales, and performing the role of backstop in the event of catastrophes such as the financial crisis.

Unfettered by such controls, cryptocurrency prices act more like equity prices, subject as much to performance and sentiment as they are to the laws of supply and demand.

Some central banks have considered launching digital currencies of their own. None have yet found the required levels of public interest to pursue such a venture, but as digital currencies become more mainstream, the founding dreams of decentralization and no overall control will likely fade, and central banks could join the crypto bandwagon.

It may also transpire, if the crypto market reaches anything near the proportions of the equity market, that cryptocurrencies could come under some central control. Particularly if bodies such as the Financial Stability Board (FSB) decides they represent a real threat to global financial stability.

Resolving the issues

We set out above some of the challenges of storing value in cryptocurrencies, now let’s examine if any of these issues can be resolved.

1. Poor liquidity

The issue of a lack of liquidity will only be resolved as more investors come to the market. Andrew Pritchard, managing director of Blockspace believes the market is on the cusp of transformation.

“Only a small percentage of the population have any exposure to the crypto market,” he says, but believes the institutional players are on the sidelines, watching and waiting.

“But once the public come in, they’ll drive growth in the market to the point where it blows up again and this will happen within the next 18 months,” he believes.

For this to happen, however, the market needs to become more accessible. Because of fears over money laundering and the funding of criminal or terrorist behaviour, many authorities require exchanges to carry out significant checks on their customers – this red tape is annoying for many potential clients.

 

Fears over money laundering have obliged exchanges to carry out more checks – red tape that clients are wary of

Joined-up thinking between global monetary and regulatory authorities is needed to monitor and govern the digital assets market. The dreams of truly decentralized and anonymous trading may have to be slightly compromised in order to achieve this.

This contributor to Steemit understands the problem: “Bitcoin built on the shortcomings of the traditional economic system, but to gain the degree of adoption and liquidity it enjoys now, it had to embrace elements of the system it sought to reform.

“Cryptocurrency liquidity can move from the realm of the mythical into reality only if it embraces elements from the systems it seeks to change: ultimately investors understand that in order to realize their earnings they must liquidate their digital assets.”

2. Technical challenges

It’s a good time to be a competent software engineer. Exchanges need constant maintenance and upgrades if they are to stay one step ahead of the hackers and significant talent is always needed.

Breakthroughs are also needed in monitoring what happens when an exchange is hacked: more collaboration is needed between exchanges and other possible destinations of hacked funds, so tracking the criminals can be made easier.

When forks are detected investors need to be notified immediately and told clearly what the protocol is. Furthermore, blockchain producers, exchanges and authorities need to work more closely to help identify scams and other fraudulent behaviour and educate potential investors about what to look for.

3. Regulatory challenges

There’s no answer to this: few countries around the world have financial regulations that match entirely. There are cross border bodies that do valuable work in trying to bring harmony to financial regulation, but the crypto-asset landscape remains so new that this work is only just beginning.

Only on 16 July 2018 did the FSB announce it had set out a framework for “monitoring” the digital asset market.

But starting on making the market more transparent would help bring in more investors. The hardcore crypto enthusiasts would suggest a more transparent market would necessarily mean a more centralized, controlled market that is entirely alien to the world they sought to create, but it might help bring liquidity to a volatile market.

 

The regulatory landscape of cryptocurrencies needs clarification to attract further investment

And investors generally feel more comfortable, knowing there are laws and measures that protect their interests.

In a briefing by the US Chamber of Digital Commerce (CDC) in April, Congress heard how the financial crisis helped regulators learn about the need for tools to improve transparency and co-operation between public and private actors.

“This briefing is evidence that regulators are ready to operationalize those lessons in the cryptocurrency space,” the CDC said.

4. Lack of centralized authority

This may never be a problem that needs a solution. The FSB has already declared that the crypto-asset market – as it currently stands – does not represent a risk to financial stability.

But it’s the problem of price stability in cryptocurrencies that we’re really trying to assess and for this to stabilize, a larger and more liquid market is required. If, to facilitate this, greater safety measures are needed, then some central oversight body may need to evolve.

Conclusions

The hub of the argument here is that for cryptocurrency prices to stabilize enough to be an effective store of value, and therefore a useful and widespread tool in payment systems, a more liquid market is needed.

The market needs more players for greater liquidity. Today it mainly consists of purists who bemoan any nod towards centralization. Yet the market needs better measures to protect its investors, otherwise the current hype will soon fade and cryptocurrencies will remain a mere sideshow in the capital market circus.

The market has itself tried addressing price stability by introducing such asset-backed coins as tether – backed 1-for-1 by the dollar – or the precious metals-backed goldmint. These are pegged to, and track closely, the fortunes of their respective underlying assets.

Their varying degrees of success does not necessarily mean they are attractive as investments, however. Tether is mainly used as a base currency on exchanges to transfer into alternative digital assets.

So, greater regulation, better investor protections from fraud and scams and the possibility of central oversight might make this a popular market, but it will come at the expense of the dream of decentralization.

Much depends on what happens next. Will an institutional drive prompt retail investors to crowd into the market? Greater liquidity needs to evolve to bring about the ultimate goal of price stability.

Post written by Chris Wheal
Chris Wheal is editor of OpenLedger's news and features service. An award-wining business journalists himself, he runs a team of freelance journalists from across the UK and north America.

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