Crypto assets: Financial instruments or more than that - How I came to it and why current regulatory initiatives do not get the trick yet

Crypto evolves as more than just a competitor for national currencies. Indeed, depending on the instruments one is looking to, it is a mixture of a unit of account, a precious metal with limited practical use case other than it’s preciousness, art and most importantly a commodity - as precious metals with a practical use case - for a digitised world. This will drive the value of crypto assets in the long run. And regulating crypto assets as if it was just another financial instrument or service will result in welfare losses as it reduces the application of crypto to the financial characteristics and it would not serve the stated purpose.

Colleagues and friends, when I made my latest move to join BitMEX as a CFO, I was asked by many of my former colleagues and friends why I would take such a risk and what drives me into crypto. Especially as I have a broad background in classical financial services which - at first glance - would not make me a credible suddenly turned crypto maximalist. But neither am I on the side of crypto critics like Nouriel Rubini. Who actually just is looking for a new ‘doom story’ to prove that his prediction of the global financial crisis was more than just a one-time success of chance (a black swan).

Crypto as currency contender - Maybe … and more

But let’s not get personal, Nouriel Rubini has had a lot of reasons for his criticism especially around Bitcoin. In my opinion, he is misled by the train of thought that crypto ‘just’ is kind of a currency phantom. It is easy to get trapped by this view as it was stated by crypto evangelists. That it can serve as a competitor to the current financial system which is based on a nationally - or supra-nationally in the context of the Euro - issued backed and therefore central unit of account. This backing builds on two characteristics: The states that backs a currency accepts this unit of account to pay taxes due combined with a representing a pool of potential physical violence through the existence of police and military forces. However, a national currency is a bit more than just “fiction plus violence’ (I refer to Arthur Hayes' great piece in his Crypto Trader’s Digest series). It is determined by the value that members of those national states and outsiders (for the matter of reserve currencies) attach to the existence of those national states and the trust they have in the extending existence of those states combined with economic success and the upholding of the physical force they can exert to nationals and outsiders. It is the value of the network which determines the potential value of the backed currency.

In this regard, a crypto asset (let’s not call it a currency) which creates a network of users who place value and trust in the existence of that asset and network will rise in value with every additional user. Some call this a ponzi scheme. But that’s not true. It is what we nowadays call network effects and understand much better than some half century ago. Every additional user who transacts with this asset either as a unit of account to buy other assets increases the value of the usage - called liquidity. And interestingly, especially Bitcoin is used to buy another asset: USD and other relevant currencies - to a much lesser extent though. Maybe an underlying use case of Bitcoin is to be able to use it as a unit of account and value benchmark for national currencies rather than to buy goods and services directly.

IMHO this is actually what drives hectic crypto regulation in some countries. Because it could form a kind of reserve currency without the need to have a lot of actual transactions and the ability to manipulate. In this case, the criticism about the slowness of the network stares into space. And it would explain why the ‘safeness’ of any crypto network (not the individual participant) is key to the success. And as of today, mainly Bitcoin would be able to serve as such.

Precious metal of the digital age - Most probably

Originally, precious metals had hardly any real economic use case - which often is forgotten. They were first mined because some people wanted to own them for their limited availability and the beauty of it’s appearance after refinement. It was - and is - extremely energy and cost intensive to extract (mine) precious metals. And the value attached to it is purely subjective. But still, it is agreed upon and we have global markets (spot, derivatives, custody etc.) for precious metals. And part of the subjective value is driven by extraction (mining) costs and scarcity. Everybody is able to acquire those but not in huge quantities. Gold e.g. plays a mixed role - it once in a while serves as reserve currency to national currencies, collateral for national currencies (the Gold standard though is long gone) as well as limit unit of account. However, it can be transferred only limitedly, it is costly to do so, mining is extremely expensive and harms the environment, but still it is used.

Don’t you think that this sounds like a lot of similarities to crypto assets if one would look for a digital representation of precious metals? Well designed crypto assets and the corresponding networks (like Bitcoin again but as well Ether and similar ones) have a beauty of their own. They can’t be just copied or replaced easily and have limited availability. As this is the case directly with Bitcoin and indirectly with networks like Ethereum, where the network - not the asset - has those characteristics.

Crypto Assets as piece of art - More than has been thought

Which leads to the next striking analogy. Basically art has the same characteristics as precious metals. The main difference is that the effort to get a decent piece of art is not so much physical labor and energy to extract it (mining). A willful act of human creativity and time is needed for the creative process plus resonance from/with others. Basically, it works under network effects, too. If you create something which others would see as a piece of art - purely subjective, you create value out of next to nothing. The bigger the group of people - the network - that sees art in what has been produced, the higher the value and price of this item is. And the more limited the supply, the higher the value and price is, too.

Networks behind crypto assets have characteristics of the art market, too. And the higher the technical beauty is in the eyes of the ones longing to hold such assets and the more people in whom it resonates, the higher is the intrinsic value and price of such assets.

Crypto assets as commodities - Absolutely

And here comes the often criticised real life use case for certain types of crypto assets. In my opinion, crypto assets like Ether or Polkadot (just as an example) will serve as THE soft commodity of the digital age. They are needed to enable decentrally verified transactions in the digital space. This refers to the ability to run verification and value allocations with so called smart contracts. If one believes in things like increasing automation, decentralised management of transactions without human intervention, internet of things and more, then those crypto assets will be the underlying commodities needed to produce those services. And the more those services proliferate, the higher the demand for such commodities will be. You could think of Lithium as a commodity to build computers. And crypto assets will serve as commodities for the interaction of such computers with each other. 

It’s a bit like crude oil. When it was discovered in large quantities, nobody knew what a real life use case it could have to use such quantities. In the end, it was the commodity that enabled electrification of the world and ensured mobility of large parts of the world’s population. Sounds quite like the crypto discussion.

So what?

I do not know which crypto assets will serve those use cases depicted above. Even the Bitcoin might vanish at some point in time. No reserve currency stayed forever. Hardly any piece of art is valued over time in the same way except for absolute scarcity. Only a few commodities have the same value all the time over centuries and volatility is extreme. And technical progress might even lead to the development of new crypto assets that will have higher values and prices than the current ones.

But I believe that as long as the digitisation of the world will progress, crypto assets will have an intrinsic value that many critics deny. And they do so because they look at those still new animals as if they were the replacement of something. In fact, it’s something new. Like Apple’s first iPhone. ‘Who needs a phone without keys,’ and later ‘Why shall we have speech recognition for phones?’ We could go on with this.

Life can only be understood backwards, as Kierkegaard once said, but it must be lived forwards. Experts and critics do the explaining, entrepreneurs do the living.

But more importantly, while being rather a supporter of well crafted financial regulation, I believe that regulating the crypto assets market as if they represent financial instruments or services only will result in large welfare losses. Because it would reduce international network effects greatly. And as depicted above, it has much more characteristics in other areas. In which we have different or no regulation. Though in those markets we have all kinds of markets and services (even for art markets): Spot markets (outright buying and selling), Derivatives (futures, forwards, more complex ones, securitised exposure, insurances), Custody and more. Nobody would regulate commodities or art markets like we do with financial services. There should be a convergence to internationally accepted standards to support the growth of the underlying networks. But the market dynamics will be different than with pure financial markets.

One thing we can conclude: Crypto is here to stay in many forms. It will be partly like in financial markets but we need to live life forwards and develop the right standards and services to exploit the full value potential of this technical solution. And that’s what drove me to join BitMEX. Live life forwards instead of just explaining it backwards.