Portfolio managers seek investments that promise high returns and low correlations with their other positions.  For the past few years, crypto currencies have demonstrated these qualities better than other major asset classes, such as US equities, US bonds, gold, US real estate, oil, and emerging market currencies.

So professional investors have noticed… but much skepticism remains and there’s little understanding of what, exactly, is driving this value.

Some arguments justify these values by pointing to the utility that crypto currencies provide, such as enabling cross-border payments, tracking assets, or hedging inflation.

My position is that, while these arguments are true, they miss the forest for the trees.  The way to understand crypto currencies is to think of them as digital monetary commodities, and these examples of utility are part of a larger story.

The larger story is the emergence of digital monetary commodities as a competition to become a better form of money.

What is a monetary commodity?

A monetary commodity is anything imbued with monetary value.  Throughout history, people have use cowry shells, beaver pelts, tally sticks, shiny metals, and pieces of paper redeemable for shiny metals as money.

But this form isn’t random.  According to Xapo CEO,  Wences Casares, “anthropologists go as far as saying that if you describe an environment in which a tribe lives, they can predict what’s going to emerge as money.”

A tribe that lived by the beach would use shells.  Another that hunted on the plains would use animal hides.

Shells and animal hides are okay forms of money, but gold is better.  What if you want to buy something that costs less than one shell?  They don’t divide easily.  What if one animal hide is nicer than another – it is worth more?

These desirable qualities can be expressed as scarcity, fungibility, divisibility, transferability, and durability.  And it is because of these qualities that gold emerged as the archetypal form of commodity money.  Gold is rare and limited by the physical world.  Any two ounces of gold are identical.

These features of gold led people to imbue it with monetary value, and as such the value of gold does not follow the same kind of frameworks that value commodities like oil or aluminum.  People consume ordinary commodities, they hoard monetary ones.  And it is this hoarding dynamic that led to a global gold market of $7 trillion.

Isn’t the idea of a new form of money… crazy?

In our lifetimes, we are accustomed to using our local fiat currency as money.  It strikes many as a stretch to imagine a new form.

But history would tell us otherwise.  Anthropologist David Graeber examined ancient forms of money used in societies across the world in Toward an Anthropological Theory of Value.  He concludes that the value of money flows from “human meaning-making, which far exceeds rationalist/reductive economist paradigms”.

Or as Yuval Harari argues in Sapiens, what sets Homo Sapiens apart from other human species is our ability to tell stories.  Concepts such as America or Limited Liability Corporations or “this piece of paper is money” don’t manifest as physical realities, but they are real insofar as they are stories we believe.

This belief has imbued objects ranging from shells to animal skins to gold to dollars with monetary value.  This belief still operates today; for example:

  • In 1991, a regional currency in Ithaca, New York (called Ithaca Hours) was adopted by thousands of businesses.
  • Today, over 150 crypto currencies have market caps exceeding $1 million.

Agreeing that something new is money is surprisingly common.

The utility of a digital monetary commodity

Let’s start with a broad overview of three forms of money:

How to create

With fiat, creation is a political tool.  Fiat currency gives a country control over its money supply, which it can use to finance wars or moderate business cycles.

Whether this is a good or a bad thing is beyond the scope of this essay, but some implications are:

  • The dollar makes a poor store of value, losing a few percent of its purchasing power every year.
  • Printing too much money is a failure mode that has occurred in the past, and is a risk factor for the future.

Dollar Supply

Bitcoin Supply

Before 2009, no one knew how to create decentralized digital tokens with scarcity.  Bitcoin showed the how it can be done, and this innovation made digital monetary commodities possible.

Note the smooth curve that asymptotically approaches 21,000,000 coins. This curve will never change – it’s in the DNA of bitcoin.  Even if miners centralize and change this 21M limit, the community would fork the code and restore “bitcoin classic” with the original supply.  Interestingly, the message embedded in bitcoin’s genesis block reads “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks”, showing Bitcoin’s intent of making monetary policy algorithmic.

Many people see immense value in money that cannot be inflated or debased.

How to Transfer

Here crypto clearly has the lead.  Gold must be handed over physically.  And fiat currencies are encumbered by various AML/KYC/money transmitter regulatory issues.

With crypto, transfers are unblockable, nearly instantaneous across the globe, and at near zero cost. The value of this feature increases the more sovereign powers attempt to restrict the flow of money.

Ease of Use

Crypto currencies are hard to use, which inhibits their adoption today by the mainstream.

Much of the difficulty in using crypto currencies comes from the regulatory constraints around the on/off ramps from fiat to crypto.  However, the more crypto grows, the more economic activity will take place without needing conversion to fiat, which will reduce this burden.

Another difficulty is in private key management, necessary to keep coins secure. This obstacle may eventually be overcome by a combination of improved technology and improved understanding of the underlying concepts.

Familiarity

Monetary value follows from belief, and it’s harder to believe in something new.  For example, everything in this essay about the utility of bitcoin was true 7 years ago.  But bitcoin was so new then that 10,000 of them were traded for two pizzas.  $100 invested in bitcoin in May 2011 would be worth $20 million today.

However, every day that crypto currencies exist is one more day of familiarity.  Our model of the world goes back only as far as our memories. When children of today become investors of tomorrow, bitcoin will be as familiar as gold.

Programmable

Crypto currencies introduce a new concept of programmable money.  This programmability is being used today by companies that want to raise funds.

Instead of registering as a Delaware C Corp, and restricting fundraising to domestic accredited investors, companies can issue and sell tokens with a few lines of code.  Most of these tokens run on Ethereum, which is the leading programmable crypto currency (far more so than bitcoin).  So far, this use of programmable money raised $8.6M for Golem and $16.8M for Cosmos – all in under 30 minutes!

Ronald Coase wrote in The Nature of the Firm that “people begin to organize their production in firms when the transaction cost of coordinating production through the market exchange, given imperfect information, is greater than within the firm”.

Programmable money can allow business processes to be encoded in the blockchain, with prices and contract rules fully transparent.  By reducing the transaction cost of price discovery and contract negotiation, programmable money can reduce the size of firms.  This reduction in firm size will yield efficiency surplus to consumers, and accrue value to the programmable currency.

We have just scratched the surface for what we can do with programmable money.  We know it’s useful, and neither gold nor fiat has this property.

Belief Feedback Cycle

Cryptographic tokens have the properties of money, in some ways better than any previous forms of money.  And humans commonly imbue tokens with monetary value through belief.  By connecting these two, we create a feedback cycle.

More belief leads to more utility leads to more belief, etc.

To use the George Soros’ Theory of Reflexivity, a rising price for monetary commodities increases the utility of the commodity, thereby increasing demand for the commodity, creating a positive feedback loop.

Is this a bubble?  Yes, but in the sense that money is the bubble that never pops.  Individual currencies can pop, but not the value in the concept of money itself.

In Conclusion

The way to understand the value of crypto currencies is as digital monetary commodities competing to be a better form of money.  And while we have frameworks for valuing commodities or fiat currencies, these frameworks break down for commodity currencies.

We can say some things.  Digital monetary commodity values will likely increase with higher interest rates and greater economic policy uncertainty.  Their value will grow with improved technology and increased usage.

No one can predict whether crypto currencies will surmount the various obstacles of difficulty, unfamiliarity, and regulatory pressures to create a positive belief / value feedback loop.  But — conceived as digital monetary commodities — they are a form of money that is functionally superior to gold, as gold was to shells. They are native to the Internet, which is increasingly becoming the environment for our economic activity. And since the total market cap of all crypto currencies is about 0.3% that of gold, there is extreme upside potential in this asset class.