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The price of bitcoin and other virtual currencies: A simple case of supply and demand
What determines the price of bitcoin and other cryptocurrencies? With few exceptions, cryptocurrencies are fiat currency — they are not backed by anything. Their value is derived exclusively by what people are willing to pay for them. The simple framework of supply and demand can identify many of the forces that are creating large price swings in these virtual currencies.
Because individual cryptocurrency supplies are tightly controlled over the short run, day-to-day variation in the value of cryptocurrencies is driven by changes in cryptocurrency demand. Demand for cryptocurrency is derived from a number of distinct economic functions that cryptocurrency can facilitate.
People negotiate trades to buy or sell goods, services, and national currencies in exchange for cryptocurrency and pay for these trades by transferring cryptocurrency between virtual wallets. The transaction does not use the banking system. It uses the self-contained blockchain and internet account addresses in place of bank account numbers.
The amount of cryptocurrency demand generated by small value trades of goods, services, and national currencies depends on the relative cost and acceptability of using cryptocurrencies. The transactions cost and exchange rate used to convert cryptocurrency into national currency (and vice versa) are updated continuously in unregulated intermediaries called cryptocurrency exchanges. Exchanges charge a fee to process and match customer buy and sell orders to exchange national currencies for selected cryptocurrencies.
The demand for cryptocurrency to facilitate small value transactions depends in part on the cost and availability of close substitute transactions services. For small payments, cryptocurrencies directly compete with financial institutions and informal remittance mechanisms such as PayPal and hawala, respectively.
Because both hawala and cryptocurrency transactions are anonymous, they are popular among those transacting in illegal goods and services or funding illegal activities or terrorism. One recent paper estimates that nearly 24 million bitcoin market participants and nearly half of all bitcoin transactions can be linked to illegal activities.
In addition to these channels of demand, second-generation cryptocurrencies can be used to execute an array of transactions using so-called smart contracts. These cryptocurrencies can be used to execute complex tasks on the cryptocurrencies’ blockchain. Smart contracts can do more than just transfer virtual currency from one virtual wallet to another.
CryptoKitties is a smart contract that uses the Ethereum blockchain. It allows people to use the cryptocurrency Ether to buy, breed, and sell CryptoKitties. (Why anyone would want to do this is beyond me.) Still, the point is, newer generations of cryptocurrencies have blockchain algorithms that can perform new functions beyond just transferring cryptocurrency between virtual wallets. The new functionality is designed to generate an additional source of cryptocurrency demand.
A final source of cryptocurrency demand are the virtual wallets of agents that buy, sell, and “hodl” (hold) cryptocurrency as they attempt to generate capital gains. Such investors may undertake arbitrage between cryptocurrency exchanges, speculate on cryptocurrency price volatility, or simple buy and hold cryptocurrency if they believe that the virtual currency is a long-term appreciating asset.
Shocks in the demand for cryptocurrencygenerate cryptocurrency price volatility. In the past, demand shocks have been associated with news that authorities have identified and closed illegal operations that rely on cryptocurrency payments system. Actors associated with the illegal operation or related operations are forced to move or exchange cryptocurrency quickly, often multiple times, as they attempt to evade detection. Moreover, such policing actions often trigger new government actions to control or prohibit the use of cryptocurrencies. All these factors curtail the cryptocurrency demand related to illegal activities.
News of losses at cryptocurrency exchanges due to hacking also generate shocks in cryptocurrency demand and price volatility as users reassess the safety of their cryptocurrency holdings. Many agents respond to such news by exchanging their cryptocurrencies for national currency or by moving positions to virtual wallets with greater perceived security.
Finally, just like any speculative financial product, changes in investor expectations can create wild swings in cryptocurrency demand. Technical trading, speculation, and loss of confidence among “hodling” investors can generate large swings in cryptocurrency prices.
Cryptocurrencies have evolved quickly, and plans are in place to introduce new cryptocurrencies at a rapid pace. Given these dynamics, it is unclear to me why investors should expect a single individual cryptocurrency like bitcoin to be an appreciating asset over the long term. New blockchains and cryptocurrencies can and are being created. Few national currency supplies are as uncontrolled. There are no limits on the number of virtual currencies that can be created.
In the short run, cryptocurrency bubbles can inflate and deflate, creating the opportunity for bubble-surfers to harvest gains and post losses. But in the long run, it seems unlikely to me that cryptocurrencies will replace national currencies as the primary vehicle for facilitating trade.
For more, RSVP to attend my upcoming AEI event: Cryptocurrencies and blockchain: Techno-gold or fool’s gold?