INSIGHTS

Patrick Lehner

Tue, Nov 12


Crypto-Asset trading: Buy or Sell?

Cryptocurrencies, as opposed to conventional fiat money, rely not on a central bank or government enforcing them via coercion and authority of the state. Rather, they rely on the consensus of the involved parties who share the same perception of what decentralised cryptocurrencies are and represent. In contrast to the general notion that cryptocurrencies are necessarily trustless – or necessarily must be trustless – in order to function appropriately, they do in fact only work if a sufficient level of mutual trust exists amongst all participants.

 

 

The difference in the two concepts is interesting: while the former describes the interactive behaviour of nodes that can vote without influencing each other’s decisions beforehand, the latter describes the encompassing condition of maintaining at least one cryptocurrency. This means that despite the criticism directed at decentralised, digital currencies for having no intrinsic value, ironically, their value seems to be the product of their capacities and users’ trust in them over an open period of time.

 

Owing to the young age of this newly emerged asset-class, definitions of blockchain-based assets are to be used with caution, as they are rarely peer-reviewed yet. In a paper published by the European Central Bank (ECB) in May 2019, researchers define them as “[…]  a new type of asset recorded in digital form and enabled by the use of cryptography that is not and does not represent a financial claim on, or a liability of, any identifiable entity.” They propose that the assets’ novelty and particular risk profile is based on “[…] the absence of an underlying fundamental value.”[1]

 

This can be seen as the report’s underlying axiomatic assumptions on which argumentation and conclusions rest. Since an entire industry developed based on a perception of cryptocurrencies and their value that is deviating from that of the report, the ECB’s assumptions are not inclusive enough and will not suffice to grasp the full scope of available implications. As long as stakeholders agree on assigning crypto-tools and products value for various reasons, for instance bitcoin as an independent payment system, they will maintain their status as assets.

 

 

Unlike cryptocurrencies however, which have their own dedicated block chain that stores, carries out, and administrates all input and transfers of the respective currency, utility tokens are created as transaction units for new services that are offered on already existing, programmable blockchains. Dent Wireless, a telecommunications firm that built its services on top of the Ethereum block chain, is a good example to illustrate the functionality of utility tokens. Dent’s tokens are used as a unit of account to facilitate transactions taking place on top of the Ethereum block chain. If users of Dent’s services buy its tokens in the Dent app or at a crypto exchange, they can either trade those tokens for data packages in the Dent app or follow the price development of the Dent token and either buy more or sell.

 

Usually, crypto exchanges determine whether they trust a company that offers an entirely novel block chain (and its associated currency) or a company using an existing block chain to run their services. They do it simply but effectively by allowing them to be traded on their platform. How successful the exchanges are in picking durable coins that offer either improved technology (cryptocurrencies or smart contracts) or a great product built on top of an existing block chain (utility tokens) subsequently determines the reputation of the exchange. As the feeling of trading crypto assets is comparable to trading forex or equity, similar methods for the valuation of the assets are applied.  

 

Essential however, is the fact that each Initial Coin Offering ICO, as the offering of crypto assets is referred to, can vary dramatically in size. While there soon will be a total of 21 million bitcoins in circulation, the target for Dent coins is to circulate 100 billion by early 2020. In June 2019, there are 72 billion in circulation. This constant issuing of coins influences more or less strongly the value of the ones already in circulation. In the case of Dent, this suppresses the price per coin, but due to the high volume of circulating coins, does not affect the overall market capitalisation of Dent’s crypto assets.

 

 

With 72 billion Dent-tokens in circulation, its market capitalisation on 10 June 2019 lies at $128,495,639 which means every single token is worth some 18% of a dollar, and buying larger quantities is therefore affordable for retail investors. This in combination with a lack of experience on all sides implies high price volatility and suggests fast-growth opportunities.  The world’s total above-ground gold reserves, using a $1,275/oz spot price, are worth about $7.7 trillion, and the world’s stock markets’ capitalisation is roughly $73 trillion – some 30 times and 300 times smaller, respectively.[2]

 

As reiterated in its recent report on crypto-assets, the ECB claims that “[c]rypto-assets currently do not pose a material risk to financial stability in the euro area.”[3] Two aspects, however, remain problematic: one being the influence that time has on the aforementioned developments, another being the fact that many retail investors take out loans in order to finance their crypto-asset speculations. Regarding the former, it should be proffered that concomitant with disruptions stemming from technological and financial advancements, the crypto-market is erratically – and not steadily – developing over time. The ECB’s report itself illustrates this best, as their data collection process ended in January of 2019, since when total crypto market capitalisation in fact doubled – an increase of $125 billion in five months.

 

 

If the identified pattern continues, a stable reason for the recent growth of the crypto-market is the upcoming bitcoin mining-reward halving in May 2020. This halving of rewarded bitcoins for computing stations that verify transactions on the bitcoin block chain is usually preceded by a surge in price. This as well as growing adoption and knowledge of crypto assets amongst institutional and retail investors alike has the potential to create a market of overwhelming size for one-dimensional bureaucrats in the comparably short timeframe of two years.

 

The latter – retail investors getting into debt to speculate in cryiganypto-assets – exacerbates already unstable global debt levels. Increased and seemingly unaccounted for new debt can play a crucial role in shifting weight and creating disequilibria. This pared with a lack of technical knowledge and trading experience might in fact create a multiplied debt impact as even highly efficient markets take their time to readjust – and many times fail to do so if levels of speculations strongly overvalue trending assets.

 

What we might see is indeed a fintech-bubble following a major price correction of the dominating cryptocurrencies. While conventional financial-technology firms have been subject to studies for a reasonable amount of time, newly-emerged companies that offer for instance blockchain-based services or products are now hastily being brought to exchanges and traded – often by amateurs. That these retail investors might lack the know-how to carefully assess a reasonable valuation of said companies – especially as even investment professionals regularly gamble high and lose high – is a fair assumption and should be understood as a signal.  

 

Who that will be is normally determined by the quality of the underlying technology (level of decentralisation and other aspects), real market adoption of the product and its impact on the problem it is aiming to solve, as well as how these companies are run (employees and management). Assessing all of these aspects before looking into the price and the market capitalisation of the crypto project of one’s interest might prevent millions of speculators from losing a lot of money.

 

 

Patrick is a Research and Development Associate focusing on the political, economic, and philosophical implications of financial technology and globalisation. He is a tutor in cryptocurrency at London School of Wealth Management. Patrick holds a BA (hon) in Philosophy and Chinese studies from the University of Munich, Germany, as well as a MSc in The Political Economy of Emerging Markets from King's College London.

 

Reference

 

[1]  ECB Occasional Paper Series No 223 / May 2019, p.3.

[2] http://money.visualcapitalist.com/worlds-money-markets-one-visualization-2017/

[3] ECB Occasional Paper Series No 223 / May 2019, p.21.


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