Investing in Cryptocurrencies

This being a free country, I tend to believe that people should be able to enter into whatever mutually acceptable contracts that they want. That said, I’ve been watching the development of cryptocurrency markets with concern. Increasingly, cryptocurrencies seem to be gaining traction, where, in my estimation, growth in the acceptance of these products has arisen more out of hype and false promises than because these currencies meet any true legitimate need. (Illegitimate needs, on the other hand, aren’t lacking.) In any case, my beef is that I can’t stand it when people legitimize purchases of cryptocurrencies by calling them “investments.”

Although my sensitivities about this terminology may not be universally accepted, I make a distinction between gambling and investing based on the way capital is used. Invested funds serve to finance a business activity designed to deliver some good or service. As a rule, businesses raise working capital either by borrowing (i.e., debt) or by issuing stock (equity). In my definition, purchasers of debt instruments (e.g., notes or bonds) and purchasers of stock are investing. Irrespective of whether the assets are acquired at origination or as seasoned instruments, buyers of these products can legitimately be considered investors. I also put purchases of real estate under the umbrella of investments, as these assets may generate services that can return revenues from rentals; but that’s about it for investments.

More concretely, I don’t consider purchases of a wide variety of “non-traditional” asset classes to be investments. For example, I exclude precious metals, commodities, currencies, and a whole array of derivative instruments, like options, futures, forwards, and swaps from the category of investments. Rather than investors, these users would fall under one of three categories: hedgers, speculators, or arbitrageurs.

Hedgers start with particular risks and then identify highly correlated derivatives that could be used to mitigate those original risks. Speculators buy or sell to reflect their assessments as to the direction of coming price changes. If they’re right, they win; if they’re wrong, they lose. Often, however, speculators fulfill the critical role of taking on the risk that hedgers seek to avoid. And finally, arbitrageurs assure that derivatives are priced efficiently relative to the underlying instruments upon which the derivatives are based. In markets where hedgers, speculators, and arbitrageurs are active, the three categories are often analogized as a three-legged stool, where speculators and arbitrageurs are essential participants that enable hedgers the ability to access desired derivative positions whenever needed.

And then there’s gambling. The defining feature about gambling is that it bears no connection to any economic activity. Instead, its sole consequence is to transfer wealth from one party to another. Willing participants in a gambling operation essentially sign on to picking each other’s pockets. One might argue that any speculator who buys anything with the hope or expectation of subsequently selling that item at a profit should be considered to be a gambler, but I think it matters if the speculation somehow fosters a larger social good. Generally, I think of gambling as an activity void of any such social benefit.

I don’t mean to be disparaging about gambling. Lots of people engage in this activity, finding it fun. I don’t happen to be one of them. For me, it’s a fools game, where, in the vast majority of cases, the costs of gambling are excessive, and hence the chances of being a winner — particularly over time — are unfavorable. I’d probably find gambling more fun if I thought I had a better chance of profiting from it.

Turning now to cryptocurrency… I don’t see how anyone can quibble with my characterization of trading cryptocurrency as gambling. Such transactions do nothing for capital formation. Given the volatility of cryptocurrency prices, the notion of cryptocurrencies being used as a medium of exchange is ludicrous. That might be an attribute claimed by those seeking to expand these markets, but usage as a medium of exchange is inconsequential. Unquestionably, the vast majority of buyers of cryptocurrencies are doing so for speculative purposes, hoping to be able to liquidate at some time in the future, at a higher price. This situation, however, is a case in which everyone is a speculator, with no natural hedgers. That is, the only people who bear risk from owning crypto currencies are other speculators. Put another way, the only affected parties in cryptocurrency transactions are the two participants of the trade — both speculators.

Contrast that composition with those of traditional commodity markets where buyers and sellers of physical commodities bear a market risk that lends itself to hedging. Clearly, with commodity derivatives, speculators often trade against speculators, but that action affords the needed liquidity that allows hedging to be a viable option for commercial enterprises involved with the physical commodities. Nothing comparable to the natural hedger exists in cryptocurrency markets.

Speculations in the traditional markets and in most (but not all!) derivative markets perpetuate a social good that transcends the boundaries of the contracting parties. Promoters of cryptocurrencies may claim that the creation of their decentralized marketplace is a worthy social good in and of itself; but I don’t buy it. The social ills that are facilitated by functioning cryptocurrency markets (e.g., money laundering and other criminal activities) are, in my mind, real and overriding, while the benefits of a decentralized and largely unregulated marketplace are a chimera.

Given the growing industry seeking to expand the population of prospective cryptocurrency holders it’s not unreasonable to expect prices of at least some cryptocurrencies to move higher; but whether rising prices can be sustained will likely be heavily dependent upon optimistic price expectations being realized. If and when those expectations are not realized, the public’s appetite for these products will likely wane, and we should expect to see a stampede to the exits. Just when those turning points will occur is anybody’s guess. It’s a gamble.

As stated above, I have a laissez faire attitude about how people spend their money — or at least I have some appreciation for that ideal. At the same time, when it comes to cryptocurrencies, I tend to feel that the only people who will reliably make money off these markets are those who service the holders of the cryptocurrency, rather than the purchasers themselves. I’m referring to the creators, marketers, brokers, market makers, exchanges, and, of course, the lawyers and lobbyists pushing this industry. This cadre of promoters is pursuing its own interests with little regard for the standard of care that would be required by a fiduciary. It may be too late to put the genie back in the bottle, but perhaps by correctly characterizing this activity as gambling with little if any extraneous social benefit and considerable social cost, we might discourage some prospective buyers from getting involved. That would be my hope.