Classifying cryptocurrencies

Whenever biologists stumble on a strange specimen, they first try to see if it fits into the existing taxonomy. If it doesn't fall within any of the pre-existing categories, they sketch out a new one for it.

For people like myself who are interested in monetary phenomena and finance, Bitcoin and other cryptocurrencies like Dogecoin and Litecoin have presented us with the same challenge. How can we classify these strange new instruments?

Because they have the word 'currency' in them, the knee-jerk reaction has been to put cryptocurrencies in the same bucket as so-called fiat money, i.e. instruments like bank deposits and banknotes. But this is wrong. Bitcoin, Dogecoin, and other cryptocurrencies are fundamentally different from $100 bills or Citibank deposits. 

To see why, here is a chart I published last year at Sound Money Project:

I've located cryptocurrencies in the zero-sum outcome family. Banknotes and deposits are in a different family, win-win opportunities. The property that binds all zero-sum games together is that the amount of resources contributed to the pot is precisely equal to the amount that is paid out of the pot. Jack's ability to profit from his cryptocurrency is entirely dependent on the next player, Jill, stepping forward and taking them off him at a higher price. Likewise, the amount Jack wins from the lottery is a function of how much Jill and other players have contributed to the pot.

Compare this to a stock or a bond. As long as the firm’s managers deploy the money in the pot wisely, the firm can throw off more resources than the amount that shareholders and bondholders originally contributed.

People have been asking me to extend this classification to other assets. Below I've made a more extensive chart:

Similar to the first chart, I've put Bitcoin, Dogecoin, and other cryptocurrencies in the bets & hedges category along with insurance, futures & options, and various gambles such as lotteries. I describe the members of this family as sterile uses of wealth. Unlike more productive uses of wealth, which increase society's resources, bets and hedges transfer existing resources from one person to another.

I disagree with you, JP

No doubt others will disagree with my classification scheme. For instance, why not put cryptocurrencies in the consumer goods section? After all, aren't cryptocurrencies sort of like collectibles? Don't people primarily collect sports cards, old coins, and crocheted doilies because they expect these objects to rise in value, just like the people who buy cryptocurrencies?

Collectibles and other knick-knacks have sentimental, symbolic, ornamental, and ceremonial value. Even if they can't be sold (most knick-knacks can't), they are still valuable for the above reasons. Not so Bitcoin, Dogecoin, and Litecoin. Cryptocurrencies are pure bets on subsequent people accepting or buying them. If no one steps up, the tokens don't have any other redeeming features that can salvage their value.

Are cryptocurrencies like art? Leonardo da Vinci's Salvator Mundi sold for $450 million to a Saudi prince in 2017. Surely Salvator Mundi's consumption value isn't that high. It would seem that its value is entirely predicated on what the next aesthete will pay, in the same way that bitcoin's value hinges on whether another bitcoiner arrives.

Perhaps. But most art pieces aren't Leonardo's Salvator Mundi. The great mass of paintings that have been created over time are relatively cheap. Secondly, prices in high-end art markets may seem to be disconnected from the consumption value they provide, but that's only because these prices are being drive by the preferences and tastes of consumers who are far richer than most of us. It is this ability to consume the beauty and meaning of art that separates it from cryptocurrency.

What about categorizing cryptocurrencies as commodities? For instance, Bitcoin is often described as digital gold. Or consider George Selgin's reference to bitcoin as a synthetic commodity. Selgin's argument is that cryptocurrencies are commodity-like because they are scarce. And they are synthetic because, unlike commodities, they have no value apart from what other people will pay for them (i.e. they have no nonmonetary value).

I agree with Selgin's analysis. But because cryptocurrencies are synthetic—i.e. their purchasing power is entirely predicated on another person entering the game—I've put them in the bets & hedges category along with other zero-sum games, not the commodity family. Sure, the supply of cryptocurrencies is fixed, say like copper. But that only makes it a very special type of bet, not a commodity.

Blurred lines

The categories in my classification scheme do sometimes blur. At times the stock market becomes incredibly speculative. People start buying shares not because they expect the underlying business to produce higher cash flows, but because they expect others to buy those shares at a higher price, these buyers in turn expecting others to purchase it at a higher price. Thus buying stocks becomes for like betting on a zero-sum game than an effort to appraise the earnings potential of an underlying business.

The same applies to gold:

I'd argue that gold's price can be decomposed into two components 1) its value as a commodity and 2) the value of the lottery-like zero-sum game being played on top of its commodity value. Bitcoin lacks 1), it is purely 2). So it is sort-of like gold, but exactly like a lottery.

— JP Koning (@jp_koning) September 8, 2018

There is another type of blurriness. Notice that neither chart has a category for money. That's because I prefer to think of money as an adjective, not a category. More specifically, moneyness is a characteristic that attaches itself by varying degrees to all of the instruments in the chart above. A more money-like instrument is relatively more tradeable, or marketable, than a less money-like instrument.

So we can have money-like commodities, bonds with high degrees of moneyness, and heck, money-like lottery tickets. Even some types of banknotes will be more money-like than others. For example, you'll have much better luck spending fifty C$20 bills than you will one C$1000 banknote. Or take the example of choice urban land, which is a lot more saleable than property in the middle of nowhere. Lastly, spending bitcoins is probably much easier to do than spending Dogecoins.

For the last few centuries, the most money-like instruments have tended to be in the debt category. There are many reasons for this. Debt instruments are stable, they are light and thus convenient for transporting, they can be digitized and used remotely, they are fungible, they are difficult to counterfeit, and they can be efficiently produced.

All of you folks with some spare funds who are mulling a big cryptocurrency purchase: be careful. There are plenty of people on the internet who are aggressively marketing crypto as some sort of new society-transforming elixir, or tomorrow's money. But much of their marketing is unfounded. It is unlikely that Bitcoin or Dogecoin will ever attract the same degree of moneyness as the most popular debt instruments. Their zero-sum game nature will always interfere with their ability to attract usage as a medium of exchange. But I could be wrong.

While there are elements of cryptocurrencies that are really neat, they aren't fundamentally new. Rather, they fit quite nicely in the traditional 'bets and hedges' category. If you wouldn't bet all your savings in a zero-sum game like poker, neither should you do the same with cryptocurrencies. A bond or equity ETF is naturally productive, as is an investment in human capital. Consider them first.