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Cryptocurrencies Are a Bubble, but Could They Serve a Purpose?

By Nick Sargen
Economics Markets
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cryptocurrencies
  • The staggering price increases for Bitcoin and other digital currencies over the past year cannot be explained by fundamentals and were most likely a speculative bubble. 
  • Proponents claim digital currencies can serve as a store of value, but they are subject to large price swings. Consequently, it is dubious they can develop into a medium of exchange or unit account such as the U.S. dollar.
  • Some have argued they facilitate financial transactions through the application of blockchain technology. However, the volume of transactions are small compared with leading credit companies; yet they command much higher valuations.  
  • Meanwhile, central banks are exploring ways to issue their own digital currencies, which could compete with privately-issued ones. But, there are important hurdles that would have to be overcome. Also, China recently issued a statement banning the use of cryptocurrencies in transactions, which caused Bitcoin to plummet.  
  • The bottom line: We consider cryptocurrencies to be highly speculative instruments that are subject to capital gains tax treatment and investors need to be cognizant of their inherent risks. 

Origins of Cryptocurrencies

The past decade has seen a proliferation of digital currencies that have generated both substantial price increases and price declines. The returns for three of the largest and most well-known — Bitcoin, Ethereum, and Dogecoin — were staggering this year through early May, ranging from more than 100% for Bitcoin to 7,500% for Dogecoin.1 They have come under intense selling pressure recently, but according to The Wall Street Journal, the combined value of cryptocurrencies now rivals that of U.S. dollars in circulation.2

Bitcoin, the world’s first decentralized digital currency, is also the largest. It was launched during the 2008 Global Financial Crisis, when the presumed pseudonymous Satoshi Nakamoto designed it to be used as a medium for daily transactions and a way to shift the balance of power from financial institutions to the public at large.3 Early on, it was highly volatile because the market for it was small and illiquid.

What put Bitcoin on the investment landscape were large price increases in 2016-2017 (see Figure 1). As Kim Schoenholtz observes, they were accompanied by a surge in its weekly trading volumes during a period of high capital outflows from China, and 97% of Bitcoin exchange transactions then took place in China.4 This suggests that many of the transactions in that period may have been a means to avoid capital controls. In January 2017, the People’s Bank of China (PBOC) took measures to slow activity on the country’s three major cryptocurrency exchanges. Thereafter, the price of Bitcoin plummeted in 2018 and 2019.

Bitcoin Price HistoryWhile the cryptocurrency “fad” appeared to be over, it subsequently resurfaced in the spring of 2020. The resurgence coincided with the U.S. government launching massive spending programs to counter the COVID pandemic while the Federal Reserve lowered interest rates to zero and engaged in quantitative easing. The surge in prices since then has been fueled by an influx of money from retail investors. They have been attracted to digital currencies by the sizable price increases and the prospect they see for them to supplant traditional currencies.


More recently, some prominent investors including Paul Tudor Jones, Stanley Druckenmiller, and Bill Miller have endorsed cryptocurrencies. The payments platform Paypal has also announced it will accept Bitcoin as a payments medium. Last month, the price of Bitcoin surpassed $60,000, boosted by Tesla’s $1.5 billion investment in January. Since then, it has fallen below $40,000.

As a result, some observers now contend that cryptocurrencies are becoming a legitimate asset class. Skeptics, however, are quick to point out that digital currencies lack several attributes that are associated with traditional currencies. Most notably, because they fluctuate wildly in value and lack any backing, they cannot function as a medium of exchange or a unit of account.

The verdict is out as to whether digital currencies are a good store of value. While they have experienced explosive price appreciation recently, they have been subject to steep price declines. Bank of England Governor Andrew Bailey recently commented that they “have no intrinsic value” and people who invest in them should be prepared to lose all their money.5

Given this backdrop, it seems evident that the run-up in their prices over the past year has little to do with fundamentals. Rather, it is a highly speculative phenomenon. The value of a cryptocurrency is what the market determines at any point in time, but it can change on a moment’s notice — witness the one third decline in Dogecoin’s price after Elon Musk’s remark on Saturday Night Live that it is a “hustle.”6

What Role Might Cryptocurrency Play?

Regarding the future, investors need to consider what role cryptocurrencies might play to make them valuable to people. According to Rakesh Sharma, Bitcoin has evolved in ways that were different from its initial application as a mechanism for daily transactions that could cross national borders seamlessly.7 He observes that: “Over the years, reports have documented its use in money laundering and illegal activities even as its clunky interface has ensured that customer adoption remains negligible… It is no longer considered a medium for daily transactions. Instead, the cryptocurrency is being branded as a store of value — an alternative investment similar to gold.”
 
The problem is that whereas gold has been around for several thousand years, cryptocurrencies are a product of the last decade when interest rates were at record lows. In examining this issue, Morningstar contends that except for scarcity of supply, Bitcoin is inferior to gold on all other aspects.8 Moreover, the scarcity — in which only 21 million Bitcoins can ever be supplied — is mainly a function of the extraordinary complexity in producing them. The limited supply argument is somewhat of a misnomer, because the fact that Bitcoin is digital, means it can be cut into an infinite amount of decimals to meet future demand. 

Another argument is the real value of cryptocurrencies is the technology they deploy to handle transactions. Blockchain is a digital ledger system that stores data in blocks that are chained together in chronological order. In Bitcoin’s case it is decentralized so no single person or group has control, and the blockchains are immutable. This allows transactions to be permanently recorded and viewable to anyone. 

Various technological advances such as Lightning Network nodes within Bitcoin’s network mean that cryptocurrencies can be used in retail transactions in the future. As the Bitcoin ecosystem expands, it is argued that products that utilize it will proliferate.

The counter-argument is the volume of transactions supported by the leading digital currencies pale with the volume processed by leading credit card companies; yet their market capitalization is substantially higher. For example, Sean Williams of Motley Fool points out the following disparity:9
 
  • The big three cryptocurrencies process nearly 1.5 million transactions per day, and their combined market value is $1.56 trillion.
  • The two largest credit card companies — Visa and Mastercard — processed more than 250 billion transactions per day in 2018, and their combined market cap is $870 billion.

Based on these metrics, cryptocurrencies appear to be grossly overvalued.

Prospective Central Bank Issuance of Digital Currencies

 
The initial response of central banks was to discourage the use of cryptocurrencies or to warn of possible regulation. For example, Randall Quarles, Vice Chairman for Supervision of the Federal Reserve Board, issued the following warning in 2017: “While these digital currencies may not pose major concerns at their current level of use, more serious financial stability issues may arise if they achieve wide-scale usage.”10 With respect to Bitcoin, Quarles noted that the currency or asset at the center of the systems is not backed by other secure assets, has no intrinsic value, and is not the liability of a regulated institution.

In the meantime, central banks appear to have shifted tactics. The People’s Bank of China has begun to distribute packets of digital renminbi in pilot cities. The Chinese authorities also issued a statement this week banning the use of cryptocurrencies in payment and settlement, and in providing crypto-related products and services. This contributed to a steep sell-off in Bitcoin.
 
Meanwhile, the Federal Reserve, European Central Bank, and others have begun to assess the prospects of issuing central bank digital currencies (CBDCs). These instruments would operate much like a credit card, and they could offer some benefits for the poor and others who are currently underserved by commercial banks. They would also facilitate governments in making social transfer payments.

However, Anne Kruger points out there are several hurdles that would need to be cleared before they become widespread.11 In particular, central banks would need to strike a balance between the need for privacy and control of the financial system. CBDCs would also raise questions about where accounts would be held and what role would be left for commercial banks in disseminating credit. There are also complications internationally including whether central banks would be willing to accept other countries’ CBDCs and how they would retain control of their money supplies. To be effective, they would also require a high degree of cooperation and coordination among the major central banks.

As Krueger observes, the international issues are of particular importance for the United States, because the dollar has served as the world’s principal reserve currency, unit of account and means of payment for the past 75 years. At the same time, the increased use of political sanctions by the U.S. has created incentives to create alternatives to the dollar. With China now seeking to enhance the renminbi’s international role through digitalization, she foresees pressures for the U.S. to follow suit by adopting its own CBDC.

It is unclear how central banks will proceed. Kim Schoenholtz points out that the vast majority of the money that households and businesses use for transactions is in fact digital, while currency in circulation is typically less than 10 percent of the aggregate money supply.12 He observes: “In the United States, for example, the value of noncash payments rose from $66.7 trillion in 2003 to $177.8 trillion in 2015. Over the same period, ATM withdrawals — a proxy for cash in use — rose from a very modest $520 billion to $704 billion.” 

In this respect, we already live in a world of digital money and digital payments. Weighing the potential benefits and costs from central banks issuing retail digital currencies, Schoenholtz concludes there are enormous risks to the commercial banking system and political challenges to make them worthwhile. However, it is too early to tell how they might evolve.
 

Conclusions: Cryptocurrencies Are Not an Asset Class for Investors 

In light of these considerations, we conclude that Bitcoin and other cryptocurrencies should not be considered an asset class for investors to make permanent allocations. Rather, they are highly speculative instruments that can be traded with the potential of reaping quick gains or losses. Also, because the IRS treats cryptocurrencies as an asset, any capital gain or loss on the sale is subject to treatment on capital assets.13 Therefore, potential investors should be asking themselves whether it is prudent to purchase a digital currency that lacks transparency, pays no interest, and is subject to capital gains taxes.

Moreover, while proponents claim privately-issued digital currencies may supplant traditional currencies in the future, there is a risk they could be subject to increased regulation or face possible competition from CBDCs that would render them less desirable. Accordingly, as Tom Finn of Fort Washington wrote in his recent article Bitcoin Buyers Beware: “We want to put our funds in investments that can provide cash flow and over time returns to us cash that then can be used to purchase tangible goods and services."14
 

  

1 Statista.com, “2021”Year of the Cryptocurrency,” May 4, 2021.
2 Greg Ip, “The Great Cash Splash,” May 8-9, 2021.
3 “History of Bitcoin, ”Wikipedia.
4Bitcoin and Fundamentals,” Money and Banking.com, December 4, 2017.
5 Ryan Browne, CNBC interview, May 7, 2021
6 See May 8, 2021 episode.
7 Rakesh Sharma, “Is Bitcoin Useless,” Investopedia, April 12, 2021.
8 “Is Bitcoin Better than Gold as Investors’ Safe Haven?”  August 16, 2018.
9 “This Figure Suggests Cryptocurrencies Are in a Massive Bubble,” May 7, 2021.
10 Speech at the Financial Stability and Fintech Conference, November 30, 2017.
11 Anne O. Krueger, “The Promise and Peril of Central Bank Digital Currencies,” Project Syndicate, May 3, 2021.
12 See his blog, moneyandbanking.com, “Universal Central Bank Digital Currency?” April 23, 2018.
13 See Investopedia, “Are There Taxes on Bitcoins?” April 26, 2021.
14 Fort Washington Investment Advisors, “Bitcoin Buyers Beware,” April 20, 2021.

nick sargen

Nick Sargen

Senior Economic Advisor
Nick is an international economist, global money manager, author, and contributor on television business news programs. He earned a PhD and MA from Stanford University and BA from UC, Berkeley.

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