The Bitcoin Backlash – It’s Back to the Drawing Board Again

The reason people are uncomfortable drawing the line between currency, commodity and asset is that the line shifts.

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My last post on Bitcoin got me some push back and I am glad that it did. I would rather be read, and disagreed with, than not be read at all. I have been told that I know very little about cryptocurrencies and that I have much to learn, and I agree. The crux of the disagreements though lay in my classifying Bitcoin as a currency, not as an asset or as a commodity.

Since this classification is central to how you should think about investing versus trading, and value versus price, and goes well beyond Bitcoin, I decided to dig deeper into the classification, and provide even more ammunition to those who disagree with me and tell me how wrong I am.

Classifying Investment: The What And The Why

We are products of our own world views, and mine, for better or worse, are built around my interest in valuation. It is that perspective that led me to classifying investments into cash flow generating assets, commodities, currencies and collectibles.

To value an investment, I need that investment to generate future cash flows (at least on an expected basis), and that was my basis for separating cash flow generating assets (which range the spectrum from a bond to a stock to a business) from the rest.

The pushback that I got did not surprise me, partly because my definition may be at odds with the definitions used by other entities. Accountants, for instance, classify items as assets that I think are pure fiction, such as goodwill.

There are others who argue that any investment on which you can make money is an asset, broadening it to include just about everything from baseball cards to government bonds. In fact, cryptocurrencies have been at the center of many of these disagreements, with the SEC recently deciding to treat ICOs as securities (and thus assets), and the Korean central bank categorising Bitcoin as a commodity.

Since the judgment made by these entities have regulatory and tax consequences, I am sure that they will be debated, discussed, and disagreed with.

Why Bitcoin Is A Currency And Not An Asset...

One reason that people are uncomfortable drawing the line between currency, commodity and asset, is because the line can sometimes shift quickly. Take the US dollar, for instance. Its primary purpose is to serve as a medium of exchange and as a store of value, and it is thus a currency.

However, you can lend US dollars to a business or individual and generate interest income. That is true, but it is not the currency that is then the asset, but the loan that you make with it, or the bond that is denominated in it.

Building further, if I create a bank that takes in deposits in dollars (and pays an interest rate on them) and lends out those dollars as loans, I have a business and that business is an asset. I can value the loan and the bond based upon the interest rate you earn, and the default risk that you face, or the bank, based upon the interest rate spread it earns and the risk of default that it faces on its collective portfolio, but I cannot value the US dollar.

Can I construct investments denominated in Bitcoin or another cryptocurrency that earn me an interest or a return? Of course, but I can do that in any currency, and it is in fact, one of the functions of a currency. That does not make Bitcoin an asset!

You can already see that the question of whether Initial Coin Offerings (ICO) are currencies or assets becomes trickier, because an ICO can be constructed to give you a share of the ownership in a business (and the cash flows from that business), making it more of an asset than a currency (thus giving credence to the SEC's view that it is a security). The lack of standardisation in ICO structures, though, makes it difficult to generalise, since loosely put, an ICO can be constructed to be anything from a donation (at least, according to Kathleen Breitman at Tezos) to quasi common stock (without the voting rights).

A few of you have pointed to the networking benefits that might create value for Bitcoin, but I am afraid that I don't see that as a basis for assigning value to it. A network can become an asset, but only when you can make money off the network. The value of Facebook to me, as an investor, is not that I am part of the Facebook network (I am not, since I have not posted on Facebook in almost three years), but that I get a share of the money made from selling advertising to those on the network.

Unless you can trace monetary benefits to being part of the Bitcoin network, there is no value to being part of the network.

Visa and MasterCard are assets, not because they have wide networks and are accepted globally, but because every time they are used, they make 1-2 percent of the transaction value. To the argument that Bitcoin miners can make money as the network expands, that value is for providing a service, not for holding Bitcoin.

Unless you can trace monetary benefits to being part of the Bitcoin network, there is no value to being part of the network.

Visa and MasterCard are assets, not because they have wide networks and are accepted globally, but because every time they are used, they make 1-2 percent of the transaction value. To the argument that Bitcoin miners can make money as the network expands, that value is for providing a service, not for holding Bitcoin.

Why Bitcoin Is More Currency Than Commodity

The essence of a currency is that its primary uses are as a medium of exchange or as a store of value. The key to a commodity is that it is an input into a process that has a utilitarian function.

Oil and coal are clearly commodities, since they derive their value from the fact that they can be used to produce energy. It is true, as with currencies, that you can create an asset based upon a commodity. A share of an oil well is an asset not because you like or even need oil, it is because you hope to sell the oil to generate cash flows. It is also true that gold is a commodity, but as I noted in the prior post, I think it is more currency than commodity, because the quantity of gold that we have on the face of the earth vastly exceeds whatever utilitarian needs it might serve. It is shiny, durable, makes beautiful jewelry and has some industrial uses, but if that is all we valued gold for, it would be worth a lot less than it is trading for, and there would be less of it around.

The question with Bitcoin then becomes whether it can become (or perhaps already is) like gold.

Here is my test: If tomorrow, humanity collectively decided to abandon its attachment to gold as a value store, would its price go to zero? I don't think so, because it does have uses and while its price will drop, it will be priced based on those uses.

Applying the same test to Bitcoin, I am left nonplussed about what value to attach to a digital currency, if at the end no one uses it in transactions, it has no aesthetic value and it produces nothing utilitarian.

A Commodity Argument For Cryptocurrencies (But Perhaps Not For Bitcoin)

Some of you have pointed to Bitcoin's scarcity (created by the hard cap on production) and the fact that time and energy are spent on its production. Scarcity is neither a sufficient nor even a necessary condition for something to be a commodity.

Sand is a scarce resource, but it is not a commodity because I cannot think of a good use for it; so is bull manure, but that is a discussion for another time and day. The fact that time and energy went into the production of Bitcoin cannot be used to justify paying for it unless you can show that it is necessary for something that does create utility or value.

If, as argued by someone who commented on my last post, Bitcoin is a synthetic commodity. I can see that it is synthetic, but what conceivable use does it have that makes it a commodity? Therein lies an opening for a “cryptocurrency as commodity” defense, though it works better for cryptocurrencies like Ethereum, than it does for Bitcoin, and it requires three building blocks:

  • Block Chains and Smart Contracts will create large disruptions in businesses: You have to believe that block chains and the smart contracts that emerge from them will replace conventional contracts in many businesses, and that will generate cash flows to the contract providers. Your argument can be based upon either economic (that the transactions costs will be lower) or security (that the contracts will be more secure) rationales.
  • Cryptocurrencies are the lubricants for smart contracting: The discussion of block chains and cryptocurrency have become entangled into one discussion, but it is worth remembering that block chains predate cryptocurrencies, and can work with fiat currencies. Thus, you will have to argue that cryptocurrencies are a necessary ingredient to make smart contracts work efficiently, and that the demand for them will then rise as smart contracting expands.
  • “Your” cryptocurrency will be one of the winners: Even if you can make the first two legs of this argument, it remains an argument for growth in digital or cryptocurrencies, not an argument for a specific one. To seal the deal, you will have to explain why your cryptocurrency of choice (Bitcoin, Ethereum etc) will become the winner or at least one of the winners in the smart contracting currency race, perhaps because it has the “best technology” for smart contracting or is used the most by institutional players in the game.

Conclusion

The game is still early, and there is much that we do not know about cryptocurrencies. I remain willing to learn both from people who know more than I do (and there are many out there) as well as events on the ground. As you listen to arguments for or against cryptocurrencies, my only advice is that you go back to basics about the needs that they are filling and that you ask questions about their long term staying power.

I think it is also time for us to separate arguments about block chains/smart contracts from arguments about cryptocurrencies, since you can have one without the other, and to differentiate between cryptocurrencies, rather than defend them or abandon them all, as a bundle. To me, Bitcoin, Ethereum, Ripple and ICOs are different enough from each other, not only in structure but also in terms of end game, that they need to be assessed independently.

(Aswath Damodaran is an academician and management expert who is currently a professor of finance at the NYU Stern School of Business. This article was originally published on his blog Musings on Market.The views expressed here are those of the author’s and do not necessarily represent the views of The Quint or its editorial team.)

(This article has been published in an arrangement with BloombergQuint)

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