The bitcoin dilemma

Cyrptocurrencies in general, and bitcoin in particular, have captured the imagination of an increasingly curious global population, especially over the last year or so. But more importantly, the reason why bitcoin and other cryptocurrencies have been giving economists, users and policymakers sleepless nights is the difficulty it poses in classifying and characterising it. And to understand why it is so, one needs to step back and take a look at what we consider as the defining characteristics of a currency in the modern world. 

There are broadly two types of currencies in this world; fiat currencies and alternative currencies. The former are established by government order or “fiat” (hence the name) and their existence is essentially based on trust and trusted institutions. There is an issuer institution, a central bank or something similar, and a network of institutions permitted by the issuer institution, typically banks, where users can go to change denomination, exchange damaged currency and maintain currency denominated virtual “accounts” amongst other services. There is a strong legal and regulatory framework to ensure that this trust is maintained at all points in time and the value of the currency depends on this trust being maintained. Fiat currencies can be held in both physical (currency notes) and abstract (bank accounts) forms, with the latter relying almost completely on the trust inspired by the institutional framework. The value of a fiat currency is typically based on mass belief (or delusion, if one is unkind); a currency has value to a person only because it has value to others. Also, fiat currencies are characterised by their complete lack of alternative utility. In addition, fiat currencies are usually legal tender within at least one country. If the economic size of its home country is large enough and its institutions trusted, it may be accepted in other countries where it isn’t legal tender as well. 

 

Alternative currencies, on the other hand, exist purely because they are commonly accepted and recognised as a currency by users in the often complete absence of government or institutional support, with gold being a prime example. They are typically held only in physical form and there is very little recourse if they are damaged or lost. Abstract holding in these currencies is possible only with the introduction of trusted institutions; like gold ETFs for gold and gold bonds issued by banks. The value of an alternative currency is partly on the basis of mass belief and partly on the basis of alternative utility. All lasting alternative currencies have an alternative industrial or household use and if people stop believing in them as a currency, their value is underpinned by their alternative utility. Also, it is not necessary that these alternate currencies are legal tender in any country. At the same time, popular alternative currencies like gold have a potential international acceptance equal to the most widely accepted fiat currencies. 

The reason why bitcoin and other cryptocurrencies have caused a dilemma is because they are difficult to classify. They have many characteristics of alternative currencies and in fact, their dissimilarities with fiat currencies are often touted as their advantages. There is no centralised issuing institution and institutionalised holding and transaction framework around them. They are designed to operate without trusted institutions. In fact, the paper published by Satoshi Nakamoto, on which bitcoin is based, focuses on this one characteristic; that it does not need trusted third party institutions to maintain the sanctity of transactions. While all these characteristics add up to them being classified as alternate currencies, there are two fatal chinks in this armor.

Unlike alternative currencies, cryptocurrencies have no alternative utility. And unlike alternative currencies, they cannot be held in physical form because they exist only in the abstract. And while both these characteristics may be incredibly desirable for a fiat currency, they are disastrous when it comes to an alternative currency. Without alternative utility, there is nothing to underpin their value if faith is lost in their acceptance as a currency. And the lack of a physical existence along with the lack of trusted institutions means that there is neither reality nor trust in ownership. In essence, by focusing on ease and non-trust sanctity of transactions, an extremely crucial characteristic of currency was ignored in the devising of cryptocurrencies; sanctity of ownership. 

It is for these fundamental reasons that bitcoin and other cryptocurrencies will not occupy the mainstream and will not be a sustainable part of the global economy. But the underlying block-chain technology is another phenomenon altogether. It will transform financial markets and documentary transactions with its effects resonating long after the bitcoins of the world have vanished. You can count on it. 

The author is an economist and currently executive director & CEO of Essel Finance AMC Limited. Views expressed are personal