Decrypting the crypto myth

Bitcoin and other cryptocurrencies are generally perceived as assets, currencies or both. As impactful as cryptocurrencies’ have been as tools of speculation in current financial markets, the narrative behind the existing technology holds the key to breaking it and most fads down.

Cryptocurrencies are computer-managed ledger entries that can function as money if someone is willing to value these entries as money and use them in transactions.

Cryptocurrencies inherently possess no value whatsoever, but are valued at high prices. The reason why cryptocurrencies are the behemoth instruments seen today lies in the narratives propagated surrounding them.

The primary narrative which appeals to most cryptocurrency enthusiasts is the idea that cryptocurrencies, due to some advanced technical brilliance, excel as a currency compared with a dull old currency note.

Moreover, the benefits boasted by Bitcoin (the most prominent cryptocurrency) promoters are anonymity and security. Additionally, the use case of Bitcoin (and other cryptocurrencies) involves it being used as a currency to purchase goods and services.

Finally, Bitcoin is promoted as a financial asset which can be used as a storehouse of value analogous to gold.

Furthermore, Bitcoin is said to function in the same vein as gold because it is limited in numbers and not a productive asset.

As we have seen in recent times, Bitcoin and its peers fail to deliver on any of the promises so proudly boasted on the packaging.

For a currency to be a viable medium of exchange, the primary requirement is for it to be relatively stable in value.

Bitcoin has spectacularly failed in this respect, falling more than 56% over six months (at the time of writing this piece).

Moreover, it has also been unable to weather an interest rate increase of merely 1.75%, while the U.S. Federal Reserve has promised further stiff hikes to curb inflation.

Bitcoin vs gold

Gold, in comparison with Bitcoin, has been able to hold its own. Gold has been a mainstay in human society for millennia. However, like Bitcoin, it also derives a significant portion of value from the price people place on it (apart from the other use cases gold has, for example in electronics).

Bitcoin proponents’ claim of supposed anonymity and untraceability has been falsified in multiple instances in which governments have tracked criminal activity and recovered stolen Bitcoins.

An added defence by Bitcoin enthusiasts is quoting British economist Henry Dunning Macleod’s idea of Gresham’s law, which states that bad money (or money with lower intrinsic value) drives out good money (or money with higher inherent value). Gresham’s law implies that people eventually hoard money with greater intrinsic value (supposedly Bitcoin) and only use bad money (this label is generally assigned to fiat currencies). However, this claim has also been falsified as Bitcoin buyers were quick on the uptake to sell their holdings in exchange for fiat currency in the face of a loss of value.

The question is, if all the narrative elements of Bitcoin and other cryptocurrencies range from shaky at best, to blatantly false, how has it so effectively permeated general society?

The answer lies in how most bubbles and financial narratives spread through society. The speculative nature of Bitcoin and cryptocurrencies is undeniable. Most of the small-time investors lured into buying and holding cryptocurrencies are those looking to profit from the massive surge in Bitcoin price by more than 400% from the year 2020-21. It is challenging to deal with the fear of missing out, popularly termed FOMO.

Information cascade

When one sees their peers make money, it is hard to resist the urge to mimic their actions. The accompanying effect of faulty decision-making is called an ‘information cascade’.

An information cascade causes people to value the judgment and actions of others in contrast to their own. Furthermore, Bitcoin and other cryptocurrency trading applications have been heavily advertised before significant sports events such as the IPL and endorsed by popular Bollywood stars whom people idolise. These apps also let the retail investor take on leverage, which has caused many people to lose their savings and more.

The way to escape viral financial narratives and fads as a small-time investor is to heed the advice of timeless advice provided in the famous book ‘The richest man in Babylon’ by George S. Clason.

One of the most important rules from the book is to avoid investment opportunities which promise you supposedly great returns in a relatively short period.

The efficacy of the Bitcoin narrative was in the idea that the prices would keep rising and that the investor, no matter what the scenario was, would stand to gain a tidy profit. Additionally, another rule which the investor Warren Buffet also says is to avoid investment opportunities which you do not inherently understand well. Bitcoin and cryptocurrencies are just another brick in the wall of the countless previous narratives which have spread and collapsed in the history of financial markets.

(Anand Srinivasan is a financial consultant, Sashwath Swaminathan is a research associate at Aionion investment services)

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Printable version | Jun 27, 2022 5:39:15 pm |