Cryptocurrency prices have decreased drastically since the beginning of 2022, with their detractors feeling validated by this development. Bill Gates’ recent critical comments on cryptocurrencies may have added to the impression that cryptocurrencies are not useful. In many respects, Gates’s critical stance is justified: cryptocurrencies are highly volatile, don’t generate sustainable revenue streams, and some, such as Bitcoin, detrimentally impact the environment. However, the conclusion that cryptocurrencies are useless is overblown.
Cryptocurrencies as a new asset class
The reason that cryptocurrencies are useful is that they represent a new asset class, providing unique value to some investors. To better understand this point, we need to look at two dimensions according to which assets can be characterized: virtuality and third-party risk. Virtuality refers to the material nature of assets. Some assets are material, such as real estate or gold. Others are immaterial, like shares and money (for the most part, with exceptions being coins and bills). Third-party risk refers to the likelihood that a third party compromises the value of the asset.
Both material and immaterial assets have existed for a long time. Owning material assets comes with several disadvantages: they need to be protected from theft and destruction, can arguably be more easily confiscated, and can be difficult or impossible to move from one place to another. Therefore, for many investors, immaterial assets are more attractive. However, most immaterial assets in today’s financial world have a relatively high third-party risk. To buy or sell them, one needs to go through a financial institution, which introduces a censorship risk. It also means that a substantial part of the population is excluded from the opportunity to buy or sell assets. The Federal Reserve estimates that 22 percent of American adults have only insufficient or no access to banking services. Moreover, governments could shut down these financial institutions or blacklist individuals or companies. In addition, central banks can take actions that lead to inflation.
Overall, the high reliance on these third parties in the financial sector introduces risks and vulnerabilities. With cryptocurrencies, there is now an asset class that combines immateriality with low third-party risk. This provides unique advantages to investors, making cryptocurrencies a useful investment alternative under certain circumstances.
What are the advantages for cryptocurrency investors?
For investors seeking assets that are not only immaterial, but also associated with low third-party risk, cryptocurrencies provide an interesting option. Third parties are less able to compromise their value. There are several reasons for this. There is no central party, such as a central bank, that can increase supply drastically, thereby undermining their value. Moreover, governments will find it difficult to confiscate cryptocurrencies or to prohibit transactions. While is also the case for certain other material assets such as gold, cryptocurrencies are immaterial, which makes them more difficult to steal, less prone to destruction, and easier to move around.
The unique characteristics of cryptocurrencies can be valuable in particular for people living under circumstances where institutions are not functioning properly, which implies heightened third-party risk. For instance, cryptocurrencies are widely adopted in hyperinflation-ridden Argentina and Venezuela. For refugees, storing their wealth in material assets such as gold may be even less feasible. Again, here cryptocurrencies may represent a viable alternative.
The future of cryptocurrencies
Despite their promise, cryptocurrencies face manifold challenges that need to be overcome. While they are immaterial, cryptocurrencies are not without third-party risk themselves. The decentralization that facilitates the low third-party risk of cryptocurrencies is not an inherent feature of cryptocurrencies; it needs to be enacted in practice. There are several sources of third-party risk in cryptocurrencies: for instance, mining pools can compromise their integrity, and software developers may introduce backdoors. Research at ESSEC and other institutions is ongoing to identify these third-party risks and potential remedies, so that it’s possible to identify and execute the potential of cryptocurrencies to provide immaterial assets without third-party risk in the future.