Bitcoin Backlash: Back to the Drawing Board?

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 read at all. I have been told that I know very little about crypto currencies 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 for those who disagree with me to 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 cashflows (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 surprised 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, crypto currencies 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 categorizing 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 that 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 crypto currency that earn me 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 standardization in ICO structures, though, makes it difficult to generalize, 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% 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 Crypto Currencies (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 “crypto currency as commodity” defense, though it works better for crypto currencies like Ethereum than it does for Bitcoin, and it require three building blocks: 

1. 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 willl be lower) or security (that the contracts will be more secure) rationales.
2. Crypto Currencies are the lubricants for smart contracting: The discussion of block chains and crypto currency have become entangled into one discussion, but it is worth remembering that block chains predate crypto currencies and can work with fiat currencies. Thus, you will have to argue that crypto currencies are a necessary ingredient to make smart contracts work efficiently, and that the demand for them will then rise as smart contracting expands. 
3. “Your” crypto currency 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 crypto currencies, not an argument for a specific one. To seal the deal, you will have to explain why your crypto currency 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 has the most buy in by the institutional players in the game.

I think that the first leg of this argument will be easy to make, the second leg a little more difficult and the third leg will need the most convincing. Even if you can show, based upon today's technology, that you have the "best" smart contracting currency, how do you build barriers to entry that prevent you being pre-empted by another innovation or technology down the road? 

Conclusion

The game is still early, and there is much that we do not know about crypto currencies. 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 crypto currencies, 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 crypto currencies, since you can have one without the other, and to differentiate between crypto currencies, 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.

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Past Blog Posts on Crypto Currencies

1. Bitcoin Q&A: Bubble or Breakthrough?
2. Crypto Currencies: Future of Money or Speculative Hype
3. The Bitcoin Boom: Asset, Currency, Commodity or Collectible

Read More

The Bitcoin Boom: Asset, Currency, Commodity or Collectible?

As I have noted with my earlier posts on crypto currencies, in general, and bitcoin, in particular, I find myself disagreeing with both its most virulent critics and its strongest proponents.  Unlike Jamie Dimon, I don't believe that bitcoin is a fraud and that people who are "stupid enough to buy it" will pay a price for that stupidity. Unlike its biggest cheerleaders, I don't believe that crypto currencies are now or ever will be an asset class or that these currencies can change fundamental truths about risk, investing and management. The reason for the divide, though, is that the two sides seem to disagree fundamentally on what bitcoin is, and at  the risk of raising hackles all the way around, I will argue that bitcoin is not an asset, but a currency, and as such, you cannot value it or invest in it. You can only price it and trade it.

Assets, Commodities, Currencies and Collectibles
Not everything can be valued, but almost everything can be priced. To understand the distinction between value and price, let me start by positing that every investment that I will look at has to fall into one of the following four groupings:

1. Cash Generating Asset: An asset generates or is expected to generate cash flows in the future. A business that you own is definitely an asset, as is a claim on the cash flows on that business. Those claims can be either contractually set (bonds or debt), residual (equity or stock) or even contingent (options). What assets share in common is that these cash flows can be valued, and assets with high cash flows and less risk should be valued more than assets with lower cash flows and more risk. At the same time, assets can also be priced, relative to each other, by scaling the price that you pay to a common metric. With stocks, this takes the form of comparing pricing multiples (PE ratio, EV/EBITDA, Price to Book or Value/Sales) across similar companies to form pricing judgments of which stocks are cheap and which ones are expensive.
2. Commodity: A commodity derives its value from its use as raw material to meet a fundamental need, whether it be energy, food or shelter. While that value can be estimated by looking at the demand for and supply of the commodity, there are long lag and lead times in both that make that valuation process much more difficult than for an asset. Consequently, commodities tend to be priced, often relative to their own history, with normalized oil, coal wheat or iron ore prices being computed by averaging prices across long cycles.
3. Currency: A currency is a medium of exchange that you use to denominate cash flows and is a store of purchasing power, if you choose to not invest. Standing alone, currencies have no cash flows and  cannot be valued, but they can be priced against other currencies. In the long term, currencies that are accepted more widely as a medium of exchange and that hold their purchasing power better over time should see their prices rise, relative to currencies that don't have those characteristics. In the short term, though, other forces including governments trying to manipulate exchange rates can dominate. Using a more conventional currency example, you can see this in a graph of the US $ against seven fiat currencies, where over the long term (1995-2017), you can see the Swiss Franc and the Chinese Yuan increasing in price, relative to the $, and the Mexican Peso, Brazilian Real, Indian Rupee and British Pound, dropping in price, again relative to the $.
   
4. Collectible: A collectible has no cash flows and is not a medium of exchange but it can sometimes have aesthetic value (as is the case with a master painting or a sculpture) or an emotional attachment (a baseball card or team jersey). A collectible cannot be valued since it too generates no cash flows but it can be priced, based upon how other people perceive its desirability and the scarcity of the collectible.  

Viewed through this prism, Gold is clearly not a cash flow generating asset, but is it a commodity? Since gold's value has little to do with its utilitarian functions and more to do with its longstanding function as a store of value, especially during crises or when you lose faith in paper currencies, it is more currency than commodity. Real estate is an asset, even if it takes the form of a personal home, because you would have had to pay rental expenses (a cash flow), in its absence. Private equity and hedge funds are forms of investing in assets, currencies, commodities or collectibles, and are not separate asset classes. 

Investing versus Trading

The key is that cash generating assets can be both valued and priced, commodities can be priced much more easily than valued, and currencies and collectibles can only be priced. So what? I have written before about the divide between investing and trading and it is worth revisiting that contrast. To invest in something, you need to assess its value, compare to the price, and then act on that comparison, buying if the price is less than value and selling if it is greater. Trading is a much simpler exercise, where you price something, make a judgment on whether that price will go up or down in the next time period and then make a pricing bet. While you can be successful at either, the skill sets and tool kits that you use are different for investing and trading, and what makes for a good investor is different from the ingredients needed for good trading. The table below captures the difference between trading (the pricing game) and investing (the value game).

	The Pricing Game	The Value Game
Underlying philosophy	The price is the only real number that you can act on. No one knows what the value of an asset is and estimating it is of little use.	Every asset has a fair or true value. You can estimate that value, albeit with error, and price has to converge on value (eventually).
To play the game	You try to guess which direction the price will move in the next period(s) and trade ahead of the movement. To win the game, you have to be right more often than wrong about direction and to exit before the winds shift.	You try to estimate the value of an asset, and if it is under(over) value, you buy (sell) the asset. To win the game, you have to be right about value (for the most part) and the market price has to move to that value
Key drivers	Price is determined by demand & supply, which in turn are affected by mood and momentum.	Value is determined by cash flows, growth and risk.
Information effect	Incremental information (news, stories, rumors) that shifts the mood will move the price, even if it has no real consequences for long term value.	Only information that alter cash flows, growth and risk in a material way can affect value.
Tools of the game	(1) Technical indicators, (2) Price Charts (3) Investor Psychology	(1) Ratio analysis, (2) DCF Valuation (3) Accounting Research
Time horizon	Can be very short term (minutes) to mildly short term (weeks, months).	Long term
Key skill	Be able to gauge market mood/momentum shifts earlier than the rest of the market.	Be able to “value” assets, given uncertainty.
Key personality traits	(1) Market amnesia (2) Quick Acting (3) Gambling Instincts	(1) Faith in “value” (2) Faith in markets (3) Patience (4) Immunity from peer pressure
Biggest Danger(s)	Momentum shifts can occur quickly, wiping out months of profits in a few hours.	The price may not converge on value, even if your value is “right”.
Added bonus	Capacity to move prices (with lots of money and lots of followers).	Can provide the catalyst that can move price to value.
Most Delusional Player	A trader who thinks he is trading based on value.	A value investor who thinks he can reason with markets.

As I see it, you can play either the value or pricing game well, but being delusional about the game you are playing, and using the wrong tools or bringing the wrong skill set to that game, is a recipe for disaster.

What is Bitcoin?

The first step towards a serious debate on bitcoin then has to be deciding whether it is an asset, a currency, a commodity or collectible. Bitcoin is not an asset, since it does not generate cash flows standing alone for those who hold it (until you sell it).  It is not a commodity, because it is not raw material that can be used in the production of something useful. The only exception that I can think off is that if it becomes a necessary component of smart contracts, it could take on the role of a commodity; that may be ethereum's saving grace, since it has been marketed less as a currency and more as a smart contracting lubricant.  The choice then becomes whether it is a currency or a collectible, with its supporters tilting towards the former and its detractors the latter. I argued in my last post that Bitcoin is a currency, but it is not a good one yet, insofar as it has only limited acceptance as a medium of exchange and it is too volatile to be a store of value. Looking forward, there are three possible paths that I see for Bitcoin as a currency, from best case to worst case.

1. The Global Digital Currency: In the best case scenario, Bitcoin gains wide acceptance in transactions across the world, becoming a widely used global digital currency. For this to happen, it has to become more stable (relative to other currencies), central banks and governments around the world have to accept its use (or at least not actively try to impede it) and the aura of mystery around it has to fade. If that happens, it could compete with fiat currencies and given the algorithm set limits on its creation, its high price could be justified.
2. Gold for Millennials: In this scenario, Bitcoin becomes a haven for those who do not trust central banks, governments and fiat currencies. In short, it takes on the role that gold has, historically, for those who have lost trust in or fear centralized authority. It is interesting that the language of Bitcoin is filled with mining terminology, since it suggests that intentionally or otherwise, the creators of Bitcoin shared this vision. In fact, the hard cap on Bitcoin of 21 million is more compatible with this scenario than the first one. If this scenario unfolds, and Bitcoin shows the same staying power as gold, it will behave like gold does, rising during crises and dropping in more sanguine time periods.  
3. The 21st Century Tulip Bulb: In this, the worst case scenario, Bitcoin is like a shooting star, attracting more money as it soars, from those who see it as a source of easy profits, but just as quickly flares out as these traders move on to something new and different (which could be a different and better designed digital currency), leaving Bitcoin holders with memories of what might have been. If this happens, Bitcoin could very well become the equivalent of Tulip Bulbs, a speculative asset that saw its prices soar in the sixteen hundreds in Holland, before collapsing in the aftermath.

I would be lying if I said that I knew which of these scenarios will unfold, but they are all still plausible scenarios. If you are trading in Bitcoin, you may very well not care, since your time horizon may be in minutes and hours, not weeks, months or years. If you have a longer term interest in Bitcoin, though, your focus should be less on the noise of day-to-day price movements and more on advancements on its use as a currency. Note also that you could be a pessimist on Bitcoin and other crypto currencies but be an optimist about the underlying technology, especially block chain, and its potential for disruption.

Reality Checks

Combining the section where I classified investments into assets, commodities, currencies and collectibles with the one where I argued that Bitcoin is a "young" currency allows me to draw the following conclusions:

1. Bitcoin is not an asset class: To those who are carving out a portion of their portfolios for Bitcoin, be clear about why you are doing it. It is not because you want to a diversified portfolio and hold all asset classes, it is because you want to use your trading skills on Bitcoin to supercharge your portfolio returns. Lest you view this as a swipe at cryptocurrencies, I would hasten to add that fiat currencies (like the US dollar, Euro or Yen) are not asset classes either.
2. You cannot value Bitcoin, you can only price it: This follows from the acceptance that Bitcoin is a currency, not an asset or a commodity. Any one who claims to value Bitcoin either has a very different definition of value than I do or is just making up stuff as he or she goes along.
3. It will be judged as a currency: In the long term, the price that you attach to Bitcoin will depend on how well it will performs as a currency. If it is accepted widely as a medium of exchange and is stable enough to be a store of value, it should command a high price. If it becomes gold-like, a fringe currency that investors flee to during crises, its price will be lower. Worse, if it is a transient currency that loses all purchasing power, as it is replaced by something new and different, it will crash and burn.
4. You don't invest in Bitcoin, you trade it: Since you cannot value Bitcoin, you don't have a critical ingredient that you need to be an investor. You can trade Bitcoin and become wealthy doing so, but it is because you are a good trader.
5. Good trader ingredients: To be a successful trader in Bitcoin, you need to recognize that moves in its price will have little do with fundamentals, everything to do with mood and momentum and big price shifts can happen on incremental information.

Would I buy Bitcoin at $6,100? No, but not for the reasons that you think. It is not because I believe that it is over valued, since I cannot make that judgment without valuing it and as I noted before, it cannot be valued. It is because I am not and never have been a good trader and, as a consequence, my pricing judgments are suspect. If you have good trading instincts, you should play the pricing game, as long as you recognize that it is a game, where you can win millions or lose millions, based upon your calls on momentum. If you win millions, I wish you the best! If you lose millions, please don't let paranoia lead you to blame the establishment, banks and governments for why you lost. Come easy, go easy!

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Past Blog Posts on Crypto Currencies

1. Bitcoin Q&A: Bubble or Breakthrough?
2. Crypto Currencies: Future of Money or Speculative Hype

Read More

The Crypto Currency Debate: Future of Money or Speculative Hype?

When it comes to any finance-related questions, I am fair game, and those questions usually span the spectrum, from what I think about Warren Buffett (or why I don't agree with everything he says) to whether tech stocks are in a bubble (a perennial question for worry warts). In the last few months, though, I have noticed that I have been getting more and more questions about crypto currencies, especially Bitcoin and Ether, and whether the price surges we have seen in these currencies are merited. While I have an old post on bitcoin, I have generally held back from talking about crypto currencies in this blog or in my other teaching for two reasons. First, I find that any conversation about bitcoin quickly devolves into an argument rather than a discussion, since both proponents and critics tend to hold strong views on its use (or uselessness). Second, I find that some of the technical underpinnings of bitcoin, ether and other cryptocurrencies are beyond my limited understanding of block chains and technology and I risk saying something incredibly ill informed. While both reasons still persist, I am going to throw caution to the winds and put down my thoughts about the rise, the mechanics and the future, at least as I see it, of crypto currencies in this post.

The Market Boom

Any discussion of crypto currencies has to start with the recognition that the experiment is still young.  Satoshi Nakamoto's paper on bitcoin was made public in October 2008 and implemented as open source in January 2009. Less than ten years later, the market capitalization of bitcoin alone is in excess of $40 billion and the success story, at least in terms of bitcoin as an investment, can be seen in the graph below:

The initial rise could have been a flash in the pan, a fad attracting speculators, but in the last two years, Bitcoin seems to have found new fans, as can be seen below:

Bitcoin's success, at least in the financial markets, has attracted a host of competitors, with Ethereum (Ether) being the most successful. Ether's rise in market price, since its introduction in 2015 has been even more precipitous that Bitcoin's, though it has pulled back in recent weeks:

The list of crypto currencies gets added to, by the day, with a complete list available here, with the market caps of each (in US dollars) listed. At least from a market perspective, there is no doubting the fact that crypto currencies have arrived, and enriched a lot of people along the way.

The Mechanics 

While the crypto currencies emphasize their differences, the most successful ones share a base architecture, the block chain. A block chain is a shared digital ledger of transactions in an asset where the validation of transactions is decentralized. I know that sounds mystical, but the picture below (using bitcoin to illustrate) should provide a better sense of what's involved:

The key features of a block chain are:

1. Decentralized verification: The validation and verification of a transaction is sourced to members, called miners in the crypto currency world. Verification usually involves trying different algorithms (hashes) to find the unique one that matches the transaction block, and the successful miner is rewarded, currently with the crypto currency. At least, as I understand it, this process requires more brute force (powerful processors trying different algorithms before you find a match) than intellectual firepower.
2. Complete and open records: Every transaction, once validated and verified, is converted into a block of data that is recorded in the block chain ledger, which is accessible to everyone in the network. If you are worried about privacy, the transaction records do not include personal data but take the form of encrypted data (hashes).
3. Incorruptible: A block chain, once recorded and shared, cannot be changed since those changes are visible to everyone in the network and are quickly tagged as fraudulent. Thus, the ledger, once created, becomes almost incorruptible.

In effect, a block chain is a digital intermediation process where transactions are checked by members of the network, and recorded, and once that is done, cannot be altered fraudulently. As you can see from its description, the block chain technology is about far more than crypto currencies. It can be used to record transactions in any asset, from securities in financial markets to physical assets like houses, and do so in a way that replaces the existing intermediaries with decentralized models. It should come as no surprise that banks and stock exchanges, which make the bulk of their money from intermediation, not only see block chains as a threat to their existence but have been early investors in the technology, hoping to co-opt it to their own needs.  

The Currency Question

If you define success as a rise in market capitalization and popular interest, crypto currencies have clearly succeeded, perhaps more quickly than its original proponents ever expected it to. But the long term success of any crypto currency has to answer a different question, which is whether it is a "good" currency.  Harking back to Money 101, you measure a currency's standing by looking at how well it delivers on its three purposes:

1. Unit of account: A key role for a currency is to operate as a unit of account, allowing you to value not just assets and liabilities, but also goods and services. To be effective as a unit of account, a currency has to be fungible (one unit of the currency is identical to any other unit), divisible and countable. 
2. Medium of exchange: Currencies exist to make transactions possible, and this is best accomplished if the currency in question is easily accessible and transportable, and is accepted by buyers and sellers as legal tender. The latter will occur only if people trust that the currency will maintain its value and if transactions costs are low.
3. Store of value: To the extent that you hold some or all of your wealth in a currency, you want to feel secure about leaving it in that currency, knowing that it will not lose its buying power while stored.  

Given these requirements, you can see why there are no perfect currencies and why every currency has to measured on a  continuum from good to bad. Broadly speaking, currencies can take one of three forms, a physical asset (gold, silver, diamonds, shells), a fiat currency (usually taking the form of paper and coins, backed by a government) and crypto currencies. Gold's long tenure as a currency can be attributed to its strength as a store of value, arising from its natural scarcity and durability, though it falls short of fiat currencies, in terms of convenience and acceptance, both as a unit of account and as medium of exchanges. Fiat currencies are backed by sovereign governments and consequently can vary in quality as currencies, depending upon the trust that we have in the issuing governments. Without trust, fiat currency is just paper, and there are some fiat currencies where that paper can become close to worthless.  For crypto currencies, the question then becomes how well they deliver on each of the purposes. As units of account, there is no reason to doubt that they can function, since they are fungible, divisible and countable. The weakest link in crypto currencies has been their failure to make deeper inroads as mediums of exchange or as stores of value. Using Bitcoin, to illustrate, it is disappointing that so few retailers still accept it as payment for goods and services. Even the much hyped successes, such as Overstock and Microsoft accepting Bitcoin is illusory, since they do so on limited items, and only with an intermediary who converts the bitcoin into US dollars for them. I certainly would not embark on a long or short trip away from home today, with just bitcoins in my pocket, nor would I be willing to convert all of my liquid savings into bitcoin or any other crypto currency. Would you?

So, why has crypto currency not seen wider acceptance in transactions? There are a few reasons, some of which are more benign than others:

1. Inertia: Fiat currencies have a had a long run, and it is not surprising that for many people, currency is physical and takes the form of government issued paper and coins. While people may use credit cards and Apple Pay, their thinking is still framed by the past, and it may take a while, especially for older consumers and retailers, to accept a digital currency. That said, the speed with which consumers have adapted to ride sharing services and taken to social media suggests that inertia cannot be the dominant reason holding back the acceptance of crypto currencies.
2. Price volatility: Crypto currencies have seen and continue to see wild swings in prices, not a bad characteristic in a traded asset but definitely not a good one in a currency. A retailer or  service provider who prices his or her goods and services in bitcoin will constantly have to reset the price and consumers have little certitude of how much the bitcoin in their wallers will buy a few hours from now.
3. Competing crypto currencies: The crypto currency game is still young and the competing players each claim to have found the "magic bullet" for eventual acceptance. As technologies and tastes evolve, you will see a thinning of the herd, where buyers and sellers will pick  winners, perhaps from the current list or maybe something new. It is possible that until this happens, transactors will hold up, for fear of backing the wrong horse in the race.

Ultimately, though, I lay some of the blame on the creators of the crypto currencies, for their failure, at least so far, on the transactions front. As I look at the design and listen to the debate about the future of crypto currencies, it seems to me that the focus on marketing crypto currencies has not been on transactors, but on traders in the currency, and it remains an unpleasant reality that what makes crypto currencies so attractive to traders (the wild swings in price, the unpredictability, the excitement) make them unacceptable to transactors. 

The Disconnect

You can see the disconnect in how crypto currencies have been greeted, by contrasting the rousing reception that markets have given them with the arms length at which they have been held by merchandisers and consumers. In the graph below, I focus on the divergence between the market price rise of bitcoin and the increase in the number of transactions involving bitcoin:

While the price of bitcoin has increase more than a thousand fold, since the start of 2012, the number of transactions involving bitcoin was only about thirty two times larger in July 2017 than what it was at the start of 2012. In my view, there are three possible explanations for the divergence, and they are not mutually exclusive:

1. Markets are forward looking: If you are a believer in crypto currencies, the most optimistic explanation is that markets are forward looking and that the rise in the prices of Bitcoin and Ether reflects market expectations that they will succeed as currencies, if not right away, in the near future. 
2. Speculative asset: I am second to none in having faith in markets, but there is a simpler and perhaps better explanation for the frenzied price movements in crypto currencies. I have long drawn a distinction between the value game (where you try to attach a value to an asset based upon fundamentals) and the pricing game, where mood and momentum drive the process. I would argue, based upon my limited observations of the crypto currency markets, that these are pure pricing games, where fundamentals have been long since forgotten. If you don't believe me, visit one of the forums where traders in these markets converse and take note of how little talk there is about fundamentals and how much there is about trading indicators.
3. Loss of trust in centralized authorities (governments & central banks): There can be no denying that the creators of Bitcoin and Ether were trying to draw as much inspiration for their design from gold, as they were from fiat currencies. Thus, you have miners in crypto currency markets who do their own version of prospecting when validating transactions and are rewarded with the currency in question. For ages, gold has held a special place in the currency continuum, often being the asset of last resort for people who have lost faith in fiat currencies, either because they don't trust the governments backing them or because of debasement (high inflation). While gold will continue to play this role, I believe that for some people (especially younger and more technologically inclined), bitcoin and ether are playing the same role. As surveys continue to show depleting trust in centralized authorities (governments and central banks), you may see more money flow into crypto currencies. 

The analogy between gold and crypto currency has one weak link. Gold has held its value through the centuries and is a physical asset. For better or worse, it is unlikely that we will decide a few years from now that gold is worthless. A crypto currency that few people use as currency ultimately will not be able to sustain itself, as shiner and newer versions of it pop up. Ironically, if traders in bitcoin and ether want their investments in the crypto currencies to hold their value, the currencies have to become less exciting and lucrative as investments, and become more accepted as currencies. Since that will not happen by accident, I would suggest that the winning crypto currency or currencies will share the following characteristics;

1. Transaction, not trading, talk: From creators and proponents of the currency, you will hear less talk about how much money you would make by buying and selling the currency and more on its efficacy in transactions.
2. Transaction, not trading, features: The design of the crypto currency will focus on creating features that make it attractive as a currency (for transactions), not as investments. Thus, if you are going to impose a cap (either rigid like Bitcoin or more flexible, as with other currencies), you need to explain to transactors, not traders, why the cap makes sense. 
3. Trust in something: I know that we live in an age where trust is a scarce resource and I argued that that the growth in crypto currencies can be attributed, at least partly, to this loss of trust. That said, to be effective as a currency, you do need to be able to trust in something and perhaps accept compromises on privacy and centralized authority (at least on some dimensions of the currency). 

It is also worth noting that the real tests for crypto currencies will occur when they reach their caps (fixed or flexible). After all, bitcoin and ether miners have been willing to put in the effort to validate transactions because they are rewarded with issues of the currency, feasible now because there is slack in the currency (the current number is below the cap). As the cap becomes a binding constraint, the rewards from miners have to come from transactions costs and serious thought has to go into currency design to keep these costs low. Hand waving and claiming that technological advances will allow this happen are not enough. I know that there are many in the crypto currency world who recognize this challenge, but for the moment, their voices are being drowned out by traders in the currency and that is not a good sign.

If you expected a valuation of bitcoin or ether in this post, you are probably disappointed by it, but here is a simple metric that you could use to determine whether the prices for crypto currencies are "fair". Currencies are priced relative to each other (exchange rates) and there is no reason why the rules that apply to fiat currencies cannot be extended to crypto currencies. A fair exchange rate between two fiat currencies will be on that equalizes their purchasing power, an old, imperfect and powerful theorem. Consequently, the question that you would need to address, if you are paying $2,775 for a bitcoin on August 1, 2017, is whether you can (or even will be able to) but $2,775 worth of goods and services with that bitcoin. If you believe that bitcoin will eventually get wide acceptance as a digital currency, you may be able to justify that price, especially because there is a hard cap on bitcoin, but if you don't believe that bitcoin will ever acquire wide acceptance in transactions, it is time that you were honest with yourself and recognized that is just a lucrative, but dangerous, pricing game with no good ending.

Conclusion

Crypto currencies, with bitcoin and ether leading the pack, have succeeded in financial markets by attracting investors, and in the public discourse by garnering attention, but they have not succeeded (yet) as currencies. I believe that there will be one or more digital currencies competing with fiat currencies for transactions, sooner rather than later, but I am hard pressed to find a winner on the current list, right now, but that could change if the proponents and designers of one of the currencies starts thinking less about it as a speculative asset and more as a transaction medium, and acting accordingly. If that does not happen, we will have to wait for a fresh entrant and the most enduring part of this phase in markets may be the block chain and not the currencies themselves.

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