The wild west of cryptoassets

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Aaron Carter: Who knows how that really plays out? And I think you’ve seen a lot of these, as I said, it’s a gold rush. But there’s no price discovery that’s lasted over time. Things will go from being worth almost nothing to being worth tens of thousands of dollars almost overnight. But there’s no support there if someone tries to sell them. If it’s a fad and it starts to go away, what are these things going to be worth?

Bipan Rai: Hello, everyone, and welcome to another edition of The FX Factor podcast. Again, as usual, this podcast is available through the usual platforms. That includes iTunes, Google and Spotify. So a bit of a different direction we’re going to take with this podcast, we’re going to deal with a relatively controversial subject for the markets, and that is, of course, cryptocurrencies. And again, we get asked all the time what we think about cryptocurrencies. Where they’re headed, whether or not they’re a viable asset class. Some of those questions we’re going to try and attempt to answer today. And today we’ve got a special guest who’s rejoining us from our prior episode on the repo market. This time, I brought him along to speak a little bit about the crypto market, cryptocurrency market, I should say. We’ve had some interesting discussions in the past. And, of course, he’s got several interesting takes on different cryptocurrency assets. His name’s Aaron Carter. Aaron, how are you, man?

Aaron Carter: I’m doing great, Bipan. Thanks for having me back.

Bipan Rai: Good to have you back. You know when we’re talking about cryptocurrencies, Aaron, and I’m sure you’ll agree, there’s way too many to count out there. As a last estimate. I believe there’s somewhere close to three to four thousand cryptocurrencies. I’m not sure if I’m off by a thousand or two there. But again, you know, it’s relatively easy to get confused by the different types. Aaron, why don’t we start off with Bitcoin and just sort of get to the nuts of what it is exactly and how it relates to the blockchain. What can you tell us about Bitcoin?

Aaron Carter: Yeah, so if you look at it in terms of other, comparing it to other currencies, let’s say. Everything else is essentially maintained centrally, right? So you’d have like the Bank of Canada, the Fed, they have accounts that hold the reserves of the banks. Those individual banks hold accounts that list all of their customers and their assets. So you always have a central counterparty that maintains a ledger, if you will, of every account and how much it holds. And then you rely on that one central authority to move funds back and forth. And now you compare that to blockchain and the basic idea is that it’s decentralized. There’s no one authority. So it works by a method of consensus. The technical parts of this is probably a little bit above my head. So apologies to the people who really understand it very well. But essentially by decentralizing it, you say for any transaction to be verified, there’s a cryptographic calculation that has to be done, various nodes or servers, if you will, compete to calculate it. So they’ll put all the transactions in. They will try to crack the crypto hash and the one that gets the answer and everyone else can verify if their math is correct. And that’s the key point, is that you can’t just introduce transactions without everyone else verifying it. Once that’s verified, it’s added to the blockchain. Right, so that blockchain is just an ever growing list of all the transactions, including all the history of every transaction that’s ever been made and which accounts on which funds. But it doesn’t rely on any one central processor. It’s distributed computing across the entire world.

Bipan Rai: Right. It sounds very intensive from an environmental perspective as well. We’ve certainly seen a lot of that in the news, wouldn’t you agree?

Aaron Carter: We have, yeah. That’s been a very common topic in the past few weeks. There’s been a lot of debate around the energy use. And it’s true, like just by nature of it, you can say that if you’re getting a whole lot of different servers to verify transactions, that’s naturally going to use more energy than if you have one central authority doing it. But the question there is it’s not necessarily are you using more energy, it’s that are you getting enough value out of the extra energy that you’re using? That’s certainly debatable. And there’s a lot of movement in the crypto space that’s trying to reduce energy consumption like Ethereum, which we’ll get into later, I’m sure, is looking to move to proof of stake instead of proof of work. So that means essentially using one of a group of trusted nodes, they get assigned to verify transactions. So you still have some cryptographic safety around it, but you’re massively reducing the energy consumption as a way to solve that problem, but still give you the properties of a blockchain that people are looking for, which is that decentralized nature.

Bipan Rai: Right. The one that everyone sort of is the most familiar with and gravitates towards is, of course, Bitcoin. But there’s also other types of currencies out there as well, Aaron. Are there are any others that you like to follow on the usual?

Aaron Carter: Yeah, there’s kind of the main ones, Bitcoin, Ethereum, Dogecoin has been the one that is getting a lot of media attention lately. So you said I might have some controversial opinions on that. So let’s start with one right out of the gate. I don’t think we can call all of these cryptocurrencies because I think most of them don’t actually meet the definition of currencies. They’re not really a medium of exchange. You know, like Bitcoin obviously is being used mostly as a currency and you can buy things with it and whatnot. But a lot of them just really don’t have that use case yet.

Bipan Rai: Yeah, I mean, we can break that down. I mean, usually if you’re looking at something as a type of money, you mentioned that a medium of exchange is one. The second one is that it’s got to be a unit of account. So usually when you’re sort of listing how much assets you own on your balance sheet, for instance, you usually account for it in types of a certain currency. And, you know, given the volatility of Bitcoin, I don’t think that’s going to be a viable option for cryptoassets in general. The third one is, of course, the store of value. And that’s really what I want to ask you about today, Aaron. I mean, if there is any sort of chance for cryptocurrencies like Bitcoin or Ethereum, you know, do you ever see any sort of opportunity there for them being a viable asset class based on the fact that they do have some degree of store of value?

Aaron Carter: Yeah, and I think describing them as cryptoassets might be a better term for a lot of them. So looking at them as a long term store of value, I don’t know if we can say that that has been proved out yet. It’s still pretty early days in the crypto space despite Bitcoin being around for, say, 10 years. That’s why it has the brand name value is because it’s the longest and it’s got the biggest network effect so far. But a lot of these things are brand new. We see new ones popping up every single day. And whether any of them are going to have staying power, I think that remains to be seen even for some of the big ones. There’s challenging issues with Bitcoin itself to see if it’s going to go the distance as well.

Bipan Rai: Right. So I’m going to push back a little bit because I do think that the rise of cryptoassets, I think is a response to something. I mean, they didn’t just evolve out of nothing. And I think, you know, one of the things that often gets mentioned is the fact that they’re a response to inflation. But what we’ve seen over the past couple of weeks is that that’s not true. You shouldn’t be buying crypto assets if you think we’re headed into an inflationary environment. On the contrary, I think what it is a response to is the fact that there’s been this massive surge of macro liquidity. And the way I define that is sort of this expansion of central bank balance sheets across the developed world and even in some emerging central banks as well. This expansion of balance sheets has primarily been driven by the accumulation of assets in the domestic economy. That’s not something that’s going to go away, Aaron. You think about, you know, if the Fed were to, say, taper its QE purchases, that’s fine. That’s completely different than, say, shrinking its balance sheet by selling off their assets. What do you think about that? Do you believe that the digital currencies are in response to this sort of new age of monetary policy and QE and the expansion of balance sheets?

Aaron Carter: Yeah, I think that’s one way to look at it. There’s kind of a lot to unpack there. But let’s touch on that inflation, as you mentioned, and mostly the fear of inflation, right? So the two primary drivers of markets are still always goes back to fear and greed. So we have a lot of people that are fearful that inflation might be coming, right? If you have all of this QE going on, so much liquidity everywhere in the world. And most asset classes are already incredibly expensive, right, because discount rates are so low. So what are you really going to do? Like where can you put your money to save it as a store of value? You know, and I think a lot of people are getting more distrustful of the classic system. So they’re looking for something outside. And that’s what cryptocurrency purports to offer. I don’t think it’s necessarily the best answer for most people or for many people at all. But that’s a lot of what attracts people to it. That’s the allure is that, hey, it’s something that’s decentralized, it’s outside of any one monetary regime’s control. So this is somewhere where you can put your money and not have to worry about that. It comes with a whole host of other worries that I think most people aren’t aware of. So it’s a bit of a wild west, but that’s the main thing that seems to get people through the door. And then the flip side, of course, is you see so many people making a lot of money in cryptocurrencies. Of course, you only hear of the stories generally that work out, but that’s where the greed side kicks in, right? So you have those two things have really gotten into the public conscience about everybody is asking about cryptocurrency right now.

Bipan Rai: Right. So I think what you’re saying is that maybe there’s some degree of potential there, sort of as a hedge against this world where we just see this excess macro liquidity and maybe a hedge against fiat currencies over the longer term. But it doesn’t justify the valuation that we’ve seen in cryptocurrencies over the past little while. I mean, I think Ethereum is up by, went from what, thirty dollars to say over three thousand now.

Aaron Carter: Yeah, it’s plus or minus a thousand dollars on the day recently, but yeah, it’s gone up a lot. And that’s what you said, right? If people are looking at these as a hedge, that’s not a great hedge. Something that is so volatile is not really a good way to hedge. It might be kind of more like some optionality. Like if you have a very small percentage of your portfolio in Bitcoin, then you can weather the volatility. And if it happens to be something that lasts and goes up a lot, then sure, you could consider it a small hedge. But I don’t think it is something that people should look at as a viable alternative yet.

Bipan Rai: Right. So what about some of the offshoots that we’re seeing with respect to cryptoassets? I mean, you and I have spoken quite frequently about non-fungible tokens. Do you want to speak a little bit about what they are and why they’ve taken off a little bit or a lot over the last little while?

Aaron Carter: Sure. Well, let’s touch briefly on alt coins in general, right? So one thing to keep in mind with crypto is that the cost of production on these is essentially nil, right? So when you have the ability to create something for almost nothing and the immense upside that people see, you know, you’re naturally going to have a lot of people just starting these things up. And most of these assets are going to be worthless because, that’s the marginal cost of production on them. So I think there’s a lot of a gold rush mentality to get into these right now. And you’ll see, NFTs are a perfect example, people creating NFTs of everything they can just to cash in, you know, so whether those have staying power or not, again, it goes back to like, well, if you can create them for zero cost, why would they have any value other than things that are truly rare and desirable? These are digital assets, if you will. You could literally just copy paste them and have identical copies of any NFT out there. The only thing you don’t have with it is, I guess call it the bragging rights to say that yours is the authentic one that is validated on a blockchain. Does that matter to most people? What about property rights on these things? If you go and create some piece of art and create an NFT, but I like it and I copy it and I print it out or I post it on my web page or something, do you go to sue me? Do you say you own this NFT and I don’t have the rights to use it? None of that has been figured out yet. Like, this is an entirely new area. So I think there’s going be a lot of development in that over the next few years.

Bipan Rai: Right. So I guess what the main problem I’m hearing with NFTs is the fact that there really is a lack of scarcity. You might not have that same issue with a few of the other cryptoassets out there, but it’s really stark and really glaring when we’re talking about NFTs, is that correct?

Aaron Carter: Yeah, it’s technically scarce. But if it’s a digital asset and it’s listed on a blockchain, we have to keep in mind all the ideas of anonymity behind this. The blockchain is a public ledger. So you could go look at the NFTs on the blockchain and then just copy them. It’s very easy to access them and then to make your own version of it or your own copy. So technically, yes, it’s a scarce asset in that you have the only official entry in one decentralized database, essentially, but anyone else can have a copy of it or view the same files. So who knows how that really plays out? And I think you’ve seen a lot of these, as I said, it’s a gold rush. But there’s no price discovery that’s lasted over time. Things will go from being worth almost nothing to being worth tens of thousands of dollars almost overnight. But there’s no support there if someone tries to sell them. If it’s a fad and it starts to go away, what are these things going to be worth?

Bipan Rai: Right. Why don’t we take things a step back a little bit? How would you compare Bitcoin to some of the other alt coins out there, like, say, Ethereum or Doge or Cardano?

Aaron Carter: Yeah. So let’s think of it, the best analogy I heard for this was that Bitcoin is digital gold and Ethereum, Cardano, those are more like oil, like they are used. They have computational use, if you will. So if you want to execute smart contracts, you do that using like Ethereum or Cardano and you pay the network using them as currencies. So they have a use case. Like a good way to think of a lot of cryptoassets again is what is the use case? And if you think of them almost like software instead of currencies or this, you know, magical crypto thing that I don’t know what it does. Well, what is the actual use of it as a piece of software and Ethereum drives smart contracts. Those can be very useful. Cardano can do the same. I’m not as familiar with that one, but it sounds like it’s got a very good use case as well. So if they allow me to transact in a decentralized way, executing essentially commands or contracts or anything else, well, now it’s something I’m going to use, right? Now it’s still subject to competitive pressures that if someone were to create a new blockchain, a new cryptoasset that provided similar services better, then maybe people would switch to that. But you have that network effect and you have an actual use case. Bitcoin, on the other hand, like you and I have discussed this before, is it really great as a way to transact? You just can’t do that many transactions a second. I mean, you look at credit card processors, you know, tens of millions of transactions a second are no problem, Bitcoin, I think the per second transaction volume is thousands, tens of thousands, like relatively low. You couldn’t really have consumer economy using that. But that said, as a store of value, if you think of it like digital gold, you know, people aren’t buying and selling gold all day, every day. But it still has that mental space of here’s something that I can trust and I can use it as a long term form of savings. So aside from the volatility, I think that’s where Bitcoin gets its use cases, that it has that strong network effect, that brand name recognition. And it’s just been around so long. It’s the biggest. It’s the most well recognized. So, you know, maybe it has a good use case for that.

Bipan Rai: So, you know, another common type of cryptocurrency is the token. And oftentimes, you know, a lot of people tend to use the word token and coin synonymously. We need to make a differentiation. You know, oftentimes when we’re comparing tokens to, say, Bitcoin or even other alt coins, we need to remember that a token, you know, cannot function independently. Rather, a token is based on a network of another cryptocurrency, therefore, can be thought of in terms of a relationship and dependency. What do you think about tokens? What can you sort of say about them relative to, say, some of the other alt coins out there?

Aaron Carter: Yeah, a lot of these, it seems to me, are trying to layer on other blockchains, right? So I know that I think Bitcoin actually doesn’t have anything else layered on it. I might be wrong, though, because there’s so much going on in the space. But I know Ethereum, for example, is one that allows other tokens to layer onto it because, you know, Ethereum is, call it like a digital oil as compared to Bitcoin as a digital gold so Ethereum allows you to power things. So other cryptoassets are tokens, would use Ethereum as the underlying blockchain to power their own token or coin. So you’ll have interactions between the two, which really then just drives the use case for whichever the underlying cryptoasset is that many of them are using.

Bipan Rai: So what we’ve seen is that more institutional investors are now getting involved in the space of cryptoassets. You know, it’s sort of a transformation in the way that institutional investors are looking at cryptocurrencies and other cryptoassets. Do you think that it’s here to stay?

Aaron Carter: Yeah, I think this is why the space definitely has some staying power. And even though it’s a bit of a nascent industry, you know, you go back to anything like when dotcoms first started, a big explosion, a lot of money coming in, but many of those companies are gone. However, today that industry is still one of the most profitable and the biggest ones out there. You know, it’s a very exciting space still. And I think crypto is the same. When you have more institutions getting involved and looking at it and saying, OK, regardless of which one actually lasts or whether some become completely useless and go to zero value, the space in general and the ability of the technology to work globally in a decentralized fashion, like that’s clearly got some value and provides things that people want. You know, there’s a supply and demand there. So as soon as the institution started getting involved and bringing real money to the table, I think that kind of gave the asset class, you know, like a stamp of, not quite like tacit approval yet, but at least this is interesting enough. We’re going to start looking at it. We think it’s here to stay. You know, there’s probably going to be regulation that comes along with it and probably some of that’s going to be very, very welcome because it is a bit of a wild west out there. And you do want to make sure that by the time it gets to the average investor, they’re protected or safeguarded somewhat to the extent possible in this space. And with the institutions themselves getting involved and we’re seeing more ETFs, you know, more people are applying for products that have SEC approval on this. It really shows that history has started to look at this and saying it’s going to be around for a while and we’ve got to take it seriously.

Bipan Rai: Yeah, absolutely. And speaking of institutional involvement, let’s talk about the ultimate of institutions especially when it comes to money, central banks. They’re certainly looking more and more towards issuing cryptocurrencies of their own. And again, for several different reasons that, you know, regular readers of our publications will know about. But in essence, you know, when we’re talking about central bank digital currencies, this is a topic that’s still very much nascent and things are very amorphous and it is a bit of a wild west in terms of what they’re going to eventually look like. What do you know about CBDCs, Aaron? I mean, are there any particular design concepts or things that you’ve seen out there that really stand out to you?

Aaron Carter: I think you probably know more about this space than I do. But I think the interesting thing about it, right, is if you go back to, you know, why are people interested in this? They don’t quite trust the main financial institutions is maybe one part. But another part is that we’re used to, you know, incredibly fast technology that adapts quickly and suits our needs. And it happens so quickly now, except in some of these older institutions. So currencies, the ability like Bipan, we go out for dinner. Well, eventually we’ll go out for dinner again when that’s legal. But we go for dinner and you pick up the bill and I want to send you some money, right? That might take half an hour or an hour or more to do that from my phone, right? Why can’t that be instant? You know, or you put it on your credit card bill and you want to see that transaction update in your account instantly and it might not get posted for a few days. You know, like that is so far behind technologically. I think that’s the main thing that people want. And I think that’s what a lot of central bank digital currencies are going to try to solve. It’s like we’re going to look for giving more real time ability for people to manage their accounts and to move money, hopefully within like the regulated safety of the standard financial institutions. You know, it’s giving people the value of the usability that they want without having to go outside the system into the wild west. So I think that’s really where we’re going to see CBDCs thrive.

Bipan Rai: Right. And you brought up a very good point is the fact that more and more of what we’re seeing is transactions take place out of the central banks’ jurisdictions. And again, that’s a huge risk for many reasons that are probably outside of the scope of this conversation. But in essence, if you look at the actual use of cash, it’s gone lower. And one of the advantages cash has is that it is broadly accessible within an economy. And if we’re starting to see less and less cash being used in an economy and some of the more rural places in a particular country, if you see less cash use and you see more of these alternative payment methods pop up, then automatically you run the risk of maybe exclusion. In particular, that’s troublesome for a central bank, especially when it’s responsible for a public good like money. So when we consider the central bank digital currencies, we really need to look at it from four different factors. The first one is that it needs to be universally accessible. The second one is that it needs to be electronic for obvious reasons. You can’t really have a digital currency without it being electronic. Third, naturally it’s going to be central bank issued. And again, you know, central banks issue different kinds of money, like cash, which the general public does have access to, but also reserve balances to domestic commercial banks, which the public does not have access to. And the third one is that it’s got to be peer to peer. That’s the you know, these are the challenges that central banks are currently looking at when they are issuing their own types of central bank digital currencies. And there’s a wide array of design choices out there that I don’t think there’s been much of a consensus around one particular design that central banks are going to adopt. Again, this is still very much an amorphous field. And certainly this could take different shapes. You know, from what we’ve seen over the last or at least from what we expect now. The one thing I will mention is that, you know, contrary to what some other people out there might say, it does not herald, at least at this point in time, a sort of shift away from the US dollar as a reserve currency. Can it potentially dent the US dollar standing as a reserve currency over the long term? Certainly there is that possibility, but there are several other factors we need to consider when we think about reserve currencies and the US dollar’s viability going forward as one. You know, if anyone has any questions about this topic, please feel free to reach out again. I’ll be more than happy to address some of those questions. So, Aaron, I think we covered a lot of the ground that we wanted to talk about today. And again, thank you so very much for joining us for this edition of The FX Factor. And of course, we’ll have you back to talk about other topics, including, you know, what we’re seeing in the repo markets, because, again, it does feel like that’s becoming a topic of interest, again, especially in the United States. Thank you so very much, Aaron, for joining us.

Aaron Carter: Yeah. Thank you for having me again, Bipan.

Bipan Rai: Excellent.

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