Occam's Razor

So I’m continuing to explore cryptocurrencies and specifically why anyone would want to buy them. One obvious reason is greed. While returns on most cryptocurrencies is marginal or negative, as pretty much anyone with a computer can make their own cryptocurrency, the big name cryptocurrencies tend to appreciate exceedingly well. They get a buzz, so that alone makes people want to buy them. It’s gotten to where I can buy Bitcoin at a kiosk at our local grocery store.

In the last five years, one BitCoin appreciated 4075%. You won’t get that return in an index fund. In 2017, Ethereum was virtually unknown and could be purchased at $9.59 each. It’s now worth $3232.61, so it’s up nearly 40,000%! (Technically, Ethereum is the platform, and Ether is the digital currency.)

There’s no way to know which of these coins will take off while the vast majority of them languish. It probably can’t hurt to buy at least some of these coins on the hopes that while most will languish a couple might take off and you could profit from those purchases. Even with established digital currencies though, there are major ups and downs. My BitCoin investment is worth a modest $140.59 at the moment, and my Ether is worth $90.89. A few months ago though my BitCoin was valued at closer to $200. I bought the Ether only recently, but at the moment I’m losing money on it as I spent the $100 in cash in my BlockFi account for it.

Obviously my investment is trivial, but it’s there mostly to get my head around this stuff. So far for me the return has been good but not great. Since it can all appreciate or depreciate very quickly, it doesn’t seem wise to invest too much. It’s clear in general though that digital currency millionaires are very few and that most of us who are late to the party will assume more of the risk because these coins cost more to buy.

I did watch a YouTube video on these currencies recently. It evolved into a discussion on what money is and talked about the gold standard. The U.S. dollar was once tied to the gold standard. What made the dollar valuable was that gold itself is time consuming to mine and process. The gold in our nation’s vaults was “proof of work”. The gold was valuable because it was hard to acquire, which made the dollar valuable because the number of dollars in circulation was (in theory anyhow) proportional to the amount of gold in our vaults.

Digital currencies are trying to create “proof of work”. “Mining” a BitCoin, for example, requires a lot of computing resources and energy use. The computers you use aren’t free and the electricity they use to create it is not free either. Maybe the algorithms used to create the currencies are free but if you manage to mine a new BitCoin (it’s becoming computationally prohibitive) you will sure expend a lot of treasure to do so. This in theory makes the coin worth money.

What makes it valuable though appears to be that buyers reward BitCoin sellers for the hassle it took them to create the coin. The energy and computer resources it took to make the coin can’t be recovered. Gold though is different. It’s a physical thing, although it is expensive to store because it has value and it’s not easy to use it to pay for things as it is, in effect, too precious to be used for routine financial transactions.

But inarguably the existence of these coins proves “proof of worth” because creating these coins is hard to do. If you don’t believe me, try creating one yourself with some spare PCs. For me the question then becomes, “Yeah, so what?” I can dig a hole ten feet deep in my backyard. The fact that I dug it indicates proof of work, but is it valuable? Maybe it would be if I turned it into a root cellar. Building a root cellar is probably cheaper than building an extension to my house for this purpose. With digital currencies though, the fact that you own some part of a virtual coin that was hard to create doesn’t mean much unless you can do something with the coin.

And with most of these coins, their primary value is not to buy stuff with them, at least not directly for most coins, but that they can be traded. Unlike U.S. currency, a digital coin is infinitely splitable. I own 0.00298038 of a BitCoin. I don’t prove ownership of it by pulling it out of my pocket, or from a piece of paper properly notarized saying I do. I own it because a record exists in multiple BitCoin blockchains stored on publicly accessible servers worldwide. I’m pretty sure it’s not directly tied to my name and address, but indirectly with my email address. I can verify my ownership if needed with the private key in my digital wallet or on the BlockFi digital exchange if I exchange it for something else, such as U.S. dollars.

It turns out though that there are other ways these coins generate “proof of work”: the hassle of creating records that show the transfer of these coins from one person to another. These blockchain servers don’t work for free: you have to compensate them for the hassle it takes to make these trades, generally in a percentage of the coin you are trading. If you have a digital coin broker, you compensate them, who probably become the entity to ultimately compensate those who place the transaction on multiple registers. For example, you can see the fees BlockFi charges here. You can think of these fees as similar to interest charges on your credit card or the fees that Visa or Mastercard charge businesses to manage credit card transactions, costs which are largely passed onto you in the form of higher prices.

So in effect these are like taxes, which means that digital coins aren’t quite coins and their price is a bit inflated to cover the cost of using them. If I use some coins to buy a pack of gum at the drug store I may pay a sales tax, but the store won’t have to pay Visa or Mastercard for the privilege of taking my real coins.

If your head is spinning, I’m not surprised. None of this is obvious to most people when they buy digital currencies, but you will be charged coming and going into this market. The profits go to those that “mine” the coin and the brokers that let you trade the coin. They also go to you if you exchange the coin for more than you paid for it after factoring in these fees. But the risk is on you. You will be charged to get into the market, and if you decide to cash in your chips, unlike the casino, you’ll be charged on the way out too.

I suspect except for a few lucky millionaires the real winners are the miners and the brokers managing all this technology, and it won’t be you.