Economic analysis of “cryptocurrencies”

“Cryptocurrencies” have become a popular buzzword in the Bitcoin community and media. It seems like every Joe is talking about how wonderful and significant these “cryptocurrencies” are. Supposedly they are the future of money, and while it’s not certain at all that Bitcoin will challenge government issued currencies at some point in the future, one of these “cryptocurrencies” surely will. The common knowledge will also instruct you how important and necessary it is to hold cash balances in all sorts of these tokens, because any one of them could become the next US dollar. Not only that, but Bitcoin investors should never hold more Bitcoin than “they can afford to lose” – it is absolutely possible that tomorrow they will wake up and Cryptocurrency X is suddenly the new Bitcoin, while Bitcoin lies in ashes.Financial prudence dictates that holding Bitcoin cash balances is dangerous and only a minuscule portion of a man’s portfolio should be dedicated to Bitcoin as a result.

The first problem with this narrative is that it is very difficult to find supporting evidence or logically consistent arguments in favor of these claims. Another problem is that if taken to its full logical conclusion, money would cease to exist in the future (as nobody could be sure that what is money today will be money tomorrow, nobody could hold cash balances for its main purpose – to offset uncertainty of the future) and civilization without money and market prices is doomed to collapse back to primitive subsistence level survival and barter. Therefore, the goal of this investigation will be to take a closer look at what currencies are (with an extra focus on “cryptocurrencies”), why people demand them and what various properties determine the likelihood of long term success and survival of a currency.

The first step of our discussion will focus on the word “currencies” since it automatically implies that members of the “cryptocurrency” class have certain properties one would expect from currencies. It seems obvious that if we randomly took a bunch of bananas and started calling them “biocurrencies” that compete with the US dollar, something unusual would be going on. If we then started pitching them to investors as currencies, red flags should start popping up. An independent observer might notice we are using sophistic manipulation to trick people into having a certain impression of and object without providing supporting evidence. Labeling something by a word does not mean it automatically belongs to a category this word represents. It is first necessary for us to find out what the distinguishing characteristics of currencies are and then check if our bunch of bananas posses those characteristics. Only in case they do can we label them “biocurrencies” with any intellectual integrity. This is exactly what we will attempt to do in the first section of our discussion in respect to “cryptocurrencies”.

Distinctive characteristics of money

Before we start let’s just clarify we use the words “money” and “currency” interchangeably for purposes of this discussion.

We will begin the investigation by exploring what special features distinguish money from other goods and assets traded on the market. One angle we can take is identifying different reasons people have for demanding a specific good or an asset:

  1. consumption – when people demand a good because they expect it will be able to render an effect that will move them to a state of higher satisfaction despite the costs
  2. production – when people demand a good because they expect to be able to employ it in production of consumption goods
  3. investment – when people demand a bond or equity with an expectation of greater satisfaction from discounted future returns these assets yield compared to present costs of acquiring them
  4. exchange – when people demand a good to exchange it for another good or service in the future
  5. speculation – when people demand a good because they expect market conditions will change in the future in such a way that they will be able to sell the good at a profit (but in general, expectation of future changes – or lack of changes – in the market is a necessary component of all forms of demand)
  6. a combination of the above

Looking at the list above and drawing from personal experience we can see that the particular characteristic that distinguishes money from all other assets is that money is demanded for the sole purpose of exchanging it for another good or service in the future. This holds true even for commodities such as gold that held the role of money in the past. As far as a specific quantity of gold was demanded by an individual for the purpose of exchange, it was money. In case it was not demanded for exchange, the specific quantity of gold was not money but a consumption / producer good or a speculation. Money is a category of goods that are specifically demanded as media of exchange.

It is questionable how many out of the thousands of existing “cryptocurrencies” have ever been purchased with the intent to exchange them for goods or services in the future. Since this is an empirical question for which no observed statistical data set exists, we are not able to draw any conclusions. All we can do is further analyze what contributing factors influence the demand for media of exchange.

Before we do that, we can at least provide a host of unscientific observations which, even though they do not provide conclusive evidence,  still influence relative strength of the argument. First let’s propose a little experiment for the reader – try to attend a meeting or gathering of “cryptocurrency” enthusiasts. Offer as many people as possible an option to buy an item they own in exchange for US dollars, Bitcoin and other “cryptocurrencies”. Based on how many positive answers you get for each offer you can gauge the possibility of various types of “cryptocurrencies” being used in exchange. Based on the author’s empirical experience from various “crypto” meetups around the world (yes, purely anecdotal claims with very weak argumentative strength), it is basically impossible to exchange goods and services for anything but Bitcoin and perhaps 1-3 of some other tokens that happen to be fashionable at the time. It is important to add that the fluctuations in popularity of the other tokens are considerable and so far all of them have eventually faded into oblivion. Nxt, Dogecoin, Litecoin, Auroracoin, Quark and host of others have had their fad periods which eventually vanished as predicted – but even in their prime only a small fraction of people willing to accept Bitcoin in exchange for goods and services would also be willing to accept any other token other than for a steep premium.

Even with weak empirical experience we can still say that if out of thousands of members of the “cryptocurrency” class only a handful at a time can be practically used in exchange for goods and services, it is not possible to label them by the word “currencies” or money. Another piece of anecdotal evidence suggests that the vast majority of these tokens are demanded strictly for speculation and as consumer goods for gambling. People hold them because they hope their price will increase in the future and they will be able to sell them for money and make a profit. As such, this class of tokens should be called “crypto speculative tokens” or “crypto gambling tokens” rather than currencies, since hardly any of them (easily above 99%) have ever been used in any exchange for goods or services whatsoever. The fact is that at the time of writing this article only Bitcoin has ever been used as a medium of exchange by at least a tiny number of bigger, mainstream market participants / businesses.

For the sake of the argument let’s accept that there exist at least some other tokens that are demanded as media of exchange at least by small groups of people. Let’s try to analyze what forces are at play when various goods / assets compete as media of exchange and how likely they are to survive. In order to do that, we will take a closer look at how various factors and properties of goods influence their suitability for being media of exchange.

Relevant properties of media of exchange

It can be observed that goods that have historically been used as money usually outperformed other goods in respect to certain characteristics, specifically: divisibility, durability, fungibility, ease of storage and transportation, marketability, liquidity and store of value.

The first four categories (divisibility, durability, fungibility, transportability + storability) are objective characteristics of every good and can be described by its relationship with entropy. There seems to be a market pressure for goods with minimum entropy (in respect to the 4 categories above) to emerge as money. By minimum entropy we mean the amount of energy that needs to be expended in order to achieve the intended effect in each category.

In more detail, divisibility means how much energy expenditure is required to produce various quantities of the money in question and durability describes how much energy is necessary to keep it from losing its physical properties in time (decay, corrosion, etc.). Fungibility means how much energy is necessary to produce two identical units of money and verify that two units of money have identical properties and are thus interchangeable. Transportability means how much time and energy expenditure is required to facilitate exchange of ownership over various distances between various market participants. Storability means how much energy is necessary to secure ownership of the money in question against malevolent actors.

Modern forms of money seem to have solved the problem of entropy quite well (except for artificial obstacles in transportability and storability) and not much competition can exist in these areas as a result. US dollar, for example, is almost as good as it gets in terms of divisibility, durability and fungibility, because it exists mostly as an abstract digital token on banking system’s computers. The only problem is the banking system and other payment networks that are used to store it and facilitate changes of ownership between market participants as they erect artificial barriers to transactions and introduce risk of fraud, confiscation and bankruptcy.

We should note that in this respect “cryptocurrencies” don’t differ from government currencies or between themselves either. Bitcoin, Litecoin or the US dollar have basically the same divisibility, durability and fungibility and thus can’t compete based on these criteria. The competition must occur in the remaining realms: marketability, liquidity, store of value, transportability and storage.


Marketability describes how easy it is to find another market participants that accept given good in exchange for other goods or services. Unlike the first 5 categories, marketability is not an objective property of the good itself, but instead depends purely on (expected) preferences of market participants. Marketability is a term that refers to and describes minds of people rather than goods. Interestingly enough, marketability has a circular dependency on itself. An individual demands money because (among other things) he expects that other individuals will accept it in exchange. Those other individuals in turn demand it because they expect the same behavior on part of the former individual and other participants of the market. As such, marketability of money is a social institution, an expectation of specific social behavior.

Marketability is a function of number of people that expect given good can be used in exchange. It doesn’t seem like there is an objective, scientific measure of marketability, but we could try to create a heuristic measure based on graphs. We can imagine the market as a complete graph (a simple undirected graph in which every pair of distinct vertices is connected by a unique edge), in which each vertex represents a market participant and each edge represents a possibility of market exchange. We can then introduce an index of usability which equals the number of edges in the graph, representing the set of all possible exchanges between money holders:


A graph representing 7 market participants and the number of possible exchanges between them as edges of the graph.

The index of usability of the graph above would be 21. In general, we can express the index of usability as


where n is the number of market participants that accept the good in question in exchange. The interesting thing about the index is that there is a convex relationship between the number of participants and number of possible exchanges.


This means that if we accept that index of usability is a reasonable expression of marketability, we can say that marketability of a good raises exponentially with the number of market participants that demand it. To demonstrate how powerful this effect is, here are a few examples:

  • 10 participants : marketability = 45
  • 100 participants : marketability = 4,950 (10 times more participants, over 100 times more marketable / useful in exchange)
  • 10000 participants : marketability = 49,995,000
  • 1 million participants : marketability = 499,999,500,000

For example if we take a 100 times bigger group, from 100 to 10,000 participants, the usability is over 10 000 times higher. That means that even tiny differences in number of participants produce massive differences in usability of the network as a whole.


A complete graph with N=30 vertices.

 Marketability can also be described from the point of view of entropy. It is the inverse amount of energy that needs to be expended by participants of the system to find partners for exchange, spread information, calculate prices and plan for the future. It also describes how economic activity is enabled between participants of the system. We can say that there exists a clear pressure for every market participant to be a part of the biggest group of people that accept certain good in exchange, or in other words market participants are rewarded for exchanging goods and services using the most marketable good on the market (money). This is true simply because of laws of physics and how much energy expenditure is necessary to exchange information. There also exist a force in the opposing direction, as demanding goods with lower marketability comes at an opportunity cost of all the benefits of marketability of the biggest network.

“Store of value”

When people talk about “store of value”, what they mean that the market price of money (or also its purchasing power) is less  volatile as with other goods/assets and does not decrease with time. The problem with this view is that no such thing as a store of value exists, certainly not as an objective quality of any good or asset. Market price of every good is determined by supply and demand, which in turn are determined by a score of factors that nobody is able to fully comprehend, predict or analyze. Demand for money, just like any other good, depends on preferences of market participants. These preferences can change from day to day for unexpected reasons. People can decide to increase their demand for money because current market situation makes them believe increased saving is prudent, or they decrease it in favor of capital investment because perceived risk of doing so has lowered. This means (as far as demand goes) that a good is as good a store of value as people’s future actions determine it to be. When talking about “store of value” people are (as far as demand goes) describing not objective properties of a good but future expectation of market participant’s actions.

The only objective quality of a good that determines future market price is the difficulty of newly produced quantity entering the market. A good would be a better “store of value” if (all things being equal) the new supply entering the market would be relatively lower than new supply of other competing goods. If we accept that there is not much we can say or predict about future demand of any good, the difficulty at which newly created supply of a good enters the market is its only objective property market participants can take into consideration when deciding which good is likely to perform well as a store of value.

Since market participants must decide which good to demand as money based on incomplete information and estimation of the future, two aspects will be especially influential:

  • perceived subjective understanding of the difficulty at which new supply can enter the market in the future (how much people think they know about the chance of different quantities of new supply entering the market in the future)
  • estimated quantity of new supply entering the market

To illustrate what this means, imagine a relatively new good that has increased its market supply in the past few 5 years by 5%,1%, 10%, 4% and 2% respectively (with an average increase in supply of 4.4% per year) and another good that has been on the market for a long time while increasing its supply by 5.5% on average but with much lower standard deviation (perhaps with series looking like 4.5%, 5%, 6%, 5.5%, 5%,…).

There will be 2 forces at play here influencing people’s demand for both goods as expected stores of value. One will be favoring the lower average supply increases of the first good, the second one will favor the subjectively perceived confidence (that can turn out to be completely wrong in the future) in strength of precision of prediction of future new supply of the second good. To express this in simpler words, the market will prefer money that:

  • has low expected increase of supply in the future
  • people have high confidence in the first expectation

Virtuous cycle

What we have said so far has significant importance for how potential competition to become money between multiple goods will play out. Specifically it is the emergence of virtuous loops. Let’s imagine a scenario in which 2 goods with completely identical properties (in terms of the Aristotelian features) and future supply expectations compete as money. Let’s say they start in an equilibrium price in year 1. Market participants either predict good 1 will be the better store of value (and demand good 1 as money), good 2 be the better store of value (and demand good 2 as money) or assign various probabilities to either of the goods being a better store of value (and demanding respective quantities of good 1 and good 2 as money). What happens next is that at some point in the future new information which was not part of someone’s expectations emerges and forces market participants to reevaluate and adjust their demand. Let’s say that in our scenario information will surface that new supply of good 1 is now expected to be lower than previously thought. This will cause some market participants to sell good 2 and buy good 1. That means that demand for good 1 has now increased and demand for good 2 decreased, making good 1 a better store of value than expected since its market price is now increasing more than expected. On the other hand, the market price for good 2 has decreased, making it a worse store of value as expected.

This benefits good 1 two-fold: not only has its price increased compared to what was expected, it’s relative usefulness as store of value has increased even more since price of good 2 is lower than expected at the same time. This market action now changes the situation and distorts the original equilibrium. The unexpected superiority of good 1 as a store of value now incentivizes market participants to restructure their original allocation of cash balances in favor or good 1. Subsequently, demand for good 1 increases even more, making it an even better store of value than expected and good 2 even worse than expected. This in turn forces market participants to adjust their demand again, exchanging good 2 for good 1. This virtuous loop continues until good 1 is the only money left and monetary demand for good 2 completely disappears.



Double virtuous cycle

Besides a virtuous cycle in increased demand and better function as a “store of value”, there is an even stronger virtuous cycle interplay between “store of value” and marketability. If two goods competing to be money are in equilibrium and there are market participants who exclusively demand one or the other good as money, a change in demand for one good as a store of value will also induce change in demand for marketability. When the first described virtuous cycle kicks in and influences at least 1 market participant demanding good 2 to instead demand good 1, it has dramatic impacts on the index of usability (our metric of marketability). Let’s imagine a case where there are 10 market participant demanding both good 1 and good 2 as money and they are in equilibrium.


Initial equilibrium with both goods having 10 market participants demanding them as money.

Now let’s take a look what happens to the equilibrium state when at least 1 participant starts demanding good 1 instead of good 2:


New state after 1 market participant started to demand good 1 instead of good 2 as money.

We can see that even a tiny change in demand has a massive effect on marketability of both goods. The marketability of good 1 is now 152% that of good 2. This new state now presents a challenge to market participants who originally demanded good 2 both for marketability and as a store of value. There is now an opportunity cost associated with demanding good 2 as far as marketability goes. This penalty for demanding good 2 will pressure holders of good 2 to start demanding good 1 as money instead. With the new incentive it is also necessary to expect that new market participants who currently demand neither good 1 or good 2 are now more likely to demand good 1 in the future as previously thought. This means good 1 is now expected to be a better store of value than good 2, levying yet another penalty on demand of good 2.



The opportunity cost of holding good 2 is snowballing and creates a strong pressure on the market to demand good 1 as money instead.

This means that a strong self reinforcing virtuous cycle exists between marketability and store of value. Even if two goods start in an equilibrium, the first change in demand for marketability, store of value or a change in expected new supply entering the market will introduce opportunity cost and pressure on the market for only one of the two goods to eventually be demanded as money.


Liquidity is a property that often gets confused with marketability. Whereas marketability describes the number of participants on the market, liquidity describes market capitalization of a currency – the capitalization of demand and supply. Liquidity is the ability of an asset to be exchanged for goods or services without influencing the price, in short periods of time. Imagine a person in the real world who wants to sell a very expensive asset, for example 10 tons of gold. He has a much higher chance of successfully completing the transaction in a short time and getting the market price when he demands US dollars in exchange for the gold as opposed to Ukrainian Hryvnia, because US dollar is much more liquid. The same holds true in the opposite direction, it is easier to buy an expensive asset in a short period of time and getting the market price for US dollars than it is for Hryvnias.

Liquidity puts a cap on the size of transactions that a currency can facilitate. Currencies with high liquidity will enable bigger transactions (in short periods of time without paying a premium) than currencies with relatively lower liquidity. If a big Chinese investor wants to convert 100 million yuan into US dollar, he will not have a big impact on the US dollar market. On the other hand, if he decides to convert the same amount into Bitcoin, he will either have to pay a huge premium or split the conversion in multiple small transactions spanning long periods of time – even then the amount would probably be so big that it would significantly impact the market price of Bitcoin.

Just like marketability, liquidity of a currency generates a positive feedback loop – as it increases it allows ever “bigger” market participants to join the market and makes the currency a better store of value as a consequence, while decreasing the liquidity and usability as a store of value of all competing currencies.

Liquidity is a weaker predictive feature of currency “strength” than marketability because it is more easily influenced by single wealthy market participants. We can illustrate this problem on a hypothetical example: let’s have two currencies, A and B with identical liquidities. While currency A has 100 market participants demanding it, currency B is only demanded by 3 big players. If a few people demanding A change their preferences and no longer demand it, the relative damage to the usability of currency A is relatively tiny compared to a situation where even 1 person changes preferences regarding currency B. The difference in both cases is risk. It is safer to hold cash balances in a currency that is demanded by a larger number of market participants because change of preferences of single individuals has relatively lower negative impact on the system as a whole.

The problem with “cryptocurrencies”

The problem with the idea of cryptocurrencies is, that they cannot compete with each other in terms of divisibility, durability, fungibility, supply management and storage costs because they cannot differ from each other in these respects more than marginally, if at all. The only areas where they can compete are:

  • marketability
  • liquidity
  • store of value
  • transactional system

We have shown there is a strong reinforcing virtuous cycle between marketability, liqudity and store of value. This means that even if 2 identical “cryptocurrencies” started in an equilibrium, even a slight change would put in motion a process that would eventually motivate every market participant to demand only one of them as money.

In fact, the role of marketability is much stronger in “cryptocurrencies” than in other goods, because they practically have a fixed and totally predictable supply. The “store of value” function is then purely determined by demand. Since the only difference between “cryptocurrencies” are marketability and liquidity, they are the only determining factors of demand. As a consequence, market participants will inevitably demand the network with the highest marketability and liquidity as money.

Transactional system

The transactional system is theoretically the only objective property of “cryptocurrencies” where there can be any difference and competition. We say theoretically because “cryptocurrencies” are just software, which means any technical advantage one network introduces can also be implemented in all other networks. Perhaps it could be possible that multiple networks with fundamentally incompatible architectures could exist at the same time, but this could only be relevant if it had any significant impact on the ability to store and exchange ownership of the tokens from the point of view of entropy. If one network required a significantly lower expenditure of energy to achieve the same effects as its competitors, it would have a chance to take on the marketability of the biggest network in a battle. The “savings” in entropy would have to be big enough to overcome the opportunity costs of foregoing the massive networking effect of the currently biggest network.


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