November 20, 2018

Are Cryptocurrencies Indeed Currencies? Part 1

Are Cryptocurrencies Indeed Currencies? Part 1

One of the most interesting arguments of the modern age of financial investment is that between the opponents and supporters of digital money. On one side, those against cryptocurrencies contend that Bitcoin and other such digital currencies are a scam and that people who are “fooled” into buying them will soon pay the price for their gullibility, while supporters contend that it is a legitimate asset.

However, the reason why the issue is so divisive is simple: both sides cannot really agree fundamentally on what exactly digital currencies are. The most compelling argument is that the likes of Bitcoin are not cash-generating assets but instead are currencies with features similar to commodities. This means that they cannot be valued or invested in, only priced and traded.

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Understanding Assets, Commodities and Currencies

To better understand the classification of cryptocurrencies, we have to examine the following three groups of investments:

  • Commodity:

The value of a commodity comes from its utility as a raw material that meets a particular human need, such as energy, food or shelter. Although an estimate of this value can be made by examining the commodity’s supply and demand, they both have long lead times, making them more difficult to evaluate than cash-generating assets.

Possibly the best illustration of the similarity between cryptocurrencies and traditional commodities is its analogy with gold. When viewed as hard assets, they both have important characteristics in common, namely scarcity, finite supply and inherent value, all of which show that digital coins are not only an asset, but a viable medium for trade.

  • Currency

A currency is defined as a medium of exchange which is a store of purchasing power and can also be used to denominate cash flows. Viewed in isolation, currencies cannot be valued and do not have any cash flows. However, they can be priced by comparing them to other currencies.

In the long term, any currencies that are widely accepted as a medium of exchange and can also maintain their purchasing power will see an increase in their price when compared to those which do not have these characteristics. However, in the short term, there are other forces which determine the price, including manipulation of exchange rates by governments.

Like any other currency, you can readily exchange most of the major cryptocurrencies for goods or services as they are accepted worldwide as viable modes of payment. These digital currencies are not endorsed by any municipality or country as official currencies. In this respect, cryptocurrencies can be viewed as more of an article for barter than actual legal tender.

  • Cash Generating Asset

An asset is something that currently generates cash flow or is expected to generate cash flows in the future. When you own a business, it is an asset, and the same applies to any claim you may have on the business’ cash flows.

These claims could be contractual (in the form of debt or bonds), residual (equity) or contingent (options). The thing that all assets have in common is that their cash flows have a value whereby any assets that have low risk and high cash flows, are valued higher than those with more risk and low cash flows.

As mentioned before, cryptocurrencies do not feature cash inflows and cannot – as currencies – be valued in isolation, therefore they cannot be classed as cash-generating assets.

The Final Word

The meteoric rise of Bitcoin and other cryptocurrencies and their entry into mainstream finance has cast the spotlight on digital coins and has also divided opinions on whether they can really be classified as currencies or commodities. The truth is that you can make a case for either classification, though the official answer will largely depend on political influence and your geographical location. Also, check out our post on how cryptocurrency works in general.

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