Why cryptocurrency may be in the process of becoming the new gold

The idea that cryptocurrency could change in a mere decade from a baffling computerized oddity to something akin to gold seems crazy. Or maybe something out of a fairy-tale fantasy like the Grimm brothers' Rumpelstiltskin.

For most of us, using a magic spinning wheel to create gold from straw in exchange for the promise of a first-born child is no easier to accept or comprehend than transmuting a string of numbers in a computer into something of real and lasting value.

But there are signs that is what we are seeing now, as investors buy into the most famous crypto example, bitcoin, which teetered this week at what seems like perilous heights above $50,000 US for a single unit. A year ago, it was valued at $10,000 US.

As bitcoin and its many competitors go more mainstream, cryptocurrency appears to be passing through a transformation from something weird to an accepted financial tool with real value.

A change from 'Wild West' investment 

Bitcoin, while the best known, is just one of many cryptocurrencies based on a similar principle: they're digital, rather than existing in a physical form; they're encrypted, using advanced mathematics; and they're decentralized, meaning they're unregulated and not government-issued.

An owner stores the unique secret code to each currency unit in an electronic wallet, and a bit more math — called blockchain — is like a public ledger that explains the transaction history of all the coins. Although the number of coins is limited, firing all that math around the internet uses tons of computer power and thus tons of electricity.

As comedian John Oliver once described it, it's "everything you don't understand about money combined with everything you don't understand about computers."

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What so recently seemed the province of financial know-nothings who treated crypto with the fanaticism usually reserved for religion, trading of the digital coins is now going respectable.

Elon Musk and his $1.5B U.S. purchase of bitcoin may still feel a little eccentric, but even before the Tesla billionaire's move there were plenty of signs that large institutional investors were taking a cryptocurrency stake.
 

"Bitcoin has always had a retail groundswell, people who have an interest in technology, and it was seen as a 'Wild West' investment," Bradley Duke, CEO of the ETC Group told the Financial Times in January. "That has really changed in the last six months."

Just last week with the support of CIBC subsidiary CIBC Mellon, Canada's Purpose Investments got approval to launch an exchange traded fund based on actual bitcoin, allowing respectable investors to take a stake using a regulated dealer. The Chicago Mercantile Exchange already deals in bitcoin futures. U.S. banks including BNY Mellon are moving toward offering bitcoin trading to clients. Analysts say other banks including JPMorgan Chase are "salivating" to get a piece of the action. 

So how does all this interest result in cryptocurrency having a real value? According to a new generation in the financial industry, unless something gets in the way, crypto is on the path to even greater credibility and increased trading.

"We think we're at the foothills of this long trend of financialization and institutional adoption," said Duncan MacInnes, a fund manager at the conservative money management company Ruffer.

Highly speculative and prone to 'funny business'

But where those foothills lead is still uncertain, despite the surge in institutional and Elon Musk interest. There are many credible doubters and good reasons why new digital coins may yet fail as a standardized marker of value.

Just one highly credible expression of those doubts came from Bank of Canada Deputy Governor Tim Lane last week.

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"The recent spike in their prices looks less like a trend and more like a speculative mania," said Lane in a speech on alternative methods of payment titled Changing How We Pay. He insisted that, while surprised by the rise of digital currencies ("the world has been changing even faster than we expected") cryptocurrencies do not have what it takes to become a valid form of exchange.

Among the flaws are the digital currencies' volatility, their devastating use of energy now reckoned to be more than the electricity consumption of Argentina, and their use as a tool for illicit payments by organized crime.
 

European Central Bank chief Christine Lagarde called it "a highly speculative asset, which has conducted some funny business and some interesting and totally reprehensible money laundering activity."

Crypto needs regulation, she said at a conference last month.

Value in the eye of the investor

But if central banks and governments are going to act to rein in the use of crypto, they will have to act quickly, because even while the transmutation of digits into gold is not certain and far from complete, cryptocurrency's progress in that direction, in the face of decades of scoffing by traditionalists, is now hard to deny.

Just like precious metals or stocks or even currency, the value of financial goods depends on whether we believe they are valuable. As I pointed out in 2013, when a bitcoin was worth a laughable $87 US having just lost two-thirds of its value, the price of anything is only what you can sell it for.
 

Even the price of gold — which has a well-accepted intrinsic value as an industrial necessity and pretty jewelry — is not really based on how it's used. Instead that price is determined by the collective notion, discovered in the market, of what people are willing to pay for it as a financial instrument. The same applies to cryptocurrencies.

People who believe cryptocurrencies have value, either as a tool for trade, an inflation hedge, or even just as a store of value in the distant future where gold doesn't work so well, are more willing to buy when the price falls below what they think its price should be.

There are many reasons cryptocurrencies may not make the transition to something of lasting value. Governments and central banks who don't want competition as the sole printers of money could still move against them citing their use for "funny business" to enact regulations that would sap their value.

Their energy use may lead to them being banned or shunned in an overheating world. Their cryptography could be compromised, perhaps by quantum computers. They could be brought down by fraud.
 

As Tim Lane and many others have suggested, bitcoin prices may indeed be a temporary mania based on the idea of getting rich without work. Respectable investors may have their fingers too badly burned to touch them ever again.

Maybe, unlike the fairy tale, all of Rumplestiltskin's gold will turn back to straw.  

But the longer cryptocurrencies trade widely and the more respectable they become, and so long as they don't disappear altogether, the greater the chance of them becoming a useful unit of commerce for the new space age.

Follow Don Pittis on Twitter @don_pittis