One of the most difficult challenges in finance is how to price crypto assets. Bonds pay interest. Stocks pay dividends. What exactly do crypto assets pay? Well, other people value them, too, but what does that depend upon? How can crypto valuations be connected to something real?
The executive summary of my current thinking goes something like this: the value of crypto assets comes from a few core uses — plus, and this is crucial, how much investors value the volatility of crypto assets. It is this latter feature which explains much of the day-to-day price shifts of crypto.
Start with the core uses. Some of these are already established, others are more speculative. One well-founded core use is that you can use crypto assets to pay off your blackmailer or data thief. (Crypto proponents hate this example, but when it comes to a core use, it is the closest thing crypto has to a “sure thing”.) Whether this is socially desirable is another matter, but it is privately beneficial to hold some crypto in order to pay ransoms.
Other core uses could involve crypto assets as “digital gold”, crypto assets in gaming environments, crypto assets in the metaverse, crypto assets as a means of paying off “smart contracts”, and crypto assets as underpinning decentralised finance, or DeFi. These uses vary in their degree of acceptance and their likelihood of success, but all of them are possibilities.
Crypto prices are in part a moving bet on how much the demand for crypto will increase to satisfy these varied uses. For my purposes it suffices that some core demands exist, and so the value of more useful crypto assets will not fall to zero. What I am most interested in is which forces might operate on top of these relatively well-understood factors.
Much of the primary value of crypto assets is from their price volatility, which is part of their appeal. I raised this possibility some while ago, tongue in cheek, but upon further reflection it seems to me an actually useful (albeit counterintuitive) way of thinking about crypto assets. The general idea of price volatility as a value dates at least as far back as Fischer Black, one of the founders of options price theory.¹
In standard economic theory, investors are risk averse, meaning they prefer more stable consumption patterns to less stable ones. That is usually true, but it does not mean investors always prefer more stable investment prices — a crucial distinction.
Consider this hypothetical: you are given an envelope containing US$1. You are then offered the opportunity to exchange it for an envelope which contains either twice the money (that is, $2) or half the money (50c), each with 50% probability. In essence, you are accepting some exchange-rate volatility.
Most people will find this bet a pretty good one. The new expected value of your envelope is (0.5x$2) + (0.5x$0.50), or $1.25. That is a higher expected value than your original dollar.
If you are perched at the margin of subsistence, this bet might seem too risky. But for most investors, who have some level of wealth, it is an improvement in prospects, though with some additional risk.
Bitcoin and other crypto assets are essentially offering you a form of this bet. To be sure, this 50-50 bet does not exactly describe the price dynamics of crypto assets. But it is one way of illustrating that crypto prices, relative to the dollar, will either go up a lot or down a lot. The bet helps show that some investors might welcome price volatility — or, if you wish, call it exchange-rate volatility. And with even wilder swings in value, there is more extreme price volatility, which can be even more appealing.
So, when bitcoin and other crypto assets come along, they are a new source of expected gain — precisely due to their price volatility. It is like being invited into a casino where the odds favour you rather than the house! You won’t always win, but a lot of people will want to keep playing.
The conventional wisdom is that people fell in love with crypto because it rose so quickly for so long, and surely that is a big part of the story. But even a crypto asset that is equally likely to fall as to rise in value is a highly attractive asset, at least from the perspective of expected pecuniary returns.
That is the basic hypothesis, anyway. But there are some counterintuitive complications, the first of which is that you cannot take the volatility value of crypto as a given.
Say, for instance, that over time more people see that holding some crypto is a good investment. That boosts demand and raises the price of crypto assets, which makes crypto prices more stable, as knowledge spreads of the benefits of holding crypto.
As crypto prices become more stable, the volatility benefits from crypto diminish. After a while, when investors see lower price volatility, they will be less interested in crypto. They will sell, creating downward pressure on prices.
As investors repeatedly experience these swings in value, they might understand them better. They might take them for granted
But the story does not end there. Then the volatility game starts up again. As the price is falling, investors will wonder: exactly how much has crypto volatility fallen? How much do other investors mind? Exactly what kind of process is driving these developments?
All of those questions will reintroduce some additional volatility in the market, and in turn boost the demand for crypto once again. A game of seesaw will set in, with no obvious resting point.
The market will cycle back and forth. There is no particular reason to think this process will converge on a single “proper price” for crypto — thus matching the price patterns for major crypto assets such as bitcoin and ether.
Over the longer run, there might also be a downward trend in the volatility of crypto prices. As investors repeatedly experience these swings in value, they might understand them better. They might take them for granted. They might even become a little bored by them. All these factors could make the demand for crypto more stable, thereby lowering the volatility value of crypto and in the longer run lowering the prices of the major crypto assets.
There is another factor that could lower the volatility value of crypto assets. Consider again the core uses of crypto, starting with ransom payments and ending with DeFi. Whatever you think of that menu of options, over time its value will become better understood and more certain. So the price volatility resulting from “changing estimates of the value of the core uses” will at some point go down. That, too, will make the volatility premium on crypto lower, and may lower crypto values in the process.
That is another reason why the strategy of buying more crypto now is not straightforward: even if crypto proves itself beyond a shadow of a doubt, and commands a broad social consensus, its long-term value could end up lower because much of its volatility premium might disappear.
This theory also explains why so many distinct crypto assets have proliferated. Network effects might have been expected to lead to one or two dominant crypto assets, and as certainty about crypto uses increases that is probably what will happen. But in this Wild West phase of crypto, investors are looking for volatility. If there is a new crypto asset with at least one core use, and lots of volatility, investors may find it appealing. They won’t just stick with bitcoin. That said, if those initial core uses don’t pan out (and they usually do not), the market may indeed end up with a few major dominant crypto assets — after a lot of experimentation with even more volatile assets.
At this point, you might be wondering whether, from a social point of view, this analysis damns crypto. Holding crypto might (under some circumstances) be a good investment decision, but does that create value for broader society? Or is it just a vacuum pump, boosting wealth for its holders and sucking wealth away from others?
Upon some reflection, crypto looks better than it appears. First, in the short run, most crypto wealth isn’t spent. Some people simply enjoy the feeling of greater wealth and protection. By the time they and their heirs spend all this wealth, crypto prices might be much lower.
Second, the same questions can be asked more broadly about exchange-rate speculation. Its social value is uncertain, yet given the difficulties of maintaining fixed or pegged exchange rates, a lot of it isn’t going away. But maybe the volatility premium of crypto will diminish, just as for most normal currencies exchange-rate movements are small relative to total value. Exchange-rate volatility is something the world has managed to live with, and perhaps the same will eventually be true for crypto volatility.
Calm rather than hysterical analysis of crypto, and predictable regulatory treatment of crypto, can help bring about more mature crypto markets. That in turn could lower the volatility premium on crypto as well as the price. Unfortunately, so far neither of those developments is immediately in the offing — but I am optimistic that, over time, they will be.
The bottom line: even risk-averse investors can seek out some volatile price movements. This means that the future of crypto assets will be more persistent than many people expect, and will not require those assets to become more stable or fully satisfy a long list of practical uses. That said, when greater stability does eventually come, crypto will lose some of its lustre — and future prices may disappoint some of crypto’s most ardent advocates. — (c) 2022 Bloomberg LP