The Major Flaws of Cryptocurrencies

Summary

There are many factors that have not been considered regarding the risk of cryptocurrencies.
Currencies need to satisfy three conditions to be currencies; have a unit of account, be a store of value and be a medium of exchange. Most if not all cryptocurrencies do not satisfy the final condition.
Most projects within the cryptocurrency market have a lot of barriers that need to be overcome to survive.
It is hypothesized most cryptocurrencies researched have a major flaw. Cryptocurrency investors want the price to increase, and users of the product associated with the cryptocurrency want the price to decrease as it would lower operational costs.

Introduction

Cryptocurrencies have had a lot of problems in the past month, with the demise of Bitconnect, the blocking purchases of bitcoin by financial institutions such as banks and the ban of cryptocurrency marketing. The investors within the cryptocurrency market still believe certain projects that are currently being worked on will be successful. However, there are many factors that have not been considered regarding the risk of cryptocurrencies, including their major flaw.

This blog will discuss examples of cryptocurrencies, traits of a currency, the barriers of cryptocurrency projects and a hypothesis on the major flaw of most cryptocurrencies.

Examples of cryptocurrency projects

To put these projects into context, some of these projects researched are shown below. Most of the founders of cryptocurrency projects have created companies for their respective projects.

Dash is trying to be a faster version of bitcoin (whereby bitcoin uses a currency and tracks all bitcoin payments on a block chain).
OmiseGO wants to design an inexpensive way to conduct financial transactions.
WaBi seeks to design a system for users to test if products are authentic and not counter fit.
Ripple is a project that is designed to support quick transaction between financial institutions in cryptocurrency or tokens that support fiat currencies.
Bitconnect was primarily a project where investors who held bitcoin could invest their bitcoin into Bitconnect by exchanging their bitcoin for Bitconnect, and reinvesting that Bitconnect to increase the interest paid to an investor in Bitconnect.

Traits of a currency

Cryptocurrencies are created by people running a project, to sell to a market and use with their project. These cryptocurrencies are designed to be used through a computer. However, given that the cryptocurrency market is using these coins more as a store of value, they may be no longer seen as a currency.

For a financial medium to be a currency, it needs to satisfy all three of the following conditions.

A unit of account: A currency needs to have a unit of measurement to represent its value. For example, the Japanese Yen is counted in Yen.
A store of value: A currency needs to be able to be stored and used later. For example, $1 USD, if stored in a bank for five years, should be able to be spent as $1 USD (excluding inflation or interest).
A medium of exchange: A currency needs to be something that people buy and sell from one another. For example, you can give $2 to a supermarket, and they will give you a carton of milk.

*The cryptocurrencies researched have been the top 200 on coinmarketcap.com as of 28th of January 2018 (coinmarketcap.com, 2018).

All cryptocurrencies researched satisfy the first condition. Most cryptocurrencies researched satisfy the second condition, since some are not used at all. However, most if not all cryptocurrencies do not satisfy the last condition.

Cryptocurrencies will most likely not be generally accepted as a medium of exchange for three reasons.

All cryptocurrencies researched for this article do not have any way to put downwards pressure on their coin’s prices (i.e. reduce the price of their coin). If prices go too high (eg. Bitcoin reaching around $18,000 USD in December, this lead to fees exchanging Bitcoin drastically increasing).
Not enough trust. There is not enough trust in cryptocurrencies to be used as a currency due to their fluxuations in price. It is doubtful, people will use a cryptocurrency as a medium of exchange if there is a chance the currency can drop by a large amount daily (roughly +5%), with respect to a fiat currency (eg. USD) for no apparent reason, as seen in the past year from May 2017 to present.
Too much is held as a store of value. A currency is considered healthy if it is being used often for everyday exchanges. Most cryptocurrencies on the market are not being used for their purposes involving the project they are assigned to. They are used as a store of value for investors. Thus, as a result, these coins are not used as a medium of exchange.

The barriers of cryptocurrency projects

An asset should increase in price the more value it either adds or can add to a given section of a market. There has been a lot of hype over the projects that cryptocurrencies are associated with. However, there are a lot of risks a project will need to overcome to be successful. These risks are outlined below with regards to a project management life cycle.

Graph 1: Product development life cycle stage with respect to cost and time

(Adams and Brandt 1978)

Concept stage

Relevance: A project may become irrelevant by not fully solving the problem it was designed to fix, another project solves the problem better, another project is more cost effective, investors loose interest or the costs to implement the project are too high.
Technology Obsolescence: The block chain technology may be eclipsed by other forms of technology. For example, there may be no need for Ripple, if there is a faster method of transacting finances between institutions without using block chain.
Time: In the time it takes the project to fully develop, another project or a better system may have been developed, which would mean, the longer the project takes, the more susceptible the project will be to threat of new entrances or substitute products or services.

Development stage

Funds: A project may run out of funds whilst developing their project. They may increase their funds by asking for investors or selling cryptocurrencies to investors. They may even not get enough funds to initially start the project in some cases.
Costs: Since most projects are using cryptocurrencies to generate revenue, how will the project create a revenue stream? Will the demand the project is targeting generate enough revenue for the project to be profitable overtime? What if the project is going into a market with lots of competitors (eg. Dash and Bitcoin), will it be able to maintain a competitive edge and compete? Have the project owners planned for a situation if the demand increases for their services or product? How would the project make changes to meet this increase in demand?
Demand: A person or group or company must be incentivised enough to buy or rent (as a service) the use of these projects. This may not happen due to companies not being interested in the project, too much change, too much risk from change, security concerns or even the price of using or buying the project being too high.
Scope: How well will this project solve the problems that the project is trying to solve. After a project’s development stage, could the problem have changed enough to have the project less relevant than it was when being developed?
Marketing: Will potential clients want to deal with a product when the price for using the project (i.e. the coin’s price) heavily fluctuates with the market?

Execution stage

Ongoing costs: Would the project have enough funds to continue to run effectively? How much memory, processing power, skilled employees, office space and funds are now required to run the project minimally and optimally?
Revenue streams: How will the project gain revenue apart from through cryptocurrencies offered? What other revenue streams will the project be utilizing to generate revenue?
Demand Changes: Will the plan to increase the scale of the project if demand increased be sufficient? What if there are costs that have not been accounted for or the costs of computer processing parts is too expensive for the project to upgrade given its revenue streams?

There are a lot of risks associated with these kinds of projects, especially since most of these projects are independent of a major financial backer.

Hypothesis on the major flaw of most cryptocurrencies

The main way cryptocurrency investors invest into these projects that are offering cryptocurrencies, is by buying the coin that is associated with that project on a public market. For example, to support Ripple's project, someone would purchase XRP on a website that has an open market where one can trade fiat for XRP.

Since a cryptocurrency investor is taking this coin and holding it, they are using this coin as a store of value. Holding a value of cryptocurrency means there is less of that cryptocurrency being traded, which means the price increases due to the coin becoming scarcer, because there is now less of that cryptocurrency being traded in the market.

If some institution, person or group was using a project’s cryptocurrency, they would want the cost of the coin to decrease, because it will decrease their operational costs for using the project. The more a client relies on the project, the greater the desire to have a reduction in the price of the cryptocurrency being used.

However, the price is controlled by the market, not the company in charge of the project. Having the price of using a project's systems is completely regulated by who controls the currency. In this case it is the cryptocurrency investors. This means, users of a project will have to deal with cryptocurrency investors wanting to increase the price of the coin to increase their profits. This directly increases the operational costs for the users of the project.

There is now a situation where investors who bought cryptocurrencies want the price to increase, but users of the project want the price to decrease. This puts the two most important groups in regards to a project's cryptocurrency price, namely the cryptocurrency investors and the users of the project, with opposing goals. Therefore, the struggle for price between these two groups will reduce the demand for that project if there is a chance operational costs for projects dramatically increase as we have seen from May 2017.

Conclusion

In conclusion, all cryptocurrencies researched seem to not abide by the third rule of a currency. There are many barriers which must be overcome to succeed, and a major flaw of most cryptocurrencies is, the users of the project and the cryptocurrency investors will always have opposing goals for the value of the cryptocurrency associated with a project.

In this writer’s opinion, most of the projects should be praised for trying to find solutions to real world problems. However, the way in which they have gone about acquiring funds may lead to a conflict between two parties that may be detrimental to projects using its cryptocurrencies in a public market.

References

Adams, JR and Brandt , 'SE 1978, 'Organisational Life Cycle Implications for Major Projects', Project Management Quarterly, Vol 9, no. 4, p. 32 - 39.

BitInfoCharts 2018, Bitcoin Avg. Transaction Fee historical chart, retrieved 14th February 2018, https://bitinfocharts.com/comparison/bitcoin-transactionfees.html.

Coinarketcap.com 2018, ‘Historical Snapshot – January 28, 2018’, retrieved 29th of January 2018, https://coinmarketcap.com/historical/20180128/.

Fulton, T n.d., ‘Whitepaper’, github.com, retrieved 14 February 2018, https://github.com/dashpay/dash/wiki/Whitepaper.

Poon, P et al. 2017, ‘OmiseGO Decentralized Exchange and Payment Platform’, OmiseGo Team, retrieved 14 February 2018, https://cdn.omise.co/omg/whitepaper.pdf.

Ripple n.d., 'Solution Overview', Ripple, retrieved 14 February 2018, http://whitepaperdatabase.com/ripple-xrp-whitepaper/.

WaBi n.d., ‘WaBi – crypto token for safe consumer products’, WaBi, retrieved 12 February 2018, https://resources.wacoin.io/WaBI_Whitepaper_ENG.pdf.