Crypto assets – a bubble or the future?

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Madis Müller
Deputy Governor of Eesti Pank

If you ask a speculator about the hottest market right now, you will probably hear quite quickly about cryptocurrencies, bitcoin and the blockchain. This is hardly surprising either, because the media is full of articles about people who have financed their retirement by trading in bitcoin, and of news about all the many possibilities offered by new cryptocurrencies and the blockchain technology.

The blockchain technology indeed appears to be an important breakthrough that may lead to a range of intermediaries disappearing in finance and in other sectors. But this does not by itself mean that something based on the blockchain, like bitcoin, should necessarily have a very high value as an independent asset. Most investors in bitcoin and similar currencies are probably not even trying to estimate what the actual fair value is of the asset that they have bought. The investment is made mainly in the hope that further down the line there will be somebody else who is ready to pay more for the same thing. Using the traditional methods of investment valuation it is equally hard to put the fair value of a bitcoin at 100, 1000 or 10,000 dollars.


Bitcoin is not money

It is important to understand that cryptocurrencies are unable to fulfil at least two of the main functions of money in the economic sense, as their highly volatile price means they cannot function as a stable store of value or an efficient means of payment. This means it is misleading to refer to bitcoin and the like as cryptocurrency. It would be more appropriate to call them crypto tokens or crypto assets.

As a thought experiment we can imagine how the economy would function in a country where something like bitcoin is used as official currency. There are probably very few companies or people who would like being part of an economy where the exchange rate of their home currency could rise by several hundred percent over a year and then fall by half in the next few months. The initial rise would wipe out exporters, and the subsequent fall would lead to steep rises in the prices of goods and services. Most of us would probably not want to build up long-term savings in such a volatile currency or to negotiate wages in it.

It is likely that we are not currently able to foresee all possible functions that crypto assets might have in the future. But it is highly improbable that crypto assets could come to replace traditional currencies. Even so many central banks, including those in the euro area, are investigating the possible use of the blockchain technology that underlies crypto assets, to understand better the ways in which the technology could affect the work of central banks in the future.


Crypto assets linked to standard currencies

One could in principle imagine a central bank issuing, say, euros in the euro area not just in the form of cash and central bank deposits, but also by issuing virtual euros directly into the blockchain. Most central banks have probably considered the implications of this idea to some extent by now. However, no central bank has decided to issue large amounts of digital central bank money, given the risks this could imply for the stability of the current financial system.

It is easier to imagine a digital currency running on a privately built blockchain that is linked to the official currency of the country. This would be reminiscent of the currency board system that we used to know. This is not an entirely new idea either, as a group of large international banks are trying to set up a consortium to do this to simplify securities settlements. It may be that crypto assets linked to official currencies find other uses in the future, even if we are not able yet to foresee how such a change would affect traditional banking over the long term.


Why would we need estcoin?

One of the three versions of estcoin proposed by Enterprise Estonia and known as the euro estcoin would also fall in the category of a crypto asset linked to a traditional currency. I have to admit we were struggling at Eesti Pank with how to comment on this proposal, as it did not spell out clearly the practical problem for e-residents that such a crypto asset would best solve. It would have no obvious advantage over regular bank transfers as a method for payments. Especially so given that in a year’s time we expect instant payments to become the new norm in Estonia, allowing retail payments between banks to be settled in a matter of seconds and seven days a week. The introduction of instant payments, thanks partly to the efforts of the central banks in the euro area, will solve a real problem of payments moving between banks only during working hours and doing so too slowly.

Solutions based on bitcoin have however already shown that retail payments in the blockchain are neither fast nor cheap, especially when the number of them reaches a critical mass. A good example of this is the news this week that the North American Bitcoin Conference in Miami stopped selling tickets in bitcoin, considering it too complicated and expensive a method of payment. It is of course possible that digital tokens could yet have some practical application for Estonian e-residents. It would probably be easier to search for such applications if we can first clearly define the problems that can be best solved with the help of a digital asset such as estcoin. Estonia would not have to start from zero in its search for solutions, as practical applications for the blockchain technology have been extensively researched and tested in different countries for years already.


Virtual tokens instead of shares

The blockchain technology is also linked to a new way of raising money from investors through the sale of virtual tokens or ICOs (initial coin offerings), which raised a total of 3.7 billion dollars last year. The biggest ICOs have raised hundreds of millions of dollars, and some of them have also attracted more traditional investment funds. There have been a lot more ICOs however that would not have found investors through more traditional channels. A good local example is an Estonian company that sold virtual tokens promising to set up a payment institution, a bank or something else depending on the amount of funds raised from investors. It would not be possible to get much money from traditional investors simply for such an idea, but according to the website of Polybius Foundation OÜ more than 30 million dollars have already been invested in the project. Those used to more traditional businesses may also find it unusual that the ‘white paper’ of Polybius promises to distribute only 20% of its future profits to investors who have funded the company. This however does not seem to be an obstacle for investors, who are receiving virtual tokens instead of old-fashioned shares.

A good example of the popularity of everything related to blockchain technology is that of the Nasdaq-listed beverage company Long Island Ice Tea. Shares of the company leapt 500% after it informed the exchange that it now intends to focus on blockchain technology rather than on producing soft drinks, therefore changing the name of the company accordingly. The firm is now known as Long Blockchain. Such stories bring to mind the famous saying ‘this time is different’, which is taken by professional investors as a sign to sell their investments when they hear it offered as a justification for the price of an asset.

ICOs appear to be a phenomenon that will probably result in many gullible enthusiasts losing large amounts of money. This in turn is likely to lead to expectations that rules for the issuing of traditional securities would be extended to the so far largely unregulated virtual tokens, or that the supply of such tokens should be even more strictly restricted. Steps have already been taken in this direction. The Securities and Exchange Commission in the US for example has stated that ICOs that meet certain conditions will need to be treated as issues of securities. The Financial Supervision Authority in Estonia has taken a similar view of ICOs, while China and South Korea have decided to ban ICOs completely. There is a lot of confusion around ICOs given the novelty of the area, and the talk of innovation can attract investors to some very dubious projects. The market is however slowly maturing. In positioning Estonia as an attractive country for registering ICOs, it is worth being very careful about what sort of virtual businesses we really want to support. Rushing in too fast and positioning ourselves as a jurisdiction that promotes and supports ICOs could just as well end up causing more harm than benefit to the e-Estonia success story.

At Eesti Pank we have set ourselves the broader goal of being well informed of financial innovation and of the opportunities and risks offered by new technologies. We need to be aware of what it could mean for consumers, as well as for the industry and financial stability. As a good partner to the government, the Financial Supervision Authority and businesses, we are certainly interested in looking into how the Estonian regulatory environment can evolve in order to support innovation while at the same time keeping enough focus on risk management.


This article should not be considered as a response from Eesti Pank to blog posts of the e-residency project. The central bank freely shares its comments and opinions with the government and with Enterprise Estonia through regular consultation and discussions.

Published date: 
15.01.2018