What connects Cthulhu, a Doge meme, and Putin? Well, there are cryptocurrencies which refer to all of them. And what is even funnier is that the market capitalization of Dogecoin, which was developed just for fun, is almost $300 million (as of April 30, 2019). Isn't it strange? We all know that a Great Cthulhu deserves much more so that people waste electricity in his name rather than in the name of that dog!
But are cryptocurrencies really just fun, waste of energy, or fraud? Not really. We mean that some of them are, but not of them. And there is a great idea behind cryptocurrencies: they do not require a central authority. This is because they solve the double spending problem. You see, the digital currencies can be easily duplicated, so the same token can be spent more than once. We need then the central third party that can verify the transactions. But the centralized system has its own problems: there is a single point of failure, and the authority has to be trusted. If it fails or mismanages the money supply, the whole system collapses. The classic example might be hyperinflation which results from the excess money printing by the central bank – the central issuer of the fiat money.
The cryptocurrencies solve the double spending problem by implementing a public ledger called blockchain which uses cryptography to avoid the need for a trusted third party to validate transactions (this is why they are called “cryptocurrencies”). Instead, transactions are verified by the users themselves and recorded in a distributed public ledger.
Cryptocurrency and Gold
Now, the link between the cryptocurrencies and the precious metals should be clear. They both are endorsed by freedom-lovers who oppose the big government and its meddling with money. They both provide alternatives to the fiat currencies which are prone to inflations, devaluations and also deflations. This is why many people consider the cryptocurrencies, such as Bitcoin or Ether, as substitutes for gold, or even call them “digital gold” or “gold for Millenials”. If you do not trust governments and central banks, you either buy gold or cryptocurrencies.
Or you look for the Holy Grail of the modern monetary system – the gold-backed cryptocurrency. There are several cryptocurrencies which tokenize gold, opening up new possibilities (such as dividing gold bars or gold coins into smaller denominations, etc.). However, investors should be careful. While the blockchain track the coins, accounting for physical stored gold is another point entirely – just as with the paper gold, there is a risk that the tokens would not be fully backed by physical gold.
However, why not invest in both? The chart below shows the prices of gold and of two most widely known and well-capitalized cryptocurrencies: Bitcoin and Ether. As one can see, the gold and the cryptocurrencies do not seem to compete with each other. Although Bitcoin and Ether moved in tandem in 2016-2019, experiencing wild swings, the price of gold was relatively stable, remaining within the narrow range of $1,200-1,400.
Chart 1: The price of gold (yellow line, London P.M. Fix, in $, weekly average), the price of Ether (red line, in $, weekly average, at Bitfinex), and the price of Bitcoin (green line, right axis, weekly average, in $) from March 2016 to April 2019.
The bottom line is that although the shiny metal and the cryptocurrencies have the common nemesis, there are not substitutes, at least not perfect ones. It should not be actually surprising. After all, gold has a long history of having monetary value and the gold market is well established, liquid and relatively stable. Meanwhile, the cryptocurrency market is young, highly volatile, and relatively small and illiquid. It’s possible that it will change in the future, but so far the cryptocurrencies are not safe haven assets such as gold, but – given their instability – rather speculative vehicles. Hence, while bullion has several investment applications, the cryptocurrencies are qualify more as trading opportunities within the investors’ portfolio than long-term investment or a portfolio insurance.