The greatest crypto fantasy of all

• “Spend cash, invest in Bitcoin. Cash is trash.” – A ‘bon mot’ from one of the Winklevosses
• “As of the end of Q2, we have converted approximately 75% of our Bitcoin purchases into fiat currency,” – Tesla Quarterly Earnings Statement (July 2022)
• “Bad coin and good coin cannot circulate together.” – A version of Gresham’s Law

This week brought news of “The Merge” – a purportedly momentous singularity in the history of humankind, or at least a big new loop in the tangled story of crypto-currency. We are told that, from now on, Ethereum (the second most popular crypto offering) will no longer be based on “Proof of Work” but rather on “Proof of Stake” (whatever that turns out to mean). The big selling point of the Merge is that the cost of “mining” the stuff will be reduced. In fact, mining won’t even have to happen anymore (too bad for Nvidia, by the way, which has floated its market capitalization on sales of the mining hardware – its share price is 92.88% correlated with the price of Bitcoin since November 2021).

In any case, “Merge parties” are said to have broken out world-wide, live-streaming from every time zone. Meanwhile, the hedge fund world has crowded into the options market to trade on the volatility that they expect.

• “‘A lot of smart money [is] buyer’… Outstanding options contracts have increased from 1.2 million at the start of the year to more than 4.6 million by Wednesday. About 80 percent of these contracts are call options… That’s a sign of ‘massive bullish sentiment.’

Of course, the existence of “massive bullish sentiment” would normally signal a decline in the market (investor sentiment is usually a contrarian indicator). The next few weeks will reveal how the merger will play out for speculators. But we already know that in practical terms it will make no difference to the long-term fundamental prospects of crypto.

The errors in the model

There are so many things wrong with cryptocurrency that it’s hard to know where to start. Unleash this piñata of fallacies and false hopes, and the nonsense comes pouring out. The ugly stuff has to do with what might be called the “moral flaws” of the crypto model: facilitating illegal transactions, money laundering, extorting ransoms, drug trafficking, porn, and god-knows-what. Then there is the astounding wastefulness of the mining process by which crypto tokens are “created”. Before The Merge, Ethereum’s carbon footprint was said to be “roughly equivalent to that Finland.” Bitcoin’s climate damage price tag is clearly somewhat larger, on par with the total energy budget of Sweden. Add dozens of hacking scandals, and background it all with the pain that naive investors struggle with in the totally unregulated crypto market. The general ponzi-like nature of the phenomenon has been apparent from the beginning. (A typical Bitcoin com-on was the one offered by Bitcoin Savings and Trust—in 2011-2012—which promised investors up to 7 percent weekly interest. It ended predictably and badly.) Today, even crypto supporters admit that “the value ” of their inventory is based on the Greater Fool showing up when they need him. Last fall, GF disappeared – and the price of Bitcoin fell by 70% (though not quite as bad as the Chinese stock market – another field of dreams – demonstrating that centralized and decentralized economies can match each other in value destruction).

Future historians will post the “What were they thinking” tales of the cryptocurrency bubble alongside Dutch Tulip Mania and Bernie Madoff in the gallery of scandal and folly.

But apart from all that – there is a deeper problem. Crypto doesn’t work. It does not and cannot serve a valid economic purpose. Not as a store of value, of course (see previous diagram). Not as an inflation hedge. Nor can it compete with the dollar, nominally or adjusted for inflation. Fiat money beats DeFi hands down.

However, the most important failure of cryptocurrency is its most practical failure: as a potential medium of exchange.

Can you buy things with it?

The short answer: You really can’t. For two reasons.

First is the question of “admission”. Where can one actually pay for a real product (not just another crypto object) with a bitcoin or similar? There is a lot of noise around it and it is said to be workarounds for vendors like Amazon that don’t accept bitcoin directly. But the fact is that after a dozen years of promising crypto-currency what currency is still not truly fungible. It is heavily discounted in the few transactions where it can apparently be used.

A currency that cannot be traded, cannot be used, fits the definition of “bad coin” under Gresham’s Law. In the presence of “good coin” (eg US dollars) crypto cannot circulate. Even in El Salvador, which has declared Bitcoin as its national currency, and even in “Bitcoin City” – which is El Salvador’s showcase for the crypto economy – Barron’s reporter who went to check things, found that “the money was almost useless; only 3 merchants out of 10 that we met in Bitcoin City would accept payment in Bitcoin. Crypto remains a speculative vehicle, with extremely limited convertibility to the real economy.

Even that’s not the worst. One can imagine, or at least argue, that over time the use of crypto by merchants in the real economy could somehow improve, perhaps with certain safeguards. That’s the premise of the Stablecoin concept, where crypto-values ​​are supposedly guaranteed by a link to real money, i.e. US dollars. Rather like the ratio between the dollar and gold in the old days.

But there is a flaw in the crypto framework that neither Merge nor Stablecoin cleverly do anything to fix. That’s it extremely low transaction processing capacity of the underlying blockchains that support Bitcoin and Ethereum. For Bitcoin, the limit appears to be about 7 transactions per second – for the entire planet. For Ethereum, the limit is said to be around 15-20 transactions per second.

Apple sells about 10 iPhones every second. That would use up Bitcoin’s capacity right there. On Amazon, the average number of transactions is 18.5 per second during the day – much higher during peak hours. Or maybe it’s 100 orders per second. During Christmas, the volume reaches 300 orders per second. Walmart processes something on the order of 100-200 transactions per second. No cryptocurrency could even handle Walmart’s or Amazon’s current level of business – let alone the transactions flowing in from tens of millions of other vendors around the world.

The extremely low transaction processing capacity limits for Crypto lead to higher costs and long delays. Barron’s the reporter found that even a simple Bitcoin money transfer took six hours to execute. (Consider how long you can wait for a credit card transaction to be verified at the supermarket before losing your patience.) In terms of price, Ethereum transaction fees averaged around $2.00 recently – but earlier this year fees were in the tens of dollars per transaction with odd peaks reaching as high as $200. (It is not clear that the merger will change this.)

Current reality-based payment systems such as Mastercard, Visa and American Express process an average of approximately 1,250 transactions per second. Peak volumes can be much higher and these real systems are designed to handle that. Visa is said to be able to process up to 65,000 transactions per second. Alipay (Alibaba’s version) has been said to have achieved actual payment volumes as high as 250,000-500,000 transactions per second during some of the most important shopping days in China.

Crypto promoters have their answers, in the form of future plans. In the next major Ethereum modification, something called “sharding” will be introduced – which will split the blockchain into many parts and increase the tps rate to 1000, supposedly. The following modification may involve further reconstruction of the ecosystem, with “roll-ups” – and will bless the waiting world with volumes up to 100,000 tps. Then there’s Solana, which supposedly has a “proof of history” mechanism to validate its blockchain, and says it can achieve much higher throughput:

• “Solana has gained traction … Blockchains processes 50,000 transactions per second and its average cost per transaction is $0.00025, according to its website. Ethereum can only handle about 13 transactions per second and transaction fees are significantly more expensive than on Solana. But it the last year and a half has settled down [Solana’s] trade-off as the blockchain network has suffered several times. Most recently, on May 1, Solana locked down for several hours before similarly being brought back online after a validator network restart.”

The breakdowns have spread:

• “On September 14, 2021, the Solana blockchain went offline a wave of transactions caused the network to split and different validators had different views on the state of the network. The Solana blockchain went offline again on May 1, 2022 and May 31, 2022. [first] the outage lasted 7 hours, and [second] one lasted 4.5 hours. On August 3, 2022, the Solana ecosystem was targeted by hackers, affecting 9,231 Solana wallets [stealing] $4.1 million total from victims. On July 1, 2022, a class action lawsuit was filed against Solana.” (Wikipedia)

It would be interesting to know the extent of the disruptive “wave” that appears to have breached the Solana system.

Blockchain is not designed for this

No cryptocurrency has anything like the capacity to serve as a medium of exchange in the modern retail economy. Blockchain is an interesting and useful technology, suitable for small networks, centrally managed, that need fast and reliable execution of high-value transactions. The Onyx system developed by JP Morgan for the settlement of wholesale repo transactions between banks is an example that appears to be successful. But blockchain cannot currently handle the capacity requirements of massive retail payment systems.

Neither Bitcoin nor Ethereum as they are can serve as a medium of exchange. The merger, whatever it amounts to, doesn’t change that.