Don’t Bitcoin More Than You Can Chew

By Reuvain Borchardt

Tao Li, an economist and professor at the University of Florida’s Warrington College of Business, discusses the recent sharp drop in the value of cryptocurrencies. Professor Li’s research focuses on cryptocurrencies and blockchain, in addition to more traditional subjects like corporate governance and financial institutions.

For the many people who still don’t know much about it, can you briefly explain what cryptocurrency is?

Cryptocurrencies are digital currencies that you can use to buy goods and services, and you can trade just like you trade dollars or euros. That’s the basic definition of cryptocurrency. It’s like the digital version of dollars and euros.

How is it created?

It’s actually pretty easy to create crypto. There are a lot of online platforms that allow you to do that. You need to go through a few steps during which you will choose the name, symbol, and total supply for your crypto.

This can get a little technical, but most of the cryptocurrencies we mention are not really cryptos, but tokens. If you really want to create a native cryptocurrency, you have to create your own blockchain, and the cryptocurrency would be attached to the underlying blockchain. But most of the cryptos are tokens, meaning they are created using existing blockchains, such as Ethereum. It’s really easy to do that. But to create a native crypto is pretty involved.

What is a blockchain?

You can think of a blockchain as a giant accounting book or ledger, which would store each transaction in a peer-to-peer network. We call it a chain because each new block will be built on old blocks, so you have a chain of transactions, and you can put multiple transactions in each block.

Some of the blockchains can have a lot of transactions in one block; in some other, faster blockchains, there are smaller blocks, where you can just put a few transactions. That’s the definition of blockchain. And each blockchain would support its native cryptocurrency.

How is a new blockchain created?

You need to build a blockchain from scratch. Basically, you have to develop your own computer code. There are now third-party services that make this process easier.

How does one go about mining cryptocurrencies?

This is really interesting. One big difference between transactions involving cryptos and transactions through centralized parties like Visa or Mastercard is that when you transact through the centralized parties, Visa or Mastercard are doing the verification for you, whereas blockchain is fully decentralized.

The miners are doing the so-called proof of work or proof of stake, a process that would verify whether you are having a genuine transaction and not a fraudulent one. The miners are doing the process for you. And of course, the miners are not doing this for free. They need some compensation. So, when the miners have verified a block of transactions — in the case of Bitcoin, one block can include thousands of transactions — once they have approved that all the transactions in this block are genuine, then they’re going to be paid with newly issued Bitcoins.

What causes one type of cryptocurrency to have more value than another?

There are a few factors. Of course, there’s always the first-mover advantage. Bitcoin is the largest and the earliest digital currency out there. However, Bitcoin has very little “intrinsic” value. You cannot really use the Bitcoin system for any other purpose than buying or selling goods, but even for that, not many merchants currently accept Bitcoin. So Bitcoin has very limited use. But there are two reasons why people still like Bitcoin. One is that it’s the first mainstream blockchain, and the second is that it has very limited inflation. The issuance of Bitcoins is limited each year.

Unlike Bitcoin, other major crypto systems like Ethereum and Solana support new platforms and apps. I believe whether a crypto promotes an ecosystem is an important factor for valuation.

A total maximum of 21 million Bitcoins can ever be mined.

Yes. And every four years, the number of Bitcoins that can be mined will be halved. So when we reach, I believe, 2041, there will be zero new Bitcoins that will be issued. Due to this limited supply, people think of Bitcoin as the digital gold.

So it’s valuable only due to its scarcity.

Right.

Bitcoin hit an all-time high of over $60,000 last November. Lately it’s been fluctuating around $20,000. To what do you attribute this fall?

There are a lot of reasons.

Mainly it’s investor sentiment. Bitcoin itself has very little intrinsic value, so it’s mostly driven by investor sentiment. When investors like risk assets they’re going to flock to Bitcoin, driving up the price, but when people are risk-off, they’re going to sell Bitcoin and the price will drop.

Of course, investor sentiment will be affected by a lot of things — like risk appetite, but also monetary policy, overall economic growth, and regulation.

Regulation is very important in the crypto market as well as in traditional financial markets. When China banned Bitcoin mining back in May 2021, Bitcoin’s price hit below $30,000.

But what’s going on right now — it’s really the monetary policy of the Fed and other central banks around the globe reacting to high inflation by increasing interest rates. That has really dampened people’s risk appetite.

So while there’s high inflation now, you believe crypto is dropping, not due to inflation, but due to the Fed’s reaction to that inflation, of raising interest rates.

Correct.

Having followed crypto for years, what trends do you see as far as when crypto falls and when it rises? Do you always see it tracking closely with issues like inflation, interest rates, or economic growth?

It’s a difficult question, because in the past decade interest rates have been very low. After the financial crisis of 2008 and 2009, the Fed aggressively lowered rates to almost zero, and we got stuck there for over 10 years. So, we actually cannot really say whether cryptos would have responded to changes in interest rates, because there’s very little evidence on that.

But with regulation, we definitely see that when countries get tough with cryptos, prices typically drop. I mentioned the China case. You saw India at some point saying that it was going to ban Bitcoin transactions, and prices dropped. That has happened a lot. Regulation affects sentiment, so crypto prices drop during those times.

Somebody did an interesting study looking at the correlation between U.S. dollar price and crypto prices. When the dollar is strong, crypto prices typically go down. It’s not clear why. But the correlation between U.S. interest rates and the dollar is very high. When the Fed increases interest rates, the dollar strengthens. And based on this correlation, you can say that when interest rates go up, crypto prices typically go down. And if you look at the traditional financial market, right now the correlation between the stock market and the crypto market is very high: When the stock market goes up, crypto goes up; and when the stock market goes down, crypto goes down.

But on the stock market, we have decades of evidence showing that when the Fed increases interest rates, the stock market typically goes down a lot. That’s because when interest rates are high, you can deposit money into a bank or buy Treasury bonds. Right now, one-year Treasury notes give you an interest rate of nearly 3%. With a safe interest rate of 3% per year, why should I take the risk of buying into crypto?

We have enough evidence that when interest rates are high, people are going to be more risk-averse. They’re going to dump risk assets and buy into safe assets. And if you think cryptos are one type of risk assets, then this should apply to cryptos.

Regarding inflation, I think in general it’s good for crypto. Because when inflation is relatively high, people are going to park their money somewhere and be less risk-averse; they want to put their money into a new investment and generate a high return. So I think crypto investors usually do not dislike inflation. But right now, high inflation is causing the Fed to increase interest rates, causing a reduction in risk-taking behavior.

So the best period for crypto is when inflation is high, but before the Fed reacts by raising interest rates?

Exactly.

On the regulatory front, the New York Legislature just passed a bill — it hasn’t yet been signed by the governor — that would establish a two-year moratorium on new and renewed permits for cryptomining facilities, because they use lots of fossil fuels. What effect do you think laws like this might have?

I think there will be a sort of gameplay between states. Let’s say half of the states would ban crypto mining, then miners would go to the other half of states. And that would bring business and other benefits to those remaining states.

Politicians now care a lot about things like sustainable development and climate change. So more states might adopt the same regulation. But miners can find alternative places to do traditional mining. So I don’t think this will affect crypto prices in the long term, but in the short term there may be fluctuations due to such transition risks.

But if the federal government ever passed a law like this, it would have a serious effect.

Exactly. Then the miners would have to go to a foreign country.

If you can make a prediction: In 25 years, are we going to look back at the period we are living in now with crypto as the nascent period of a financial revolution, or as a fad that some idiots fell for and lost a lot of money on?

Twenty-five years is a very long time!

I can change the question to “10 years from now” instead!

Whether it’s five years or 10 years or 25 years, I think that people who buy a crypto only because they think it can increase in value, and are chasing it for value, may end up in tears. Because cryptos are loosely regulated we see a lot of scams in the space, costing investors billions of dollars per year. Scammers would hype their new crypto, promising it will be the next Bitcoin or offering a high yield. After many investors have bought into the crypto, scammers can do a “rug pull” and exit with all your investment. We’ve seen that in the Squid Game crypto scandal last November. The collapse of the Terra system last month is another example. The latter cost investors tens of billions of dollars.

So crypto is not for the average investor to speculate on. A lot of the good cryptos do have a purpose. For instance, Ethereum is a very big ecosystem, which you can use to build a lot of new things like decentralized apps. So I guess the question is how entrepreneurs can use those ecosystems to build new platforms that can really benefit people, and that can really make people use those platforms on a daily basis, versus just betting on whether the crypto will go up or down.

Of course, if a platform is hugely popular, its crypto price should go up. So I think people should pay attention to this instead of just betting on cryptos like Bitcoin. Investors who identify the cryptos that create tangible value will be rewarded in the long term.

That’s my prediction.

But I think in the short and medium term, crypto prices will go down because the Fed is likely to increase interest rates for the next six months or a year.

Do you have any investments in cryptocurrencies?

I have a very small investment in Dogecoin. It was an experiment to show my students in class whether I’m going to make money or not by following the hype.

And … ?

It turns out that I’m down around 75% on Dogecoin. I was very lucky that I sold all my Bitcoin last year.