Is it a bird? Is it a plane? No, it’s a string of numbers with a U.S. dollar value that was designed to be a currency but is traded like a derivative.
Recent actions by the Securities and Exchange Commission and its apparent turf war with the other major exchange regulator, the Commodity Futures Trading Commission, have sparked a debate: Are cryptocurrencies securities or are they commodities?
I would argue that digital currencies such as bitcoin and Ethereum are neither of these things, but something else entirely. Or, rather, two separate things.
First and foremost, as the name suggests, crypto coins are currencies.
Take it from Lorenzo Di Mattia, a veteran hedge-fund manager and founder at Sibilla Global Fund, who was once approached by an investor with a proposal to launch his own crypto fund.
“I don’t know what crypto is haha,” Di Mattia wrote, over WhatsApp. “It’s not a commodity. Maybe it’s a currency.”
The original intent was certainly to create an alternative to the U.S. dollar, around which the American financial system is built. Generally, people in this country keep U.S. dollars in brick-and-mortar banks that have to hold some of their deposits in hard cash. The technical term is “fractional reserve” banking. Many of us now also move around virtual versions of the same dollars from our accounts to, say, our plumber’s bank account.
Satoshi Nakamoto’s original white paper for bitcoin in 2009 described a method of disintermediating the banking system. As noted in this blueprint, people, particularly tech savvy people, were disillusioned with the fractional reserve system, which had almost collapsed due to the reckless and greedy behavior of some of the banks that were a cornerstone of the system.
Nakamoto’s solution was a purely digital currency, bitcoin, which could never be forged and, most important, would not rely on the Wall Street middlemen. The currency would be minted with virtual watermarks created by high-powered computers. Here’s where the cryptography came in: The computer “miners” would solve complex formulas embedded in each previous bitcoin’s unique number and thereby link the newly minted coin with the ledger or blockchain. Anyone with internet access could view the blockchain, which, like a shared master bank account, recorded every single one of these verified coin creations.
Nakamoto didn’t design this system to be linked in any way to the mainstream banking system, to the U.S. dollar or to the financial markets — not to securities, commodities or derivatives markets. Bitcoin was intended to be an alternative to all that.
Almost everyone who has studied this technology agrees: bitcoin, and the copycat digital currencies that followed it with similar cryptographic protocols, including Ethereum, ripple and countless others, were a vast improvement on the U.S. dollar, in theory.
In practice, as currencies and as a means of payment, cryptocurrencies are miserable failures. More than a decade after the first pizza was sold via bitcoin (a single coin was worth a fraction of a penny at that stage, in 2010, and the pizza cost 10,000 bitcoins), approximately nobody uses bitcoin to buy pizza. There are many explanations for this failure, but the main one is that it’s simply too risky for merchants doing business in dollars to accept volatile cryptocurrencies.
If not used as currency, are cryptocurrencies used like securities? Only the minor coins. There was a trend called initial-coin offerings in the 2010s that attempted to marry share offerings and cryptocurrencies.
A security is something that gives you a stake in a company or a nation. Sometimes this stake takes “equity.” When you buy a share of Microsoft, you own a tiny piece of Microsoft, in exactly the same way as you would own half of, say, a mosquito-spraying business if you bought half of it from a friend. Sometimes the stake takes the form of debt or “credit.” When you buy a U.S. Treasury bond, you are giving a loan to the U.S. and you hold a contract guaranteeing you repayment from the U.S. Treasury.
There are other types of securities, but they all give a person a contractual stake in something.
Gary Gensler, the head of the SEC, wants his agency to oversee cryptocurrencies. He has not made the claim that bitcoin, Ethereum or any of the best-known cryptos are securities. Rather, he notes that his agency has investigated some smaller coins that were set up like securities. Gensler proposes extending his authority over the whole crypto market because platforms such as Coinbase and the collapsed FTX will always host some such coins that are technically securities:
“While each token’s legal status depends on its own facts and circumstances, given the commission’s experience with various tokens that are securities, and with so many tokens trading, the probability is quite remote that any given platform has zero securities,” is how Gensler made the argument in 2022.
Major cryptocurrencies clearly don’t give you a stake in anything. That’s why some insiders, like Joseph Lubin the co-founder of Ethereum, insist that cryptocurrencies are commodities that, like copper, gold or oil, the person buying Ethereum does so because of belief in the “intrinsic” value of the cryptocurrency.
Cryptocurrencies share this quality with commodities, but that’s the only thing the two categories have in common. The basic definition of a basic material, or commodity, is, of course, that it’s tangible. Gold appeals to commodity investors because they can open their safe and hold it in their hands.
If they are not (effective) currencies, or securities, or commodities, then how can we understand crypto in the conventional financial framework?
Cryptocurrencies, as tracked on the screens of traders’ computers, are, I would argue, derivatives. Yes, ironically, the crypto world has morphed the very thing that caused Nakamoto and other economic libertarians such revulsion about the Wall Street of the 2000s, a derivatives market. For much of that decade, the best and brightest people in America used all their intelligence to incessantly twist useful financial products such as residential mortgages into unstable, highly volatile instruments by means of stacking up massive side bets.
When they are being traded back and forth for speculative profit, which is how the vast majority of people who interact with cryptocurrencies do so, crypto coins become derivatives. Most holders of bitcoin and Ethereum care only about the price of the currency in U.S. dollars, which is a derivative value.
When a speculator buys a bitcoin, which would currently set them back about $60,000 apiece, they are basically engaging in a foreign exchange swap. In these derivative transactions, Goldman Sachs might lend JPMorgan $100 million and the rival bank lend Goldman 80 million euros, under a swap contract over a fixed timeline. The value of the “swap contract” will fluctuate based on the fluctuations in the foreign exchange market.
Like buyers of dollar swaps, holders of bitcoin don’t want to own bitcoin at all. They are simply making a derivative bet on the dollar value of bitcoin.
The other argument to regulate bitcoin and cryptocurrencies as derivatives is that they behave like derivatives. In the most volatile two-year period in its history, the S&P 500 swung by 3% or more on a grand total of 35 sessions out of a total number of roughly 400 sessions, according to research firm Redburn. Single stocks, obviously, are a lot more volatile than that, but single stocks as large as bitcoin — think Apple and Microsoft — are increasingly correlated to the S&P 500. Stock derivatives, the price of puts and calls tied to the S&P 500 or Apple or Microsoft, on the other hand, swing by 10% or more routinely day-to-day. It’s hard to find a day on a bitcoin chart where the digital currency has not moved by more than 3%.
Warren Buffett famously and presciently derided derivatives as “financial weapons of mass destruction.” Nakamoto invented bitcoin as a safe alternative to a banking system that was laden down by hundreds of trillions of dollars. Unfortunately, the gravitational pull of Wall Street’s money-centered banks has drawn in the crypto world, which is now itself a multitrillion-dollar derivatives market, in need of regulation to prevent another massively destructive meltdown.
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