Perfect Competition and the Future of Cryptocurrencies
Whether you are an active investor or just a casual observer, the rapidly proliferating cryptocurrency market affords many interesting opportunities for studying emerging economic dynamics. For example, the theory of perfect competition, which predicts that profits in a perfectly competitive market are impossible to maintain. Someone invents a good or service for which innumerable other providers quickly emerge, eliminating any control over the price the initial developer or provider enjoyed. Often referred to as moats, strategic industry advantages or high barriers to entry are of paramount importance to many investors. Warren Buffett, for example, has repeatedly stated that the existence of a wide moat often plays the deciding factor in his decision whether or not to invest in a given equity or company. In the case of cryptocurrency, the cost of entry being low, anyone with access to a computer and in possession of the sufficient knowledge able to a create one, and the barriers to entry being minimal, regulation being almost nonexistent, certain aspects of the cryptocurrency market suggest that in the long run virtually none of them are safe stores of value.
Take Ethereum, for example, the second most popular cryptocurrency behind Bitcoin. A sophisticated blockchain technology launched by Vitalik Buterin in 2015, operating on the Ethereum blockchain requires payments in Ether, its native token. As the number of transactions on the network increases so do the mining fees that go to those who process the transactions. In other words, as the Ethereum network grows, the cost users pay rises, precisely the opposite of what economies of scale are supposed to provide customers and consumers. For this reason, blockchain networks like Ethereum may provide us with a fast-paced, real-life example of what happens under conditions of near perfect competition. Specifically, that long term sustainable capital gains are impossible. With the price of Ethereum having risen so dramatically in the last six months, up over 500%, alternatives are already gaining traction. Polka Dot and Cardano are only two of many emerging cryptocurrencies that perform the same basic function as Ethereum faster and cheaper. If they continue to grow in popularity, or even displace Ethereum, they will then experience the same problems as Ethereum: the more people use the network the slower and more expensive mining will be because of the increased number of transactions that need to be quickly processed. If that happens, there is nothing, on the surface, to prevent another cryptocurrency to take their subsequent place. It is only a matter of convincing users to adopt the faster and cheaper product.
This may not, however, be uniformly true of all cryptocurrencies.
Though it was initially intended as a payment service, Bitcoin has proven wholly inadequate to that task for a variety of reasons. Slow transaction times, high fees, and even higher volatility are among the reasons most commonly cited. As such, the story in more recent years has shifted to some version of Bitcoin as a long term store of value. Digital gold, it is sometimes advertised. Due to its scarcity, if we assume demand, it’s fixity would serve that purpose. Bitcoin is hard capped, a deflationary currency of fixed supply. As to why anyone would demand Bitcoin, apart from the much publicized acceptance of the digital currency by companies like Tesla, rumors central banks may adopt them as part of currency baskets, or speculation that Bitcoin may eventually be used by institutions to settle large interbank balances, we are observing an example of Robert Schiller’s narrative economics. Bitcoin is a story, one in which it is the currency of the future, digital gold, and will continue to rise in price.
As there is nothing technically special about Bitcoin’s underlying dynamics, and it serves no useful purpose, why Bitcoin? Cryptocurrencies and altcoins as useless as Bitcoin are invented every day, after all. It may be, as some argue, that Bitcoin will survive and continue to rise in value on the basis of its brand. It is the original cryptocurrency, and like anything rare will always have some kind of market, no matter how niche - think digital numismatists, perhaps.
Given these conditions, it is difficult to imagine how Bitcoin, or any of the digital tokens vying to replace Ethereum, makes sense other than as a purely speculative asset – one in the latter case likely to be supplanted sooner rather than later.
Note: at the time of this writing the author holds positions in all of the above mentioned cryptocurrencies.
 If you are unfamiliar with how blockchain technology works, or mining, or cryptocurrencies in general, I suggest Bubble or Revolution? The Present and Future of Blockchain and Cryptocurrencies, by Neel Mehta, Adi Agashe, and Parth Detroja.