In the economic life of man, what constitutes value and qualifies as a medium of exchange is a far more plastic concept than anyone living in that age often gives credit for.

At its core, currency is about efficiency.

You have milk I need and I have potatoes you want, but instead of bartering for it (because I might not need the milk right now), currency becomes that temporary store of value until it’s time for me to go get that milk.

And contrary to popular opinion, our concept of the various forms that money should take also evolve relatively rapidly.

From pieces of eight to credit cards, each generation has waged its own battle for the soul of portable economic power and today, an ideological battle between the “crypto-anarchists” in one corner and the central bankers with their fiat-based system in the other, is underway.

For now at least, the central bankers may be feeling confident that they’re winning this ideological battle.

Cryptocurrencies On the Ropes

In March, U.S. Federal Reserve Chairman Jerome Powell, speaking at a virtual panel discussion on digital banking hosted by the Bank for International Settlements, made clear that the central bank was keeping its focus on more traditional investments and added,

“It’s (Bitcoin) more a speculative asset that’s essentially a substitute for gold rather than for the dollar.”

And last month, the Bank of England’s boss, Andrew Bailey echoed that same sentiment by saying,

“I’m skeptical about crypto assets, frankly, because they are dangerous.”

But Bailey’s admonition of cryptocurrencies may be more a warning to his central banking colleagues rather than investors or “speculators.”

Bitcoin is now worth just over half what it was in April, where the benchmark cryptocurrency hit its all-time-high around US$64,000 before coming back down to earth against a backdrop of tweets, rumors and threats of regulatory reprisals.

Much of the recent volatility in Bitcoin has been attributed to Tesla CEO and full-time tweet stirrer Elon Musk, but that would be giving Musk far too much credit.

While there are as many possible explanations for Bitcoin’s precipitous fall from grace as there are investors in the cryptocurrency, a combination of Chinese regulators cracking down on Bitcoin mining, and the unwinding of heavily leveraged bullish Bitcoin positions, has sent the benchmark cryptocurrency down to around US$38,000 at the time of writing.

But it would be a naïve central banker to take comfort that Bitcoin’s halcyon days are behind it because cryptocurrencies, much like any other asset, are built on a collective belief as to their value.

The greater danger lies in when that belief spills over into the broader financial markets.

Belief Backs Bitcoin

While there’s no immediate risk of the cryptocurrency markets taking the wider global financial system down with it, the groundwork to setup such an event is already being laid.

To understand how any one “thing” ever comes to be regarded of value, it’s helpful to move away from the world of policy makers, to the wood-paneled antechambers of academics.

Thomas Schelling, a Nobel prize-winning economist and game theorist contended that people are often able to act tacitly in concert, as long as they know that others are trying to do the same.

Without overtly agreeing to collude, circumstances could throw up what Schelling termed “focal points” around which individuals could co-ordinate their activities without explicit communication.

For instance, take one game linked to Schelling’s focal points — the Split Money Game where two players share $100 by first writing down their individual claims on a sheet of paper.

If their claims add to $100 or less, both of them will get exactly what they claimed, but if the sum is higher than $100, they both get nothing.

Unsurprisingly, almost all participants in the Split Money Game will write $50, the exact division of $100 by two and the one that ensures everyone wins.

The insight provided by Schelling helps explain the investment case for gold, but could also go some ways to shed light on the investment case for Bitcoin, which can be seen as a solution to a co-ordination game.

Gold, whether in bars, jewelry or ETFs, only has value because enough people tacitly agree that it does, a value which is bolstered by its scarcity and permanence.

Similarly, while the technology behind Bitcoin is ingenious (although arguably Ethereum has greater versatility in terms of use), it is Bitcoin’s economic incentives that recognizes human motivation that are its real party trick.

As with gold, an arguable case can be made that Bitcoin provides a hedge against fiat currency inflation, but much more than that, Bitcoin’s unique selling point is its programmed scarcity and recognition.

In that sense, the Bitcoin genie is out of the bottle and while its price may fluctuate, it has gone past the point where it can ever go to zero.

Gold’s Digital Cousin

Although academically compared to gold for the most part, recent data has provided evidence that Bitcoin may truly be gold’s digital equivalent.

According to a recent analysis by Nikolaos Panigirtzoglou of JPMorgan Chase, the pullback in flows into Bitcoin in particular and cryptocurrencies in general, coincided with fresh inflows into gold and a variety of gold-linked products.

Panigirtzoglou’s observation suggests that institutional investors may have been shifting back into gold after a flurry of interest had caused Bitcoin’s price to have risen too far too fast.

And viewed in that context, the correction in Bitcoin and the revival in the fortune of gold is increasingly looking like a relative-value trade set within a broader set of inflation hedges.

As Bitcoin’s fame grows and institutional participation increases, there comes a time when the cryptocurrency becomes “too big to ignore,” eventually morphing into something that evolves to be “too big to fail.”

With each additional Wall Street name backing Bitcoin, from Stanley Druckenmiller to Paul Tudor Jones, Ray Dalio to David Rubenstein, the reputational stakes for Bitcoin become so high that it’s hard for participants to back down.

From Goldman Sachs to Visa, PayPal to Square, the list of blue chip companies cottoning on to cryptocurrencies grows by the day.

And each subsequent wave (and crash) of adoption, raises the stakes for the cryptocurrency space as a whole.

In mid-May, the total market cap of all cryptocurrencies was estimated by CoinGecko, a cryptocurrency data site, to be in the realm of US$2.5 trillion, within two weeks, it would lose US$1 trillion.

And while those are table stakes in the financial world — it’s estimated that the daily turnover of OTC derivatives is US$2.3 trillion — each subsequent rally and crash for cryptocurrencies is drawing more investors and making the absolute numbers involved far greater.

Which is why central bankers and regulators are starting to get hot around the collar when it comes to cryptocurrencies.

Central Bankers Bummed by Bitcoin

China has tried to build a wall around the Middle Kingdom to defend it against the vagaries of cryptocurrencies, but unlike the world wide web, that wall is not hermetically sealed.

And the Biden administration has scrambled the heads of its different financial watchdogs to settle issues of jurisdiction when it comes to cryptocurrencies, so that investors render to Washington what belongs to Washington.

From Tokyo to Brussels, central bankers have waxed lyrical about the dangers of cryptocurrencies and how investors could lose “everything” by speculating in them — without pointing out that that “everything” includes the very fiat currencies they themselves are relentlessly printing and debasing.

Investors would do well to note that just the simple act of holding fiat currency incurs loss (in terms of purchasing power) through the inevitable function of inflation.

But it may be too little too late for central banks to reshape the thinking on cryptocurrencies — that window has already closed.

Like how retail investors cottoned on to meme stocks to squeeze short sellers has morphed (in some cases) to a purely ideological movement to “stick it to Wall Street, profits be damned,” cryptocurrencies now represent an economic focal point for investors to move in implicit collaboration.

And viewed from that context, it becomes easier to see cryptocurrency price volatility in the context of a broader shift to embrace risk.

Because belief matters for all sorts of asset prices, and while this most recent cryptocurrency crash can be shrugged off, at some stage the next one may be too big to ignore.

By Patrick Tan, CEO & General Counsel of Novum Alpha

Novum Alpha is the quantitative digital asset trading arm of the Novum Group, a vertically integrated group of blockchain development and digital asset companies. For more information about Novum Alpha and its products, please go to https://novumalpha.com/ or email: ask@novum.global