Thomas Hale reports in FT Alphaville:
Financial securities have constraints that can be used to model their risk and define their value. The value of the security is constrained by these realities, despite the volatility of the markets. Extreme returns are possible in unconstrained securities because there is no basis for their value. The upper bound is (an) unknown quantification of psychological appetite for speculation. Demand for cryptocurrencies is high in urban centres where young people are plagued by cash-flow problems (often caused by high living costs). Unconstrained securities plays a social role by redistributing resources.The money is “blown” on daily urban cash flows, rather than invested in legally valuable assets like housing, bonds or equities.
The traditional financial approach to nothingness is clearly summarised in King Lear. The king has gathered his daughters and demanded that they praise him. When one of them refuses to play along and has "nothing" to say, he tells her that "nothing will come of nothing".
The idea that nothing breeds nothing is also widespread in critiques of cryptocurrencies. Last week, Martin Walker came up with an elegant way of thinking about them: as zero coupon perpetual bonds — something that pays no return, and never gets repaid. This is a sophisticated kind of nothingness, in the financial sense.
Cryptos may be based on nothingness, but it doesn’t necessarily follow that they’re worthless. In fact, the value they provide might depend upon them being linked to nothing, rather than something. This is a kind of security that crops up very rarely, like precious metals, or great works of art.
Financial securities have constraints that can be used to model their risk and define their value. Bonds are issued by highly trusted borrowers, and provide predictable cash flows and specified dates of maturity, when they are converted into money. Equities provide less predictable cash flows, in the form of dividends, that come at the discretion of company managers. In the case of currencies, the value is realised through buying goods or services – a role that cryptocurrencies have yet to properly assume.
In each of those cases, the value of the security is partly constrained by these realities, despite the psychological volatility of the markets where they are traded. Very risky equities might provide very high returns, but there is still something that anchors their worth – usually a particular business proposition. Bonds will very rarely provide high returns, unless they are bought at distressed values. Currencies that actually work as currencies are anchored to their own purchasing power measured against a collective basket of goods and services available in an economy, which is why they have no value on a desert island.
In the case of something like bitcoin, there is basically no anchor. There are no discounted cash flow models, or estimated valuations in Chapter 11. If such things existed, bitcoin would be a far less effective medium for speculation. In its current form, it is a rare example of an unconstrained security, valued as a pure projection of psychological volatility in a secondary market. Such things are usually referred to as "bubbles", but they can offer a perverse kind of value.
The incentives for buying into nothingness
Why would you want to invest in something that is unconstrained? The answer is that sometimes asymmetrical utility can be derived from large windfalls. If you have a small amount of initial capital, you might take on a less favourable risk-reward profile for a shot at a higher nominal windfall that is unachievable elsewhere. The classic example of this is the lottery (which former Alphavillian Kadhim Shubber compared to bitcoin here, in relation to its entertainment value). Extreme returns are possible in unconstrained securities because there is no basis for their value in the first place. The upper bound is some unknown quantification of psychological appetite for speculation.
Now let’s consider the psychology. Demand for cryptocurrencies is very high in urban centres where young people, mostly disengaged from other financial securities, are plagued by monthly cash-flow problems (often caused by high living costs). These individuals have tendencies to blow small windfalls on luxuries, like holidays.
If they invest £200 in equities, the annual dividend returns are obliterated by their daily cash flows in a modern city. If they make £800 on that investment, they are liable to spend the proceeds, because the amount feels so distant from the lower boundary of urban residential real estate prices. This has little to do with discipline; it is better explained by the relative pricing of daily living costs, meaningful assets, and salaries.
Individuals in these situations may prefer to speculate on nothingness, hoping their peers transfer wealth to them, than plough into markets for established securities, where the risk-reward profile is better but the upper limit on returns is nominally minuscule. This also explains why, often, they are more attracted to equities that look like zero coupon perpetual bonds (certain tech companies), which are similar to unconstrained securities, except that management can extract the proceeds.
The unconstrained security plays a specific kind of social role, by redistributing resources (mostly) between the participants in a random manner. In the absence of this redistribution, a greater proportion of the money is likely to be “blown” on daily urban cash flows, rather than invested in legally valuable assets like housing, bonds or equities. Therefore, within the cohort of participants, the redistribution can create value if enough of them receive windfalls that are above a meaningful threshold, and then exit.
An opportunity to gamble
True unconstrained securities emerge very rarely, for obvious reasons. It takes an unusual set of conditions, or a profound historical rupture, for nothingness to take on worth. The other clear example of an unconstrained security is gold. Its emergence is linked to an ancient and mysterious aesthetic, much as the emergence of cryptocurrencies come in an age replete with the mysteries of technology.
But ultimately, mysterious explanations of origin are beside the point. There is demand for unconstrained and worthless securities because their potential upside, from the pooled resources of other participants, is extreme, and some kind of cost-of-living floor has emerged for people in cities, incentivising them to gamble.
Other gambling services are captured by large institutions that skew the odds unfavourably, to benefit the house and therefore their shareholders (as is increasingly the case in some areas of the crypto market). And there is always the possibility that those generations who own most of the actual securities, fearing threats to their wealth, become convinced to buy into crypto speculation themselves, giving all the earlier, more desperate and younger participants a profitable exit.
In a scenario where cryptocurrencies develop an actual value as a tax-exempt means of transacting, they’ll become a dramatically worse way to speculate, and cease to be unconstrained, and start to become something.
For now, though, their nothingness value is through the roof. As with King Lear, pure financial analysis tends to presume that nothing will come of nothing. But King Lear, after all, was deluded. And then he went mad.
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