When Satoshi Nakamoto published the bitcoin white paper ten years ago, the idea was to create an electronic cash system that might compete with the likes of Visa. But instead of using it to make payments, most of us ended up adopting Satoshi’s creation as a vehicle for speculation. So rather than use Visa as a foil for bitcoin, let’s compare it to some of the more speculative products provided by Wall Street.
Bitcoin evangelists promised us that by cutting out intermediaries, bitcoin would save everyone time and money. For speculators, this means that by betting on decentralized tokens rather than centralized products, we remove Wall Street’s greedy suits from the equation. The irony is that, in liberating ourselves from Wall Street, we speculators actually end up paying much higher fees than we otherwise would.
Unlike Wall Street’s speculative products, bitcoin is not centrally-managed. Rather, a network of decentralized nodes runs the system. To compensate these nodes for their services, 12.5 bitcoin are created every ten minutes. The instant that these 12.5 newly-minted bitcoin hit the market, the price of bitcoins gets pushed down (though we may not see it on the price charts because 12.5 bitcoins is a small amount and there are other market factors at play). The amount by which the price falls represents the quantity of resources, or fees, that have been transferred from each existing bitcoin speculator to the system’s managers (miners who verify transactions on the network).
The reason that bitcoin and ether bets are so pricey is that cryptocurrency owners are buying decentralization, and decentralization consumes far more resources than centralization.
Let’s work out how much this 12.5 bitcoin fee costs per year. At a bitcoin price of $6000, total network fees come out to $10.8 million per day. For someone who owns a single bitcoin, this amounts to 62.4 cents per day, or $228 per year. Expressed as a yearly expense ratio, that’s 3.8 percent per annum. (Sometime in 2020, the creation rate will be halved to 6.25 bitcoin every 10 minutes, the yearly expense ratio being reduced to around 1.9 percent.)
Ethereum is even more expensive to hold. Network fees currently run around 20,000 ETH per day, which works out to a yearly expense ratio of more than 7 percent.
To put these fees into context, let’s head over to Wall Street. Speculators are attracted to cryptocurrencies because of their awesome volatility, but regulated stock markets provide plenty of action too. These days, the wildest financial products are volatility exchange-traded funds (ETFs) and exchange-traded notes (ETNs). Volatility ETFs and ETNs replicate the performance of the CBOE Volatility Index, or VIX, an index of the stock market volatility derived from option prices on the S&P 500 Index. Like bitcoin, it isn’t uncommon for owners of a volatility ETF to double (or halve) their money in the space of a week or two.
The most popular of these products is the iPath S&P 500 VIX Short-Term Futures ETN, popularly known by its ticker VXX. Like bitcoin’s nodes, VXX’s manager—Barclays Bank—must be compensated for the costs of running the bet. Salaries must be paid and fancy suits and ties purchased. To replicate the VIX index, Barclays must buy and sell underlying derivatives contracts, and this involves paying fees to the clearinghouse where derivatives trades are processed.
But even after these costs, the VXX’s yearly expense ratio comes out to just 0.89 percent, far below bitcoin’s expense ratio of 3.8 percent and Ethereum’s 7.1 percent.
The reason that bitcoin and ether bets are so pricey is that cryptocurrency owners are buying decentralization, and decentralization consumes far more resources than centralization. A seasoned speculator might legitimately ask: why go with a decentralized bet on bitcoin if centralized bets on VXX pack just as much punch but are cheaper?
A key benefit of bitcoin and Ethereum is openness. The only way to buy VXX is to apply for an account at a broker, and not everyone will qualify. With cryptocurrencies, no one can be prevented from buying in. Nor can speculators be prevented from realizing their gains. Whereas a brokerage account can always be frozen by the authorities, there is no way to prevent anyone from selling out of their bitcoin or ether positions.
Hoarding decentralized tokens in a centrally-managed account makes about as much sense as paying for a room with a view but keeping the blinds drawn.
Taxes may also drive people’s preferences for decentralized speculating. Someone who wins big on VXX cannot evade taxes on capital gains because the records are all sent from the broker to the government. Bitcoin is a bearer token—i.e. it needn’t be held in an account—so it is much harder for governments to know if speculators are not paying taxes on winnings. Any extra income earned from tax dodging may go a long way to compensating speculators for bitcoin’s gigantic fees.
But many people who want action are law-abiding tax-payers and aren’t too worried about being censored from the traditional financial system. For these punters, bitcoin’s decentralization is probably not worth the price. This includes everyone who keeps their bitcoin or ether in accounts on regulated exchanges like Coinbase. Hoarding decentralized tokens in a centrally-managed account makes about as much sense as paying for a room with a view but keeping the blinds drawn. These speculators are paying massive decentralization fees while giving up all the benefits of decentralization.
To make matters worse, many cryptocurrency owners probably don’t even realize that they are paying recurring fees. Since the mechanism for compensating nodes involves the creation of new bitcoins (or ether) rather than direct debiting each owner’s address, no one actually sees the cost of holding bitcoin as a line item on their bitcoin bill.
If you need a hotel room, but don’t expect to look out the window, choose the room without a view—it’ll be far cheaper. Likewise, with so many bitcoin owners speculating on venues like Coinbase and paying taxes on winnings, the high-priced benefits of decentralization are mostly squandered. Centralized alternatives like VXX will be just as effective at getting us rich—or wrecking us—without charging massive fees to boot.