There's a 'fatal' flaw in cryptocurrencies which means they can never be real currencies

Bitcoins and a ten pound note are seen in this illustration picture taken September 27, 2017.

UBS Wealth Management economist Paul Donovan says that cryptocurrencies like bitcoin can never truly be considered currencies.
"A currency has to be a widely used medium of exchange. Cryptocurrencies are never going to achieve that. Period."
They fail key tests for what a currency actually is, including that they cannot be used as a store of value.

LONDON — Cryptocurrencies like bitcoin and ethereum will never become true currencies thanks to a series of "fatal" flaws, a senior economist at Swiss banking giant UBS has said.

Speaking at a roundtable discussion attended by Business Insider on Thursday, Paul Donovan, the global chief economist at UBS's wealth management arm, tore into the argument that cryptocurrencies could eventually replace fiat currencies like the pound and the dollar.

"The problem that cryptocurrencies face is that they fail the two key metrics of what makes a currency a currency," Donovan said. "A currency has to be a widely used medium of exchange. Cryptocurrencies are never going to achieve that. Period."

One of the main reasons for this, Donovan said, is to do with taxation, and the inability to use cryptocurrencies to settle tax liabilities.

"The reason I'm so definite about this, is that if you look in the OECD, on average, 34% of all economic activity is taxed," he said.

"Governments are not likely to accept cryptocurrencies that they do not control" to settle taxes.

"Cryptocurrencies that they do not control will not be accepted by governments for tax payments. You are therefore removing one of the main sources of demand for a currency. One of the key issues whenever we talk about monetary economics, is that the money supply should never, ever, ever be considered in isolation.

"Money supply needs to be considered against money demand. If you do not have the ability to use cryptocurrencies for the largest single transaction in the economy, then it will never be a majority medium of exchange.

Citing the example of the 1,000-year-old jiaozi — widely believed to be the first paper currency — Donovan pointed out fatal flaws in the current crypto market.

"If you're interested in historical parallels, the 10th or 11th century kingdom of Sichuan introduced a paper currency. It was an enormous success initially because the kingdom of Sichuan insisted that people pay their taxes using paper currency. As a result, there was an enormous demand, and initially the paper currency kept its value," he said.

"Unfortunately, there weren't any economists in the kingdom of Sichuan, and they just kept printing the stuff, and then money supply exceeded demand, and it all went horribly wrong."

total cryptocurrency bitcoin market cap

Donovan's point is that cryptocurrencies are almost certain to end up having huge imbalances in supply and demand, simply because there is effectively an unlimited supply of them, but a very clear demand ceiling.

"The fatal issue for cryptocurrencies is that the supply of them can only ever go up. There is unlimited upside to the supply of cryptocurrencies," he said.

"An individual cryptocurrency may have a ceiling on supply, but if were to introduce the Donovan cryptocurrency next week — which clearly would be superior to all existing cryptocurrencies — then what you would see would be a massive move out of existing cryptocurrencies, and into the new technically superior currency."

"And because you cannot reduce the supply of a cryptocurrency, that drop in demand would not be matched by a drop in supply, and therefore if demand goes down, but supply does not, we all know what happens to value. It is basic economics."

That ever-growing supply of cryptocurrencies can be seen in the recent boom in Initial Coin Offerings (ICOs). The basic concept of the ICO is that startups issue digital coins or tokens in exchange for real money used to fund projects. ICOs have become hugely popular this year, with over $3 billion raised using the method in 2017 so far.

Without a central bank to regulate things like bitcoin, Donovan said, there is simply no way of controlling the "money" supply.

In the USA right now, he said "the Federal Reserve is reducing money supply in the USA at the rate of $10 billion a month. That's because "demand for liquid dollars has dropped, and in order to preserve the value of the dollar, i.e. avoid inflation, the Fed is reducing money supply to match a reduction in demand."

"That cannot happen with a cryptocurrency," he said.

Furthermore, Donovan noted, a key feature of anything that can be considered a true currency is that it must act as a store of value — essentially meaning that you can put your money into it and be reasonably comfortable that in normal circumstances its value is not going to fluctuate massively.

Cryptocurrencies cannot do that, he says.

"Bitcoin in particular has had, I think, three hyperinflation episodes this year. That is to say its ability to purchase goods has dropped more than 25% in the course of a week. That is not a particularly stable store of value."

"Cryptocurrencies are, at the moment, universally treated as assets not as currencies for tax purposes."

"What that means is that if the price of bitcoin rises against the pound sterling and I cash in, I am liable to capital gains tax on the appreciation of the currency. If the value of sterling rises 20% against the US dollar, then I am not liable to capital gains tax on that appreciation."

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