Fixing Cryptocurrency Volatility & Market Cap Confusion

If you take the time to read this article, you will learn three important things:

(1) Why cryptocurrency “Market Cap” is broken;
(2) How to fix the “Market Cap” (actually, what to replace it with);
(3) How to resolve the violent volatility that is holding back all cryptocurrencies from becoming truly stable currencies for real-world commerce.

Debunking Bogus Economics. I’ve seen some people point to this “Why most cryptocurrency market cap is fake” article as proof that market cap is fake. There are some problems with the way “market cap” is calculated for cryptocurrencies (which we’ll cover below), but that article is technically flawed from a basic economics perspective. In fact, at the end of the article, the author implicitly admits he is not an economist nor a mathematician, which is clear from the structure of his argument.

Specifically, the author repeats the same point about 10 times in different ways; so, if you want to save time, here is his primary point:

“Cryptocurrency market caps are fake because it is impossible to trade most cryptos for U$.”

Nonsense. His argument is not based on anything other than a guess and his guess completely ignores the reality of many currency and other types of markets in the real world today. Why?

Introduction to Vehicle Currencies. He is ignoring a basic principle in Economics that economists call a “vehicle currency.” A vehicle currency, by definition, serves as an intermediary currency between two different currencies that cannot trade on the same market. You can visualize it as a “vehicle” that transports value between one currency to another.

Vehicle Currencies for Small Countries. Vehicle currencies (and intermediary commodities and instruments of many kinds) are required in many situations. For example, many small countries have currencies that are not trusted enough by international investors and currency markets; thus, they must convert their currencies into USD (the most common vehicle currency) to participate in international markets.

Vehicle Currencies for Sanctioned Countries. Vehicle currencies are also required in situations when economic sanctions and trade embargoes are imposed on a country (e.g., Iran, Syria, North Korea. . .). When this happens, the sanctioned country can’t trade directly with other countries because the banking systems of other countries will not process the sanctioned country’s currency.

Vehicle Currencies for Thinly Traded Currency Markets. Many small countries have relatively little currency in circulation, which means large currency exchanges simply can’t make money from them. So, many small countries are forced to find relatively shady currency traders who charge very high prices to exchange the local currency for a vehicle currency (usually USD).

Circulating Value vs. Locked Value. One of the biggest problems with crypto “market cap” is that the data providers don’t differentiate between coins that have already been issued and are circulating vs. coins that are “locked up,” pending some kind of future event, or not circulating for several other reasons. If 50% of a crypto’s coins are locked up, that’s just like USD locked up in a safe. If they’re not circulating, then they’re not really pushing value throughout the economy; thus, they shouldn’t be counted.

Lost Coins. Many coins (currency) are lost forever due to theft and incorrect wallet-targeting. These lost coins are not in circulation, but they’re still counted in the market cap calculation. This is like gold coins at the bottom of the ocean: If they’re not in circulation, then they don’t transport any value throughout the economy and should not be counted.

Last Traded Unit Price Dramatically Over-Inflates Market Cap. If you have 10 cookies and somebody is dumb enough to buy one for $1 million, that means you now have $10 million worth of cookies, right? Uh . . . no, but that’s exactly how crypto market cap measures market cap today. This doesn’t happen in equities markets (or any other real market) because the rise in price is confined by something relatively tangible like a company’s book value and it’s Price-to-Earnings (P/E) Ratio. However, for virtually all cryptos today, there’s nothing tangible to anchor them to, which makes them vulnerable to all kinds of irrational animal spirits.

Is Crypto Market Cap Useful At All? Yes, but in the same way that the Dollar Index is useful to observe the rise and fall of the percentage change in the value of the USD based on an arbitrary starting value of “1” on an arbitrary starting date. However, in contrast to crypto market cap, the Dollar Index doesn’t quantify the actual fiat value of the underlying USD currency circulating in the economy. In fact, nobody runs around saying, “The M1 money supply * the inflation rate = $10 trillion market cap, woohoo!” because that’s stupid and it doesn’t make any sense from a real-world economic perspective. But that’s similar to what happens in the crypto markets today.

The Dollar Index Works Very Well. In fact, all indexes generally work just like the Dollar Index (including stock/bond/commodities/currencies indexes) and they are very useful for analyzing directional price and volume action in any market without needing to assign an aggregate financial value to the entire market. That’s the way aggregate crypto markets should be measured. However, to do that, all the exchanges would need to come together and agree to abandon the idiotic market cap delusion and simply set a specific starting index date and a specific starting coin price for each coin (it can be any starting price) and then present their data from that date forward as an index value for each coin, not a market cap. That’s all that is necessary to solve the “market cap” problem.

But What About Using Metcalf’s Law, Hash Rates, Mining Fees. . .? I’ve seen several proposals to fix crypto market cap based on Metcalf’s law (i.e., # of users^2 * crypto unit price), mining fees earned * # transactions, hash rates, and some other factors. However, all those factors are still vulnerable to various forms of market manipulation and/or they don’t logically map to the actual flow of value throughout an economy. Most importantly, they’re not necessary if we measure aggregate crypto market value changes with an index like we do with the USD and all other fiat currencies.

But How Do We Measure the Price of each Crypto Coin’s Value? This question is no different than: How do we measure the price of each USD’s value? Why is it no different? Because, since Nixon killed the Gold Exchange Standard in 1971, the price of the USD has been totally arbitrary, floating against all other fiat currencies, just like the price of cryptos floats against each other today. However,  the rise/fall of the USD’s price has been confined by something. What is that “thing”? Without that “thing” every fiat currency on Earth would frequently float to the sky and drop to the Earth, doomed to perpetually violent volatility. In fact, that’s what is lashing all cryptos today as I type (e.g., Ethereum down ~80% over the past six months after it was up over 1,000% in the previous six months).

The Exchange-Value Stabilization Effect of Real Commerce. Just like cryptos (backed by faith in algorithms), the USD isn’t backed by anything except for the “full faith and credit” of the USG. So, they’re both backed by “faith”. By definition, "faith" is belief, which is based on human imagination. However, the reason the USD’s value is not violently floating all over the map like cryptos is because the USD is constantly used as an actual medium of exchange (one of the three primary functions of any currency) in actual commerce. The process of constant commercial exchange is that “thing,” which imposes discipline on the pricing action in the USD currency market (or any fiat market). Why is this true? Because, when people buy real products/services with USD, they are extremely sensitive to any significant changes in the USD-based price of the goods/services they buy.

Confirming This Hypothesis. The simplest way to confirm this hypothesis is to watch any customer’s behavior when you try to violently change the price of any product/service for no apparent reason, just like in the crypto markets. Customers simply won’t enter such a volatile market to purchase anything that really matters to them, which means those markets would be relegated to speculative trading only. Merchants know this; so, they preemptively self-regulate the price of their products/services to keep their price volatility as low as possible because they know that’s the only way to make sure their customers will keep coming back. Every functional market works exactly this way, but . . .

The Crypto Currency Markets Are NOT Functional Markets. This is because there’s nothing to impose discipline upon the price action of each crypto coin’s value, i.e., their prices are not confined by the Exchange-Value Stabilization Effect of Real Commerce described above. So, until cryptos are used much more frequently in actual commerce, the volatility of cryptos will continue to remain high. But the volatility is what prevents people from feeling confident enough to use cryptos in commerce more frequently in the first place. So, we have a chicken-and-egg problem.

The Chicken-and-Egg Problem of “Complementary Demand”. In Economics, we use the phrase “Complementary Demand” to describe the chicken-and-egg problem that all emerging markets face when they attempt to transition from an agrarian society to an industrialized society. For example, an automobile industry cannot emerge without complementary parts industries emerging simultaneously to supply all the parts to the auto industry (steel, tires, glass, etc.). And without significant foreign exchange reserves, emerging countries cannot import their parts from other countries; thus, they face a chicken-and-egg problem, which can prevent their nascent industries from ever getting off the ground.

Cryptocurrency & Emerging Markets Face the Same Chicken-and-Egg Problem. On the surface, this “complementary demand” concept might seem totally irrelevant to cryptocurrencies, but it’s actually the exact same problem that all cryptos are suffering from today: Crypto tokens are missing their real-world product-complement because it’s currently so difficult to use cryptos in real-world transactions. Thus, there’s nothing to confine cryptos to a stable, quantifiable and confined price, which is why their prices float all over the map.

Crypto-Product Pair is Like a Quantum Superposition. My description above might seem like I’m talking about backing cryptos with gold or some other scarce resource. No, recall the USD’s price is relatively stable even without a commodity backing. Thus, this “crypto-product” pair is more akin to the principle of a quantum superposition. However, in this case, the value of a crypto and the value of a product/service must collapse into a single object of value frequently enough within a market to squeeze the price of all cryptos in the same market into a more stable price range. (Recall: This crypto price squeeze is reinforced by consumers who are extremely price-sensitive to the crypto’s product complement.) More specifically, a crypto cannot manifest a stable, confined price range without being frequently attached to products/services in the real world. Until then, the price of the cryptos violently float up and down like a helium balloon in a windstorm.

How Do Emerging Markets Overcome the “Complementary Demand” Problem? Contrary to what some people believe, ALL national governments start out by protecting and subsidizing their nascent industries. This includes all major economies today, including the U.S., U.K., Japan, South Korea, China, Germany, Singapore, Chile, France, Canada. . . . Why is this important? Because we should perceive the Gini market as a “nascent industry” and approach its development in exactly the same way that every successful emerging country has approached their economic development throughout human history.

We Should Learn from Emerging Market Development Principles. There are well-established steps to growing every emerging market, but it requires foresight, organizational discipline, the resolve to ignore pressures from special interest groups and speculators that want to get rich quick, and highly coordinated execution between policymakers and industry during the early, formative years. In this context, the Gini team is the "emerging market coordinator" right now. I know staunch libertarians hate this kind of logic, but they're ignoring the history of every successful economy on Earth.

The reality is this: If Gini doesn't manage the rollout and development of the Gini cryptocurrency market like a nascent industry of a developing country, the crypto markets will never be tamed. There will never be a cryptocurrency that is actually viable for real-world commerce. Additionally, without a commitment to this approach, the Gini team would have too many pressures to appease the speculative profiteers and market whales to make any significant course corrections along the way, which is what has substantially paralyzed Bitcoin and all other major cryptocurrencies today.

The Dirty Crypto Secret. Many (probably most) blockchain project teams and crypto traders love the existing volatility because it’s a lot easier to get rich and suck wealth out of the economy when the price of a cryptocurrency can skyrocket on any day. And the steep price rise/fall gives more experienced traders opportunities to manipulate markets and fleece the newbies. Additionally, given the oligarchy of mining pools with their USD billions invested in the existing infrastructure, none of them are going to be very enthusiastic about anything that would significantly reduce the volatility. That's why we believe Gini's unique nascent crypto market philosophy is likely humanity's only chance to see a cryptocurrency market grow the way every successful economy has grown in human history.

Bottom Line: Until/unless a nascent crypto market is systematically developed in a highly coordinated way between a crypto project’s team and many crypto-accepting merchants to overcome the “complementary products” chicken-and-egg problem, we will probably never see any cryptocurrency become stable enough to use in real-world commerce. This is exactly why we are implementing the Gini Ecommerce Portal, which is intended to maximize Gini's price stability in a way that no other cryptocurrency can achieve today.

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