Aswath Damodaran, professor of finance at New York University, recently weighed in on Bitcoin and the digital currency market in a recent post and video. He makes no pretense of being as technologically savvy as some, but his experience and knowledge in corporate finance and equity valuation gives him an interesting perspective.

Bitcoin’s successes

Professor Damodaran points out that

“The success part of a cryptocurrency is what they’ve done in the market…Bitcoin has soared and markets have treated it very well.”

Today the market capitalization of Bitcoin is around $53 billion. While that is relatively small in comparison to the market capitalization of companies like Amazon or Apple, Professor Damodaran says that this is a respectable number considering Bitcoin's humble origins.

The professor cites characteristics of Bitcoin:

  • Decentralized verification

  • Complete and open records

  • Almost incorruptible

The currency test

Many economists have put Bitcoin and other cryptocurrencies through the “currency test.” The definition of currency is three-fold: it must be a unit of account, a medium of exchange and a store of value. Damodaran agrees with this definition but argues that currency is, in fact, a continuum.

While the US Dollar, the Swiss Franc and the Venezuelan Bolivar are all currencies, one might reasonably conclude that one is better than another. The “quality” of a currency is fluid and can change over time.

The professor argues that

“If you define success as a rise in market capitalization and popular interest, cryptocurrencies have clearly succeeded.”

However, he qualifies these remarks by stating that in the long term, success is dependant on whether Bitcoin becomes a “good” currency.

What makes a good currency

Professor Damodaran does not believe that there is any “perfect” currency: not gold, nor fiat, nor crypto. While gold holds tenure as a globally respected currency through the ages, it is difficult to use both as a unit of account and a medium of exchange. The quality of fiat currencies varies greatly by which government backs them. Damodaran says “...without trust fiat currency is just paper.”

WIth respect to cryptocurrency, he believes it is quite functional, being fungible, infinitely divisible and countable. However, cryptocurrency falls short as a medium of exchange. Very few retailers accept Bitcoin for payment. Those who do accept Bitcoin only do so because of intermediaries who immediately exchange the currency into fiat.

Because of Bitcoin’s notorious volatility, merchants list prices in dollars rather than Bitcoin. While high volatility is attractive to traders, it discourages mainstream adoption.

Adoption hurdles

Professor Damodaran makes important conclusions as to why cryptocurrency is not being widely accepted for transactions:

  • Inertia: Cryptocurrencies are still new and it takes time for people to change their financial habits. It took almost twenty years for debit and credit cards to become widely accepted.

  • Competition: With hundreds of cryptocurrencies available, there is competition and confusion.

Less trading, more transacting

Regardless of investor or speculative interest, Damodaran makes the reasonable argument that

“A cryptocurrency that never gets used ...for transactions will not survive...in the long term. There can be no good ending to that story.”

Instead of focusing on a currency’s speculative potential, Professor Damodaran thinks there needs to be more emphasis on dampening volatility and adding features which make digital currencies more useful for ordinary transactions.

Cryptocurrencies have risen meteorically in value due to speculation and trading. This might be part of the problem as there is a clear drive market for the tradability of these currencies. Damodaran feels that this is partly the fault of developers. Instead for mainstream adoption, there must be a focus on transactions as a goal.