Bitcoin (BTC) is thought to act as a buffer against inflation, but it has yet to establish itself fully or achieve mass adoption. In theory, because it’s easy to access and its supply is predictable—and central banks cannot manipulate it arbitrarily—cryptocurrency should serve as a hedge against inflation. But currently, investors aren’t viewing it that way.
The cryptocurrency market is following the stock markets closely. Some may wonder why that is, so let us explore what stops cryptocurrencies from being a defense against inflation and what would need to happen to make them an effective hedge in the future.
Inflation is picking up speed, and prices for just about everything are now higher than they have been in years, except for the cryptocurrency market, which is scurrying in the other direction.
How do cryptocurrencies act in inflation?
Cryptocurrencies provide a distinctive answer because of their lack of a central governing bank. But if something isn’t there, you can’t lose faith in it. Because its supply is finite, it naturally rises in value. Users of a blockchain coupled with proof-of-stake mechanisms may access their funds at any time and continue to earn staking rewards on their existing balance.
As a result, the real annual percentage yield is determined by the chain’s economic activity via its treasury and staking reward distribution methods. Those features appear to address the inflation problem in conventional monetary systems, but there are still some problems.
Let’s take a look at the factors that motivate people to invest in and keep cryptocurrencies. The majority of cryptocurrency owners are optimistic about the future potential of those technologies, indicating some of their value is not currently present. They’re speculative bets.
Bitcoin has achieved decentralization, but its exuberantly high energy expenditures have not been addressed, and the majority of mining forces are still concentrated in a dozen mining pools. Ethereum also has concerns with energy use and mining pool concentration.
Furthermore, decentralized exchanges (or DEXs) are not as practical to use as centralized exchanges currently. The DEX with the highest transaction volume, Uniswap, has less efficient pricing in comparison to a centralized exchange. To be fair, these issues are being confronted. The third generation of blockchains is tackling energy consumption and decentralization head-on. Privacy is also improving.
As more people invest in cryptocurrency, they are slowly adapting to the idea that their wallets can always be traced. This is seen as an advantage by new users who were hesitant about blockchain technology because of its transparency. Traditional finance projects that use mathematical equations with cryptocurrency features are working on making DEXes more efficient.
Trust is something cryptocurrency still needs
Before crypto may serve as a bulwark against inflation, it must first reach critical mass and be integrated into society. Crypto has traits that suggest it will have future value in an ecosystem that is still attempting to establish its foundations.
The crypto economy is still waiting for applications that will fully exploit the power of decentralization without sacrificing quality or experience, which is crucial for widespread adoption. A payment system in which each transaction costs $5 and the value is constantly lost would be unrealistic.
Until decentralized applications and real-world payments with cryptocurrencies are as helpful as their centralized counterparts, the cryptocurrency market will continue to be regarded as a speculative investment.
Inflation is not simply caused by printing more money; an asset’s value does not automatically depreciate with increased numbers. For example, between September 2008 and November 2008, the number of billions of U.S. dollars in circulation tripled, yet inflation decreased.
Loss of confidence in the central monetary system is a primary driver of inflation, which has become an exacerbated issue due to corporate price gouging, pandemic relief packages, and disruptions to supply chains (partially due to the war in Ukraine). The big money print of 2021 didn’t create inflation but made it worse.
In terms of presence, keeping up with the cash supply alone is not a daunting task for a store-of-value currency. The circulating supply does not necessarily include what is kept. Gold, for example, exists in very large amounts as jewelry, bullion, and so on, but in significantly lower quantities on the commodity market.
If we factored in all the gold that has been mined on Earth, its market value would be completely different. This is because jewelry and bullion are not traded in the market, meaning they do not affect supply and demand. The same logic can be applied to currency.
Inflation is caused by a lack of confidence that an asset will maintain its value in the long term. Since most commodities are scarce, anyone who’s aware of the increased supply but uncertain about the monetary policy will account for it when setting prices. Inflation then becomes a self-fulfilling prophecy.
Cryptocurrency as an inflation hedge is possible, but not yet
So, if bitcoin isn’t the inflation hedge that it’s been marketed to be, what does this mean for investors? Is it still worthwhile keeping it in your portfolio or sticking to a strategy that includes a share of cryptocurrency?
Cryptocurrencies do not work as an inflation hedge during times of high volatility and market uncertainty. Nonetheless, when compared to fiat currencies, their relatively tiny market capitalization makes them perform well in steady growth markets, where they easily outperform the market and where the relatively modest size of the cryptocurrency market compared with fiat currencies works in their favor.
The current solutions to the problem of usability are not going to work in the long run because they rely on speculation and have low transaction volumes. When financially unsustainable blockchains fail, it hurts the whole ecosystem, which means that any promising long-term solution gets derailed by scammers.
If the crypto community becomes more reliable and hardworking, every established protocol will improve, and digital currency will become protection against inflation. At present, cryptocurrencies act like growth stocks, countering inflation during times of stable economic development but losing value in financial crises.
As cryptocurrencies continue to develop, they will become an increasingly effective way to protect your investments during periods of market turmoil. During these times, it is wise to be cautious with your crypto investments and not put all your eggs in one basket.
However, this will gradually change as blockchain technology continues to develop. More people will start using cryptocurrencies as a way to protect themselves from inflation. The necessary infrastructure is already in place.