Lessons for Cryptocurrencies from Foreign Exchange Markets

This essay brings insights from the academic literature on foreign exchange rate determination to the analysis of cryptocurrency markets. We present a simple framework to summarize the factors that determine exchange rates. To the extent that cryptocurrencies are like national currencies issued by central banks, their pricing can be analyzed using these models of exchange rates. As a preliminary, it is helpful to recall the traditional delineation of the three roles of money: it is a medium of exchange, a store of value, and a unit of account. The medium of exchange function refers to the usefulness of money for making transactions. Rather than the cumbersome search and matching problem that would arise if trade were by barter, money eases the process by allowing people to sell their goods and services for money, and to buy goods and services from other agents using money. Money is also an asset, which makes it a store of value. Often money earns very little or no pecuniary return. Forms of money include, for example, currency, demand deposits, and other checkable deposits. All of these pay a lower return than, for instance, short-term paper, but that difference reflects the implicit return to money arising from its utility in performing transactions. Finally, prices of goods and services are quoted in terms of money. Indeed, the convenience of money is connected to the stability of prices. When the prices quoted in terms of money are stable and predictable, people are more willing to hold money for transactions even though money provides little or no direct pecuniary return. Currency is one form of money and has somewhat different properties than other forms of money such as checking deposits. For transactions that involve small amounts, it is very convenient, but is quite cumbersome relative to other types of money for larger transactions. An important property is that transactions using currency are nearly completely anonymous. It is impossible to trace the buyer or seller of a product or service when the business is conducted with cash. Money, in turn, is one form of liquid assets. Nickolas (2018) defines liquid assets as: “cash on hand or an asset that can be readily converted to cash. An asset that can readily be converted into cash is similar to cash itself because the asset can be sold with little impact on its value.” There is a close relationship between liquidity and safety, when safety is defined as in Gorton (2017): “A safe asset is an asset that is (almost always) valued at face value without expensive and prolonged analysis. By design, there is no benefit to producing (private) information about its value, and this is common knowledge.” From these definitions, we can conclude that safe assets are liquid, and liquid assets are safe. Section 1 presents a framework for foreign exchange rate determination. The next section considers the similarities and differences of cryptocurrencies and national currencies, and applies lessons from the model of foreign exchange rates to the pricing of these digital currencies. The third and concluding section discusses implications for policy.