Crypto’s value comes from ‘crypto’s volatility’

One of the most difficult challenges in finance is how to price crypto assets. Bonds pay interest. Stocks pay dividends. What exactly do crypto assets pay? Well, other people value them too, but what does that depend upon? How can crypto valuations be connected to something real?
The value of crypto assets comes from a few core uses — plus, and this is crucial, how much investors value the volatility of crypto assets. It is this latter feature which explains much of the day-to-day price shifts of crypto.
Start with the core uses. Some of these are already established, others are more speculative. One well-founded core use is that you can use crypto assets to pay off your blackmailer or data thief. (Crypto proponents hate this example, but when it comes to a core use, it is the closest thing crypto has to a “sure thing.”) Whether this is socially desirable is another matter, but it is privately beneficial to hold some crypto in order to pay ransoms.
Other core uses could involve crypto assets as “digital gold,” crypto assets in gaming environments, crypto assets in the metaverse, crypto assets as a means of paying off “smart contracts,” and crypto assets as underpinning decentralised finance, or DeFi. These uses vary in their degree of acceptance and their likelihood of success, but all of them are possibilities.
Crypto prices are in part a moving bet on how much the demand for crypto will increase to satisfy these varied uses. For my purposes it suffices that some core demands exist, and so the value of more useful crypto assets will not fall to zero. What I am most interested in is which forces might operate on top of these relatively well-understood factors. Much of the primary value of crypto assets is from their price volatility, which is part of their
appeal. The general idea of price volatility as a value dates at least as far back as Fischer Black, one of the founders of options price theory.
In standard economic theory, investors are risk-averse, meaning they prefer more stable consumption patterns to less stable ones. That is usually true, but it does not mean investors always prefer more stable investment prices — a crucial distinction.
Consider this hypothetical: You are given an envelope containing one dollar. You are then offered the opportunity to exchange it for an envelope which contains either twice the money (that is, $2) or half the money (50 cents), each with 50% probability. In essence, you
are accepting some exchange-rate volatility.
Most people will find this bet a pretty good one. The new expected value of your envelope is (0.5 x $2) + (0.5 x $0.5), or $1.25. That is a higher expected value than your original dollar.
If you are perched at the margin of subsistence, this bet might seem too risky. But for most investors, who have some level of wealth, it is an improvement in prospects, though with some additional risk.
Bitcoin and other crypto assets are essentially offering you a form of this bet. To be sure, this 50-50 bet does not exactly describe the price dynamics of crypto assets. But it is one way of illustrating that crypto prices, relative to the dollar, will either go up a lot or down a lot. The bet helps show that some investors might welcome price volatility — or, if you wish, call it exchange-rate volatility.

—Bloomberg