10 January 2018 | 5:32AM EST

Global Markets Analyst

Bitcoin as Money

n To a modern American observer cryptocurrencies can seem like a solution in Zach Pandl
+1(212)902-5699 | zach.pandl@gs.com
search of a problem. Money derives its value from its usefulness in facilitating Goldman Sachs & Co. LLC

transactions and diversifying portfolios. The US Dollar serves both purposes Charles P. Himmelberg
+1(917)343-3218 |
relatively well—or at least better than the main alternatives—so it is in high charles.himmelberg@gs.com
Goldman Sachs & Co. LLC
demand around the world.
n The same cannot be said for many other types of money. In certain parts of the
world, and at points throughout history, multiple currencies have circulated in the
same economic area—a phenomenon known today as “Dollarization”. Moreover,
governments often restrict the use of domestic and foreign currencies within
their borders. In these circumstances, it is natural to see how alternative—
possibly digital—forms of money could be useful.
n We find some evidence that the demand for cryptocurrencies has come from
regions with currency instability and/or capital controls. But other data point to
retail speculation. In practice, Bitcoin and other digital currencies face significant
practical hurdles to wider adoption—including potential government regulation
and excessive volatility.
n So could Bitcoin succeed as a form of money? In theory, yes, if it proves capable
of facilitating transactions at a low cost and/or providing better risk-adjusted
returns for portfolios. In practice, however, the bar looks high. The currencies of
most developed market economies already deliver these monetary services quite
well. And if blockchain technologies go mainstream, as seems likely, the bar will
look even higher. That said, Bitcoin (and cryptocurrencies more generally) may
offer viable alternatives in countries and corners of the financial system where
the traditional services of money are inadequately supplied.

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Goldman Sachs Global Markets Analyst

Bitcoin as Money

At the root of much of the debate about Bitcoin is confusion about the nature of
money.1 In the textbook treatment, money in an economy serves as (i) a medium of
exchange, (ii) a unit of account, and (iii) a store of value. Or, in everyday language, money
is the item that we offer or receive for the purchase or sale of goods, services or
assets2—it is simply a device that facilitates transactions in a market economy. The
confusion arises because the physical properties of money are practically arbitrary—
paper bank notes, gold coins, digital tokens or stone disks could all serve the purpose.
Instead, the value of money derives from its usefulness. Therefore, digital currencies
like Bitcoin could prove to have value, if they can demonstrate their usefulness relative
to existing forms of money.

Demand for money comes from two sources: transaction demand and portfolio demand
(Exhibit 1). Economists have a number of theories for the transaction (or liquidity)
demand for money, but they all boil down to the same thing: we cannot easily exchange
(non-monetary) financial assets (“assets”) for goods and services, so we tend to hold
some amount of monetary assets (“money”) to facilitate consumption. Transaction
demand for money declines with expected returns on assets (the opportunity cost of
holding money), increases with transaction costs (like brokerage fees), and increases
with income (because more transactions require more money). Portfolio demand for
money also declines with expected returns on assets, and one could argue this is why
some precious metals (such as gold) are more like money than other assets.3 Finally,
portfolio demand for money increases with uncertainty about asset returns and
increases with wealth (because more wealth means larger money balances).

Exhibit 1: Two Sources of Money Demand

Demand for Money

Transaction Demand Portfolio Demand

‫)ޓ‬DOOVZLWKH[SHFWHGUHWXUQVRQDVVHWV ‫)ޓ‬DOOVZLWKH[SHFWHGUHWXUQVRQDVVHWV

‫ޓ‬5LVHVZLWKDVVHWWRPRQH\WUDQVDFWLRQFRVWV ‫ޓ‬5LVHVZLWKXQFHUWDLQW\DERXWDVVHWUHWXUQV

‫ޓ‬5LVHVZLWKLQFRPH ‫ޓ‬5LVHVZLWKZHDOWK

Source: Goldman Sachs Global Investment Research

1
Here we use “Bitcoin” with a capital “B” to refer to the unit on the network, consistent with our standard
practice of capitalizing exchange rates like the Dollar and Yen. In other publications, capital-B “Bitcoin” can
refer to the blockchain peer-to-peer network.
2
This definition paraphrases John Kenneth Galbraith in Money: Whence it Came, Where it Went, 1975.
3
For a detailed discussion on gold and precious metals as money, see “Fear and Wealth”, Goldman Sachs
Commodities Research, 17 October 2017.

10 January 2018 2
Goldman Sachs Global Markets Analyst

Nominal exchange rates are the relative price of two forms of money, and their
fluctuations result from these same demand drivers.4 An exchange rate appreciates
because of higher transaction demand—e.g., due to export competitiveness or an
increase in cross-border M&A—or because of higher portfolio demand—e.g., investors
expect relatively higher returns or relatively lower risk on assets denominated in that
currency. Although we do not often consider this factor for major exchange rates, a
currency could also appreciate because it provides lower asset-to-money transaction
costs, and therefore becomes more useful for transaction purposes (a possible selling
point of cryptocurrencies).5

When Money Malfunctions

To a modern American observer, cryptocurrencies can seem like a solution in search of a
problem. In recent decades the US Dollar has served its purpose relatively well:
consumer price inflation has averaged 2.1% over the last 30 years, and the real
trade-weighted exchange rate is about 3% above its average of the same period. It is
true that the US financial system wobbled during the financial crisis, but the underlying
problem was not the currency per se: the Dollar actually appreciated 16% between
June 2008 and March 2009. The Dollar accounts for about 65% of global foreign
exchange reserves and is the denominate currency in global trade—about 30% of global
trade flows excluding the US are invoiced in USD. In other words, transaction and
portfolio demand for the Dollar are very high.

The same cannot be said for many other types of money. In certain parts of the world,
and at points throughout history, multiple currencies have circulated in the same
economic area. In academic research this is called “currency substitution”, but it is more
commonly known today as Dollarization.6 Many countries with a history of currency
instability and/or underdeveloped financial markets use the US Dollar for the traditional
functions of money—as a medium of exchange, unit of account and store of value. In
sub-Saharan Africa, for example, many currencies have been debased by high inflation
and the mismanagement of money supply. As a result, Dollarization is widespread:
foreign currencies account for more than 90% of deposits and loans in the DR Congo,
and Zimbabwe demonetized its own currency in 2015 (a variety of foreign currencies
now circulate). The US Dollar is the official currency of Ecuador and a variety of smaller
nations, where no separate legal tender circulates. The Peruvian economy remains
significantly Dollarized today despite stable inflation over the last decade—a legacy of its
experience with hyperinflation in the late 1980s. In these circumstances, it is natural to
see how alternative—possibly digital—anchor currencies could be useful as well.

Government regulation can also restrict the use of outside currencies in various ways.
For example, countries can limit the amount of foreign exchange that can be held in

4
What about supply? In an economy where the central bank targets nominal interest rates, the supply of
money responds endogenously to changes in demand (i.e., the supply curve is perfectively elastic at a fixed
price/yield).
5
Network externalities may help reduce transaction costs; discussed further below.
6
Of the sizable academic literature on this subject, we would recommend a paper by Stephen Poloz, the
current governor of the Bank of Canada: “Currency Substitution and the Precautionary Demand for Money,”
Journal of International Money and Finance, 1986.

10 January 2018 3
Goldman Sachs Global Markets Analyst

bank deposits (e.g., Mexico) or by certain types of investors (e.g., pension funds in
Poland). They can also tax foreign exchange transactions or maintain multiple official
exchange rates, and capital controls may limit the degree to which residents can convert
domestic money into foreign exchange. Prominent recent examples include: (i) the
prohibition on purchases of foreign assets by Greek banks, (ii) limits on currency
conversion in Cyprus, and (iii) the use of various quotas for overseas investment by
China.7 In situations such as these, where residents are unable to accumulate traditional
foreign exchange, a decentralized currency such as Bitcoin could attract significant
demand, especially if it is not (yet) legally recognized as a currency.

Lastly, while Bitcoin and other cryptocurrencies employ innovative technologies, there is
nothing particularly unusual about new types of money or monetary systems. Probably
the best recent example was the introduction of the Euro in 1999. The Euro began as a
fixed exchange rate system between 14 EU member states, but is now the official
currency of 19 EU members plus a handful of smaller European nations8, and is the
second most common currency held in foreign exchange reserves and used in global
trade—partly displacing the US Dollar. Some economists make the case that the IMF’s
Special Drawing Rights—in a redesigned format—could also play a role as an
international currency in the future. In theory at least, there is no reason why
cryptocurrencies could not do the same.

Tracking Demand
We see some evidence that the demand for cryptocurrencies could be related to
dissatisfaction with current monetary systems. For instance, a Google Trends search
shows that the highest search intensity for “Bitcoin” over the last five years (scaled to
overall search volumes in the country) came from Nigeria, South Africa and Ghana, all
countries with currency instability and/or restrictions on the use of foreign exchange—
places where alternative forms of money might see natural demand. In addition, Bitcoin
exchange volumes in China rose sharply following the tightening of capital controls in
2016. They subsequently collapsed when cryptocurrencies were more stringently
regulated last year (Exhibit 2).

Other data look more consistent with a classic speculative bubble. First, Bitcoin
exchange volumes are now dominated by investors in Korea and Japan—countries with
no recent history of monetary instability and/or unmet portfolio diversification needs
(Exhibit 3). Second, cryptocurrency prices are correlated with Google search volumes
(Exhibit 4). This may point to significant retail investor participation in these markets.
Third, until the launch of Bitcoin futures, it was generally not possible to short the
market—a common feature of speculative bubbles.

7
All examples published by the IMF in its Annual Report on Exchange Arrangements and Exchange
Restrictions.
8
Kosovo, Montenegro and San Marino.

10 January 2018 4
Goldman Sachs Global Markets Analyst

Exhibit 2: China Trading Volumes Rose Following Capital Controls, then Fell Following Bitcoin Regulation

Million CNY Bitcoin Exchange Monthly Volume Million

200 200

180 180

160 160

140 140

120 120

100 100

80 80

60 60

40 40

20 20

0 0
2013 2014 2015 2016 2017

Source: Bitcoinity.org, CryptoCompare.com, Goldman Sachs Global Investment Research

Exhibit 3: Demand Growth from Japan and Korea Exhibit 4: Prices Correlated with Search Volumes

Million Bitcoin Exchange Monthly Volume Million Index Index

Ethereum
12 JPY KRW USD All Others Ex-CNY 12 120 Google Search Volume Price per USD (RHS) 800

10 10 700
100
600
8 8 80
500

6 6 60 400

300
4 4 40
200
2 2 20
100

0 0 0 0
Jan-16 May-16 Sep-16 Jan-17 May-17 Sep-17 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Source: Bitcoinity.org, CryptoCompare.com, Goldman Sachs Global Investment Research Source: Google.com, CryptoCompare.com

A remaining question is what to make of the many types of digital currencies on the
market. According to the website coinmarketcap.com, there are currently more than
1,300 different cryptocurrencies available today (including both coins and tokens).9 As
discussed above, the value of money comes from transaction demand and portfolio
demand. However, the value of a particular type of money is also enhanced by network
externalities. The US Dollar derives some of its value from the fact that it is universally
accepted as payment in the United States, and widely accepted as payment throughout
the world. For a specific cryptocurrency to succeed, it may require support from
network externalities—i.e., a “critical mass”—but this may be challenging given the
large number of coins available.

9
The total market cap of the cryptocurrency universe is approximately $670bn, or roughly the same value of
all cash US Dollars held outside the US (according the Federal Reserve’s Flow of Funds Accounts).

10 January 2018 5
Goldman Sachs Global Markets Analyst

A Case for Crypto?

In practice, Bitcoin and other digital currencies face significant practical hurdles to their
adoption as outside forms of money, and many of their possible benefits come with
significant drawbacks—several of which were highlighted by our colleagues in an earlier
report (Top of Mind: All about Bitcoin, March 11, 2014).

First, some features of cryptocurrencies that might make them competitive with
alternative stores of value are also features that are likely to attract government scrutiny.
In particular, the anonymity of many cryptocurrencies makes them a useful medium of
exchange for criminal activities, including tax avoidance and the circumvention of capital
controls. As such, it would be surprising if continued growth in their popularity did not
eventually attract greater regulation and law enforcement action by government.

Exhibit 5: Not a Very Stable Store of Value

BTC

WTI

Silver

Gold

S&P 500

EURUSD

10y Treasury

1y Treasury

1m T-bill

0% 1% 2% 3% 4% 5%
Daily Volatility

Source: Goldman Sachs Global Investment Research

Second, the fact that cryptocurrencies function without central banks may make them
valuable as inflation hedges or stores of value, but also makes them vulnerable to
demand-driven fluctuations in price. Such volatility makes them poorly suited as a
substitute for money generally—which is why most nations eventually abandoned the
gold standard in favor of fiat currencies that can more easily stabilize the purchasing
power of money by making the necessary supply adjustments in response to changes in
money demand. The recent fluctuations in Bitcoin and its relatives suggest they are
much too volatile to serve as money (Exhibit 5). Volatility would likely need to come
down dramatically (either naturally or through the widespread adoption of
cryptocurrencies designed to better stabilize purchasing power via supply adjustments)
before we see broader adoption.10

10
There is a more subtle point here as well: part of the reason why the US Dollar serves as an effective store
of value around the world results from its negative correlation with emerging market exchange rates at times
of broader market stress. A good “store of value currency”—USD, CHF, JPY, or gold—should have this
feature.

10 January 2018 6
Goldman Sachs Global Markets Analyst

We should also stress that, as money, cryptocurrencies should have low expected
returns in the long run, despite their high returns recently. Our working assumption is
that long-run cryptocurrency returns should be equal to (or slightly below) growth in
global real output—a number in the low single digits.11 Thus, digital currencies should be
thought of as low/zero return or hedge-like assets, akin to gold or certain other metals.
This could still mean that prices increase at a faster rate as the technology is adopted—
an analogy might be the value of a biotech company that invents a drug, which
eventually becomes a generic—but there is an inherent contradiction between
cryptocurrencies as high return assets on the one hand, and stores of value relative to
goods and services on the other.

So could Bitcoin succeed as a form of money? In theory, yes, if it proves to be more

useful than the alternatives—in terms of facilitating transactions at a lower cost and/or
providing better risk-adjusted returns for portfolios. In practice, however, these gains
look small, at least in developed market economies. Transaction costs are relatively low,
exchange rates and price inflation are broadly stable, precious metals can be used for
portfolio diversification, and governments place few restrictions on holding foreign
currency or foreign assets. That said, the widespread use of the Dollar outside the US—
and full Dollarization in some countries—suggests there is already demand for an
internationally accepted medium of exchange and store of value. In those countries and
corners of the financial system where the traditional services of money are inadequately
supplied, Bitcoin (and cryptocurrencies more generally) may offer viable alternatives.

Zach Pandl

Charles P. Himmelberg

11
Here, we have in mind the standard theory that real money balances are a function of output/income in the
long run, assuming stationary returns on assets.

10 January 2018 7
Goldman Sachs Global Markets Analyst

Disclosure Appendix
Reg AC
I, Charles P. Himmelberg, hereby certify that all of the views expressed in this report accurately reflect my personal views about the subject company
or companies and its or their securities. I also certify that no part of my compensation was, is or will be, directly or indirectly, related to the specific
recommendations or views expressed in this report.
I, Zach Pandl, hereby certify that all of the views expressed in this report accurately reflect my personal views, which have not been influenced by
considerations of the firm’s business or client relationships.
Unless otherwise stated, the individuals listed on the cover page of this report are analysts in Goldman Sachs’ Global Investment Research division.

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