The cryptocurrency world has continuously grown since the launch of Bitcoin in January 2009. The novel cryptocurrency was initially launched as a payment technology, namely, to make peer-to-peer transactions without the need for a financial intermediary between the parties.1 That the cryptocurrency phenomenon unveiled during the 2008 crisis is no accident. Justified or unjustified, it is another reaction against the so-called “evil” financial market during the financial crisis.

Since then, the question of whether cryptocurrencies such as Bitcoin can become money has been at the center of much discussion and debate. The recent monetary reform in El Salvador, which mandates the acceptance of Bitcoin as a means of payment, only fuels the debate over the feasibility of cryptocurrencies as money. History shows that new moneys do emerge. History also shows that private money can work as efficiently, if not more efficiently, than state money. Yet cryptocurrencies in general, and Bitcoin in particular, face a few significant challenges to becoming well-established money, that is, a commonly accepted means of exchange. Much expectation rests on Bitcoin, the forerunner in the crypto-world. However, Bitcoin faces three crucial challenges to becoming money: (1) the scalability constraint, (2) the need to break network effects, and (3) the problem of choosing the right monetary rule.

The scalability constraint problem

This problem relates to the number of transactions that a cryptocurrency technology can verify per second (TPS–transactions per second). Consider the situation when you buy a coffee at a coffee shop. You swipe a debit or credit card, and after just a few seconds and beeps, the transaction is verified and approved. A few moments later, you get your cup of coffee. For instance, VISA can certify up to 56,000 TPS. Paypal can do up to 115 TPS (0.2-percent of VISA). Bitcoin can only authenticate seven transactions per second. Bitcoin’s TPS is well suited for a small community with only a few transactions. But, as the number of Bitcoin users and transactions increases, a bottleneck occurs, delaying transactions beyond a threshold acceptable for a well-functioning means of exchange. Ironically, miners who certify Bitcoin transactions can charge a fee to move a transaction up the line—a similar type of fee that ideally would be avoided with a peer-to-peer technology such as blockchain.

The scalability constraint can be a significant deterrent for a cryptocurrency to graduate to money. The issue is not simple. For many cryptocurrencies, increasing their TPS capacity means reducing the safety of their transactions. Intuitively, the faster a transaction is verified and recorded in the blockchain, the easier it is for a miner to pass a fake transaction to the record. On the contrary, the more time a transaction waits to be verified, the more time for other miners to spot a fake trade being added to the network and take action before it becomes final.

A new cryptocurrency that wants to have a competitive TPS can do so at the expense of less security or resigning itself to being a decentralized network. VISA, for instance, is a centralized network (only VISA gets to see the transactions that need verification). For cryptocurrencies built on decentralized doctrine, this is not an option because decentralization is part of their identity. Yet, there are two options to get around the scalability constraint.

The first one is called SegWit, a shorthand for segregated witness. It works this way. A block in the blockchain contains information such as the transaction amount and “witness” information such as a timestamp. By moving the “witness” information to an attached block, the SegWit, space is freed for more transactions to be added to the main blockchain. SegWit allows increasing the TPS without sacrificing the information being recorded in the blockchain. SegWit is one of the options to increase Bitcoin’s TPS.

The second one is known as the lightning network. In this case, two parties open their private communication channel to perform all their business transactions (secured by a smart contract). Once their business is complete, they only report the final balance to the main blockchain. Say, for instance, that two parties perform ten transactions in their business. Then, all they have to do is report to the main blockchain their final transaction that cancels any outstanding balance between the parties. The previous nine transactions take place in the “lightning network.” This parallel blockchain allows for fast and immediate certification of the first nine transactions between the involved parties.

Whether SegWit and the lightning network are enough to deal with the scalability constraint is yet to be seen. These two developments remain examples of private solutions to what is perceived as a high transaction cost in the Bitcoin network.

Network effect problem

“Money is a network good. The more individuals and firms use the same means of exchange, the more beneficial it is to use the same means of exchange.”

An important characteristic of money is that it depicts network effects. A network good is one whose utility depends on the number of individuals connected to the network. A typical example is a phone. These goods are useless if no one else has one—no point in having a phone if there is no one to call. The more individuals have a phone, the more utility this device yields to the consumer. A more modern example would be social networks such as Facebook, Twitter, or Instagram. Money is a network good. The more individuals and firms use the same means of exchange, the more beneficial it is to use the same means of exchange. If everyone around me uses U.S. dollars, it is easier for me to use U.S. dollars even if I like Bitcoin better.

Because of the network effect, network goods compete in contestable markets. These are markets where competition is for all-or-nothing. The network good that wins takes all or most of the market share, and the network good that loses must leave the market or only capture a minor share. The presence of network effects is, of course, significant. Any cryptocurrency that aims to become money must break the network effect of already well-established currencies. Network effects are tough to break even for higher-quality goods. Remember the short-lived experience of Google+, intended to compete with Facebook?

The toughness of network effects is not mere speculation. We can look at real-world examples. A relevant one for this discussion is the fate of the Somali shilling after the collapse of the government. The Somali shilling value went into a free fall. There was no enforcement to keep Somalis using their national currency. All they had to do was start using the money of any of their neighbors and trade partners. Yet, a currency (or network) swap did not occur. The network effect was just too strong. Cryptocurrencies face a much tougher challenge. Cryptocurrencies are not contesting the market for depreciating currency, as was the case with the Somali shilling. They contest the market for currencies such as the U.S. dollar, the Euro, the British Pound, or the Japanese Yen (to mention just a few).

Breaking the network effect is not easy. Yet, some market processes help in this respect. Take the presence of a middleman between a buyer and a seller. Say a consumer who owns cryptocurrency wants to purchase a good from a seller who wants U.S. dollars. There is an entrepreneurial opportunity to become the middleman between these two. The middleman takes the cryptocurrency from the buyer and gives U.S. dollars to the seller. Problem solved. The buyer uses his crypto, and the seller gets his dollars. The seller does not want exposure to the price volatility risk of a cryptocurrency such as Bitcoin, but the middleman seeks to profit from that risk.

These middlemen are unintentionally helping to expand the cryptocurrency network. Yet, it is doubtful that the presence of these middlemen is enough to break the network effect of currencies that are well established at the international level. Even the middlemen measure their profits in terms of U.S. dollars (or any other currency). Any cryptocurrency that aims to become money should pay serious consideration to the presence of network effects.2

The monetary rule problem

The third problem I want to comment on is how the supply of cryptocurrency should behave. For exposition purposes, I divide cryptocurrencies into three generations. The first generation of cryptos is built around a fixed supply conception. This is the case with Bitcoin. Even if the money supply increases for these cryptocurrencies, it does so at a decreasing rate up to the point where no more cryptos are created. The concept is that of a fixed money supply, even if the application is not a literal one.

The second generation of cryptos are stablecoins that fix their exchange rate with a currency such as the U.S. dollar. In this case, the supply of cryptos varies (or should vary) as needed to maintain the exchange rate fixed.

The third generation is a more recent development. In this case, the cryptocurrency neither fixes the money supply nor the exchange rate against another currency. Now changes in supply are aimed at maintaining monetary equilibrium. If demand goes up, more cryptos are created. If demand goes down, cryptos are taken out of circulation. This is the case of yet-to-be-launched Quahl (formerly known as Initiative Q).

The problem with the first generation of cryptocurrencies should be apparent. Their supply cannot accommodate changes in demand. In other words, the fixed-supply conception is a recipe for monetary disequilibrium and high price volatility. The fixed supply notion is a problem for a cryptocurrency to become money. Still, it is a good feature for trying to reap capital gains (buy at a low price, sell at a high price). If supply is fixed (a vertical line in the typical demand and supply graph), any change in demand translates to price changes. No wonder currencies such as Bitcoin are so volatile. No wonder, also, that cryptocurrencies such as Bitcoin have become more of an investment vehicle than a new type of money. On the contrary, if the supply is horizontal, then any change in demand produces a change in the quantity supplied with no impact on its price.

The problem with the second generation of cryptocurrencies is that, as long as they maintain their fixed exchange rate policy, they become a substitute, but not necessarily a competitor, of other currencies. And, if they abandon the fixed exchange rate policy, they are not stable anymore. These are cryptos without their own monetary identity. They do not have an independent monetary policy. Because they are fixing themselves to another currency, they cannot provide a higher-quality monetary policy than their pegged currency.

The third generation of cryptocurrencies has a more suitable constitution in terms of potentially becoming money. But, they face the challenge of deciding the behavior of their cryptocurrency supply. We may understand the principle that money supply must equal money demand to achieve monetary equilibrium. Yet, this does not mean we know how to operationalize this principle. Don’t central banks around the world face similar problems? It is straightforward to code a fixed supply of cryptocurrencies. But, it is complicated to code the rule needed to maintain monetary equilibrium.

Looking at the case of Bitcoin, one gets the impression that the leading cryptocurrency may have been inspired by an incomplete picture of the gold standard. Its logo is a gold coin; Bitcoin producers are called miners, and the quantity of bitcoins follows an output function with decreasing marginal returns (just as would be the case of mining gold out of the ground). Why do I say the inspiration is incomplete? Because the gold standard, or maybe more precisely a free banking regime, did not work just with gold coins. Besides gold, there were banks that issued convertible banknotes. Money supply did not depend only on the production of gold (primary creation of money) but also on the issuance of banknotes (secondary creation of money). This secondary creation of money plays a crucial role in maintaining monetary equilibrium. It seems, once again, we have an ironic turn of events. Cryptocurrencies came to be in order to avoid financial intermediaries. Yet, these financial intermediaries play a crucial role in maintaining monetary equilibrium, the desired feature of any cryptocurrency aiming to become money rather than another payment channel or technology.

The case of El Salvador: No more than a pyrrhic victory

Some circles in the crypto world celebrated El Salvador’s decision to enforce the circulation of Bitcoin.3 On June 6th, 2021, El Salvador’s president, Nayib Bukele, announced a new law that would make Bitcoin the country’s official currency. That this decision took place in a dollarized country only adds to the excitement of Bitcoin gaining market share. On June 8th, the law was presented to Congress and passed as a new law.

The biggest issue with Bukele’s initiative is the now-famous Article 7. This article states that every “economic agent must accept bitcoin as payment when offered to him by whoever acquires a good or service” (bolds added). An exception is allowed if the merchant does not have the technology to transact in Bitcoin. The same law, however, clarifies that the state will “promote the necessary training and mechanisms” needed for unprepared merchants to be able to accept bitcoin as payment (article 12).

El Salvador’s adoption of Bitcoin is, at best, a pyrrhic victory. Suppose Bitcoin becomes a significant means of exchange in El Salvador. This outcome is so by force of law, not by an emergent choice of economic agents freely and spontaneously interacting in the market. Suppose now that Bitcoin fails to become a significant means of exchange in El Salvador. In this case, even with legal enforcement, Bitcoin cannot become a major currency. One would expect that the rise of Bitcoin to money would be driven by its own merits and benefits, not by the state’s regulatory power.

Final comments

For more on these topics, see the EconTalk podcast episode Jim Epstein on Bitcoin, the Blockchain, and Freedom in Latin America. See also “Cryptocurrency, Money, and Adam Smith,” by John Burrow, Adam Smith Works, January 13, 2020; and “The Economics of Bitcoin,” by Robert P. Murphy, Library of Economics and Liberty, June 3, 2013.

Even though my comments may sound pessimistic, I think of them as a realistic assessment of cryptocurrencies becoming a generally (very widely) accepted means of exchange. There is much to be expected from the cryptocurrency phenomenon. Yet, any hope that a cryptocurrency will become money must be realistic regarding the challenges that this evolution implies.

First-generation cryptocurrencies can evolve to become high-risk/high-return investment vehicles. Second-generation cryptocurrencies can grow to become payment technologies free of price volatility risk. Finally, the third generation of cryptocurrencies has a better chance to work more similarly to money if they manage to capture some market share and maintain monetary equilibrium (not an easy task).


[1] Satsohi Nakamoto, “Bitcoin: A Peer-to-Peer Electronic Cash System.” PDF file.

[2] Malakiva Nair and Nicolás Cachanosky, “Bitcoin and entrepreneurship: breaking the network effect,” The Review of Austrian Economics. July 18, 2016.

[3] George Selgin, “The Bitcoin Law: Nayib Bukele’s Counterfeit Free Choice in Currency.” June 17, 2021.

*Nicolás Cachanosky is Associate Professor of Economics at Metropolitan State University of Denver (MSU Denver) Department of Economics, Senior Fellow at the American Institute of Economic Research (AIER), and Fellow at the UCEMA Friedman-Hayek Center.

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