By: Steve Smith
As Bitcoin and Ethereum soar beyond $9,000 and $400, respectively, and a host of new digital assets are sold through Initial Coin Offerings (ICO), I thought it would be useful investing advice to give a general overview. This introduction will try to answer the basic question: what are cryptocurrencies?
Since money began to replace the barter system some 3,000 years ago, currencies have taken on many different physical forms, running the gamut from shells to gold to the paper most of us use today. But one thing they all have in common is they mostly lack any real intrinsic or practical value—the ability to use shells as rudimentary tools, gold to fill cavities and paper to burn notwithstanding—but rather rests on the collective faith of the users in the currency’s ability to be exchanged for goods and services.
In this sense, we should distinguish between “price” and “value”; currencies tend to have the former, which can change depending on the level of faith or confidence in the ability to purchase things. The full, and often philosophical, discussion of what drives price is beyond the scope of this article, but suffice to say, for most fiat currencies it rests upon the stability and economy of the sovereign nation which “backs” it.
Given the potential for political and economic turmoil, people have historically looked to gold and diamonds, thanks to their relative portability and uniform acceptance, as an alternative to fiat or sovereign currency. Note that currencies should derive much of the value from scarcity; that is, only the government can print it. As such, it is interesting to watch the recent actions from Central Bankers to “print” money through quantitative easing to debase their currencies.
This has created a cloud of distrust regarding even the most stable currencies such as the Euro, Yen and U.S. Dollar. As the Weimar Republic and many other nations throughout history have learned, economic disasters occur when governments ignore the value proposition and recklessly print money.
As you’ll see, cryptocurrencies have to be designed to have a limited supply, and to be extremely difficult to counterfeit.
Given advances in technology, is it any surprise the latest form of alternative currency resides on the internet? This article will discuss the basics of cryptocurrencies and the important technological innovation, blockchain, that supports it. I’ll also offer my thoughts about whether cryptocurrency, whether it’s Bitcoin, Ethereum or some other digital offering, can become a true currency worthy of investment.
A Primer on Blockchain
Cryptocurrency is an independent digital currency that uses cryptography to maintain privacy of transactions and control the creation of the respective currency. While not recognized as legal tender, cryptocurrencies are becoming more popular for legal and illegal transactions alike. Bitcoin (BTC), developed in 2009, is the most popular cryptocurrency. It accounts for over half the value of the more than 750 cryptocurrencies outstanding, with an overall value of approximately $150 billion in 2017.
In this article, we’ll refer to cryptocurrencies generally as BTC, but keep in mind there are many Cryptocurrencies (CC), each with unique properties and price behavior. And while Bitcoin may appear to be the currency of choice, Netscape and AOL internet search show that early market leadership does not always translate into future market dominance.
Before explaining how a Bitcoin (or any cryptocurrency) is created, acquired, stored, used and valued, it is vital to understand blockchain technology, the innovation that spawned BTC. In researching this topic, we came across a plethora of puzzling descriptions of algorithms that support it. We’ll try to keep it to the basics, on the premise that one doesn’t need to know how to build an engine to drive a car. But we encourage you read more if this topic proves of interest.
Blockchain is an open database or book of records that can store any kind of data. A blockchain database, unlike all other databases, is stored real time and is accessible for anyone to view its complete history of data.
The term block refers to a grouping of transactions, while chain refers to the linkages of the blocks. For instance, when a Bitcoin transaction is completed, Bitcoin “miners” work to solve the cryptographic algorithm that will enable them to link it to the chain of historical transactions. As a reward for being the first to solve the calculation, the miner receives “newly minted” BTC. As the chain grows, the effort needed to solve and verify the algorithms increases in complexity and demands greater computing power.
As an aside, consider the following statement by Bitcoin Watch from Goldman Sachs, “BTC worldwide computational output is currently over 350 exaflops – 350,000 petaflops – or more than 1400 times the combined capacity of the top 500 supercomputers in the world.”
Needless to say, a tremendous amount of computing resources and energy are being used by Bitcoin miners, and it is still in its infancy.
The takeaway is that blockchain is an open, real-time database that provides anonymity to its users. It is not controlled or regulated (yet) by any government. Bitcoin (BTC) miners, driven by the incentive to earn BTC, and fees at times, verify and authenticate the database.
Blockchain technology is incredibly powerful, and will likely revolutionize data management regardless of whether cryptocurrencies thrive or disappear.
Bitcoin Mining (Creation): New Bitcoins are created as payment to BTC miners that solve the aforementioned calculations that verify transaction data and link it to the blockchain. This ingenious reward system incentivizes miners to compete to perform these calculations, allowing the blockchain to expand. As of May 2017, there were approximately 16 million bitcoins outstanding, out of a proposed limit of 21 million. As the blockchain grows, the calculations required to mine BTC and add to the chain become more complex, making each bitcoin harder and costlier to earn than the prior one.
Obtaining and Storing Bitcoin: Other than mining Bitcoin, the only other way to obtain them is via transactions and exchanges. One can earn bitcoin by selling a product or service to someone willing to pay in BTC, or one can purchase them with traditional currency through a BTC exchange. BTC can be exchanged for cash or goods and services in a similar fashion. There are reportedly over 100 BTC exchanges, and BTC ATMs are gaining in popularity. BTC’s are stored in a so-called “wallet”. Wallets may reside on a mobile phone or a desktop computer. The decision to use one versus the other largely comes down to a trade-off between security and ease of use.
Transacting with Bitcoin: Each wallet has a unique key which serves as a personal identifier. When one wishes to transact, the buyer and seller swap their personal keys and the transaction information is posted for miners to verify and post to the blockchain. The identity of the buyer and seller is never revealed. This is one reason that black market, money laundering and tax avoidance transactions are popular on BTC exchanges. While not 100% accurate, you can think of a BTC transaction process as like a debit card transaction, but instead of banks verifying, approving and transferring cash to fund the transaction, miners fill that role.
Valuing Bitcoin: As mentioned above we tend to view the “value” of cryptocurrencies through their price or purchasing power. In this sense, they are just like valuing any other currency. One can compare BTC to U.S. dollars or to any other currency. Currently, BTC is rising rapidly versus all major currencies thus its purchasing power is following suit. As marginal interest in BTC versus sovereign nation currencies increases, the rise in value could continue.
One pertinent and interesting differentiation is the blockchain technology represents an important innovation and can add a layer of true “value” such as the ability to move large amounts of data, to underlying cryptocurrencies. We believe the big gains will be in unearthing the next generation of cryptocurrencies coming to market through Initial Coin Offering (ICOs) that have this added layer of value.
Crypto, Currency or Investment Fad?
Since BTC started trading in July 2010, it has risen over 51,000 percent! This meteoric rise in the price of a bitcoin has certainly attracted many traders and speculators to the cryptocurrency space. While price gains are certainly drawing short term players, others are buying it for its promise as an alternative currency. New cryptocurrencies are attracting an increasing amount of capital; in 2017 ICO’s have raised over $100 billion, which is more than has raised all the U.S. stock market Initial Public Offering (IPO) in 2017.
The question investors, not short-term speculators, are tasked with answering is, “Will enough people value BTC (or other CC) to make it a respected and often used currency?” In our opinion, the two most crucial pieces of information needed to answer that question are how governments will respond to the rise, and whether merchants and businesses accept it.
On the former it seems unlikely governments will want to let cryptocurrencies become officially recognized as that would be anathema to why people are attracted to them; they provide anonymity and a disconnect from said centralized government control. Accordingly, taxes cannot be efficiently assessed, black market transactions are made easier, and fraud can easily escape the eye of law enforcement.
On the latter front we are seeing a rapid expansion in the use and acceptance of BTC, as financial institutions such as Fidelity will now let you track your wallet through your standard brokerage account and companies from Wal-Mart to mom and pop shops are accepting it.
Here are some basic pros and cons of cryptocurrencies (CC) :
- CC is unregulated, allowing users to avoid taxes or any other kind of governmental, banking, and law enforcement scrutiny.
- CC is in limited supply, which should help it to retain its value over time. One caveat is the fact that there are many competitors, each with their own rules about creation.
- CC creation is not subject to the whims of central bankers that appear constantly looking to devalue their respective currencies via inflation. Again, we believe the recent success of cryptocurrencies is a meaningful sign that central bank actions have not gone unnoticed by the users of traditional currencies.
- Transacting in CC is easy. As more sellers of goods and services accept BTC, its flexibility improves.
- Typically storing CC is less expensive than most other national currencies, as well as precious metals. Additionally, transaction fees and other banking costs are largely avoided.
- CC is unregulated. Regulations to enforce market structure and prevent fraud are not available. There are over 750 cryptocurrencies, and the number is growing rapidly. Which one will emerge as the dominant currency beyond the first mover stage? Conversely, which ones will fail and leave holders with nothing?
- CC security is not foolproof. Wallets have been hacked on both desktop computers and mobile phones. Due to the anonymous nature of the exchanges, remediation of such actions is difficult.
- Price volatility makes accepting CC a risky proposition. Accordingly, transaction fees are becoming popular by many merchants.
- The energy costs and computing power associated with mining CC are massive and will increase as the complexity of the blockchain and the number of users grow. Limited resources could drive up costs.
It won’t be a smooth or steady path, but I believe cryptocurrencies (CC) are here to stay, and many will continue to see a rise in both price and value.