- Cryptocurrencies (such as bitcoin) function as a digital network of peers who are able to pay one another for goods and services through a de-centralized, encrypted currency system.
- Cryptocurrencies’ primary source of intrinsic value stems for widespread acceptance and usage, making the currency highly volatile and extremely risky currently.
- While there are great benefits to usage of cryptocurrencies, I recommend sitting on the sidelines for now to wait and see how these systems develop, gain public acceptance and increase security measures to meet user needs.
2016 was a good year for cryptocurrencies, with all seven of the top currencies ending the year on a high note having gained in value against the U.S. dollar. A lot of people have been closely watching this new phenomena with extreme interest and trying to understand the implications of cryptocurrencies (such as Bitcoin, the most famous of all the cryptocurrencies) not only on financial markets but also in the lives of ordinary citizens. In this blog I’ll provide you with the basic knowledge and resources you’ll need to to be properly armed going into the cryptocurrency world and provide some of my own opinions of the future and use of it.
Definition of Currency
Before we begin, though, we must cover a brief overview of what exactly money (and subsequently, currency) is and why we use it to better understand the risks of cryptocurrency. By definition, currency is a medium of exchange, an item used to facilitate the buying/selling of products and services. In ancient times, the only thing people could trade were perhaps livestock and crops. Trading livestock for crops and crops for livestock was not an easy endeavor as these items were not easily divisible or exchangeable, as a result currency moved to usage of gold and silver coins. Why? Use of such coins followed a few basic principles necessary to be considered currency:
- It is easily divisible
- It is fungible
- It is transportable
- It serves as a unit of account
- It has stored value
Cryptocurrency adheres perfectly to almost all these principals, with the exception of the principle of store of value. The reason for this is that cryptocurrency, unlike the U.S. dollar or euro, is not backed by a central banking authority nor holds intrinsic value like a commodity (e.g. gold and silver which are actually used in both industrial applications as well as personal consumption). In order for cryptocurrency to gain intrinsic value, there has to be widespread usage and holding of cryptocurrency by individuals who have the expectation that others are willing to accept it as a form of payment in the future. We’ll explore why this is a major problem for cryptocurrencies later in this blog.
How Cryptocurrency Works
Understanding cryptocurrency isn’t exactly intuitive (I admit, it took me a few re-reads to get it, but in case there are any errors here, I hope some pros reading this will point them out!) as it consists of many integral parts, but we’ll start with a short and sweet definition followed by a slightly more detailed explanation to fill in the gaps.
The broad definition of cryptocurrency (and a good one I borrowed from Wikipedia) is “a digital asset designed to work as a medium of exchange using cryptography to secure the transactions and to control the creation of additional units of the currency.” Bitcoin is the first decentralized cryptocurrency to go mainstream and is currently the most widely used. For the sake of this blog, I will focus on bitcoin as the primary cryptocurrency since it is the most well documented. For informational purposes, other cryptocurrencies include: Ethereum, Ripple, Litecoin, Monero, Ethereum Classic and Dash.
Bitcoin can be best thought of as a peer-to-peer network of individuals transacting exclusively between one another without the need of a designated third party (a central banking authority, for example) to facilitate and approve the transaction. These transactions enable proof and transfer of ownership of goods and services through public electronic distributed ledgers (also called the “block chain“) that are verified and approved by peer-created and reviewed algorithms (also known as “mining“). It may also be known as the most prominent triple entry bookkeeping system in existence according to one source.
Let’s break this process down a bit further. Let’s say you want to purchase a product using bitcoin, your first step is to download a program that allows you to setup and maintain a “Bitcoin Wallet”. This wallet gives you a unique address and allows you to transact using bitcoins as you please. A list of such programs can be found here: Bitcoin Wallet list. Once one of these programs is installed you may be able to purchase bitcoins through a number of ways: either by selling goods/services online and allowing for bitcoin payment, purchasing bitcoins from a bitcoin exchange, or “mine” for bitcoins yourself. The mining of bitcoins is sort of the heart of the whole bitcoin system which we’ll come back to in a moment. Once a transaction is completed, a public record or ledger (i.e. “block”) in the bitcoin network is created, authenticated (by the network) and then added to the database (i.e. “chain”) of transactions.
This is where the mining process comes in. The mining process is a sophisticated algorithm that works behind the scenes of the bitcoin network to authenticate transactions. From what I understand, specialized hardware and software used by miners (simply individuals or groups in the community who own and operate the hardware and software needed to run the algorithms) authenticates each bitcoin transaction by solving a set of mathematical problems to obtain a “proof of work” which ensures each transaction is authenticated and then recorded. Once this is complete, miners get paid in bitcoins for their work; however, as incremental transactions are added to the block chain, the difficulty of solving for proof of work increases both in terms of problem complexity and computational power and making it more difficult to earn bitcoins as the network grows. It is understood that creation of these bitcoins is somewhat controlled as the network is supposedly setup to halve the number of bitcoins created each year until the total number of bitcoins in existence reaches 21 million. At that point, miners will likely be paid a fee for their mining services. That may have been a lot to swallow, but if you’re interested in additional details, here are some great resources to dig further into how mining works:
Pros and Cons of Cryptocurrency
Now that you have a basic understanding of how bitcoin works, let’s take a look at some of the pros and cons of this financial innovation and try to understand where using bitcoin may be useful and where it could cause problems.
The most prominent feature of using bitcoins is the speed and reliability of conducting transactions. Since the bitcoin network and its transactions are exclusively operated online using sophisticated computing and algorithms rather than going through another financial intermediary, the cost of the transactions decreases significantly (Credit cards and online payment systems typically charge between a 2%-to-4% fee for the transaction). Additionally, bitcoins can be transferred across borders almost seamlessly rather than having to conduct expensive wire transfers. Transactions can also be conducted unanimously, thereby protecting individual’s personal information. Lastly, bitcoin’s network is supposedly highly secure, therefore reducing the risk of theft. This point, however, should be taken with some reservation as a well-publicized story hit headlines in 2016 about hackers stealing money from the bitcoin network. See that Bloomberg story here.
That being said, one should be cautious that, like anything else that exists online, there is a real risk to the bitcoin system being hacked and your money lost forever. At least with FDIC-insured banks, your money is insured up to $250,000. Another issue is the value of the bitcoin in relation to the USD, which brings us back to the issue of store of value and in addition, volatility. The chart below shows the value of a bitcoin over the past several years.
One can easily see the risk involved in transacting and holding on to bitcoins is significant given the high level of volatility in pricing of the currency. Like any other currency, bitcoin’s value is determined by the laws of supply and demand. The more demand there is for the currency with respect to supply, the higher the price will tend to be. The primary reason for the extreme volatility though is the absolute number of individuals willing to transact in the new currency. Because bitcoin is relatively new, there are fewer users of it than say users of U.S. dollars. For example, the dollar amount of transactions on FOREX markets averages about $5.3 trillion on any given day with the USD making up 85% of that or $4.5 trillion. Compare that to recent data from blockchain.info who estimates the average daily value of bitcoin transactions between January 2016 and January 2017 to be a mere $162 million. The difference in value of transactions and therefore, liquidity, is extremely large and given the relatively small size of the bitcoin market, it takes far fewer trades to produce a large swing in price, thereby increasing the amount of volatility one could expect to see. Not only is the current small size of the market an issue for volatility, it also raises serious concerns as traders with deep pockets may be able to easily manipulate the market making this a dangerous playground for smaller investors and traders. At the time of writing this (January 5th, 2017), bitcoin had recently hit new highs against the dollar and subsequently saw a knee-jerk correction of nearly 10% to the downside in just one day. That’s something one is almost guaranteed NOT to see in any FOREX market.
Before moving on, let’s return to store of value briefly. Unlike precious metals or other physical commodities, cryptocurrencies have a very limited intrinsic value. A cryptocurrency cannot be used in any other way but to conduct financial transactions. It cannot be refined into a fuel for your car, it cannot be burned for warmth, it cannot be transformed into decorative jewelry, it cannot be used to create batteries, electronics, PV cells or spacecraft parts. The point here is that the intrinsic value of cryptocurrency relies solely on the public’s acceptance and use of it in the future which exposes it to significant pricing risk. The moment people lose confidence in its ability to transact, it becomes worthless as can be seen in the chart above. Precious metals and commodities like oil, though may depreciate in value from time-to-time, will retain some intrinsic value so long as there is demand for their use.
What’s Needed for it’s Long Term Sustainability
If cryptocurrency is to continue to not only survive, but also grow in this world dominated by fiat currencies, two things are critical to its success:
- Highly sophisticated level of security for the network. In other words, the cryptocurrency system has to be secure enough to withstand hacking from outsiders and you can bet that any hacker with an agenda will target these systems.
- Widespread acceptance and trust of cryptocurrency by individuals and businesses. Though many online retailers (such as Overstock and WordPress) are already accepting bitcoin payments, many of them still seem skeptical of holding on to the cryptocurrency. An article by MONEY highlights this point perfectly noting that many of these companies request 100% of the bitcoin be converted immediately into U.S. dollars.
As mentioned above, there are undoubtedly some great benefits to having a digital, decentralized currency such as bitcoin to use, but this currency should not be the ONLY currency one uses in their day-to-day affairs. Though useful, one should be careful not to over expose themselves to any cryptocurrency for the reasons stated above so adding cryptocurrency as a minor supplement to your portfolio of payment methods (cash, checks, credit, PayPal, etc.) should be relatively safe.
At this point, I am not itching to jump on any cryptocurrency bandwagon; however, if one day I discover cryptocurrencies can be used to purchase big ticket items like homes and automobiles while saving significantly on transactions costs (brokerage fees, closing costs, commissions, etc.), then I would suddenly become extremely interested in utilizing it. If you’re like me – an ordinary America citizen with no vested interest in cryptocurrency and no interest in becoming a miner – then the best play at the moment is to patiently sit on the sidelines and wait to see what happens next.