Bits about bitcoin: what you need to know about the cryptocurrency
How do bitcoin and other cryptocurrencies differ from other, more traditional currencies?
Hardly a day passes without someone mentioning or asking about what appears to be the latest craze – bitcoin.
Colleagues, friends and casual acquaintances all seem to have a tale to tell about how much they’ve made trading the cryptocurrency (as currencies like bitcoin are called) – and they are quick to reproach the sceptics who express any doubts.
And these are not just your proverbial shoe polishers or hairdressers. Many of the bitcoin bulls are involved in technology or financial technology (fintech), so they have a good grasp of the arcane concepts behind cryptocurrencies, such as blockchain and mining. There are investment professionals among them too. Granted, there are also pure speculators out there with little knowledge of the concepts but with a desire to make a quick buck (or bitcoin) from trading.
The technology allows funds to be transferred in real time around the world, bypassing the middle man.
So, there’s enough interest in bitcoin and other cryptocurrencies like ethereum to justify some research into the topic. Your humble author has resolved to try to understand it better, and this article represents the first steps. I hope to follow up in good time with further articles – and I also hope I won’t have to retract too much of what I say now!
It’s important to know whether bitcoin (or any other cryptocurrency) is a fad, and whether the market represents a bubble or an asset with long-term value.
To answer these questions, one needs to know how bitcoin and other cryptocurrencies differ from other, more traditional currencies. The first thing to understand is how they work and the role of blockchain technology in transactions. Here I quote John Haynes, Investec Wealth & Investment’s head of research in the UK, from an article titled “eCash: Financial evolution or revolution?”:
“A bitcoin is essentially an electronic receipt whose ownership is transferred between parties under the supervision of a decentralised verification process known as mining.
“In this process, when a transaction is made (a bitcoin is spent), instead of sending the details of the transfer of ownership of the bitcoin to a single central administrator for verification and settlement (as in the case of Visa/Mastercard), the transaction is registered as a transfer of ownership of that bitcoin by broadcasting it to a network of many miners (effectively accounts clerks), who race to compile a correct ledger of all transactions completed in a 10-minute window.
“The first miner to register a solution that is subsequently corroborated by over half of the other miners receives a newly created bitcoin reward to spend.
“The verified ledger (known as a block) is added to the register of all transactions undertaken for all bitcoins that have ever existed and hence the current ownership of all bitcoins in existence – known as the blockchain.”
Herein lies what is so exciting about the blockchain technology: it creates a permanent ledger that cannot be deleted or changed. It is therefore (so far) 100% secure and every transaction is traceable. The technology allows funds to be transferred in real time around the world, bypassing the middle man. Little wonder that firms like Goldman Sachs and others are looking at ways of harnessing blockchain technology.
It should be pointed out there is a limited amount of bitcoin that will ever be mined – only 21-million, with the last one mined in about 2040. As more are mined, so the difficulty and cost of procuring new bitcoins increases (not unlike a normal mine’s output). Hence the supply cannot be manipulated by governments and central banks, unlike the fiat currencies we use every day. Furthermore, transacting in bitcoins effectively circumvents the usual payments system, and therefore the usual regulatory controls and surveillance, so it appeals to the underworld. Little wonder that some of the recent ransomware attacks (like WannaCry) demanded payment in bitcoin.
Leaving aside the thorny matter of illicit transactions for now, the question then becomes whether bitcoin and its peers will eventually displace traditional currencies as a trusted store of value between transacting partners. Much will depend on how the technology evolves and whether bitcoin can retain its standing as the leading cryptocurrency. It will also depend on how well traditional currencies maintain the trust of traders and investors.
This is the crux of the matter. Remember that fiat currencies evolved out of the shortcomings of being linked to gold or silver. It would require a serious debasing of the US dollar, euro, yen and even the yuan for this to come to pass. And presumably real assets such as gold, art and collectables would also appreciate sharply in such a scenario.
It’s also possible that such a transition would be more gradual, which would be good news for long-term cryptocurrency bulls.
However, governments and the banking system could also be forced to adapt and incorporate elements of blockchain technology. Could we see fiat currencies evolving into quasi-cryptocurrencies themselves, just as they evolved out of gold-backed currencies – leaving the likes of bitcoin to fall by the wayside? Or will we see a world in which fiat and cryptocurrencies live side by side?
Notwithstanding the above, there is much cause for caution over the recent surges in the price of bitcoin, which resemble some of the asset bubbles of previous generations. Even if bitcoin (or ethereum, which has also been rising sharply) becomes a major established currency, there is much scope for speculators to lose their shirts in the medium term. Recent high levels of volatility would seem to indicate this.
In the long term, bitcoin and its peers have a future if traditional currencies fail to adapt to the changing needs of commerce and investment. I remain firmly on the fence!
The views expressed above are those of the author and may not necessarily represent those of Investec Wealth & Investment.
This article was paid for by Investec.