CryptoCurrencies – A Beginners Guide To Digital Assets 29th March 2019
When an asset doubles in value in a matter of months, it tends to attract some attention. If it doubles again, it attracts everyone’s attention. Bitcoin is the original cryptocurrency, its meteoric rise has become a mainstay of conversation across the world. At time of writing, the bitcoin price now hovers near €3,500 EUR ($4,000 USD).
Unfortunately, while most people may be able to say, “I’ve heard of Bitcoin,” a large percentage of them still aren’t quite sure what it is – and are even more confused about Ethereum and Ripple. In fact, Bitcoin helped birth new markets for over 5,700 other crypto currencies and assets worth $140 billion today, double what it was only 2 years ago. Yet the true impact of Bitcoin is actually far more reaching than this – it’s not the currencies but the innovation of the blockchain technology itself that is changing entire markets, whilst causing ripples with central banks and the financial industry.
Cryptocurrencies have not been without controversy. They have been under a barrage of negative press since first arriving in 2009; even more so after breaking out in 2017 and then throughout last year as prices pulled back from their dizzying highs.
Yet despite concerns about security, criminal use and volatility, cryptocurrencies have proliferated at a exponential pace, with companies developing new applications and uses for their blockchain networks which are becoming increasingly adopted. As adoption continues, it is no wonder that previously vocal critics are walking back on their previous comments:
“Bitcoin is a fraud. It’s worse than tulip bulbs. It won’t end well.”Jamie Dimon, CEO JP Morgan Chase, Sept 2017
“I regret calling it a fraud…The blockchain is real. The bitcoin to me was always what the governments are gonna feel about bitcoin as it gets really big…”Jamie Dimon, CEO JP Morgan Chase, Jan 2018
What are those who don’t follow the technical arguments supposed to make of crypto currencies when big names in finance keep changing their views? If you are interested in this market space, consider this your beginners guide.
What Is Blockchain?
Imagine a spreadsheet that is duplicated thousands of times across a network of computers, then imagine that this network is designed to regularly update this spreadsheet itself without any interference. This is a basic understanding of the blockchain. In the simplest of terms, the blockchain is a simple yet ingenious way of transmitting information from A to B in a fully automated and secure manner.
The current financial system requires third parties to store all your personal and financial information. Acting as middlemen allows them to ‘verify’ transactions. This method is not only time consuming and costly, but with all information controlled by one group, the chances of a security breach is high. The traditional systems have a single point of failure, one attack on the system and everything on their servers including your information can be compromised.
In a distributed system, the network itself records and verifies the transaction amount alongside the sender and receiver’s encrypted addresses. This way, the transactions are transparent whilst ensuring personal privacy. Transactions are also faster and cheaper due to no need for a third party.
User A initiates sending a bitcoin to user B, the process creating a ‘block’. This block is verified by thousands, perhaps millions of computers distributed around the world. The data is encrypted granting the user anonymity, however the information available for anyone to track if they wish. Once verified, the transmission is executed and the block is added to all the others in a ‘chain’, stored across the network, creating a unique record with a unique history. Falsifying a single record would mean falsifying the entire chain in millions of instances at the same time across the world. That is virtually impossible.
The Cryptocurrency Universe
Bitcoin is a software than forms a decentralised, peer-to-peer payment system with no central authority like the Bank of England or any other central bank. Bitcoin emerged in 2009, in the shadows of the financial crisis. Anyone can create an account to buy and sell Bitcoin. The price of Bitcoin then fluctuates based on supply and demand. Bitcoin is not a company. It is a digital commodity.
Bitcoin runs on a software called ‘blockchain’, a highly automated immutable digital ledger. All transactions occurring across the network are recorded to ensure trust and authenticity, whilst encryption allows the user to maintain anonymity. In other words, you can use it to send/receive payment anywhere in the world securely using bitcoin ‘tokens’, without the need to go through a bank as the ledger itself checks authenticity.
Some people buy Bitcoin because they want to store their money somewhere other than a bank. Some buy Bitcoin as an investment, believing that its price a few months or years from now will be substantially higher than its present valuation. And some people buy and sell Bitcoin and other cryptocurrencies to trade the fluctuating values like traditional forex markets.
While Bitcoin is designed to be nothing more than a valuable commodity and payment system, Ethereum is a ledger technology that enables developers to build and deploy decentralised applications using ‘smart contracts’. In this case, ‘smart contract’ means automation of extremely complex processes in demanding business applications. The tokens used to power the network are called ‘Ether’ and they can also be traded in market.
There is heavy support behind Ethereum’s technology in what is called The Enterprise Ethereum Alliance. This is a group of Fortune 500 companies that are focusing on building and adopting Ethereum’s blockchain into their businesses. The potential to impact the way companies conduct business is clear.
Additionally, the Ethereum network split in two back in 2016. This is a complicated process called a ‘hard fork’, but the result is a separate Ethereum, based on the original Ethereum blockchain but without the improvements, trading as ‘Ethereum Classic’.
XRP is the native currency of the Ripple Protocol – a blockchain system meant to enable the near instant and direct transfer of money between two parties. Any type of currency can be exchanged, from fiat currencies, to gold, to even airline miles. Whilst the network can be used person to person, this isn’t the primary focus. Ripple solves a different problem to Bitcoin, allowing for cheap and near-instant settling of payments between different currencies and even different payment systems across borders.
Do Cryptocurrencies Have Value?
Ever since Bitcoin came into existence it has fascinated me that it is always being compared to gold, as if in order to be accepted, it must somehow delegitimise the most enduring form of real money in history. The first question that should be asked is does bitcoin have any value at all?
Intrinsically no, but then neither does the British Pound, the Euro, the Yen, U.S dollar, Swiss Franc or any other government-issued currency. Yet they still enjoy broad use as a medium of exchange. So many people simply misunderstand what cryptocurrencies are and what they can be; so this is my attempt at explaining how I have come to understand cryptocurrencies and their place as a store of value:
First, a single bitcoin is simply an encrypted packet of information. That encrypted package is used to record value and transmit it to someone else and deliver that recorded value. So, if the encrypted package of information can travel across the internet holding value instantly and securely, then Bitcoin, by being the encrypted ledger of transaction itself – has value. Its use as a medium to exchange value securely makes it a commodity and if one is using that commodity to send value to someone else, then bitcoin is being used as money.
Secondly, a commodity’s intrinsic value is correlated with it’s scarcity. Bitcoin’s supply limit is only 21 million coins. This limit on the number of coins is why bitcoin is perceived as a commodity as its overall supply is limited vs global demand. Gold is prized as a function of both its own scarcity and a global population that accepts it has value. Bitcoin is no different, only more recent. Whilst Bitcoin can’t be held in physical form, it can be exchanged for currency, anywhere worldwide – like gold.
Is Bitcoin Money?
Only time will give us the answer to this question. However I will offer my understanding. In 1912, an Austrian economist, Ludwig Von Mises, put forward his ‘Regression Theorem’, as an explanation as to what ‘money’ is and why we use ‘things’ as money. The short version is: in order for ‘something’ to be considered money, that ‘something’ must have value as a commodity first.
A commodity thus becomes money if it is increasingly valued for its use as a medium of exchange of other things as well as it’s own intrinsic value. Gold fits this theorem as it can function as both: it is a commodity, but it is also globally accepted as a store of value and can be exchanged anywhere in the world.
This is where, alongside traditional stores of value such as precious metals, I believe cryptocurrencies have a role that could increase as global financial markets become increasingly precarious: if you can shift financial wealth out of an asset that is losing purchasing power into an asset that is holding it’s own or even gaining in purchasing power, it would be illogical not to do so.
Bitcoin is not replacing Gold as a store of value. Bitcoin not only satisfies the Regression Theorem’s definition, it is beginning to prove itself to be a viable digital store of value. With the global economy looking increasingly unstable, increasing levels of debt and currencies being devalued through the use of quantitative easing, the need of individuals to seek ways to move their at-risk wealth into other assets is increasing. As cryptocurrency valuations increasingly stabilise, the potential for a self-reinforcing feedback loop increases: as the value of cryptocurrencies rise, it attracts more capital, prices push higher, and so on. As I suspect capital will do with all stores of value as economic uncertainty increases.
© 2019 EBLN DMCC