- Wealth PMS
This is a guest post by Rohit Shenoy about the “cryptocurrency” that’s doing the rounds: Bitcoin.
We’ve certainly come a long way from the days of the barter system being adequate to keep the world humming along. Money has evolved and adapted to the needs of the age – from grains and livestock to coins, then paper and, more recently, digital currency. The latest upstart to vie for the position of “This is what’s next” is barely 10yrs old, isn’t being pushed by any government or the breakthrough of a leading technology company. On the contrary, Bitcoin is the brainchild of an as yet unknown person(s) whose own account of the digital currency is valued at over $12B at the current exchange rates. In a frenzied move, reminiscent of the tech IPOs of the 1990’s Bitcoins value has come a long way in a short time – from mere pennies to over $12k/Bitcoin as of this writing (and climbing as much as $500/Bitcoin each hour). As can be expected, there is much debate as to its efficacy and future prospects including whether it is really currency in the traditional sense or more an asset, like Gold. In judging its potential and, perhaps, ultimately being able to place a value on it, a review of its “Business Case” or what it is trying to improve on and solve may hold the key.
A Brief Overview of Bitcoin:
Bitcoin is a digital currency that is based on a distributed ledger technology called “Blockchain.” What that means is that unlike the US Dollar or the Indian Rupee there is no governmental central bank that issues it or even any traditional banks in the middle to effectuate and record transactions – no central administration whatsoever. Instead, the issuance of this currency, limited to a lifetime supply of 21 Million, is achieved through a process called “Mining,” wherein Bitcoins are generated, electronically, by solving complex computational puzzles on the Bitcoin Network – achieved by anyone with the computing power and the expertise, known as “Miners.” If you’re not cut out for “Mining,” electronic or otherwise, then you can go the easier route of purchasing already mined Bitcoin for US Dollars, Yen, Euro etc at the prevailing exchange rates. These can then be stored in multiple ways, either online with the many wallet providers or even on your own personal laptop. Just get a unique address or addresses similar to a personal email, which can then be used to transfer funds or buy & sell goods and services.
The recording, including verification, of the transactions is also carried out by the decentralized network of computers & Miners, for a fee. Just as you would expect in the current banking system, every time a transaction is initiated in the Bitcoin Network certain aspects are verified including ensuring that the account initiating the transaction is legitimate (i.e. a real account and being initiated by the actual owner of that account), is in turn directing the beneficiary to be another legitimate account, and has the funds to execute. The resultant addition and subtraction of Bitcoin to each account is also recorded and reflected in the individual account balances. However, unlike the current system, each and every transaction is recorded, grouped into blocks and linked to each successive transaction in a virtual chain thereby creating the Blockchain. This extensive and complete record or ledger is in turn housed on multiple Miners systems (in many cases in its entirety) creating a distributed ledger network.
The Business Need:
The Blockchain technology at the heart of Bitcoin is certainly revolutionary in that it records each and every transaction. This chain makes it easier to determine who (the account rather than the identifiable characteristics like name, address etc. of the actual person) owns the Bitcoin to be transacted, in what amount and the origin. Since the ledger builds on each previous transaction and is decentralized it also becomes extremely difficult to modify retroactively by a hacker or counterfeiter, adding to the integrity of the records. The result being that the need for “trusted” third parties like banks or payment processing firms that currently verify & record transactions is eliminated and replaced by an improved, transparent process with much smaller players like the Miners.
Going deeper than the technological advancement supporting disintermediation there is the concern of systemic risks posed by a large and concentrated banking system (refer to Chart below). In fact, it was in 2008, during the depths of the recent global financial crisis that Bitcoin was conceptualized in a paper titled, “Bitcoin: A Peer to Peer Digital Cash System.” After the real estate bubble in America burst, banks were on the brink of collapse endangering the deposits and funds that had been entrusted to them. At one point a money market fund, a near money equivalent and “risk free” investment run by Lehman brothers, lost 3% of its value in September 2008. The unthinkable of losing your money in heretofore “safe” investments or even not being able to access your own funds became a reality.
Even in normal times some banking features are sub optimal and restrictive. These can include limits placed on daily withdrawals, transaction amounts and transfer of funds, not to mention the time it may take to settle the transfers – some as long as a few days owing to systems limitations, process inefficiencies and, in more understandable cases, regulation. Add to that list high fees including a charge at many institutions for the “privilege” of just depositing your money with them, it’s almost enough to seriously consider stuffing your money underneath your mattress.
In addition to these banking system issues, there is also the ever-rising threat of inflation, a natural byproduct of fiat currency & central bank actions. In recent times that threat has loomed large due to the actions taken by central banks to respond to the financial crisis. “Flooding” the world with money post the crisis has been an effective tool to get credit flowing again and ward off deflation. The central banks have expanded their balance sheets almost threefold since, going “all in” on a program generally referred to as Quantitative Easing(QE). It’s a plan that has largely worked as judged by steady global economic growth, much improved employment and resilient capital markets. These results, however, do not eliminate the possibility that this never before tried experiment can have consequences later on that include high inflation – after all how can the value of something that is in such large supply (money) not take a hit.
Source: “Markets have year to Wait Before Balance-Sheet Hi:-Evercore ISI,”Chris Anstey, www.bloomberg.com, Jul 12th, 2017
All of this, the systemic risks laid bare in 2008/2009, ever larger banks with pricing power and the inflationary fears of ongoing quantitative easing have led to a growing mistrust of the banking system and an interest in alternative solutions. Trying to string it all together one can argue that the business need for improvement goes something like this: create a currency or a means of exchange that acts as a stable store of value, is always accessible by the owner in any amount or geography, is easily transferrable with trust, secure, has low transactional and storage fees, the value of which cannot be manipulated by a central authority, and maintains a level of value that doesn’t debase over time (and breathe…). Quite the mouthful, but then again utopia isn’t a straight forward concept. Of course, it goes without saying that it should be digital, in keeping with the technological advancements of the time.
How Bitcoin Fares at Meeting the Business Need:
Blockchain Technology & Distributed Ledger: Bitcoin, powered by Blockchain technology, does indeed satisfy the trust conundrum. You don’t necessarily need a government to back up the currency or a bank to be a trusted intermediary as long as you associate value with the currency or in this case, the technology underlying Bitcoin, much like gold has an inherent value. Put another way, perhaps the value perceived by the market in Bitcoin is for no other reason than the fact that it is an alternative to governmental fiat currency and central planning – “Providing Trust in a Trustless World” as some have described it.
As relates to the issue of systemic risks, the benefits of a decentralized network of smaller players should drastically reduce the threats. The added benefits of eliminating restrictions on transfer amounts, and faster verification & settlement adds to Bitcoins attractiveness. Access to all your money when you want it and where you want it!
Low Fees: At about 0.0001 Bitcoin in many cases, fees have been relatively low as compared to credit card fees of 2-3%. However, in recent times there has been an uptick with increased transaction volume seeking quick confirmations, while the increasing exchange rate has resulted in much higher dollar fees as well. These fees may drastically rise when all Bitcoins have been mined (by 2140) or earlier as the reward of newly minted Bitcoin for recording blocks gets cut in half every 4 years, eliminating a key form of payment to Miners who maintain the Blockchain ledger. Currently, Miners are rewarded in two ways: 1) by the issue of newly minted Bitcoins for verifying and recording blocks of transactions (80+% of Miner revenue), and 2) the transaction fees paid by the parties (<20% of revenue). Should costs of Miners continue to increase with computing power & energy needs to solve more complex puzzles then fees may also increase in lockstep, absent any technological advancements (a little over 16.5MM Bitcoin have been mined so far of the 21MM cap).
Inflation Hedge: On the inflation issue, Bitcoin tries to solve the problem by limiting supply (though it is important to note that each Bitcoin is further divisible into 100 MM parts, the smallest being referred to as a “Satoshi”). How effective that limited supply will be in maintaining value would be determined by the market in time.
Sustainability of Decentralized Network: In terms of the network, it’s yet to be proven if this system will function well and improve in the face of operational issues, cost pressures to maintain the system, technological inefficiencies and as incentives or fees are lowered. Additionally, these more “democratic systems” also depend on a consensus framework, which isn’t always efficient and can result in splits within the network. This concern of sustainability is among the most serious in Bitcoins longer term success.
Security: Recent hacks at exchanges such as Mt. Gox where 650,000 Bitcoin was stolen and numerous other schemes wherein hackers were able to get access to individual accounts by getting at private keys are the sort of risks that plague all digital technologies and not unique to Bitcoin. Rather, given the value, the crypto currency is becoming more of a target for hackers. This is probably where people yearn for the fraud protection services offered by big banks or insurance schemes like FDIC insurance in the US that insures upto $100k in deposits.
Regulatory Uncertainty: For the large part regulators around the world have not taken an active interest in crypto currencies thus far. Though there are many warnings published and some bans on trading altogether indicating that the regulators are watching intently, a more consistent, global framework hasn’t yet been established. The tax structure, Know Your Customer requirements, audits etc. are yet to occur worldwide and are currently applied in a patchwork way across some regions. Some of this is because the currency is still emerging with a market cap of a little less than $200B.
It’s also precisely due to the lack of regulation that Bitcoin had become the preferred form of payment on the dark web and is probably still in use by many dubious entities without check. Rest assured though that some form of regulation will prevail if it continues to rise changing the playing field. It’s unclear what effect precisely these regulations will have and if they would enhance or hurt. Outright bans, entirely possible, would certainly put a chill on the market.
Energy Usage: The downside of the Blockchain and distributed ledger is the enormous and increasing amounts of power needed & consumed by the network of computers and servers. Digiconomist, which tracks the energy consumption of the Bitcoin network estimates that Bitcoin would rank as the 63rd largest consumer of energy if it were a country, beating out Morocco and Oman. Each Bitcoin transaction, Digiconomist notes, requires the same amount of energy as the collective, daily energy needs of nearly 9 U.S. households. With those alarming statistics we might be looking at a massive energy hog in the future as Bitcoin matures and gains acceptance – one that the world cannot afford.
Volatility: Lastly, it’s hard for a currency to be effectively used in the face of extreme volatility as has been the case for Bitcoin. Something that moves $500-1000 in value in a day wouldn’t serve well as a means of exchange for daily transactions or even most other transactions. This is also where, judging by historical cases and applying them to Bitcoins vertical price chart, one can make a strong “bubble” argument – Too far, too fast.
The counter would be that if you believed in the concept and viability of Bitcoin as indeed currency then there is a long way to go in terms of price, much higher still than the current, dizzying heights. Take gold as a comparable, which has a market value of around $7.7T. If people were to assign 10% of golds value to Bitcoin then the value of the crypto currency would be higher than $40,000! This kind of “what ifs” are not too far-fetched if indeed you have a reliable currency which is widely accepted.
To summarize the business case for Bitcoin is to extol the versatility and far reaching possibilities of Blockchain and the Distributed Ledger technology. Its ability to disintermediate banks or, more accurately, reimagine banking in a time where there is widespread mistrust is timing an entrance to perfection. Having the added benefit of being the first mover with the largest acceptance among crypto currencies and a rapidly growing user base adds to the allure. It’s no wonder that momentum has followed, driving up the value rapidly, which in turn creates the cycle of higher prices as people fear of losing out.
However, this is yet a new, untested system in its infancy with many flaws that need to be worked on. Traditional money and banking have survived thousands of years through upheavals of war, dynasties and even revolution. Governments too have become more active recently and it will only be a matter of time before more widespread regulations start to intervene. So, it’s foolish to think that banking or governments will be disintermediated.
What is more likely is that Bitcoin is the beginning, an asset similar to gold rather than a currency and a hedge against central planning. The future may bring a better solution either by fixing Bitcoins flaws, favorable regulation or moving focus to a new currency altogether. Google wasn’t the first to bring “Search” to the world but it is today the best and the largest. So too we could find that in the world of Digital Currencies with many new entrants another may dominate the space while Bitcoin still exists in some form. The one thing that seems more certain is that the underlying technology of Blockchain & Distributed Ledger has the promise and capability to reimagine many industries, particularly banking.
Rohit is a private investor based in Bangalore. He has deep experience in insurance and financial management, and spends time mastering grasshopper pushups when he can. The original article is at https://www.linkedin.com/feed/update/urn:li:activity:6344151464423849984.