Cryptocurrency

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1. 1.       There is a lot of talk in Australia around cryptocurrency, particularly Bitcoin – for the everyday person, what is a cryptocurrency?

 

Cryptocurrencies and tokens are digital or “virtual” assets –literally blips on a computer screen or in a computer file -- that serve as a medium of exchange just like familiar fiat currencies do. The “price” of a cryptocurrency or token in AUD is an exchange rate at which cryptocurrencies can be converted into AUD, in the same way that the AUD/USD exchange rate is the price at which AUD can be changed into USD. Bitcoin is the best-known cryptocurrency, but there are now more than 200 others, the most popular being Ethereum, Ripple, Dash, Litecoin and Monero. Bitcoins and “altcoins” – alternative coins to Bitcoins – also have a store-of-value. In September 2018, that aggregate value is around $USD 220 billion, of which 40% or so is Bitcoin as measured by aggregate market cap (though market caps are at best a rough guide to store-of-value in crypto-land). Tokens are issued in Initial Coin Offerings (ICOs) by companies looking to fund development of services, loosely a crowd-funding version of traditional corporate IPOs; the tokens are rights to future payments or services and trade in Bitcoins or altcoins on a secondary market. There were about $USD 4 billion of ICOs in 2017 and $USD 17 billion for the first half of 2018.

 

                Typical fiat currencies are tracked in a centralized database (i.e., ledger) of transactions that are stored, controlled, and monitored by a country’s central bank (e.g., RBA) and its commercial banks (e.g., NAB, ANZ, Westpac). Central banks create money by printing bank notes that each have a unique serial number.  The unique serial number on each note prevents the occurrence of double spending (i.e., preventing an individual from spending the same amount twice).  Only legitimate notes with the unique serial number are allowed to be entered into the database of transactions such as our bank accounts.  For example, when you deposit cash into your bank account the teller or ATM will confirm that the notes that you have provided are legitimate and record the transaction as a deposit in your bank account and a withdrawal from the payor account. 

 

Blockchains are decentralized databases (i.e., ledgers) of accounts, balances and transactions. The “world’s oldest blockchain” is generally considered to be a hashing function (like a signature) produced by a data storage company called Surety since 1991. Amazingly, Surety published its hash values in the classifieds section of the New York Times as the public ledger.  Bitcoin arrived later as the first combination of a valid blockchain and electronic or digital cash like Zcash where the latter had been around since the time of the dotcom boom and bust in the late 1990s. Nowadays many transaction applications for blockchains beyond recording Bitcoin and other cryptocurrency payments are being developed.

 

Entries into a blockchain ledger can only be made by fulfilling specific conditions: Different types of cryptocurrency or other assets (e.g. an Australian Treasury Bond) require the fulfilment of different specific conditions to be met before legitimate transactions are recorded into a decentralized but networked database. A moment’s thought leads one to appreciate the formidable challenges in designing a consensus protocol for multiple parties to participate in accurate but decentralized transaction updates in a blockchain: For example, how to handle autonomously the above-noted problem of the “double-spend” that could occur if two parties are doing updates that are not perfectly synchronized in time, and how to limit and reward participants in the update process?

 

Technically, cryptocurrencies use a Peer-to-Peer (P2P) blockchain as a decentralized ledger of transactions.  Transactions are broadcast to the P2P network and are verified to be genuine based on a user’s private key (kept in a digital wallet).  Transactions are confirmed by Bitcoin miners who can only add the transaction to the blockchain once they have performed a complex mathematical calculation (i.e., hash function). Bitcoin miners are an essential part of the crypto endeavor as they help to add legitimate transactions into the blockchain, and collect a fee (i.e., mined Bitcoins) for doing so given the proof-of-work in solving the hashing function.  Blockchains are an immutable record of historical transactions.  The process of mining (i.e., adding legitimate transactions to the blockchain) is the only way that Bitcoin can be created.  This is one factor that differentiates Bitcoin from a fiat currency where money can be printed by a central monetary authority.

 

1. 2.       Will Bitcoin and cryptocurrencies have any effect on other currencies worldwide e.g. AUD or USD?

 

Any impact of Bitcoin and other cryptocurrencies on fiat currencies is likely to be in the long-term.  Presently, the two primary challenges being faced are the high volatility of Bitcoin prices and the time taken to add new transactions to the blockchain of Bitcoin.

 

Due to Bitcoin’s large price swings, businesses are unable to price their products and services in it.  This dampens its use as a means of trade and currency.  Presently, the turnover of Bitcoin per day is about $100 million, whereas the total amount of forex (FX) transactions per day is $5.1 trillion.  A coin called tether that is “tethered” or pegged to the USD by being allegedly collateralized one-for-one with USD reserves, has been developed to produce a stable crypto price in USD. Bitcoin is only about 0.002% of the FX market, so cryptocurrencies still have a long way to go before becoming a serious contender to existing fiat currencies. 

 

In the long term, we expect the price volatility of Bitcoin (and other cryptocurrencies) to settle down and new cryptocurrency frameworks/technologies to allow for more efficient processing of transactions -- “stablecoins” like tether will conceivably play an important role in the settling. As this happens, it is likely that the use-case for cryptocurrencies in pricing and trading goods and services and as a method of payment becomes more viable.  Even then, Bitcoin will have less impact on developed country currencies (i.e., USD, Yen, GBP, AUD, Euro, etc.) that are well established and whose citizens will continue to use their home currencies as a means of trade.  Currencies that might suffer or even disappear as a result of Bitcoin are countries whose currencies are highly volatile and weak (e.g., Venezuelan Bolivar, Zimbabwe dollar) and where governments may have imposed capital controls, etc.

 

1. Given the recent drop in the price of cryptocurrencies, does Wall Street predict Bitcoin will reflect tulip mania or a transition towards becoming a long-term currency for digital-savvy generations?

 

This is a complex question with strong opinions on both sides. Skeptics describe Bitcoin and cryptocurrency qua a store-of-value in colorful language as a “fraud” and “probably rat poison squared” (Warren Buffet, May 2018), and allude to irrational market bubbles reminiscent of the Tulip-mania of the 1600s and the Dotcom boom of the late 1990s.  These skeptics confidently predict that the equilibrium price of Bitcoin is about zero, or at least would be if only its use for nefarious transactions was successfully shut down. Proponents, on the other hand, point to crypto’s and blockchain’s “disruptive” potential to revolutionize exchange and decentralized payments record-keeping while also playing a role as a store of value free from inflation taxes. Detractors concede that there is already some traction in Bitcoin trading, but then hasten to add that something like 25% of Bitcoin traffic is black-market-related. In addition, governments in China and South Korea have clamped down on ICOs and exchange trading of crypto in part because of the role they played in evading capital outflow restrictions and money laundering. On the other hand, the non-sanctioned activities behind crypto transactions are arguably no greater than those in the Web’s early days where money was also made mainly in pornography, sale of prohibited goods, evasion of royalties, and other black-market activities. Nor is the “traceless transfer” of fiat money in money laundering and drug sales an unknown phenomenon! Cryptocurrency’s reputation is undoubtedly not helped globally by the current secondary Exchange trading in cryptocurrencies that resembles the “wild west,” with scattered, fragmented and unregulated trading, price manipulation, wash trades and the like. But again, a ready counter-argument that fiat currency trading is hardly sacrosanct either is presented by the recent scandal in the London fix in the conventional fiat currency market.

 

Theoretically, investments that are stores of value generate returns via periodic payments while an investor owns them along with a lump sum when sold.  For example, when investors purchase a house (i.e., stocks, bonds, currencies), they collect a rent (i.e., dividends, coupons, interest) and hopefully a capital gain upon selling the house.  On the other hand, Bitcoin and tulips do not generate any periodic payments while these assets are held (ICOs might); nor did Dotcom stocks pay dividends in their heyday. But the lack of periodic payments does not ipso facto turn “growth stock” or asset prices into bubbles.  Indeed, even in the case of the Dutch tulips, there is good economic-historical evidence that those tulip bulbs were in fact rationally priced given the fundamentals of the bulb futures contracts at the time! In 2018 the now-FAANG (i.e., Facebook, Apple, Amazon, Netflix, Google) stocks that were dot-com stocks in the supposed “dotcom bubble” don’t look to have been outrageously over-valued. Perhaps, one can argue, the “madness of crowds” supposedly underlying tulip mania has in reality more to do with the crowding of dilettante commentators than irrational investor crowding behavior! But there is no doubt that valuing growth assets during initial waves of innovation, especially where the network aspect of the innovation is critical, is difficult.

 

Bitcoin is sometimes compared to gold. There are indeed apparent similarities: Both have a convenience yield insofar as Bitcoin can be used in payments systems and gold is currently used for cosmetic (i.e., jewelry) and industrial (i.e., aerospace, electronics manufacturing) purposes. Gold is also a precious metal as a rare element (approx. 3.1 x 10^-7 % in the Earth’s crust), and current technologies are unable to fully replicate or re-create gold. As noted above, Bitcoin is algorithmically likewise limited in supply – indeed, “Satoshi Nakamoto” is said to have coined the term “mining” for Bitcoin precisely because the work-intensive act of creating Bitcoin resembled gold-mining. But alas there is no theoretical limit on the number of substitutable cryptocurrencies that can be formed – indeed, some of these substitutes like Ethereum are designed to have advantages over Bitcoin -- platinum instead of gold! A cynic might also argue that, platinum aside, silver is a close substitute for gold for many purposes. Distributed apps (“dapps”) in the form of computer code that sit on top of a cryptocurrency-blockchain protocol and have the potential to provide valuable services like the apps on your Smartphone; the tokens (“altcoins”) in Initial Coin Offerings that promise a payoff for “smart contracts” in crypto-land to deliver these useful dapp services therefore very plausibly have real value.

 

What about the track record of cryptocurrency as a store-of-value? Obviously, there is a “survivor bias” in the question – if cryptocurrencies and bitcoin had indeed gone to zero value (some have!), we wouldn’t be writing about them some ten years after their introduction, and unless you are an economic historian, you likely wouldn’t be interested in reading about them! Researchers who have looked systematically at past returns data find that they are highly skewed – if you picked a basket of the 50 top cryptocurrencies in 2013 and equally weighted them, you would have earned an eye-popping 2.5% per day to the end of 2017 (e.g. Hu, Parlour and Rajan (2018)), but on most of them you would have lost 1% to 2% per day!  Moreover, the evidence is that there is no serial dependence in Bitcoin price changes – what happened over the last few days or months is not going to help you predict price changes tomorrow. So, in 2018 year-to-date, there has been a drop of roughly 65% in the market’s assessment of Bitcoin’s worth, but given no measurable serial dependence in Bitcoin prices, there’s a 50:50 chance of higher or lower prices in the future. Historical analysis has also revealed that crypto coin prices have been strongly correlated with Bitcoin, so there is little investment help in diversifying across other coins from a passive risk-reduction viewpoint.  A partly common but partly idiosyncratic risk across cryptocurrencies as a store of value is the risk of being hacked, for example as Ethereum was from DAO in 2016

 

An interesting case study for the possible path of development in the crypto-blockchain space is one of the earliest forms of Peer-to-Peer (P2P) file sharing using Napster (i.e., year 2000) that involved the sharing of music files.  The reaction from several major music labels was that this was piracy and akin to robbing recording artists of their hard-earned royalties. As internet technology improved, P2P sharing expanded towards movies and TV shows. Film studios started to publicize the negative impacts of movie-piracy and tried to co-opt internet service providers in apprehending customers who were downloading movies illegally.   Entrepreneurs like Steve Jobs from Apple recognized that it was not so much that the majority of public wanted to break the law and download music illegally, but that the consumption of music was changing such that people did not want to buy whole albums or CDs and were willing to pay a small fee for songs that they liked, especially when they could curate them as their own personal playlists.  He negotiated an agreement with the music labels and this functionality of pay-per-song was incorporated in iTunes in 2003.    Fast forwarding to today, we can easily stream music in Spotify (i.e., mainstream in 2012) and movies on Netflix (i.e., mainstream in 2013) for a minimal monthly subscription fee.  The success of these businesses and the size of their subscription base is evidence for how they’ve captured and met the needs of the market.  It has been a case study of how recording labels, film studios, and internet firms have been forced to adapt and evolve with customer demands over time and the time span of these events took approximately 15 years. The potential analogy to evolution in the crypto space is obvious.

 

Separate from cryptocurrencies, it is easy to see where blockchain technology could also have a real value, but there are again predictions both ways --- “predictions are difficult, especially about the future” is the caution often attributed to the great physicist Niels Bohr. One line of prediction is that blockchains will usurp back-office legacy payment systems with application well beyond just transactions in cryptocurrencies. As an Australian example, Commonwealth Bank just announced that it is working with the World Bank to manage a bond issue, cleverly nicknamed BONDI, that uses only blockchain ledger record-keeping. Potential applications beyond financial markets for decentralized databases and the creation of an immutable record of historical transactions extend to politics (i.e., preventing electoral voter fraud), healthcare (i.e., accurate and up-to-date medical records for the individual), government contracts (i.e., keeping track of subcontracting entities in large-scale government infrastructure projects), and carbon emissions along a supply chain.  For these reasons one could argue that blockchain technology is destined to stay, but it will probably evolve over time to a different shape or form that is more amenable to regulators and the market. On the other hand, blockchain detractors argue that the decentralization in blockchains makes them slow, cumbersome, and power-hungry: Bitcoin is estimated to be able to execute 3 to 4 transactions per second (and Ethereum 20), whereas centralized Visa can process on average around 1667 transactions per second. Developers of Bitcoin and Ethereum supplements called Lightning Network and Raiden Network respectively, are suggesting that they’ll scale to 1 million transactions per second, while Visa counters that “based on rigorous testing” it can already accomplish 56,000 transactions per second.

 

Arguably an answer is already emerging: with some standardization, a decentralized ledger has real potential as a “shared/networked database” which is permissioned for “big data” access – this is particularly the case for a ledger handling non-fungible assets like say tracts of real estate rather than units of Bitcoin. The retort is likely to be that a standardized, permissioned blockchain barely resembles the disruptive vision of its original founder(s). Perhaps the debate converges to a distinction without a difference!

 

 

4)  Will Bitcoin be regulated? If so, how?

 

It is obviously not easy to regulate a space where the technology is still evolving with opinions about pros and cons as divided as that just discussed.  We provide some insight into regulatory considerations in the US with its large financial markets. Considerable attention was paid to the SEC’s rejection in July this year of an application from the CBOE and Winklevoss twins (Gemini) seeking to list and trade shares in a bitcoin exchange-traded product called the Bitcoin Trust. In its rejection, the SEC expressed concern that: “…because the underlying commodities market for this proposed commodity-trust ETP is not demonstrably resistant to manipulation…the ETP listing exchange must enter into surveillance-sharing agreements with, or hold Intermarket Surveillance Group membership in common with, at least one significant, regulated market relating to bitcoin.” In spite of their concern, the SEC’s order included an assurance that the “disapproval does not rest on an evaluation of whether bitcoin, or blockchain technology more generally, has utility or value as an innovation or an investment.” One of the Commissioners, Hester M. Peirce, dissented from the Commission’s decision, expressing concern that the Commission’s “… approach creates the very real risk that investors might conclude—reasonably, but incorrectly—that any exchange-traded product approval means that [the SEC has] done due diligence on the underlying asset and the markets in which it trades and that the exchange-traded product or the underlying asset carries [the SEC’s] imprimatur. We never do the investor’s analysis for her.  Implying that we do does nothing to advance investor protection. The investor contemplating putting her money at risk needs to conduct her own due diligence.”