Cryptocurrencies, e.g. Bitcoin, have been in the news a lot, but what are they, what is the technology that drives them and what is the future for this relatively new form of exchange? This article briefly describes Cryptocurrency and the software behind it, Blockchain.
What is Cryptocurrency
Cryptocurrencies are digital means of exchange. Because most cryptocurrencies aren’t regulated by national governments, they’re considered alternative currencies – mediums of financial exchange – that exist outside the bounds of state monetary policy.
Cryptocurrency existed as a theoretical construct long before the first digital alternative currencies debuted. Early cryptocurrency proponents shared the goal of applying cutting-edge mathematical and computer science principles to solve what they perceived as practical and political shortcomings of “traditional” currencies. (also known as fiat currencies from the Latin ‘let it be done’).
Although Bitcoin was the first established cryptocurrency, between 1998 and 2009 there had been previous attempts at creating online currencies with ledgers secured by encryption. Two examples of these were B-Money and Bit Gold, which were formulated but never fully developed. In 2008, a paper called Bitcoin – A Peer to Peer Electronic Cash System was posted to a mailing list discussion on cryptography. It was posted by someone calling themselves Satoshi Nakamoto, whose real identity remains a mystery to this day.
The upshot: No bitcoin user has to trust anyone else, because no one can cheat the system.
Most, but not all, cryptocurrencies are characterized by finite supply. Their source codes contain instructions outlining the precise number of units that can and will ever exist. Cryptocurrencies’ finite supply makes them inherently deflationary, more akin to gold and other precious metals – of which there are finite supplies – than traditional currencies like Sterling, which central banks can, in theory, produce unlimited supplies of. It is estimated there are more than 2,000 cryptocurrencies in existence, the most well-known one being Bitcoin, which is generally credited with bringing the movement into the mainstream. Others you may have heard of are Ethereum, Litecoin or Ripple.
In 2009 the Bitcoin software was made available to the public for the first time and mining – the process through which new Bitcoins are created and transactions are recorded and verified on the blockchain – began.
As it had never been traded, only mined, it was impossible to assign a monetary value to the units of the emerging cryptocurrency. In 2010, someone decided to sell theirs for the first time – swapping 10,000 of them for two pizzas. If the buyer had hung onto those Bitcoins, at today’s prices they would be worth more than $100 million.
What is Blockchain
Blockchain is the digital ledger behind cryptocurrencies, blockchains are either the most important technological innovation since the internet or a solution looking for a problem to solve. Don and Alex Tapscott, authors of Blockchain Revolution (2016) stated “The blockchain is an incorruptible digital ledger of economic transactions that can be programmed to record not just financial transactions but virtually everything of value.”
The original blockchain is the decentralized ledger behind the digital currency Bitcoin. The ledger consists of linked batches of transactions known as blocks (hence the term blockchain), and an identical copy is stored on each of the roughly 200,000 computers that make up the Blockchain network. Each change to the ledger is cryptographically signed to prove that the person transferring virtual coins is the actual owner of those coins. But no one can spend their coins twice, because once a transaction is recorded in the ledger, every node in the network will know about it. The idea is to both keep track of how each unit of the virtual currency is spent and to prevent unauthorized changes to the ledger. The upshot: No bitcoin user has to trust anyone else, because no one can cheat the system.
In other words, it is the digital equivalent of double entry book-keeping and the inbuilt digital security means that banks are starting to look seriously at how they can apply the technology. Indeed, we are seeing adverts on television directly referring to Blockchain technology.
Blockchain technology is like the internet in that it has a built-in robustness. By storing blocks of information that are identical across its network, the blockchain cannot:
- be controlled by any single entity; and
- has no single point of failure.
Bitcoin was invented in 2008. Since that time, the Bitcoin blockchain has operated without significant disruption. (To date, any of problems associated with Bitcoin have been due to hacking or mismanagement. In other words, these problems come from bad intention and human error, not flaws in the underlying concepts.)
The internet itself has proven to be durable for almost 30 years. It’s a track record that bodes well for blockchain technology as it continues to be developed.
Cryptocurrencies are also increasingly popular tools for money laundering – funnelling illicitly obtained money through a “clean” intermediary to conceal its source
The blockchain network lives in a state of consensus, one that automatically checks in with itself every ten minutes. A kind of self-auditing ecosystem of a digital value, the network reconciles every transaction that happens in ten-minute intervals. Each group of these transactions is referred to as a “block”. Two important properties result from this:
- transparency data is embedded within the network as a whole, by definition it is public; and
- it cannot be corrupted altering any unit of information on the blockchain would mean using a huge amount of computing power to override the entire network.
In theory, this could be possible. In practice, it’s unlikely to happen. Taking control of the system to capture Bitcoins, for instance, would also have the effect of destroying their value.
Advantages of cryptocurrency
There is a built-in scarcity value. Most cryptocurrencies are hardwired for scarcity – the source code specifies how many units can ever exist. In this way, cryptocurrencies are more like precious metals than fiat currencies. Like precious metals, they may offer inflation protection unavailable to fiat currency users.
Loosening of Government Currency Monopolies. Cryptocurrencies offer a reliable means of exchange outside the direct control of national banks, such as the Bank of England or European Central Bank. This is particularly attractive to people who worry that quantitative easing (central banks’ “printing money” by purchasing government bonds) and other forms of loose monetary policy, such as near-zero inter-bank lending rates, will lead to long-term economic instability.
In the long run, many economists and political scientists expect world governments to co-opt cryptocurrency, or at least to incorporate aspects of cryptocurrency (such as built-in scarcity and authentication protocols) into fiat currencies. This could potentially satisfy some cryptocurrency proponents’ worries about the inflationary nature of fiat currencies and the inherent insecurity of physical cash.
Fewer Barriers and Costs to International Transactions. Cryptocurrencies don’t treat international transactions any differently than domestic transactions. Transactions are either free or come with a nominal transaction fee, no matter where the sender and recipient are located. This is a huge advantage relative to international transactions involving fiat currency, which almost always have some special fees that don’t apply to domestic transactions – such as international credit card or ATM fees. And direct international money transfers can be very expensive, with fees sometimes exceeding 10% or 15% of the transferred amount.
Robust Privacy Protections. Privacy and anonymity were chief concerns for early cryptocurrency proponents and remain so today. Many cryptocurrency users employ pseudonyms unconnected to any information, accounts, or stored data that could identify them. Though it’s possible for sophisticated community members to deduce users’ identities, newer cryptocurrencies (post-Bitcoin) have additional protections that make it much more difficult.
Disadvantages of cryptocurrency.
Lack of Regulation Facilitates Black Market Activity. Probably the biggest drawback and regulatory concern around cryptocurrency is its ability to facilitate illicit activity. Many grey and black-market online transactions are denominated in Bitcoin and other cryptocurrencies. For instance, the infamous dark web marketplace Silk Road used Bitcoin to facilitate illegal drug purchases and other illicit activities before being shut down in 2014. Cryptocurrencies are also increasingly popular tools for money laundering – funnelling illicitly obtained money through a “clean” intermediary to conceal its source.
The same strengths that make cryptocurrencies difficult for governments to seize and track, allow criminals to operate with relative ease – though, it should be noted, the founder of Silk Road is now behind bars, thanks to a years-long investigation.
Potential for Tax Evasion in Some Jurisdictions. Since cryptocurrencies aren’t regulated by national governments and usually exist outside their direct control, they naturally attract tax evaders. Many small employers pay employees in Bitcoin and other cryptocurrencies to avoid liability for payroll taxes and help their workers avoid income tax liability, while online sellers often accept cryptocurrencies to avoid sales and income tax liability.
According to the IRS, the U.S. government applies the same taxation guidelines to all cryptocurrency payments by and to U.S. persons and businesses. However, many countries don’t have such policies in place. And the inherent anonymity of cryptocurrency makes some tax law violations, particularly those involving pseudonymous online sellers, difficult to track.
Potential for Financial Loss Due to Data Loss. Early cryptocurrency proponents believed that, if properly secured, digital alternative currencies promised to support a decisive shift away from physical cash, which they viewed as imperfect and inherently risky. Assuming a virtually uncrackable source code, impenetrable authentication protocols (keys) and adequate hacking defences, it’s safer to store money in the cloud or even a physical data storage device than in a back pocket or purse.
However, this assumes that cryptocurrency users take proper precautions to avoid data loss. For instance, users who store their private keys on single physical storage devices suffer irreversible financial harm when the device is lost or stolen. Even users who store their data with a single cloud service can face loss if the server is physically damaged or disconnected from the global Internet (a possibility for servers located in countries with tight Internet controls, such as China).
Often Can’t Be Exchanged for Fiat Currency. Generally, only the most popular cryptocurrencies – those with the highest market capitalization, in dollar terms – have dedicated online exchanges that permit direct exchange for fiat currency. The rest don’t have dedicated online exchanges, and thus can’t be directly exchanged for fiat currencies. Instead, users have to convert them into more commonly used cryptocurrencies, such as Bitcoin, before fiat currency conversion. By increasing exchange transactions’ cost, this suppresses demand for, and thus the value of, some lesser-used cryptocurrencies.
At the time of writing, there is little regulation of cryptocurrencies. The Financial Crimes Enforcement Network (FINCEN) in the USA is due to report to the G20 with proposals for international regulation and the Financial Action Task Force (FATF) is considering the KYC implication of the secrecy surrounding ownership of cryptocurrency.
It’s less than a decade in, and cryptocurrency has already made a statement in the financial sector. Seemingly out of nowhere, this currency has managed to get people’s attention and, often, their admiration. And it’s already affecting some aspects of the general public’s lives, including entrepreneurship.
Institutional investors may not currently have confidence in cryptocurrency as an asset class. Regulation of the sector, and recognition of cryptocurrency as an asset class, will go some way to improving confidence and therefore cement cryptocurrency into the mainstream much like equities or property today.