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BITCOIN – 10 Questions

Bitcoin and other cryptocurrencies have become a multi-billion asset group in recent months.  But is bitcoin a security, commodity, currency or something else?  With 10 questions, we try to demystify some of the key elements and controversies surrounding bitcoin while also trying to identify next steps in its evolution.

 

  1. What is a cryptocurrency?

A medium of exchange, created, stored and traded electronically using encryption techniques designed to control the creation of monetary units and to verify the transfer of funds.  A few important features:

  • It has no intrinsic value; in other words, it is not redeemable for another asset such as gold
  • It has no physical form
  • It is not backed by any central bank
  • Its network of users is completely decentralized

 

  1. How is bitcoin part of blockchain technology?

The blockchain is a public ledger that records bitcoin transactions.   For a medium of exchange to work without a central bank or financial institution to manage transactions, every participant in the network (called “peers” or “nodes”) needs to keep track of all transactions ever made on the network.   Transactions such as Lisa sends X bitcoin to Sally are broadcast to this network using specifically designed software.  A critical element of the transaction on a decentralized network is to ensure that when Lisa sends a bitcoin to Sally, everyone knows that Lisa has removed that bitcoin from her balance and enabled it to be transferred to Sally.  As there is no central authority or financial intermediary (think: Venmo or Zelle), everyone who participates in the network needs to update their “ledgers” or records of every transaction.  This also gives rise to term “distributed ledger” where every peer has a record of the complete history of all transactions and thus of the balance of every account.

The “block” in blockchain is the set of new data that is created and verified from each new transaction or new bitcoin created (see Question 9 on bitcoin mining).  Once created and verified by all peers in the network, the “block” is added to the existing blocks of data, thus creating a “blockchain”.

  1. Leaving aside its meteoric rise in price, what are the merits of bitcoin?

For its supporters, bitcoin’s appeal as an asset stems from it being a store of value outside the control of central banks.  In fact, unlike any currency in the world, it is predetermined that there will only be 21 million bitcoins ultimately in circulation (today there are slightly over 13.25 million).  So unlike central bank-backed currencies, bitcoin cannot be devalued through continuous issuance.

Other proponents of bitcoin will point to its potential use as a medium of exchange.  Anecdotally there are examples of single merchants who accept bitcoin as a form of payment although it is difficult to ascertain the total value of marketplace acceptance.  Claims of billions of dollars of daily transaction volume haven’t been supported by any detail on where that commerce is taking place or what is being bought and sold with bitcoin.   And certainly the notion that it could be used as a medium of exchange may be in conflict with how it is trades as an asset.

 

  1. What are the drawbacks from using bitcoin for transactions?

The most obvious drawback from using bitcoin a medium of exchange is its current lack of acceptance in routine business transactions.

In addition, much like its upside volatility that makes bitcoin attractive for traders and speculators, that same volatility makes its less ideal for many transactions.  Imagine agreeing to sign a contract on November 28, 2017 to pay for a new home with 30 bitcoin.  That would have been equivalent to $300,000 based on bitcoin’s US dollar price of approximately $10,000 that day.   If you were to assume the closing of the purchase took place one week later, you would take possession of the house and the seller would receive 30 bitcoin.   While you might be happy with your new home, the seller would be ecstatic with the deal as the 30 bitcoin you delivered would have had a US dollar value of $450,000 one week later.

Thus, if it continues to exhibit high volatility, bitcoin may have more appeal as a trading instrument versus a medium of exchange.

 

  1. Isn’t Bitcoin or any type of cryptocurrency more secure than bank deposits?

Supporters of cryptocurrency have touted its security features (see Question 9 on bitcoin mining), yet like credit cards and online bank deposits, hackers that are able to gain access to a bitcoin account, or wallet, can spirit out the cryptocurrency just like they can with traditional financial accounts.  Recently a cryptocurrency mining service called NiceHash reported that 4,700 bitcoin had been stolen through a company computer that had been compromised.  In 2014, Mt. Gox, once the largest bitcoin exchange, collapsed after being robbed of more than $470 million of bitcoin.   In short, it doesn’t appear that the security of owning bitcoin is any less risky than that of traditional financial accounts.

 

  1. Is Bitcoin regulated in the United States?

The primary securities and financial markets regulator in the United States is the Securities and Exchange Commission (SEC).  While acknowledging that cryptocurrencies have been purported to provide many of the same functions as long-established currencies such as the U.S. dollar, the SEC has not ultimately determined that bitcoin or other cryptocurrencies are in fact a currency or a security.

The SEC has however, issued recent statements that warn both main street investors and registered financial firms about the risks of trading cryptocurrencies which may present “great opportunities for fraud and manipulation.”

  1. How can you trade or invest in bitcoin or other cryptocurrencies?

To trade the asset directly, bitcoin and other digital currencies can be bought and sold on unregulated cryptocurrency exchanges such as Coinbase, GDAX, Bitfinex, Bitstamp, itBit, Gemini and Kraken.

Recently, both the CBOE and the Chicago Mercantile Exchange allowed for futures trading on bitcoin.  In effect, this gives the holder of a futures contract exposure to price movements in bitcoin until the contract expires.  Unlike most futures contracts, when a bitcoin futures contract expires the holder does not receive bitcoin (the “underlying”) but rather nets the difference between the price at which they bought the contract and the price of bitcoin at contract expiration.   Depending on the exchange, at expiration the settlement price for bitcoin can be:  i) from a single digital asset exchange, Gemini Trust Company (for CBOE contracts), or ii) an aggregation of trade executions on four digital asset exchanges between 3:00 p.m. and 4:00 p.m. GMT (for CME contracts).

In the United States attempts to establish regulated investment vehicles, such as ETFs, for tracking bitcoin have been denied by the Securities Exchange Commission on grounds that the markets in which bitcoin trades are unregulated and subject to manipulation.   However, since the introduction of futures markets for bitcoin, a plethora of ETFs have been proposed that would track the bitcoin futures prices.

  1. What is the difference between bitcoin and an Initial Coin Offering (ICO)?

Virtual coins or tokens are created and disseminated using distributed ledger or blockchain technology.  Recently promoters have been selling virtual coins or tokens in ICOs.  These are often described to coin or token purchasers that the capital raised from the sales of ICOs will be used to fund development of a digital platform, software, or other projects and that the virtual tokens or coins may be used to access the platform, use the software, or otherwise participate in the project.  Issues arise when promoters and initial sellers have lead buyers of the virtual coins or tokens to expect a return on their investment or to participate in a share of the returns provided by the project. Crossing into a world where “expected returns” are discussed or promised will immediately draw the attention of securities regulators who will require disclosures similar to those in Initial Public Offerings.

In short, ICOs a very similar to start-ups in which early investors buy equity that may be sold for a significant profit if the venture is successful.  Hence the Securities Exchange Commission has emphasized in its communications that “(d)epending on the facts and circumstances of each individual ICO, the virtual coins or tokens that are offered or sold may be securities.  If they are securities, the offer and sale of these virtual coins or tokens in an ICO are subject to the federal securities laws.”

In the case of bitcoin, its claim is that it is already a currency that has its own distributed ledger and technological infrastructure.  Regulators in the United States have not definitely determined that bitcoin is a security.  That said, the trading of bitcoin – security or not – is regulated by the SEC and subject to scrutiny related to anti-money laundering and know-your-customer obligations among other regulations.

  1. What is bitcoin mining?

While traditional money is created through central banks, bitcoins are “mined” by bitcoin miners, i.e., network participants that perform extra tasks.

Bitcoin miners set out to chronologically order all transactions by including them in bitcoin blocks. This prevents a bitcoin holder from transferring the same coin to two different buyers (this is sometime referred to as the “double spend” problem).

At the risk of oversimplifying, finding a block most closely resembles a type of network lottery. Each attempt to try to discover a new block is essentially a random guess for a lucky number (often referred to as “hash”).  For each guess, a miner has to exert energy. Not physical energy, but computer processing power using sophisticated mining software and dedicated computing hardware. Most of the guesses fail and a miner will have wasted that energy.  However, once about every ten minutes somewhere, a miner will succeed and thus add a new block to the blockchain.

This also means that any time a miner finds a valid block, it must have consumed energy for all the failed attempts.  All this effort is considered “proof of work”.  Such proof of work prevents miners from creating bitcoins out of thin air: they must burn real energy to earn them. Secondly, proof of work perpetuates and further secures a single bitcoin ledger history.  It would be practically impossible for a hacker to try to fraudulently obtain a bitcoin by changing its transactional history. The hacker would have to redo all of the work that has been done to catch up and establish the full chain. It is often why miners are considered to help “secure” the bitcoin network.

In exchange for securing the network, and as the “lottery price” that serves as an incentive for burning this energy, each new block includes a special transaction.  This transaction awards the miner with new bitcoins, which is how bitcoins first come into circulation. At bitcoin’s launch, each new block awarded the miner with 50 bitcoins, and this amount halves every four years.  Today each block includes 12.5 new bitcoins. Additionally, miners get to keep any mining fees that were attached to the transactions they included in their blocks.

Currently, Bitcoin mining has become increasingly specialized and is mostly done by dedicated professionals with specialized hardware, cheap electricity and often big data centers.

  1. What’s ahead for bitcoin and other cryptocurrencies?

As bitcoin cruises towards $20,000 at the end of 2017, it is apparent that traders are comfortable bidding it up higher and higher each day.  Are they concluding that, because it had gone up most days in the past year, it stands to reason that it is probably going up the next day?  Likely.  And indeed, a lot of traders have made a career’s worth of earnings in the last year, or even last month, trading it.

For others sitting on the sidelines wondering if there still is an opportunity to make money investing in bitcoin, a good rule of thumb for considering an investment in any asset is to factor in its intrinsic value.  Despite the meteoric (read: speculative) rise in their prices, all cryptocurrencies ultimately will have to evaluated on the basis of how much value will they derive from their use as a medium of exchange and as store of value.   Importantly, if bitcoin and other digital currencies do not achieve success as a medium of exchange, they will have no practical utility and thus no intrinsic value and won’t be appealing as a store of value.

A helpful set of questions to help solve this are:

  1. i) In the long run is bitcoin going to supplant the existing base of global currencies including the US dollar, Euro and Yen?
  2. ii) Will bitcoin find itself considered universally accepted along with other traditional currencies?

iii) Will it ever gain traction as a medium of exchange?

The last question is likely the most relevant.  Unlike traditional fiat currencies, bitcoin needs blockchain technology to facilitate its use as a medium of exchange.   Yet blockchain technology does not exist exclusively for transactions denominated in bitcoin.   In theory, any currency can be used to transact in the blockchain universe.  In practice, we are already seeing widespread adoption in financial markets of blockchain technology for transactions that are denominated in major currencies.   If bitcoin or any other cryptocurrency cannot grab a meaningful share of this area of the market, the long run answer to the third question will become fairly obvious.

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