BitcoinFeb 15 2018

What is cryptocurrency and where did it come from?

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What is cryptocurrency and where did it come from?

"With Bitcoin, the scarcity makes nothing valuable."

So says comedian JP Sears in one of his video sketches, published in December last year when the rise of bitcoin seemed inexorable.

Shortly after this was published, a fireman friend of ours asked us at a party how to invest in bitcoin, because he didn't have much in the way of savings and he wanted to be a millionaire by the time he is 40. 

The father-of-two happened to be in a room with four financial journalists with 80 years' experience between them, who advised him to pay off his debts, put more into his pension and start saving into tax-efficient investments such as Isas, before committing all his meagre savings to something so racy.  

The problem with headline-grabbing investments is not usually the investment itself - it is the rush of ill-informed people towards it without any consideration for risk, reward, regulation, understanding of how the investment works, and that all-important factor of taxation.

But what caused a local hero and an American comedian to pontificate about cryptocurrency? How did Bitcoin and its companion cryptocurrencies such as Ethereum and Litecoin garner such interest in them? Where did they come from and where will they go?

Actually, what IS Bitcoin? 

Lilian Chovin, investment strategist at Coutts, puts it simply: "As a payment system, Bitcoin is a way of getting money from one person to another, rather than as a currency itself.

"So, when you buy or sell Bitcoins to make a transaction, you are in fact trading the tokens attached to Bitcoin's payment protocols. 

"These tokens can then be converted back into the native currency of the buyer and seller in the transaction."

Background

The birth of Bitcoin can be traced back to 2008, when a paper was published under the name of Satoshi Nakamoto - who may or may not be a real person - describing the Bitcoin cryptocurrency.

In 2009, the first few blocks of bitcoin were mined; at the same time, the blockchain database on which cryptocurrency operates was also devised by the mysterious Nakamoto.

For many months, bitcoin was in what could be described as 'beta' testing mode - worth just six cents (US$0.06; £0.04) and doing very little for a long time.

Bitcoin emerged from the frustration people had with the established banking system in the fallout of the global financial crisis. Philipp Pieper

There was a slight upturn in interest in 2013, when it rose to approximately £600, and then did nothing again for a long time. Then suddenly, it seemed to spring into life in 2017.

Alongside this, more cryptocurrencies sprung up; in 2017 alone approximately 550 cryptocurrencies started trading, such as Bitcoin Gold, Cardano, Walton, and the rather unorthodoxly-named GroinCoin. 

Some of these did not survive, but others did surprisingly well, with new releases of blocks of coins in January this year. The longer-established currencies - Litecoin, Ethereum, Bitcoin and Ripple, for example - saw huge price increases.

Bitcoin, the poster-child of cryptocurrency, rose to $19,343 (£13,807) on 16 December 2017. But in percentage terms, relative newcomer Ripple was the best-performing currency of 2017, rising from $0.25 (£0.17) on 11 December, to $3.40 (£2.40) on 7 January, before collapsing to $0.65 (£0.46) by 6 February.

There are now 1,384 currencies as at the time of writing (perhaps even more by the time this is published). Some of the most-traded ones and the support services infrastructure supporting them can be seen in the infographics below.

(Source for the infographics is the Global Cryptocurrency Benchmarking Study, Cambridge Judge Business School).

Anyone can launch a cryptocurrency and create it at any time, for any purpose. For example, one coin gaining currency (if you pardon the pun) in Australia and beyond is Dentacoin.

Clinics such as the Dental on Flinders, in Melbourne, joined the Dentacoin network to assist people to pay for treatments that will help prevent tooth loss and decay.

Dr Max Ganhewa, dentist at the practice, comments: "Dentacoin could help shift the paradigm from 'drill and fill' dentistry to a prevention-focused approach. It will also help build a tightly-knit dentist-patient community." The practice now allows 50 different types of cryptocurrency to be accepted as payment. 

Mining

Cryptocurrencies can be mined by speculators. But this isn't any old Gold Rush-style 'head for the mountains with a pickaxe and a canary, boys' style of mining. 

This is a sophisticated protocol development, whereby 'miners' group unconfirmed cryptocurrency transactions into new blocks and add them to the global ledger, the blockchain. 

Because they provide the necessary computing power to secure a blockchain by computing vast number of hashes to find a valid block.

The two previous sentences are full of words but what do they mean? Once again, the new lexicon developing around blockchain and bitcoin can be a barrier to understanding. 

Any rise in the Bitcoin price is likely to increase its effect on the environment. Paul O'Connor

Effectively, a hash is the output of a hash function in computing. A hash function is a mathematical algorithm that can be used to map data of arbitrary size to data of fixed size.

For cryptocurrency, a hash function will map any data of any size to a bit-string of a fixed size (called a hash). It is meant to be a one-way function and cannot be reversed.

The way in which hash functions relate to cryptocurrency therefore means creating a series of fixed-size bitstrings, a hash. The quicker you create these blocks of hashes when 'mining' the better, because this increases your opportunity of finding the next block and receiving the reward you get from completing an operation in the Bitcoin code. 

So for tech-savvy people, rather than trading Bitcoin and relying on being able to time price movements accurately, they can instead 'mine' for bitcoin by creating these bit-strings, these hashes, into blocks they can then add to the global blockchain ledger. As a reward, they get their Bitcoins.

The 116-page Global Cryptocurrency Benchmarking Study by Dr Garrick Hileman and Michel Rauchs of the Cambridge Centre for Alternative Finance at Judge Business School is a long read, but very helpful in delineating how mining works, how people can put cryptocurrency into virtual 'wallets' and the various risk management and challenges.

Competition and cost

One big development is that mining has gone from the purview of a few PC users to a global operation, with self-miners competing against globalised cloud mining services and even remote hosting services, whereby people can take part in the process of mining cryptocurrency without having to run the equipment themselves.

These servers are huge and because the operations have become so professionalised, the money to be made by mining is probably more than the money to be made by people trading bitcoins. 

According to the Cambridge study, bitcoin miners alone have earned more than $2bn (£1.4bn) to date (see chart).

Some analysts have commented there has to be an ultimate end to the creation of blocks on the global ledger. What happens when space runs out? 

Will there be new blockchain ledgers created? Will there be a finite number of bit strings that can be mined and hashed together to create these blocks?

Moreover, transaction fees as a percentage of total Bitcoin mining revenues have risen significantly, at more than 6 per cent as of the first quarter 2017, up from less than 1 per cent in 2014. Perhaps as a result, transaction fees are starting to rise, just as the price of cryptocurrencies is falling.

Could this also start to put the brakes on heavy mining activity?

As Coutts' Ms Chovin explains: "Transaction fees are quite high compared to other forms of payment.

"With the demand for Bitcoin taking off, the cost of making transactions has risen to as high as $40 (£28) per transaction. This is a little high if you are trying to buy a sandwich for lunch.

"By comparison, debit card transactions typically cost around 30 basis points of the transaction, a £4 sandwich might come with a transaction cost of around a penny."

Supply and demand

The Cambridge study said both small and large miners were also concerned about fierce competition among miners of the same cryptocurrency, and insufficient availability of capital to continually replace or upgrade current mining infrastructure, which could also put limitations on how much can be mined. 

Following Adam Smith's laws of economics, this supply-demand scenario could support price rises in the future as it becomes harder, or at least more competitive, to mine for the same currencies and therefore supply starts to tail off. This could be a good thing for investors wishing to sell and make a profit.

However, the demand for cryptocurrencies is also having a big effect on the supply of energy, with huge demands being placed on countries; national grids - especially in China. There is a cost to the planet in mining cryprocurrencies.

Paul O'Connor, head of Janus Henderson's UK-based multi-asset team explains: "The processes supporting cryptocurrencies are hugely energy consuming, with vast numbers of computers in operation 24 hours a day, running the calculations that generate each unit of the digital currency.

Cryptocurrency puts more control in the individual user's hands than in the hands of politicians and government bureaucrats. Kara Ward

"Analysts at the cryptocurrency website Diginomics estimate the annual energy consumed in mining Bitcoin is similar to what the whole of Denmark uses, or the equivalent to the consumption of more than 3m US households." 

With most of this being based on coal-fired electricity generation, Mr O'Connor comments: "Any rise in the Bitcoin price is likely to increase its effect on the environment, since miners can justify spending more on electricity as they receive more revenue for each unit created."

Controlling your money

Controlling one's financial destiny is a big attraction of cryptocurrency, either by creating it yourself or by trading it online, with no banks or stockbrokers taking their share, and no Mifid II telling you what to do with the tokens once you have them.

As Kara Ward, financial services regulatory and legislative attorney at Venable LLP, states: "The rise in cryptocurrency stems from tech-savvy individuals and others who wanted to transmit funds easier, quicker, at lower cost, and do so as anonymously as possible by not using a third party, such as a bank.

Philipp Pieper, chief executive of Swarm Fund, explains: "In the beginning, Bitcoin emerged from the frustration people had with the established banking system in the fallout of the global financial crisis.

"There was an overwhelming view that ordinary people had trusted the experts at mainstream financial institutions with their money, and those financial institutions and experts had taken egregious advantage of that trust."

Clem Chambers, chief executive of stocks and shares information site ADVFN, has highlighted five particular drivers for the growth and popularity of cryptocurrency. It is hard to argue against the attraction of borderless, bank-less, low-regulation currency.

 He cites: 

  • Technology: the blockchain breakthrough is a core new development, which will change the world.
  • M2: A global shortage on M2 money supply as expressed by global deflationary pressures. Historically, this has fuelled private token issuance.
  • Banking regulation: There has been a crippling of the utility of money by regulation on banking. Know-your-customer, anti-money laundering rules and cash limits on spending on big-ticket items, for example. The lower utility of fiat has lowered real value and tightened supply of means of exchange. 
  • Uniqueness: The unique utility of cryptocurrency means there is bank-less banking, irreversible transactions, fast transfers and it is borderless.
  • Free money: Suddenly, the passive becomes dynamic. Mining coin is profitable and passive. 
  • Gold-Rush effect: Rising prices make for rising interest, which in turn makes prices rise.

Mr Pieper comments: "Bitcoin took root from the very real belief that individuals, no matter how small, could determine their own destiny in a way that didn't encompass banks, and wasn't subject to the stacked rules of the established system.

"Because Bitcoin is a decentralised, peer-to-peer currency network, there is no central hub or governing authority that can game the system. People hold their own money, not the banks."

Ms Ward agrees: "Its popularity was fuelled further by a fundamental distrust of centralised, sovereign monetary policy.

"To place this development in its proper context, the desire to develop and use cryptocurrency arises out of the same loss of faith in institutions that is one of the defining qualities of the generation that hit the market in the great recession.

"For inter-connected individuals, cryptocurrency puts more control in the individual user's hands than in the hands of politicians and government bureaucrats."

Dangerous drivers

But not all the drivers have been positive ones that help individuals manage their own money outside of government policy or banking legislation.

Mr Pieper adds: "This anti-establishment genesis also led some people to leapfrog outside the rule of law entirely.

"Fueled by Bitcoin, the drug-trading site Silkroad arose, and a shadow of illicitness has hung over the entire crypto space since. However, while Silkroad is long gone, crypto is not."

Boiler rooms have also been contributing to the inexorable rises we saw in 2017. 

According to Finra, the US Financial Industry Regulatory Authority, "pump and dump" boiler rooms have been pushing crypto investments to people who have little to invest and do not understand the basics of risk and reward.

In a statement in December, Gerri Walsh, senior vice-president for investor education at Finra, warned of "unrealistic predictions of exponential returns and unsubstantiated claims being made through press releases, spam email, telemarketing calls, or posted online or in social media, largely by unlicensed individuals and firms."

According to Ms Walsh: "It can be difficult for investors to avoid the lure of the cryptocurrency markets, especially when prominent people express interest in it, and news reports and social media tout the promise of guaranteed quick fortunes and skyrocketing returns.

"But it is important to do your research. Even when legitimate companies enter a hot, new sector, con artists almost always follow suit."

Social media has indeed played its part. Influencers - Twitter or Instagram users with hundreds of thousands of followers - are often paid to promote and extol the virtues of various types of good or service.

Many influencers have bigged up the use of crypto, showingcasing their lavish lifestyles as a result of their speculative investments or life choices.

Johnny Ward is an influencer on Twitter. According to his Twitter profile he has made "$1m or 2" - who's counting? We'd never heard of him before, but when he noticed some posts by FTAdviser on Bitcoin, he wades into the debate, commenting that nobody should take life advice from anyone who has to work for a salary. 

There is little point arguing with someone who has "visited all 197 countries". At the time of the Twitter exchange, Bitcoin was hovering around $17,000 (£12,000). At the time of writing, it is sitting at $6,395 (£4,573).

One might wonder how many people who put all their savings into cryptocurrency when the price was peaking are now wishing they'd taken financial advice from someone with a salary.

Economic arguments aside, the fact cryptocurrency offers 'freedom' and is seen by some as a means of creating a digital lifestyle is going to be attractive, even if the average person is unlikely to earn enough to live the lives their Instagram idols do. 

New generation 

Ironically, it is the perception among these digital natives - mostly millennials - that traditional routes of funding their house deposits or simply paying the rent are being closed to them - that is giving more credibility to less orthodox means of investment. 

And they are more likely to experiment with alternative forms of money saving and creation, outside of the traditionally advised space. 

The unique utility of cryptocurrency means there is bank-less banking, irreversible transactions, fast transfers and it is borderless. Clem Chambers

According to Matthias Kroner, co-founder and chief executive of Fidor Bank: "Cryptocurrencies are a part of the digital lifestyle, as digital natives are way more open to give trust to such a currency.

"In parallel, the access to financial information and alternative financing channels has increased drastically due to widespread usage of technology, from crowdfunding, lending, mobile, P2P payments and, of course, cryptocurrencies."

Platforms and wallets

Investors have been able to access data on investor forums such as Cryptocoin or CoinGecko, and have found it easier over the past couple of years, also through the many exchanges and investor platforms springing up, to help collate information and trading functionality of various currencies. 

These are helping to make cryptocurrency more available to the general public, providing up-to-date information and share price tracking that can be used to help inform and educate potential investors about this new asset class.

Ether is one technology platform, created by 23-year-old programmer Vitalik Buterin, who is also the brains behind Ethereum.

The latest entrant to this market is Tory peer Michelle Mone, the founder of Ultimo lingerie, and her boyfriend Douglas Barrowman.

According to sister paper the Financial Times, they are doing a $75m (£53.6m) initial coin offering (ICO) to launch Equi, an investment platform for cryptocurrency. One hopes Ms Mone, who made her fortune from underwear, can get into the market before it goes ... bust. 

Other companies are starting to launch special digital wallets, where investors can put all their virtual currency and see the information all in one place - like a form of the pensions dashboard for cryptocurrency. 

Some, such as international advisory firm deVere Group, are launching applications to help individual investors manage their cryptocurrencies in one place. 

In recent weeks, Bitcoin futures have launched on some major US exchanges, which according to Mr O'Connor, has been "an important step in the development of the cryptocurrency, giving it greater familiarity and wider usage".

Such developments are helping to form some semblance of order, security and community, taking cryptocurrency further away from the rumoured associations of its black-market and criminal use, where untraceable payments can be made for the purposes of money-laundering, for example, towards greater legitimacy.

simoney.kyriakou@ft.com