All the ingredients for life on earth were available in the primordial soup, but it took some unknown catalyst to create the right combinations. Similarly, all the technology to enable cryptocurrencies was around from the 1990s, but it took the financial crisis to provide the impetus required for Satoshi Nakamoto, whoever (s)he might be, to launch Bitcoin in early 2009. Like all good manias (and I believe we are witnessing a mania of sorts), the enthusiasm for Bitcoin has credible roots.
Bitcoin was born out of the chaos of the financial crisis. With banks going bust, the global financial system seizing up and no counterparty deemed reliable, an alternative currency suddenly had real attractions. Furthermore, a currency which had a limited issuance could be viewed as a counterweight to fiat currencies which could be created ad finitum by central banks. Crucially, it was a currency that could live in its own closed system, using the blockchain distributed ledger technology to authenticate and record transactions made over the internet. It was free from government interference and bypassed the traditional banking system.
The blockchain technology is surprisingly self-explanatory. Transactions are organised into blocks, and the authentication of each transaction, or block, is linked to the one either side of it, creating the blockchain. The authentication process is driven by the performance of a mathematical calculation which also provides encryption. The interdependency of the calculations between blocks is what creates the secure audit trail, making it theoretically impossible to interfere with history. The more transactions that take place, the more embedded previous transactions become. The ‘distributed ledger’ element of the system refers to the fact that the blockchain data is stored on multiple computers, a layer of replication that provides a further layer of security.
So how does one acquire a bitcoin, or similar cryptocurrency? The purest form of acquisition is through ‘mining’. Much as one might like the idea of physically hewing money from a seam of rock, the reality is much less tangible. The authentication process described above requires solutions to complex mathematical problems. The complexity increases as the underlying value of the currency rises, limiting the speed of issuance. The computers that provide the solutions are awarded with currency, and this will continue until all the units have been mined. Thereafter, it is envisaged that the miners will instead be paid a small fee to record and authenticate the trades – ironically making their business model more like, for example, Visa.
‘Currencies, especially the smaller ones, do not have a consistent amount of settlement capacity, which can be frustrating at best, or detrimental to their existence at worst.’
In the early days, mining could be undertaken by an individual with a laptop and a bit of nous, but the process has now become industrial as the value of cryptocurrencies has risen, with huge computing power and supplies of electricity required. Indeed, the more sophisticated operations switch their mining activities between currencies depending on where they can get the best bang for their buck. Depending on one’s point of view, that could be described as canny opportunism or worrying speculation. The result is that currencies, especially the smaller ones, do not have a consistent amount of settlement capacity, which can be frustrating at best, or detrimental to their existence at worst.
Bitcoins can also be purchased through an exchange, or acquired in return for goods or services provided. The former route remains the more viable, and is the preferred route of speculators. The latter is very much a ‘road less travelled’, as cryptocurrencies have definitely not yet entered the mainstream.
Not surprisingly, Bitcoin initially attracted technology geeks and those of a more anarchic bent, but was quickly adopted by more criminal elements, not least through the Silk Road website, a hub for drug dealing. The site’s founder currently languishes in a US prison, sentenced to life with no possibility of parole!
Be that as it may, and despite the ongoing attention of regulators, Bitcoin has continued to flourish and has spawned a raft of other alternative currencies. At the last count, there are more than 1,000 of them, some quite large (Ethereum, Ripple, Litecoin), and many very small. It is this proliferation of alternatives that is in many ways the most disturbing aspect of the story. It seems inevitable that even if an alternative currency system gains greater traction, only a minority of these upstarts can feasibly survive. They could all be acquired for Bitcoins, but more probably they will be worthless. And there is no impediment to issuing these things through what are known as Initial Coin Offerings (ICOs), which lends them a spurious air of respectability.
‘The proliferation of alternative cryptocurrencies is in many ways the most disturbing aspect of the story.’
Let us now consider the key characteristics of a currency – to be a ‘store of value’ and a ‘medium of exchange’. The dollar value of Bitcoin and its imitators has been volatile to say the least, and thus difficult to describe as a store of value. It doesn’t have any sort of yield attached to it, so it’s impossible to value on that basis. (I know gold-haters will make the same accusations against the precious metal, but at least it has some uses and a 6,000-year history as a store of value). Medium of exchange? I have yet to encounter an establishment that offers me the opportunity to spend Bitcoins – maybe I’m just not hip enough! – but it still seems to be a relatively difficult currency to spend.
There are notable exceptions. The Boston staff restaurant of Fidelity, the fund manager, accepts Bitcoin, for example. But it might take an Amazon to start accepting it for the concept to become more mainstream. No sign of that… yet.
This article is not intended to constitute personal advice and no action should be taken, or not taken, on account of the information provided.