Talk of cryptocurrencies and blockchains is everywhere. With so much to learn in what seems like an ever-changing landscape, it may seem hard to keep up. We want to share a high-level introduction of the basics, along with some real-world examples, which will hopefully allow you to follow the conversation. For ease of understanding we’ve divided our comments into two sections: we will first discuss Bitcoin and then after the conclusion, address blockchain technology.
Bitcoin – The First Cryptocurrency
In October 2008, “Satoshi Nakamoto” (whose identity remains disputed) released the Bitcoin whitepaper describing a “peer-to-peer electronic cash system” which serves as the genesis for every blockchain. By January of 2009, the software was launched and Bitcoin, the first blockchain and cryptocurrency, was born. Many believe Satoshi was inspired by the housing bubble forming in 2007 and the events of the Global Financial Crisis to create an alternative, transaction-based system free of top-down control, not governed by one single entity. As the Bitcoin whitepaper concluded, “we have proposed a system for electronic transactions without relying on trust.”
Trading of Bitcoin varies based on supply and demand of owners. Over the last several years, Bitcoin’s value has increased dramatically, spurring a mania of buying as early buyers were rewarded handsomely.
Miners – keepers of the network
The network of computers that track ownership of the Bitcoin blockchain are rewarded or paid with new shares of Bitcoins. These computers are called ‘miners’ and they all race to solve a mathematical computation when a batch of transactions forms each new block. The first to complete the task is rewarded with a share of Bitcoin. Given Bitcoin’s price growth, there are many miners competing for new Bitcoins, which increases the security of Bitcoin, but uses a lot of electricity. It is estimated that annually the Bitcoin network uses as much energy as a small country like Sweden or Malaysia.
Limits around supply
Bitcoin has a maximum supply cap set at 21 million bitcoin and is equipped with a disinflationary supply mechanism. There are 18.86 million bitcoins already in circulation today which is about 90% of the total Bitcoin supply. As a blockchain, the rules for issuance of new Bitcoins are written in its code which is unlike most central banks who have the authority to issue new money as needed.
Bitcoin is a decentralized currency operating without a central bank or political influence. History has shown that central banks have sometimes undermined the value of their currency by printing too much of it. Bitcoin advocates point to the Federal Reserves’ quantitative easing programs and the rapid growth in the supply of money as concerns that the Fed is currently undermining the value of the U.S. Dollar. While U.S. Dollar concerns have, so far, been overblown, currency concerns are very real in many countries like Venezuela, Turkey and Argentina, where politicians have influenced central banks to print more currency. In 2020, Venezuela’s inflation rate ran at a crushing rate of 2,355%. For many, Bitcoin appeals because it is a currency that offers a store of value which cannot be inflated away. Bitcoin is decentralized and issuance is predetermined and not susceptible to political aspirations.
The second reason for Bitcoin’s growth is due to its own rapid success. Early adopters have made a fortune as the price has skyrocketed. Bitcoin has created an estimated 100,000 new millionaires. Speculative fever has been rampant during the economic recovery after the pandemic shutdowns. Especially in younger investors, we are seeing higher usages in leverage and investing the stock market via options. In a 2021 MagnifyMoney survey, 80% of Gen-Z investors indicated they use leverage to invest. Bitcoin’s speculative nature and history of high returns appeals to these and many other investors.
The third reason for Bitcoin’s success is broader acceptance in the financial community. Smartphone apps like Coinbase have facilitated investments in Bitcoin. Microsoft, AT&T, Overstock and more companies now accept payments in Bitcoin. Especially in countries like Venezuela and El Salvador where Bitcoin usage has risen, many firms accept payments in Bitcoin. Ease of access for purchase and increased acceptance has continued to move Bitcoin from fringe currency to mainstream usage.
Risks and concerns
First, Bitcoin lacks a valuation metric or rationale for price. The price is determined by supply and demand which varies widely. Investing in Bitcoin is very similar to investing in gold, except more volatile. Neither Bitcoin nor gold generate income or pay a dividend. Return on investment is dependent on someone else paying more than your cost. It is impossible to accurately value Bitcoin at any price. $1 or $100,000 can be justified as either cheap or expensive.
Second, the Security and Exchange Commission has filed to regulate Bitcoin. Though the outcome is not known, regulation could remove some of Bitcoin’s appeal, especially anonymity. Bitcoin has been used for illegal activities like drug deals or ransomware demands outside of bank and regulatory authority oversight. Writers for Wired Magazine have speculated that Satoshi Nakamoto is actually a former programmer turned drug dealer who lived in the Philippines. A big part of the reforms post the September 11th terrorist attacks were anti money laundering rules that strove to defund terrorist organizations.
Given that Bitcoin’s total value is now over $1 trillion, authorities are keen to know the identities of holders and track the flow of money through the Bitcoin network. Authorities are gaining on illegal activities. For example, in June of 2021 they recovered $2.3b of the $4.4b ransomware payment Colonial Pipeline made after hackers shut down a major pipeline that runs up and down the east coast. Clearly, unfettered money transfers, money laundering, ransomware and tax avoidance represent Bitcoin’s dark side and should be monitored. Arguably, regulation might be a good thing for Bitcoin as well-constructed oversight might bring broader adoption by banks and payment networks.
Third, there is no guarantee that Bitcoin will be the cryptocurrency of the future. Certainly, Bitcoin is the most popular, but its wide price fluctuations and relative slow transaction speeds present issues for replacing the role of U.S. Dollars. It is possible that someday the Federal Reserve issues a crypto U.S. Dollar that is better suited for everyday transactions and whose price is stable. Another reason Bitcoin may not be the cryptocurrency of the future is due to environmental concerns given that extraordinary energy consumption consumed by Bitcoin miners.
While we understand that many are excited about Bitcoin and cryptocurrencies, we feel the risks and concerns stated above are too great to ignore and any investment in these assets in our client portfolios would add immeasurable risk – something that we are not comfortable with today.
For clients who are interested in trading cryptocurrencies, please take the time to understand the rules that govern the currency, like fees, new issuances and trading. If you are still determined to make an investment, we suggest you keep the investment small relative to your wealth. That way, if the price should fall, your long-term financial goals will not be impacted.
Blockchain – A Revolutionary Technology
A blockchain is a shared, immutable ledger that digitally tracks ownership and verifies transactions of an asset, without reliance on an entity overseeing the process.
Shared, immutable ledger
A blockchain is a digital ledger that tracks ownership of an asset. The ledger is public and shared on the internet. The history of ownership is never deleted and is therefore immutable. The ledger is like a check-in sheet that keeps track of every person who has entered a building and at what time. Like this check-in sheet, blockchains are a public record of each approved transaction and the history of ownership. The term blockchain refers to how the ownership data is stored. Each transaction represents a block, the history of transactions are linked together in a chain, and once approved, cannot be changed.
Tracks ownership and verifies transactions
Blockchains have shown to be safe and accurate for two main reasons: First, most blockchains use hash encryption to keep personal details like password and identity unknown. While the digital ledger is public and accessible, the identity of owners is kept safe and secure. Second, decentralized blockchains use a network of computers to approve transactions and agree on ownership. Deceiving the blockchain would require fooling more than 50% of the computers verifying ownership, which is near impossible for larger networks.
Without reliance on an entity overseeing the process
Blockchains are decentralized and do not have a bank, agency or regulator tracking ownership and facilitating the transfers. Instead, blockchains use software and a network of computers that validate a set of transactions, a block, which is added to the blockchain, the history. Owners of computers in the network receive a fee for their computational efforts in maintaining the blockchain. Despite this fee, blockchains are far lower in costs than central oversight like bank or government. This lack of central control is a big part of what makes blockchain technology so unique and appealing for many applications.
Many believe blockchain technology may be the most important innovation since the internet. Potential applications of blockchain technologies might be stock exchanges, lending, insurance, real estate titles, voting, music royalties, car sharing, healthcare, supply chain logistics and so on. We will continue to see more applications built using blockchain technology which should lower costs and improve how humans interact. The future for blockchain technology is exciting.