Bitcoin is an exciting technological innovation with the potential to disrupt or at least shape the financial world. It is however a complex technology that requires a significant amount of intellectual investment to understand properly. Dramatic price increases may tempt some armchair investors to dip their toes into the cryptocurrency world but it is critical for each individual to understand the substantial risks that they incur when taking this step and to grapple with their underlying reasons for curiosity.
There is a big difference between curiosity in an interesting technological development and speculation on a volatile cryptocurrency just because it’s grabbing news headlines. In this piece I will briefly attempt to outline; what is blockchain, what is bitcoin and discuss a few risks to help educate and inform.
What is bitcoin and blockchain?
Bitcoin is the first fully decentralised electronic value transfer system. There have been numerous other cryptocurrencies created subsequent to bitcoin with a variety of different characteristics. Bitcoin was specifically created to target electronic payments, while other cryptocurrencies target different versions of electronic value. Computing power to run programmes (Ethereum) is another example of electronic value transfer. I focus on bitcoin because it was the first, is the biggest, the most popular of the cryptocurrencies and is the one that I understand the best.
Blockchain is the technology created in order to make electronic value transfer a reality. A blockchain is basically a distributed database. Simply put, think of a giant, global spreadsheet that runs on millions of computers connected via the internet. Since transactions take place in a peer-to-peer network there isn’t a single centralised record of the ledger. A blockchain can remove the need to trust in a single intermediary who authenticates and settles each transaction, which is where we get the name Distributed Ledger Technology (DLT). The blockchain process generates a fully verifiable history of transactions that is stored on a distributed ledger across the global network and is an important element in the network security.
This is by no means a sufficient explanation. I encourage those that are interested to read the founding documents to the various cryptocurrencies to understand them and the specific properties properly.
Example of decentralised electronic value transfer
Prior to Bitcoin any financial transaction over the internet required a trusted third party intermediary to verify the authenticity of each party in the transaction.
- When John sends Steve money electronically via EFT, the bank verifies that John has the money, verifies that John has authorised the transaction, verifies that Steve has received the money, implements the transaction on the bank’s central ledger, and tells each participant that the transaction has taken place so that the goods/services can be transferred. I.E. the bank must vet, process and record the transaction.
- In Bitcoin John can send Steve money electronically and each party is able to verify the transaction without the need for trusted intermediaries. This is almost like a cash transaction. When John gives Steve cash, there is no need for verification. Steve sees the cash, John sees that Steve has received that cash and the goods/service exchange can take place.
For some, this idea of centralised value transfer isn’t very useful. Many people trust their bank to implement transactions and appreciate the legal recourse provided by the regulations in their country. For others the idea is revolutionary.
Places where people have or might have found Bitcoin useful
- Example 1, 2013 Cyprus bail-in
The 2013 the Eurogroup bailout of Cyprus’ banking sector included a one-time haircut on deposits. In other words, the authorities unexpectedly wiped off a finite percentage of people’s wealth in order to recapitalise the banking sector. One day customers had a hypothetical EUR100K in the bank and the next day they had less. This was a worrying event for those who thought that their money was safe and sound in the bank. If Cypriots were holding bitcoin instead of euros then it would not have been possible for the haircut to take place on their deposits because authorities don’t have access to bitcoin accounts.
- Example 2, 2016 Indian demonetisation
In 2016, Indian PM Narendra Modi outlawed the INR500 and INR1000 notes. Despite Modi’s optically noble reasons for this action, the Indian economy is cash reliant and many Indian’s held stockpiles of wealth in cash. Overnight these stockpiles were made worthless, which wreaked havoc with millions. If Indian’s were holding bitcoin instead of rupees their wealth would not have been made worthless overnight by a change of a regulation. Bitcoin purchases spiked in India after the demonetisation experience in 2016.
- Example 3, Saving the starving billionaire, hyperinflation
Venezuela is currently experiencing hyperinflation. The inflation rate is greater than 100% y/y, i.e. prices more than double each year. The exact numbers are very difficult to calculate but prices are rising at an alarmingly fast rate because the government has overspent, cannot collect enough tax revenue and has resorted to printing new money at the central bank to pay its bills. At such high inflation rates the social fabric of a country is torn apart because people can no longer trust in the medium of exchange. People are also so busy re-price products on a daily basis that they struggle to add value in society. Just ask South Africa’s neighbours in Zimbabwe how problematic systemic inflation becomes. If Venezuelans held bitcoin through the hyperinflation their wealth would be protected against debauchment of the domestic currency. There are examples where Venezuelans are able to buy goods in the US through bitcoin and ship them home in order to keep large families alive during these crisis conditions where food has become scarce.
- Example 4, European and Japanese negative interest rates
The central banks of Europe and Japan have both at various times over the last few years charged negative interest rates to banks on deposits held with the central bank. In a few rare instances these banks passed these negative interest rates on to actual consumer depositors in the real economy. Imagine paying R1 for holding R100 at the bank for a year rather than receiving an interest rate? For some consumers paying a negative interest rate for holding money at the bank isn’t an attractive trade-off and so they seek out alternative forms of money where they won’t be charged negative interest. Bitcoin presents an alternative where no interest rate can be involuntarily imposed on the holder.
- Example 5, Access to financial services
The previous four examples were all critically important but slightly less common scenario’s that the man on the street might hope to avoid if the trusted authorities in his/her country don’t implement negative interest rates, hyperinflation, demonetise the currency or bail-out the banks. Despite this fringe characteristic, bitcoin can actually provide major additional benefit to masses of people who are on the peripheries of the economy.
There are billions of people who are unable to access bank accounts and the services offered thereafter due to a lack of verifiable assets and identity. It is estimated that there are more people on the globe with mobile phones than bank accounts. A bitcoin account can be set up on a smart phone in minutes and provide any individual ready access to a global payments network. Access to global payments and other critical services that other cryptocurrencies will provide has the potential to ignite a financial revolution in developing economies where banking systems are far less advanced than South Africa’s.
Cryptocurrencies present a regulatory headache
Despite the excitement cryptocurrencies like bitcoin are currently largely unregulated. Regulators aren’t sure whether to classify bitcoin and what to classify it as. Is it cash, currency, a commodity or just a technology? It’s not entirely clear how to answer this question because centralised value transfer over the internet never existed before.
Blockchain applications have raised serious legal questions because many of the activities don’t fit neatly into existing legal frameworks. Here are a few examples:
- Challenging legal tender laws, which control the currency that can be used within a countries national border. Bitcoin users are able to transfer of funds and verify these transactions without any screening by a central bank or other regulated financial institutions.
- Monitoring of money laundering and other illegal monetary transactions becomes difficult if regulated financial institutions are not monitoring the value transfer network.
- Privacy laws can be challenged in cases because cryptocurrencies publicly distribute information across the network and on certain networks they make an amount of the information from these transactions publicly available too. Small transactions largely go under the radar but large enough transactions can be traced by knowledgeable participants back to the originator. Banks, for example, trade instruments in extremely large quantities, which could potentially be tracked by knowledgeable participants, but banks don’t necessarily want to provide the opportunity of open access to this information.
Lack of regulation has it’s risks, putting responsibility back with the individual
It may be a headache for regulators but the unregulated nature of cryptocurrencies is exciting. People are solving real human problems on a daily basis, which is absolutely wonderful. It is preferable if we avoided stifling the innovation through onerous regulation. Nevertheless the lack of of regulation has important implications for users.
When compared to traditional currencies, there is limited legal recourse on transactions in bitcoin. A few examples:
- If you buy a car in bitcoin but the previous owner steals it from you before the ownership paperwork is finalised, there is no record in the South African banking system of the transaction and it might be difficult for the police to prosecute on your behalf.
- If you lose your pin number for the bank you can walk into the bank and get a new one but if you lose all of your bitcoin private keys (similar to a pin) then you’ve lost that money. I say “all” because most bitcoin wallets have layers of multiple keys to help users recover their accounts but the point still stands.
Bitcoin doesn’t protect against repeated human errors.
The lack of recourse has led a couple of scams to make use of bitcoin in order to try and further their financial gain. For example, an actual Ponzi scheme like MMM has tried to use bitcoin as its medium of exchange to decrease the chance of legal recourse back to the original founders. This doesn’t imply that there is something sinister about bitcoin but it highlights the risks that surround this technology and the knowledge that is required to navigate the landscape properly. In a sense the responsibility for ones’ financial well-being shifts back towards the individual. This is both scary, risky and empowering!
Difficult for heavily regulated companies to hold Bitcoin
Lack of regulation implies that companies don’t know how to classify bitcoin. It might be possible to hold it as a long term asset but how does one account if trading daily or receiving revenue in bitcoin. There are a growing number of retailers that accept bitcoin (Amazon, Tesla, Superbalist, etc,) however it is unlikely that these companies actually hold assets in bitcoin. It’s more probable that they merely convert bitcoin back into their domestic currency, which is recognised by the local regulator and is the currency in which they pay tax.
A comparable logic transfers into the investment space. For as long as bitcoin is an unregulated instrument it is difficult for heavily regulated investment houses to purchase. Similarly, investment advisors are unlikely to assume the legal risk that could emerge if they were to advise clients to purchase unregulated instruments.
While I would prefer that regulation remains minimal for as long as possible, I expect that regulation of the bitcoin and cryptocurrency markets will take place at some stage in the future as authorities grapple with their loss of power over this industry. Regulators in South Africa are currently quite coy on the subject though. Until such time as there is clearer direction from regulators it is tricky for regulated corporates to take strong positions.
Intellectual investment as important as the monetary investment
There is a chance that bitcoin is the start of a monetary revolution that will change the face of the financial world. This level of potential warrants excitement and it is understandable if individuals dip their toes into these exciting waters. But they must be aware of the non-normal characteristics of this market. There are clear risks when walking down this path. Buying something because merely expects the price to increase without a clear fundamental reason for the purchase is the definition of speculation. The extent of this behaviour in the broader cryptocurrency space reminds me of the “greater fool theory” where people are merely hoping that they can on-sell to another at a higher price. Intellectual investment to understand the underlying reasons for global interest in bitcoin is critical, opens up an abundance of learnings and makes any monetary investment less speculative.
*For those who are keen to learn more I encourage you to join twitter and check out my brief list of highly respected people in the bitcoin community. For a start, watch Andreas Antonopoulos on youtube – I think of him as the bitcoin evangelist. You can also engage directly with me via twitter (@robprice58) or on the comments section of this article and I’ll try point you in the right direction.
*I am not a technical expert in the field of cryptography or computer programming. I am sharing my understanding at the intersection between cryptocurrencies, investments and economics to help educate in this uncertain space. I welcome comments, queries or criticisms and am very willing to learn more about this space from others.
*thanks to Mladen Colic @mladen8900 for his comments on this piece.