This article was written based on a request from UQBS marketing for the Momentum Magazine. Two additional peer-reviewed publications on cryptocurrency arose from my collaboration with Professor Emeritus Terry Marsh of UC Berkeley Haas School of Business on this topic. The links to these publications can be found on my publications page.
We hear a lot about cryptocurrency and Bitcoin in particular – but what is it?
Cryptocurrencies and tokens are digital assets – blips on a screen or in a computer file - that can be used to pay for goods or services just like traditional currencies. Bitcoin is the best known, but there are more than 200 others with the most popular being Ethereum, Ripple, Dash, Litecoin and Monero.
Traditional currencies are controlled by a central bank such as the Reserve Bank of Australia and stored in commercial banks like Commonwealth Bank, Westpac, ANZ and NAB. The central bank prints banknotes, each with a unique serial number. When you deposit cash in the bank, the teller or ATM will check that the notes are legitimate before the transaction is recorded in the database and the money appears in your account.
By contrast, a distinguishing feature of cryptocurrencies is that they use a blockchain ledger system to keep track of transactions, which differentiates them from ‘digital cash,’ something that has been around since the 1980s. To overcome the challenges involved in a decentralised system – for example, the risk that two parties may do updates that are not synchronised - entries in the ledger can only be made under certain conditions.
Transactions are first broadcast to the peer-to-peer network, then verified using the individual’s private key and confirmed by Bitcoin ‘miners’. Bitcoin miners can only add the transaction once they have performed a complex calculation. Blockchain provides an immutable digital record of economic transactions. Bitcoin miners are an essential part of the system, as they add in legitimate transactions and collect a fee (mined Bitcoins) for doing so. The process of mining is the only way to create Bitcoin – unlike a traditional currency where money can be printed by the central bank.
Currently, the total value of all cryptocurrencies is around USD220 billion, of which roughly 40 per cent is Bitcoin. Tokens are issued in Initial Coin Offerings (ICOs) by companies looking to raise funds – a crowdfunding version of an initial public offering (IPO) or stock market launch – and can be traded on a secondary market. There were about USD4 billion of ICOs in 2017 and USD17 billion for the first half of 2018.
What effect will cryptocurrencies have on other currencies such as the Australian dollar?
The two primary challenges for cryptocurrencies are price swings and the time taken to add new transactions. The volatility means businesses are unable to price their products in Bitcoin which dampens its use. Currently, about $100 million of Bitcoin is exchanged per day. Considering that in total foreign exchange transactions amount to $5.1 trillion, Bitcoin represents only about 0.002 per cent of the market, so it has a long way to go before becoming a serious contender.
In the long term, we expect the price volatility will settle down and new technologies will allow for more efficient processing of transactions, making cryptocurrencies more viable. Even so, Bitcoin will have less impact on established currencies such as the Australian and US dollar, the Yen, the pound and the Euro, and is only likely to be a threat to weak and volatile currencies such as the Venezuelan Bolivar or Zimbabwe dollar.
Is Bitcoin a bubble or is it the future of currency for digital-savvy generations?
Sceptics suggest Bitcoin is reminiscent of the Dotcom boom of the late 1990s. Some believe the price would be zero were it not for its use for nefarious transactions, and the renowned investor Warren Buffet has called it a ‘fraud’. Proponents, on the other hand, point to its potential to revolutionise record-keeping and protect money holdings from inflation and taxes.
Around 25 per cent of Bitcoin traffic is estimated to be black-market-related, and governments in China and South Korea have clamped down on it due to its role in money laundering. Arguably, this is no worse than the internet’s early days when pornography and drugs were the predominant services. Cryptocurrency’s reputation is not helped by the secondary exchanges where trading resembles the ‘wild west’. However, money laundering and drug sales are not exclusive to cryptocurrency and even in traditional currency trading, there have been recent price-fixing scandals.
While traditional investments like property or shares generate returns in the form of rent or dividends, Bitcoin does not generate any periodic returns – nor did Dotcom stocks. But that does not mean there is a bubble.
On reflection now, the FAANG stocks – Facebook, Apple, Amazon, Netflix, Google – were not outrageously over-priced in the dotcom bubble. There is no doubt that it is difficult to value growth assets during initial waves of innovation, especially where network effects play a critical role.
But how have cryptocurrencies held up as a store of value in the past? If you picked a basket of the top 50 cryptocurrencies in 2013 and equally weighted them, you would have earned an eye-popping 2.5 per cent per day overall to the end of 2017, even though most of the 50 would have lost 1 to 2 per cent per day!
The evidence shows there has not been any reliable pattern through time in crypto and Bitcoin prices, so what happened in the past will not predict the future. That is, while Bitcoin’s value has fallen by around 65 per cent against the dollar so far in 2018, there’s a 50:50 chance of higher or lower prices moving forward.
Sub-units of Bitcoins called milliBitcoins, microBitcoins and Satoshis have been proposed to function like cents do, as fractions of a dollar. The smaller denominations are proposed as a way to make Bitcoin more usable for consumers and provide an easier price point comparison against major currencies (currently 1 Bitcoin= AUD $8968.34).
Apart from cryptocurrencies, blockchain could have a real value in areas such as back-office legacy payment systems. Commonwealth Bank is working with the World Bank to manage a bond issue, cleverly nicknamed BONDI, that uses only blockchain record-keeping. Other potential applications lie in preventing electoral fraud, ensuring accurate medical records and keeping track of subcontractors on major infrastructure projects.
Critics argue that blockchain is a slow, cumbersome and power-hungry decentralised database system. For example, on average only three or four transactions per second are currently feasible in Bitcoin (20 in Ethereum), whereas Visa can process around 1,667. However, present developments promise much higher processing speeds – for both decentralised and centralised systems. Both will probably evolve over time to have different advantages in the market.
Arguably, the shape is already emerging: with some standardisation, a decentralised ledger has real potential as a ‘shared database’ with permission for ‘big data’ access – particularly a ledger handling one-off transactions such as a piece of real estate, rather than a unit of Bitcoin. Ironically the chances are that the future of blockchain will barely resemble the disruptive vision of its founder(s).