By Michael Edesess, Ph.D., Managing Partner / Special Advisor at M1K LLC.
You have all heard about bitcoin, the cryptocurrency whose mysterious creator, the pseudonymous Satoshi Nakamoto, has been nominated for a Nobel Prize – even though his, her, or their true identity remains stubbornly unknown. Spurred on by breathtaking price runups, some clients may even have asked you if they should invest in them, or if it’s safe to buy them and use them to make payments.
Most likely you dismissed the whole thing as some sort of a tulip bubble, or a creature of illicit economies like the drug trade, money laundering, and cyberhacking.
But it’s not as simple as that. This bubble could be the start of something big.
The basic facts about cryptocurrencies
Virtually all other transactions systems – whether their purpose is to transact in currencies, land titles, medical records, or something else – are conducted through the medium of centralized databases, owned and maintained by large, trusted institutions such as banks, insurance companies, hospitals, or governments. The names and personal details of the transacting parties are fiercely defended against theft by those trusted institutions. Yet there have been well-publicized hacks that have caused data leaks and serious losses. Those systems are called centralized ledger systems.
Cryptocurrency transactions, by contrast, rely on what is called a decentralized ledger system (DLS). Instead of sensitive private information being kept on a single very tightly guarded central system (with a few tightly guarded backups), a decentralized ledger allows the information to be public, stored by everyone who wants to, on their computers, and their local or cloud-based storage devices.
How then can the information be protected against theft? The answer lies in cryptography, in particular the “digital signature.” No cryptocurrency transaction can take place unless the owner of the currency (who is identified only by constantly changing encrypted “addresses”) digitally signs it. No private information resides on the public database (known as the blockchain), so your private information, which consists only of your “private key,” cannot be stolen unless you reveal it yourself.
How does a digital signature work?
The answer is by mathematics. But I’ll explain it by analogy, using an event from my childhood. When I was a pre-teenager, I liked to play with a chemistry set that my parents gave me, and any additional interesting chemicals that I could get hold of. I would visit a Merck wholesaler in a warehouse in Boston, where a nice man would sell me my chemicals in bulk. This sounds amazing now, but it’s true.
I noticed once a recipe for invisible ink. You could create two chemical solutions, one I’ll call the ink (labeled K) and the other I’ll call the “revealer” (labeled R). If you wrote on a piece of paper with the ink you would see nothing, as if you had written with water. But if you wiped it with a cloth that was dipped in the revealer, R, what you wrote would become visible, as if you had written with real ink.
I was so excited about this that I bought a number of small brown glass bottles and mixed large quantities of the two formulas, K and R, then sold them to my classmates for 25 cents for a pair of bottles – a substantial amount at the time.
Before anybody besides me had the invisible ink (I’ll now call it my “private key”), I could have used it to securely sign documents. If I gave the revealer solution, R, to everyone else (my “public key”), then they would know when they revealed the signature that I was truly the one who signed, and not a forger, because only I had the invisible ink.
If you go on to assume that there are many, many secret formulas for invisible ink (Kj, j=1,…,n), each one uniquely paired with its own revealer (Rj, j=1,…,n), you can begin to understand how it is possible that many private-key-holding individuals can each sign transactions and be secure in the knowledge that their signature can’t be forged (as long as each one’s ink formula is kept private). Furthermore, they can do this without anyone ever knowing their real-world identity or personal information.
The huge theoretical advantages over centralized private ledgers
Anybody who has sent money from an account in one country to an account in another knows that it can be very expensive and a major hassle. There may be a several-day wait, or longer, before the money can be accessed by the recipient. If the money is sent to a country like Argentina, the wait may be longer, the hassle more burdensome, and the percentage loss of funds en route enormous.
But if you send the money in Bitcoin, or some other cryptocurrency, it happens instantaneously and with no hassle whatsoever. All that is necessary is to specify how much to send to the recipient’s current cryptocurrency address (typically an encoded string of 34 characters, but it can be done by scanning a picture of the equivalent QR code), and digitally signing. The recipient could receive the cryptocurrency funds almost as fast as an email arrives.
But isn’t this just play money? Don’t you need to convert it to real money in order to spend it?
The answer is “no.” An expanding number of mainstream companies are accepting bitcoin and sometimes other cryptocurrencies in payment, at least for some of their products, including Microsoft (Xbox live), Dish Network (satellite TV), Steam (online gaming), LOT Polish Airlines, Expedia, and Whole Foods (gift cards). Noting that amazon.com has just bought Whole Foods, if amazon.com decides to accept bitcoin in payment then the game may be over and bitcoin (and perhaps ether, another cryptocurrency) will go mainstream.
Money is, simply, money if it is accepted in payment for goods and services. And the signs are that cryptocurrencies are – and increasingly will be – so accepted.
Because everybody has a replica of the same database, the system is robust and doesn’t have to be defended against cyberattacks. The details of why this claim is true are extremely complex, but it makes sense and has stood the test of time. The “blockchain” – the decentralized ledger system on which Bitcoin and virtually all other cryptocurrencies are based – is un-hackable and immutable.
The weirdness of mining
To understand better how bitcoin and most other cryptocurrencies work, and the challenges facing it, one must understand the “miner” system, which verifies transactions, adds them to a new block of the blockchain, and creates new bitcoin (at least until 2040, when the maximum of 21 million will have been created).
If everybody has the same database but it keeps being added to by a consensus process, someone must take the lead to propose what the consensus should agree to add, or there will be chaos. The way the proposer in the Bitcoin system is determined is by a kind of weighted lottery or voting system. The lottery can’t be unweighted, with every node having an equal vote, because it’s too easy for someone to artificially create the semblance of a million or billion nodes – thus stuffing the ballot box.
The way Nakamoto proposed to weight the lottery was by means of something called “proof of work” – which means simply that each node owns as many lottery tickets as his or her computer has computing power, i.e. can prove that it can do work. The node – called a “miner” – that wins the lottery gets to create and keep the next pre-defined number of bitcoins that are to be created, and also collects fees offered by the transactors.
The work that a miner has to do to prove computing power and thus increase the chances of winning the lottery (for Bitcoin, one lottery is held approximately every 10 minutes) uses up a lot of electricity. This computing power competition has reached absurd levels, with gigantic banks of mining computers set up in places with cheap electricity (and the ability to keep computers cool), like Iceland.
Why has the price of cryptocurrencies in dollars been going up so much recently?
In the last two years, the value of a bitcoin - and the price of the second-most popular cryptocurrency, ether (associated with the blockchain system provided by the Swiss organization Ethereum) - has soared and crashed.
Why are the prices so volatile?
There are certain fundamentals to consider. The Bitcoin system guarantees that no more than 21 million bitcoins will ever exist. Just suppose, for a moment, that Bitcoin takes over from all other currencies and becomes the single global currency. The total global money supply is roughly around $60 trillion, depending on how you measure it. Therefore, if the global money supply eventually becomes measured in bitcoin, each bitcoin will be worth $60 trillion divided by 21 million bitcoin, or about three million dollars per bitcoin. Recently, each bitcoin has been selling for about US$45,000 (the price jumps around a lot). So a bitcoin still hypothetically has the potential to increase in value by another 120,000%.
Now, one problem is that if holders of Bitcoin expect its value to increase greatly over time, they won’t want to spend it. But its legitimacy as money depends on its being used and accepted as payment for goods and services. The fact that people are holding on to their bitcoin, perhaps trading them but not spending them very much, means bitcoin’s key reason for legitimacy may go too long unfulfilled. (There is another reason why people aren’t spending them much – but we’ll come to that.)
Nevertheless, the trend toward legitimization has seemed inexorable. Governments have been considering what to do about it and have mostly decided to take a benign approach. Japan legitimized bitcoin and ether by pronouncing them legal while announcing certain controls that will be instituted – of course, there are governmental controls impacting all currencies, so this is nothing unusual. Some governments are even experimenting with creating their own cryptocurrencies.
And if governments want to retain their macroeconomic levers in the presence of cryptocurrencies, the governments themselves may have to purchase large amounts of cryptocurrencies, much as China stocked up on U.S. dollars after the 1997 East Asian crisis in order to guard against future crises. If governments start to purchase Bitcoin or other cryptocurrencies in bulk, that may be the tipping point that pushes them toward widespread use.
Clouds approaching
However, bitcoin has been running up against scalability boundaries that have been there all along. The fact that all replicating computer nodes download the entire blockchain of transactions that have occurred since Satoshi Nakomoto created the first block means that the database gets bigger and bigger. And the upper limit imposed by Nakomoto on the size of a block of transactions has created problems and disputes about how to fix it.
The bitcoin system is flirting with its upper size limits – especially, the number of transactions that can be included in a block per second – so transactors, in order to persuade a miner to include their transaction in the block of transactions the miner is building, are having to offer bigger and bigger fees. This is another reason – besides the incentive to hold and not spend a currency that is increasing in value – why there is currently more speculation in bitcoin than there are transactions that actually use it to pay for goods and services.
This may be the main reason – in addition to the existence of many new cryptocurrency multimillionaires – why there have been so many “initial coin offerings,” or ICOs, of late. An ICO creates a “token” (effectively a special-use cryptocurrency) that may be purchased for bitcoin or ether in order to fund and participate in a new blockchain system – which may be one built on an existing blockchain system like Ethereum’s. An equivalence may be made between the token and bitcoin or ether. One of the hopes of a participant in an ICO is that the system it builds will make the privilege of using its token highly valuable, or it will perfect the blockchain, solving some of the problems that have been encountered by the Bitcoin system, and therefore the value of a token will increase.
Will the problems ultimately scuttle cryptocurrencies and the bubble will burst?
Cryptocurrency enthusiasts argue that this will not happen – and they may well be right. There are workarounds for Bitcoin’s limitations, and there are many other cryptocurrencies too. And you may be able to park your Bitcoin, relieving pressure on the Bitcoin system, while switching to another cryptocurrency for a while or carrying out certain transactions off the Bitcoin blockchain.
Furthermore, the blockchain system – and blockchain-like systems – have caught the interest of many mainstream companies, as a way to solve their problems of incompatibility of database systems maintained by interacting players in an industry, or just the messiness of their current systems.
The inexorable driver behind all of this is the phenomenal advance of computing power and storage predicted by Moore’s law. It is behind the trend toward widespread sharing, availability, and transmissibility of information that accounts for the success of companies like Facebook, Google, and amazon.com.
We have not seen the end of the surprises these developments have wrought. Cryptocurrencies are on the leading edge of this process. It’s a technology that is still in its early stages, and its wrinkles are being worked out, but it will not, I believe, be looked back on as a flash-in-the-pan that, like Betamax, disappeared. And if that is so, its potential for disruption is incalculable.
What should advisors tell their clients about cryptocurrencies?
Cryptocurrencies are not necessarily a wholly inadvisable investment, but they are highly volatile due to the uncertainty of the long-term viability of any particular cryptocurrency, as well as of cryptocurrencies as a whole.
However, if someone wanted to take a small percentage of their investment portfolio and use it to buy bitcoin and ether – and perhaps other currencies such as litecoin (but one should be very careful about ICOs) – I would not call it foolhardy. There is reason to bet they will increase in value, so it is not like betting in a casino or buying a lottery ticket, where you can only expect to lose. And there is no apparent reason to believe their price movements are correlated with the stock market or other assets, so they may add to diversification.
In some ways, investing in cryptocurrencies is like investing in art or collectibles, or even gold. Its scarcity may propel increases in value, at least for those cryptocurrencies that continue to have value at all. But cryptocurrency has the advantage of being much more easily used as a medium of exchange than art, collectibles, or gold.
What about using Bitcoin to buy things? If one is careful about keeping one’s private key secret and secure (or the “seed” to one’s sequence of private keys, but that’s another story), there’s no reason not to hold at least a small amount of bitcoin or ether and use them to buy stuff. It’s not going to hurt you.
Keep watching this space. The fun has only begun.
I am grateful to George Peacock for inspiring my interest and research in this subject, and to George Peacock and Leonhard Weese, President of the Bitcoin Association of Hong Kong, for comments on a draft.
About the Author:
Michael Edesess, Ph.D. is an accomplished mathematician and economist with a Ph.D. in pure mathematics in stochastic processes and expertise in the finance, energy, and sustainable development fields.
He is an adjunct associate professor in the Division of Environment and Sustainability at The Hong Kong University of Science and Technology, managing partner / special advisor at M1K LLC, and a research associate of the EDHEC-Risk Institute. He is author or coauthor of two books and numerous articles published in Advisor Perspectives, MarketWatch, The Wall Street Journal, Financial Times, South China Morning Post, Bloomberg, Nikkei Asian Review, Technology Review, and other publications, and was previously a co-founder and chief economist of a financial company that was sold to BNY-Mellon. He has chaired the boards of three major nonprofit organizations in the fields of energy, environment, and international development.