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This is part one of a comprehensive primer on cryptocurrencies and blockchains that reviews a large sample (over 50 sources) of recent information from International Monetary Fund (IMF) and Goldman Sachs reports to cryptocurrency ‘expert’ analyses to crypto-industry updates. It distills all of the relevant information into one template that you can use to understand the arena, make crypto-investment decisions and advise your clients. Part two will focus on the risks of the new technology as well as how to invest, plus an update on the current state of the crypto markets. The focus now is on understanding digital currencies, blockchains and digital ledger technology (DLT) in the context of value, advantages, and returns.
Gold was discovered in California in 1848 leading to the largest land migration the world has ever seen. The next ‘gold rush’ may be under way but the migration is to a new technology of trust. Cryptocurrencies, like Bitcoin, Ethereum and Litecoin, are digital currencies based on blockchain technology that have exchange value with fiat currencies. According to Coinbase, a large crypto exchange, there are currently more than 800 cryptocurrencies worldwide. The top 10, including the above, account for most of the capital.
Bitcoin, the first cryptocurrency, came into being in January 2009 when someone, under the pseudonym, Satoshi Nakamoto, launched an online mathematical algorithm, now known as a blockchain, with the potential of providing anonymity and security to its users. The market capitalization of Bitcoin today is over $40 billion. All cryptocurrencies are valued at over $100 billion. According to Aswath Damodaran, a professor of Finance at the NYU Stern School, one dollar invested in Bitcoin at the beginning of 2012 was worth $1,026 on July 29, 2017.
According to Goldman Sachs in a recent published study, “Today, transactions are verified by a central authority – like a government or a credit card clearinghouse. Blockchain applications could replace these centralized systems with decentralized ones, where verification comes from the consensus of multiple users.” According to a recent Wired article, Bitcoin’s promise is that it can supplant national currencies and financial institutions and execute seamless financial transactions. According to Don Tapscott, a University of Toronto adjunct professor, business executive, author and speaker, it is the technology most likely to have the greatest impact on the next few decades – not social media, not AI, not robotics, but the underlying technology of digital currencies called the blockchain.
Still, contrary reports abound. According to Brett Arends of Marketwatch, China’s recent regulation of cryptocurrencies may be the first move that will reverse their upward trend. According to a recent Los Angeles Times column, in spite of its recent rise close to $5,000, Bitcoin is still a “dumb investment.”
Legendary investor Howard Marks initially came out with a negative report on Bitcoin, but recently has said that his view is evolving. According to a writer for Forbes, “There is no blockchain dot.com-style stock market frenzy yet, but it will come and understanding it will be very valuable.”
On understanding cryptocurrencies, blockchains and DLT
According to a 2016 Stanford study, “Even defining Bitcoin is complex: it can be described as a protocol, a currency, a payment system, and a technology platform.” Crypto-currencies, also known under the larger set of digital or virtual currencies (one example is airline miles), are built on blockchains and fulfill a loose definition of ‘money.’ They fulfill at least two of the three primary requirements of money, store of value, and medium of exchange. They may or may not complete the third requirement, unit of account, but that is changing fast. According to a 2016 IMF report they also do not meet the legal definition of money, that is, they are not yet accepted by sovereign governments. That is also changing.
Cryptocurrencies are organized around an online digital technology known as blockchains. Blockchains are essentially a digital record that rely on the implementation of ledger additions within a widely circulating digital chain for security. According to an SEC Investor Bulletin in July 2017, “A blockchain is an electronic distributed ledger or list of entries – much like a stock ledger – that is maintained by various participants in a network of computers.”
According to a recent study by Goldman Sachs, blockchains are “the new technology of trust.” According to Goldman, “Blockchain has the potential to change the way we buy and sell, interact with government and verify the authenticity of everything from property titles to organic vegetables.” Blockchains are the foundation for Digital Ledger Technology (DLT), one specific application of a Blockchain. If a blockchain is a brick, DLT is the wall or the house. DLT’s can be configured in open or closed (permissioned) systems. Blockchains and DLT have the potential, not only to activate cryptocurrencies, but to transform financial services and other industries. For example, applications like Blockstack could change the way we use currently use Apps. All of the over 800 active cryptocurrencies, including Bitcoin, Ethereum and others are built on blockchains.
Why is a blockchain a blockchain? Because it is a cryptographic chain of digital blocks containing multiple online or computer transactions that have occurred within short time intervals. These blocks contain gathered and ordered data. Bitcoin’s blockchains occur about every ten minutes. Ethereum blockchains reoccur in twelve seconds, using something known as a Ghost Protocol. Operators known as miners then place this block of transactions into the digital ledger (they generate a seal using a mathematical algorithm called a ‘hash function’) and send it on to other ‘miners’ for validation (called ‘proof of work’). The entire digital ledger consists of a chain of these transactional, secure digital ‘blocks.’ Thus, blockchain and DLT.
Initial Coin Offerings (ICOs) occur within a single cryptocurrency when a newly independent blockchain is formed within that currency. They are generally used as a means of funding the new development and the tokens that are created can be exchanged for the cryptocurrency, be it Bitcoin, Ethereum, or whatever. One source describes it as the cryptocurrency equivalent of an Initial Public Offering (IPO). The difference is that ICO’s are not regulated unless the tokens offered are considered securities under the law. Ethereum has multiple ICO’s that have resulted in capital inflows that have resulted in increased value.
According to Dr. Gavin Wood, Ethereum Co-Founder, Bitcoin is first and foremost a currency, but that is only one application. He makes the analogy of email as one use of the internet; as email is to the internet, various applications are to blockchains. Ethereum has developed one such application, Smart Contracts. According to Goldman Sachs, “A smart contract is a piece of computer code that describes a transaction step by step.” Once set up it can automatically execute contract conditions and payouts.
Sally Davies, Financial Times (FT) technology reporter, reiterates this view, elaborating that blockchains are a “big electronic system, on top of which you can build applications. Currency is just one." According to Goldman Sachs, “Because blockchains establish trust, they provide a simple, paperless way to establish ownership of [anything] – like concert tickets.”
Ethereum is a venture started in 2014 off of Bitcoin that MicroSoft, Intel and JP Morgan support. Though Bitcoin was the first, subsequent cryptocurrencies like Ethereum have added other applications to currency. Polybius, a crypto-bank start-up, is one example. Goldman Sachs, Banco Santander and Morgan Stanley have split off from Ethereum to form their own version of a blockchain. According to Ronnie Moas of Standpoint Research, “Currently, Ethereum has a significant lead in blockchain development and innovation.” According to Moas, many investors are speculating that Ethereum’s market cap will exceed Bitcoin’s by sometime in 2018.
Other celebrities and high-net-worth investors are getting into the game. According to a recent LinkedIn article, Mark Cuban recently joined the ranks of those involved in cryptocurrencies, supporting a new crypto-start up. Increasingly, savvy investors believe in the value. Why?
On value, intrinsic or otherwise
According to some, cryptocurrency has no intrinsic value (some economists speak of ‘subjective value,’ not intrinsic value); but, neither does a dollar bill or any other currency. The ‘intrinsic’ value of either is primarily in the faith of the holder in the issuer, and its historical value in exchange for services, goods, or other currency.
Bitcoin, or cryptocurrency, is designed to reward miners for their ‘hash functions’ in a specific currency, which creates a community that exchanges that currency (for more, see here). A community of exchange anchors value, but future community actions must build on it. According to Frankenfield in, Do Cryptocurrencies Have Intrinsic Value?, “If a cryptocurrency is going to overtake a paper currency, it will have to be a more efficient medium of exchange than paper money, while continuing to deal with the problems of trust and reciprocity.”
A Securities Exchange Commission (SEC) statement is a great clue as to its general value relative to fiat currencies: “Unlike traditional currencies, Bitcoin [cryptocurrency] operates without central authority or banks and is not backed by any government.” This perceived separation appeals to those mistrustful of governments and traditional institutions and is part of the reason for cryptocurrencies’s rise.
According to Professor Aswath Damodaran, the cryptocurrency that has the brightest future is the one that thinks about itself “as a transaction medium, and acts accordingly.” There are three primary sources for acquiring cryptocurrency. One, business transactions, two, mining, and three, retail exchanges. Each method injects value and money into the system. The more that money flows in, the more the price rises. The value comes not only from potentially anonymous transactional exchange, but from the future expectation of how blockchain and DLT will simplify and speed up transactions and provide secure and cheap global exchange.
An additional way of acquiring cryptocurrency is by providing capital for ICO’s in exchange for tokens, which also may raise the value of the token-related cryptocurrency. Ultimately, though, the value of a cryptocurrency comes from supply and demand, plus (in some cases), the finite amount of coins issued. Bitcoin, Litecoin, and Classic Ethereum discourage inflation by limiting the total number of coins that can exist to a finite number. Bitcon’s finite number is 21 million. Litecoin’s finite number is slightly higher.
In a general way, cryptocurrencies are to blockchains and DLT what a stock is to a company, or what a fiat currency is to a nation. Their value is a market’s determination of the nature of that relationship and how much it is worth. The difference is that a cryptocurrency is not exactly stock – it is a little more like buying the product of a company than shares in the company itself.
Cryptocurrencies are like stock in companies in that they are an investment in the future of a technology – blockchains and DLT. Though a generalization and perhaps an overstatement – for the present – cryptocurrencies like Bitcoin might be categorized more like fiat currencies. Cryptocurrencies like Ethereum have utility beyond mere exchange because of the manner in which they apply DLT.
Further value is created by potential advantages.
On the advantages of use
The advantages of cryptocurrency are: ease; speed; decentralization; and, theoretically at least, anonymity. Add to these lower fees or costs, especially those associated with global transactions, and reduced administration and transaction fees. Lastly, there is no need of financial institutions or of government – supposedly.
It remains to be seen whether these last two advantages will hold. Though theoretically there is no need of a bank, retail investors who acquire cryptocurrencies will need to use exchanges, and exchanges will require the same security needs and likely be subject to similar regulations as a bank, even if fees are lower. Governments will always attempt to play their hand through regulation.
Japan and Switzerland have both legalized cryptocurrencies. Ethereum was developed in Switzerland, and Japan was one of the first nations in the consortium. China and Singapore are investigating national digital currency, and the latter is involved with the development of Ethereum. As more nations come on board, and a regulatory framework is finalized, advantages of using cryptocurrencies could increase or decrease. However, in such a nascent industry, the former seems more likely – but only as long as regulation remains limited.
On comparisons to gold and silver
According to Damodaran, due to their lack of trust in government and authorities, “There can be no denying that the creators of Bitcoin and Ether were trying to draw as much inspiration for their design from gold, as they were from fiat currencies.”Bitcoin has been called the “gold” of cryptocurrency because it was the first, it must be digitally ‘mined,’ and it has a limited supply of coins. In terms of market capitalization it is also the largest at present. However, though Bitcoin presently has a limited supply, Bitcoin protocols could be changed in the future to allow a larger supply.
Litecoin has been called the “silver” of crypto-currency. It also has a limited supply, though higher than Bitcoin. Ethereum Classic, a recent split from Ethereum, has capped their supply at 210,000,000, while Ethereum has no cap at present.
Unlike gold and silver, which both have limited natural supply, utility, and desirability, fiat and digital currencies are only backed by the continued faith of those who use them. The bottom line is that all cryptocurrencies are like fiat currencies in that they are primarily supported by a system of historical exchanges (in crypto’s case, only since 2010) and value that has taken place over time and by the integrity of the nations and the communities that use and affirm them.
Gold and silver will always be essential in a complete portfolio as insurance for economic catastrophe. Depending on one’s intent, cryptocurrencies are either a speculative bet on, or an investment in, the future of a new exchange medium and a new technology.
On returns
According to Michael Lebowtiz, since Bitcoin started trading in July of 2010 its value has risen over 51,000%. There are those who invested $50,000 in Bitcoin a few years ago who have seen it grow to $2,000,000 today. The two-year gain as of late August 2017 has been 1870%.
According to Ronnie Moas of Standpoint Research, in July of 2017, investment in select cryptocurrencies could bring returns of 12x within the next decade. A 1200% gain is a conservative estimate based on 1% of global assets moving into the space.
Another analyst – who predicted that Bitcoin would hit $2000 – has a 2027 target of $100,000 for Bitcoin. Moas’s target on Bitcoin in late July was $50,000 by 2027. That assumes 28% compounded annually for 10 years.
If either of these scenarios unfold, Bitcoin, and cryptocurrencies, could be the best investment of the next decade. However, even Moas, one of the recent spokesmen for crypto’s on business channels like CNBC, expresses caution and states there are numerous risks. What could go wrong?
Part Two of Is This The Best Investment Of The Next Decade? will address the risks and challenges of this new and still developing technology and examine the present state of the markets and some of the opportunities for investment.
Seaborn Hall, AIF, has a degree in management from Georgia Tech, two masters degrees, and has studied at the doctoral level. Formerly he was a Regional Director at a national top-50 RIA; he currently manages a family investment company, writes, and publishes the Common Sense Interpretation Websites. He currently owns positions in Bitcoin, Ethereum, and Litecoin. This report should not be viewed as investment advice or a recommendation. It is for informational purposes only.
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