Bitcoin update – Q3 2017

October 23, 2017

It has been an eventful year for cryptocurrencies. The most prominent, Bitcoin, has been lodged in a battle between its stakeholders for consensus on which direction to take the software. More recently, Chinese regulators have clamped down on the use of cryptocurrencies in a move to reduce domestic financial risk. Starting with the banning of initial coin offerings, a method for cryptocurrency fund raising, they have since followed with a move to shutdown exchanges, ordering the wind down of trading activities over the last few weeks. Since the closures, executives of these exchanges have been banned from leaving the country so they may cooperate in the ongoing clean-up process.

This news led to a significant collapse in the value of such currencies, with Bitcoin falling from $5,000 to $3,000 over the course of two weeks as reports were confirmed. The response since then has been muted, with a modest rebound and many citing the impact to the currency short-lived. The currency still trades at below $4,000 today.

This is not the first time Bitcoin has been this volatile, however, there have been numerous corrections in recent years. Two in 2013, following its explosion into the mainstream as rising media attention and an expansion in available exchanges saw prices soar before falling back by over a half, in both instances. Not soon after, 850,000 Bitcoins were stolen in the hacking of the Mt Gox exchange triggering another 50% fall. Still, the price has more than trebled since the pre hack high.

Today the value of the 10 largest cryptocurrencies surpasses $100 billion and Bitcoin has around 50% market share. It is an astonishing amount for something, which seemingly has no inherent value, but we must be careful not to misunderstand how this value is derived and what that means for this as an asset.

At its core a cryptocurrency’s value is derived in the same way to that of a Fiat currency, money that a government has declared as legal tender and is not backed by a physical commodity. The value of such money is a consequence of the relationship between supply and demand and based on the faith and credit of the economy it services. Essentially, the value of cryptocurrency is whatever the participants agree it to be.

Beyond the coins themselves lies the software. This forms a decentralised ledger of transactions known as the block chain, which is verified and stored by the network as a whole. The cooperative nature aims to create a system that is secured against pinpoint errors, manipulation or fraud. Verified transactions are considered secure, because breaching the only transparent weakness requires a battle against the processing power of the network as a whole. There is value in this system as an alternative transaction management system to those that are currently used within our banking system.

There is also cost as a valuation metric. With all the processing power required to verify transactions, activity known as mining, there is an inherent transaction cost. Miners are, at this time, rewarded for mining by receiving partial Bitcoin amounts and over time the network has grown significantly in terms of its processing power. Alongside the cost of the hardware required to mine Bitcoins, energy is required to keep these machines running.

In addition to the raw infrastructure provided by the miners, there is value in the network as a user base, possibly similar to a social media network, after all, transactions require participants who use the same currency, much like a conversation requires a shared language. Finally, there is an overwhelming element of scarcity. The economist’s pure explanation of how value is created may provide some with support to rising prices. The maximum number of Bitcoins that will be created is 21 million.

If its participants decide the value of Bitcoins, it is easy to see why the value should increase; they most likely all benefit from a rising price. As it is a relatively young product, most of the flows are inward as enthusiasts hold onto their currency and the user base expands. Unfortunately, the value arguments above are subject to the same problems that surrounded oil a decade ago, “The price will keep rising… until it doesn’t”.

There is scope for any of these factors to disappear completely, rendering the currency worthless. The network of users disappear, enthusiasts lose interest, miners stop mining. Once the value starts to descend, there is increasing reason for any of these stakeholders to head for the exit, and the spiral turns on its head.

Couldn’t this argument be made for any currency? Well there are some parallels but it is important to consider the overall package. The governments that back currencies have created institutions and concrete infrastructure. They include bulging public sectors that provide support to the economy and its citizens and are geographically bound to their nation. It may require some true communal infrastructure for cryptocurrencies to represent a long-term store of value, but, by nature, they are decentralised and the network only connected by the transactions themselves.

What’s more, when something goes wrong, there is no one to call for help. You cannot recall an incorrect transaction, there is no fraud department, there is now way to recover a private key so, if lost, you may squander access to any Bitcoins associated with it. Could the biggest attraction of cryptocurrencies be its most significant weakness?

It may not matter for the time being. One of the strengths of the currency is the flexibility in the systems that manage it. Changes are constantly being proposed, accepted, rejected, improved and proposed again. While this year has seen some disparity in views, resulting in the soft fork (split) of Bitcoin Cash, effective solutions will inevitably be agreed upon and drive the innovation forward.

There are over a hundred cryptocurrencies now, each with their own merits and some argue that there are already better alternatives to Bitcoin. Like the radio and lightbulb, the original may not be the greatest success. Through these alternatives, there seems to be no limit to the availability of cryptocurrency units themselves, so the true value surely lies in the nature of the concept itself, the block chain, and this is open source intellectual property.

This may be why the most recent events in China should be so concerning. It has been said that banning Bitcoin would be like trying to ban the internet, and this is true, but if our regulators begin to dissuade its use, the populous may be deterred, and if that marks the end of the rapid expansion, it may also mark the end of soaring prices. While existing cryptocurrencies will likely remain, they may be best treated as currencies alone; used to facilitate trade between sellers and buyers. Investors beware.

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