July Newsletter: Cryptocurrency takes off

Posted by Alex Frey (@alexhfrey )

Bubbles, speculation, fiat currencies, the Federal Reserve, and the nature of money and assets. These and more are some of the tantalizing reasons we couldn’t resist talking about bitcoin way back in 2013 (the last time it was going through a speculative mania), and why we again can’t help but take the bait today.

So let’s back up a bit… In some circles, bitcoin and cryptocurrency have become big news. The reason for the excitement (OK, the excitement is really limited to a small group of people… but we are among that small group...) is shown in figures 1 to 3. They show how the price of three cryptocurrencies has varied over the last few years. The price of the oldest, bitcoin, has gone from near zero in 2010 to a high of around $3000, before falling to $2000 before publication of this article.   

The total market value of all existing bitcoins is about $39 billion, making bitcoin equivalent to some S&P 500 companies (though still less than 1% of the total value of gold in the world). If you had invested $100 in bitcoin in February of 2011, you would have about $250,000 today. Of course, you probably weren’t aware of bitcoin’s existence in 2011; and if you were, you probably didn’t invest. Neither did we.
So are cryptocurrencies a good investment today? Some people obviously think so. Per CNBC, Tom Lee of Fundstrat thinks the price of bitcoin could reach $20,000 to $55,000 by 2022. Others have also made bullish predictions.

One
Figure 1: The price of one bitcoin in U.S. dollars

Two

Figure 2: The price of ether (the currency associated with ethereum) in U.S. dollars.

Three
Figure 3: The price of litecoin in U.S. dollars. 

To consider what the future might bring, let’s go back to the beginning and start by describing what a cryptocurrency is. The original cryptocurrency, which showed the way for the others, is bitcoin. It was created in 2009 by Satoshi Nakamoto, who is considered by many to be a genius. The name Satoshi Nakamoto is pseudonymous, and while there are speculations, no one knows definitely who he or she is. It’s even possible that Nakamoto is actually a small group. 

What did Nakamoto create? As motivation it’s important to think a bit about the nature of “assets” in an increasingly digital world. To put it more concretely, what does it mean to own something? For thousands of years the only “things” to own were tangible things like gold, land, or food-stores that one had to keep in his or her possession at all times. Then we moved to “banks” that would store and hold valuables like gold for us and issue certificates, which came to be traded as currency. Then, central banks took over the function of issuing currency. At first the currency was backed by gold, but now it is just backed (in the U.S.) by the good intentions of the Federal Reserve System. Now the currency is largely digitized, and we ended up in the situation we are today where the vast majority of “money” is simply digital bits stored on computer systems. 

The realization that most money is already digital raises an interesting question: who safeguards those bits and prevents you from stealing mine, or from simply creating your own bits out of thin air? And who validates that if I pay you for something, the bits are actually real and correspond to real money? The answer is that the sanctity of the system is upheld by trusted third-parties like banks, and the ACH (automated clearing house) system ultimately managed by the Federal Reserve. These entities maintain the central ledgers or databases that hold the official record of who owns what. 

While it’s certainly worked well in many ways over the years, this system has a number of potential limitations. For one thing it concentrates security risk in third parties. Were key banks or financial institutions to get “hacked”, the consequences could be severe. For another thing, it concentrates power in the hands of the trusted intermediaries, enabling them to “charge rent” on transactions (which to some extent would include credit card transactions, debit card fees, ATM fees, and personal transfer fees). It also complicates things for dealing with international payments, since there needs to be a system for the trusted intermediaries in one countries’ banking system to deal with those of another, and this usually creates delays and an additional layer of fees. On a more abstract level, it gives entire control of the maintenance of currencies to governments, who through their central banks can create additional currency units with the click of a button – even more efficient than in the days when they literally had to use printing presses. 

Nakamoto’s genius in establishing bitcoin was in figuring out how to transfer ownership of a “digital asset” from one person to another in a secure matter that does not rely on any trusted third-party, but is instead verified through the “network” of participants in the currency. The crucial piece is the “blockchain”, which is a persistent store of all transactions in the currency’s history. The blockchain enables each participant (known as “miners”) in the currency to verify the accuracy of any transaction prior to accepting it, with no need for banks, governments, or the ACH. With this innovation, it was possible to create a kind of stateless money – a “digital gold.” 

A comparison is illustrative. In our present system, when you buy something with conventional currencies, you generally present your credit or debit card (or perhaps just the card number) to a vendor. For simplicity, let’s say it’s a debit card. The vendor sends your card information over a network to your bank. Your bank verifies that you have the needed money, debits your account, and transfers that amount to the vendor’s bank, which credits it to the vendor’s account. If the transaction is international, there may be another step which involves exchanging one currency for another. The transaction depends on the assistance of the banks and a credit or debit card network, and the banks must be trusted to maintain the proper balances for each customer. All of this typically costs between 1.5% and 2.75% of the transaction value, or a little more if more than one currency is involved. 

With bitcoin, in principle, this transaction could be accomplished by transferring bitcoins directly from you to the vendor without the intervention of any third party. The vendor can be sure that you actually have the required bitcoins, and you can be sure that the vendor’s account actually gets the bitcoins that you sent. Further, both you and the vendor could remain anonymous (within some limits) if you desire. You and the vendor could even be on different continents. 

We won’t discuss how this works in any detail, but we will give you a brief synopsis. More information can be found in reference 1, a very short book on this topic. Bitcoin depends on a network of computers (called nodes) that are distributed around the world and are independently owned and operated. Anybody can down load the bitcoin software and start running a node. They all run the bitcoin code, and collectively they maintain a ledger of every bitcoin transaction that has ever occurred (the previously mentioned “blockchanin”). Bitcoin users can submit transactions to transmit their bitcoins to other users and can receive bitcoins via transactions submitted by other users. The ledger keeps track of the bitcoin balances for each user. 

Every user of the network has a public key, a private key, and a unique address, all of which are just strings of computer characters. The public key is known to everyone on the network, but the private key is only know to the user. The address is derived from the public key and identifies a user, but the user’s name need not be disclosed. To send bitcoins a user will use his private key, which only he or she knows. The ledger itself, called a blockchain, is totally public, and all transactions can be seen by all users (but in general the users don’t know what name is associated with an address). By a clever used of public key cryptography and other concepts, this network assures that: 1) bitcoins can only be spent by the person possessing the associated private key; 2) transactions that have been submitted to the network cannot be altered; 3) once recorded in the blockchain, the record of transactions is fixed and cannot be altered; 4) a dishonest node will be discovered and suppressed by other nodes on the network. The network, which is not controlled by any one person or company, performs the functions that banks and credit card networks perform in the conventional system, and bitcoin replaces conventional currency as a medium of exchange. 

It is important to realize that bitcoins exist as only entries in the blockchain. They never exist in physical form such as paper currency or coins.
The operators of nodes are called miners. We are leaving out some important factors here, but in essence miners are rewarded for their work by receiving a small number of bitcoins that are created each time a block of transactions is processed. They may also receive a fee from the person submitting a transaction. Miners can choose which transactions to include in a block, and they will choose those that are offering a fee first, so those transactions will be processed faster. The only way that bitcoins get created is by the rewards given to miners, and these are scheduled to decrease with time so that the total number of bitcoins is limited to 21 million. When no more bitcoins are created, miners will be rewarded with user fees only. 

Bitcoins are not backed by gold, by any commodity, or by any national currency. So why should they have any value? They have value only if bitcoin becomes a useful medium of exchange or if people come to view them as a useful store of value. So why might they become a useful medium of exchange? Let’s look at some possible reasons:

1) Reduced costs. In principle, bitcoin transactions could be cheaper than the fees charged to merchants for credit card or debit card transactions (which while not paid directly by the consumer, still drive prices higher). Figure 4 shows the average fee that has been paid by users over the past few years. Remember, a user fee is optional and users pay the fee to get the miners to process their transaction quicker. Prior to 2016, user fees were negligible, but in 2017 they spiked to a peak of over $5 per transaction. This occurred because the number of transactions was approaching system limits, and users had to offer a fee to get transactions processed. At $5.00 per transaction, only rather large transactions (more than about $250) are cheaper than using a credit card. There is another way of looking at cost that makes bitcoin look worse. Figure 5 shows the total remuneration to miners, including the value of the bitcoin reward that they currently receive. It shows that miners are currently receiving about $19 per transaction, most of which comes from the bitcoin reward. When the bitcoin reward stops, miners may expect that similar remuneration from user fees. In this case, the profitable use of bitcoin would be limited to large transactions. Another factor to consider is that users will probably pay a fee for transferring conventional currencies into bitcoin and back again. At Coinbase, this fee is currently about 1%.

Four
Figure 4: Average bitcoin transaction fee (source: bitinfocharts.com)

Five
Figure 5: Average miner remuneration including the value of bitcoins awarded (data from blockchain.info). The data has been smoothed.

2) Anonymity. Some users may like the fact that their identities can be hidden. Of course, for society as a whole, it is not certain that this is in fact a benefit. The users who care most about hiding their identity may be drug dealers, porn sellers, terrorists, and the like.

3) Security. The basic bitcoin network seems to be very secure. As far as we know, no one has ever been able to commit fraud on the bitcoin network by altering a transaction or impersonating someone else’s identity. It’s reasonable to presume that many have tried. However, at the individual rather than network level, users must keep in mind that security depends on keeping their private key secret. If a thief gets a user’s private key, the thief can spend the user’s bitcoins, and there is no recourse. Note that this is very different from the credit card world. Also, if a user loses his private key, his bitcoins are lost. Again, there is no recourse. Users may store bitcoin at a third-party wallet provider like Coinbase in order to minimize these personal risks – but at this point they are back to trusting a “trusted third party” (Coinbase) to some degree. 

4) Minimization of currency exchange costs. If bitcoin becomes generally accepted around the world, currency exchange costs could be minimized. Visa charges many accounts 2% for foreign currency exchange. If people are willing to store their funds in the form of bitcoin, this fee could be eliminated. Even if they want to convert back to their national currency, the rate for exchanging bitcoins is considerably less than the rate for exchanging conventional currencies. 

5) Decentralization. The bitcoin network is not owned or controlled by any national government, company, or group. Many people regard this as a great advantage for philosophical reasons, but it also has practical benefits. It means that there is no centralized point for attacker to attack, and if one node is disabled for any reason, the rest of the network can continue working. The network can be always up and always running even though individual nodes may go off line. 

6) Automatic Monetary Policy. Normal (“Fiat”) currencies are controlled by states, which have the ability to both borrow money in their own currency, and to print money. This creates the incentive for states to “inflate” their currency, which can make state-sponsored currencies a poor long-term source of stable value. Bitcoin, by contrast, comes with a pre-ordained supply limit, making it a potentially more suitable vehicle for a store of long-term value (or a hedge against governments inflating their own currencies). 

How useful is bitcoin as a store of value? The fact that the number of bitcoins is limited to 21 million has led some people to call them digital gold. As we hinted at above, bitcoin could have value for the same reason that gold has value: the supply is limited and it can be used as a medium of exchange. In fact, it is more practical to use bitcoin as a means of exchange than gold, due to gold’s inherently physical nature. Thus bulls could argue: bitcoin is 21st century gold for a globalized and digital world economy. 

How should we then think about the value of bitcoin? Gold is no longer used as a medium of exchange, and this could give bitcoin an advantage. If any significant amount of world commerce were conducted in bitcoin, the demand for bitcoin could push the price much higher than it is now. Everyone engaging in bitcoin commerce would need a small stock of bitcoin, and this would create demand. If all the commerce in the U.S. were conducted in bitcoin (VERY unlikely), the total value of the bitcoin would have to be something like the current value of demand deposits plus cash in the U.S., which would give a bitcoin price in the vicinity of $170,000. And, this ignores international commerce. So if bitcoin were ever generally accepted, its value would soar. 

But it’s important to note that is not happening today. Per Blockchain.com, the number of bitcoin transactions per day has varied from about 180,000 to about 369,000 in 2017. That’s a lot of transactions, but it is much less than the average number of Visa transactions per day, circa 150 million. A number of regular merchants are now accepting bitcoin, but we suspect that the biggest usage comes from financial transactions (people buying and selling for speculative gains), with black-market transactions coming in second. Suffice it to say: people are generally not walking to the store and paying with bitcoin – and we candidly doubt they will anytime soon. 

So what are the negatives for bitcoin? There a quite a few in our opinion:

  1. Competition. Bitcoin was created from nothing, and competitors to bitcoin can also be created from nothing. Ether (the currency of the Ethereum system) and Litecoin are examples of competitors that already exist. At the moment, the total market value of bitcoin is more than any of its competitors, but ether is catching up. Assuming that any cryptocurrency achieves broad acceptance, it is likely that users will converge on only one or two cryptocurrencies. The currencies that don’t win the acceptance derby may become worthless. Bitcoin has a slight first-mover advantage, but there’s no guarantee it will come out on top. 
  2. Security. This was listed as an advantage of bitcoin, but it could also be a disadvantage. Credit and debit card users have some recourse if their cards are stolen or lost or if a merchant doesn’t deliver promised merchandise. Bitcoin users have no recourse if they lose their private key or if a merchant doesn’t deliver what he promised. Also for convenience, many bitcoin holders use a service such as Coinbase to hold their bitcoins. Coinbase has never had a problem that we know of, but another bitcoin exchange, Mt. Gox, did have a problem. They lost several hundred thousand bitcoins and had to declare bankruptcy. As far as we know, the bitcoin owners recovered nothing. Further, one has to question whether the bitcoin blockchain is really totally secure. Changes in the software have been made in the past and will probably be made in the future. Changes could lead to bugs that a nefarious node could exploit. Finally, there is a well-recognized vulnerability to a “51 percent attack”. If a nefarious group ever gets control of 51% of the computing power on the network, they could subvert the honesty of the system. 
  3. Scalability. At the moment, the bitcoin network is limited to about 7 transactions per second (maybe less in practice). This is clearly inadequate to handle any significant fraction of world commerce. There are proposals to modify the code to increase the transaction rate, but they can only be made if a significant majority of the bitcoin miners agree. To date, there is no agreement on how to proceed.
  4. Governance issues. For many people, the strength of bitcoin is that it is a delocalized system that is not controlled by any government, company, or person. However, this leads to problems when decisions have to be made about alterations in the code. The scalability issue illustrates this, but other questions are will undoubtedly arise in the future.
  5. Government interference. Government has a legitimate need to limit money laundering in support of drug dealing, human trafficking, porn, and the like. Government also has a legitimate need to stop money exchanges in support of terrorism. Further, governments like to have control of the money supply in their nations so they can adjust the money supply to economic conditions. In the U.S., this is managed by the Federal Reserve System. For all these reasons, governments may put regulatory roadblocks in the path of bitcoin or may outlaw it altogether. We think some regulation is almost inevitable, and this will increase the cost of using bitcoin and may cancel its benefits.
  6. Tax issues. In the U.S., the Internal Revenue service has said that bitcoin is a property, not a currency. So, when bitcoin is bought or sold (or when merchandise is bought or sold using bitcoin), profits or losses occur and must be accounted for on tax returns. This creates accounting problems for people who are using bitcoin as a currency

We haven’t yet said anything about other cryptocurrencies. Ethereum is a new blockchain network that is designed to handle many different kinds of decentralized contractual applications, not just a currency. It has received support from some major corporations, such as Microsoft. Ether is the currency intended to work with Ethereum. Unlike bitcoin, the number of ethers is not limited, but the rate of production will gradually decrease with respect to the total issued. Litecoin is advertised as having as being similar to bitcoin, but it has a faster processing rate and other technical differences. There are also other cryptocurrencies.

So having said all of this, what do we think of cryptocurrency as an investment opportunity? We often conclude newsletters like this by saying that we believe in diversity and suggesting that a small commitment is appropriate. But, at this point we see cryptocurrency as being too speculative to recommend as a piece of your long-term “lockbox” portfolio (never mind that there is currently no ETF option). Cryptocurrency is not included in the IvyVest model, and we doubt that it ever will be, but as a “sandbox” speculative play, we don’t think you would be crazy to invest an amount of money you can comfortably afford to lose in a portfolio of ether and bitcoin. We aren’t sure what the currencies will do in the very long term, but in the short to intermediate term we think there is a good chance that the world will become more enamored with them than less, and that the price will consequently go up further (though you might want to wait for things to calm down a bit before investing…).

We should close by commenting that as we were writing this, the price of bitcoin dropped from about $2500 to about $2000. Is this the bubble bursting? Probably not. Bitcoin has had significant ups and downs in the past. But, if you chose to invest, be ready for a wild ride. 

References:
1) Chris Clark, “Bitcoin Internals: A Technical Guide to Bitcoin”, 2013.
2) Paul Vigna and Michael J. Casey, “The Age of Cryptocurrency: How Bitcoin and Cryptocurrency are Challenging the Global Economic Order”, Picador, 2016.


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By Alex Frey