Cryptocurrencies and what to do about them

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By Pavan Muzumdar, CFA

When you look up the definition of the word “Currency”, there are two themes that become apparent immediately: the first is that it is a medium of exchange, and the second is that it is generally accepted in the present by a large enough number of people. These two elements must be present for anything to be a currency of any value. This is fundamentally true of the US Dollar and is also why most readers of this article will have most of their wealth in assets denominated or measured in US dollars.

A crypto-currency is no different in concept, but vastly different in execution. While the US Government ultimately controls the dollar, most crypto-currencies are not controlled by any central agency. In fact, most crypto-currencies are more like gold, than a currency issued by any country. Let’s see how.

First, a primer on ‘why gold’

A few years ago, one of my favorite shows, Planet Money, put out a very nice podcast investigating why gold became the historically accepted medium of exchange across multiple civilizations spanning the continents of earth. Their conclusion was that gold was one of the few naturally occurring metals that was rare but not too rare, stable, safe, nice looking, easy to make into coins, hard to fake, and easy to transport that made it a great candidate for a currency.

The central point here is that gold remains valuable because there is a limited supply of it in the world and making new gold, i.e. mining it, is an expensive activity and most people of the world accept its value. National Geographic in 2009 reported that throughout history only 161,000 tons of gold has been mined by humans. That’s enough to fill two Olympic sized swimming pools and one of those pools would have been filled just in the past 50 or so years. All the easy to access gold has already been extracted and any new gold, by some estimates about 2% annually, is costly keeping the value of gold high.

In fact, of all the metals naturally occurring on earth, gold is the Goldilocks material – no pun intended – that fits the bill as a global store of value, i.e. a currency. So much so, that it was only in 1971 that the US got off the gold standard, i.e. having US dollars linked to a specific amount of gold in value. And the matter isn’t fully settled. There are some politicians who believe that we should get back to the gold standard. But that’s an issue for another day.

Coming back to crypto-currencies, let’s see what makes them like gold. Of all the crypto-currencies, the most popular and wide-spread is the bitcoin. Created ca. 2009 by a mysterious character, Satoshi Nakamoto, you can read all about Bitcoin, the network, and bitcoin the currency, online. For this article, I just want to point out that the theoretical maximum number of bitcoins is 21 Million. Fair warning, trying to find out why it’s this number will take you down a rabbit-hole of math, decisions, and arguments that can make your head spin.

Just like gold is mined using extractive technologies that dig into earth, bitcoins are “mined” using expensive computers that run day in and day out executing brute-force algorithms to “discover” undiscovered bitcoins. This, by the way is where the cryptography comes into play. Again, how this works and how to get into the business of mining bitcoins is another rabbit-hole. Suffice to say, that just like gold, the supply of new bitcoins remains stubbornly difficult to change and that contributes to its ability to retain value.

Ownership is key

One thing we haven’t talked about when it comes to currencies is ownership and transactions. This is where crypto-currencies have some significant advantages over traditional currencies and why they are getting so much attention.

Before we get there though, let’s consider these two concepts in the traditional world. When you owned gold or money, historically you would have physical possession of it. As we created financial systems and institutions we didn’t need to have our wealth with us physically. We outsourced the possession to institutions, such as banks or custodians. This was and is even today a trust relationship. Today, most of us hardly carry any cash and our money is often just an amount that we see on a computer screen or a bank statement. History is filled with examples of this trust being violated and so when that happens, the result is often traumatic.

Ownership in and of itself is meaningless. For money to be useful, it must be used to buy something useful. When you have physical possession of cash, you hand it over to the vendor and receive goods or services. In an online world however, the transaction is managed electronically, most of the time using a credit or debit card. And even here, there is a nagging worry that the credit card number doesn’t fall into the wrong hands. Ultimately, there is a huge amount of trust that the buyer and seller places on the system to ensure that the transaction is executed properly.

Our current system of government and laws is the foundation upon which this trust resides. Whenever there is an ownership or transaction dispute, we rely upon this system of laws to adjudicate the dispute and provide a resolution. Then, as participants we either accept or appeal the decision, abiding again, by the rules of the system in doing so until we reach the highest court of the land. In the case of an ownership dispute, the court is essentially handing down to the people of the land the ownership record and version of truth that is then accepted by everyone.

As one might expect, this is not a perfect system and more importantly, not fast. While it may take a transaction milliseconds to execute, disputing it could take weeks or months. The system is also expensive and the institutions such as banks and credit card processing companies, are costly to run. The result is that every time you buy something using a credit card, someone, usually the merchant and then ultimately you the buyer via increased costs, are paying a fraction of transaction value in processing fees.

Enter blockchain

Imagine a world where, whenever you bought or sold something, everyone around you and everyone else was informed immediately that the sale occurred. Everyone would agree that the money that was the buyers now belonged to the seller, and the goods that were sold belonged to the buyer. There would be no dispute and from that point in time that would be the universal version of the truth. That, in effect, is blockchain.

Blockchain is an electronically implemented open and distributed ledger of transactions that is universally agreed upon by a majority of participants in a network. This is actually the secret sauce that makes crypto-currencies work. The cool feature of blockchain technology is that you can implement it without any central authority being the arbiter of the ownership record. It can be truly democratic in that when most of the parties agree on the version of truth, that is the truth. Because of this, as the number of people in a network increases, the trust in the system and validity of ownership also increases and that makes it less vulnerable to theft. And possession of a bitcoin is just knowing its number. You can write it down, you can save it on a file, or engrave it on clay. It doesn’t matter who else knows the number. Essentially, unless you give your bitcoin to someone else and have it recorded on the public ledger, it can’t be taken away from you. That you do with an electronic wallet that is password protected and uniquely identifies you.

A point of clarification here. Blockchain technology is a method of having a distributed ledger and a common version of truth and is not restricted to bitcoins or the Bitcoin network. Bitcoin only uses this technology to manage the ownership and transaction records of bitcoins. Blockchain technology can be used for other solutions as well where there is a need to have a universally accepted version of truth. Blockchain solutions can be designed to have a central authority or not. It’s just an enabling technology and being actively investigated by institutions worldwide for applications involving trust and transactions.

The fact that there is no central authority governing cryptocurrencies and the networks upon which they are traded, makes them attractive and scary at the same time. Attractive because the blockchain concept virtually guarantees a universal record of ownership across geographic boundaries. Scary, because there isn’t a Sherriff in town to resolve disputes.

That brings us to the final part of this article, what to do about them? For that I thought it would be good to switch to FAQ mode:

And of course, before we do that, the applicable disclaimer that this is not legal or investment advice!

Q. Should I get a bitcoin or other crypto-currency account?

Sure, if you want. As in anything else, if this is something you are curious about, why not? Just be careful. Research out thoroughly how to get started, which wallet you should get, etc. Start with a small amount of money and try to buy something. In general, we don’t recommend keeping any balances in crypto-currencies though it may not be a bad idea in knowing how to transact in one.

Q. Should I invest in a crypto-currency?

That brings up a bigger question. Are crypto-currencies an investment? From our perspective, no. A currency is a store of value and depending on how stable it is, could be an asset. However, it doesn’t, from our view of the world, constitute an investment. To us, an investment is something that generates a return because of some underlying source of value. A company that offers services or creates products, a piece of land or real-estate that earns rent, a bond that earns interest are investments.

Currencies are just stores of values and can be used to buy investments. To be sure though, bitcoins have gone up substantially in value over the past few years, and by the same token suffered corrections. That’s because there is an increasing interest in the currency and more people joining the network. Even so, we just see bitcoins as any other currency or form of currency, and at least at the moment, speculative and not stable enough to be a hedge against traditional currencies.  On the other hand, gold or other precious metals, which we also see as a form of currency, are more suitable for that purpose.

Again, our recommendation is if you want to buy something using bitcoin, convert just enough money to bitcoin and quickly execute the transaction. If you sell something for bitcoin, convert it back to your currency of choice as soon as the bitcoin appears in your account.

Q. Are crypto-currencies fraudulent?

Not inherently, though they can be. Because they are easy to set up, a particular currency could be victim to manipulation by a malicious participant if the implementation of blockchain is intentionally compromised and exploited. In general, something like bitcoin that now has a track record is most likely safer. There’s a really nice episode on the Radiolab podcast that describes the pains the founders of the crypto-currency Zcash took to ensure that their currency was trusted.

However, that’s not to say that you can’t lose money with bitcoin. If you lose your bitcoin, just like gold, it’s gone forever. If you unintentionally give someone your bitcoin, it’s theirs until they return it to you.

Q. What is an ICO?

An ICO, or initial coin offering, is a way for startups to raise money using special purpose crypto-currencies. Here the currencies are used as tokens and don’t necessarily confer any ownership but because they use blockchain, are liquid and can go up in value resulting in a profit for the investor. A bit of wild west in this world and the way we see it, it’s speculation squared. Not for the faint of heart and certainly not something to get into with money you can’t afford to lose.

Q. What is Ethereum?

Ethereum is an open-source blockchain platform that enables programmers to use a common set of tools to build blockchain-based networks. There is also a default currency that runs on the Ethereum platform called ether. Still a lot changing in this part of the world and the story is being written as we speak.