Presented by Summit Financial Corporation
Roughly seven years ago, Laszlo Hanyecz made a proposition on an Internet forum. Hanyecz was looking for someone to send him some pizza, so he could cure his hunger pangs. In return, he offered up 10,000 units of a little-known currency called bitcoin. Hanyecz ended up getting two Papa John’s pizzas for his bitcoin payment (which at the time was worth around $41). The exchange marked the first known purchase involving a cryptocurrency, yet for Hanyecz this turned out to be a pretty sour deal; based on their value as of October 3, 2017, those 10,000 bitcoins would now be worth in excess of $40 million!
Bitcoin has made significant strides since that first pizza transaction. Its early years were plagued by security hacks and underground black markets, but the cryptocurrency has gained legitimacy in recent years, leading to a surge in interest. On average, more than 250,000 bitcoin transactions occur every day, and with a market capitalization in excess of $66 billion, bitcoin has become the largest cryptocurrency in the world. You can even buy bitcoin through some ATMs. Despite this proliferation, there’s a healthy degree of skepticism from retailers that, according to a recent article from Bloomberg, are reluctant to accept payment in bitcoin. Investors and consumers, on the other hand, seem to be enamored of this digital currency. This has given rise to other cryptocurrency players, such as ethereum, that vow to improve upon some of bitcoin technology’s deficiencies.
As cryptocurrencies rise in number and awareness, so will your questions. This article aims to help you understand the dominating networks, their potential, and their limitations and risks.
How bitcoin works
Bitcoin is a digital currency that allows for the transfer of payment between two parties, without the help of a bank—and without government oversight. Unlike any currency that has preceded it, bitcoin has no physical form, cannot be touched, is not issued by any central bank or sovereign nation, and relies completely on a decentralized network of computers to process its transactions. Bitcoin’s appeal lies in how payments are processed (via the Bitcoin network), as transactions are recorded anonymously and securely in a public ledger, commonly known as the blockchain (see Figure 1).
A peer-to-peer network of computers, supported collectively by what are known as miners, records and approves the transactions. The miners are rewarded with bitcoins for their work. Mining requires intense computing power, as block transactions involve solving complex mathematical equations. Given the computational power behind this network, and the lack of reliance on one single computer or “node,” it’s virtually impossible for a hacker to infiltrate the network.
That’s not to say this currency doesn’t have its share of problems. The early days of bitcoin were fraught with fraud, security breaches, and dark market transactions. In February 2014, Mt. Gox, then the world’s largest bitcoin exchange, suspended trading, closed its website, and filed for bankruptcy. Nearly 850,000 bitcoins ($450 million in value at the time) belonging to customers had been stolen. One year earlier, the FBI shut down the Silk Road marketplace, the best-known underground black market at the time, which was popular for using bitcoin to sell drugs, guns, and stolen merchandise. While security in recent years has improved, it still remains a big concern with bitcoin and other cryptocurrencies.
On the more positive side, enthusiasm in recent years has centered on the push for increased awareness of bitcoin and its ease of sending payments. Jeremy Liew, the first investor in Snapchat, believes that bitcoin could reach a value of $500,000 by the year 2030, fueled by an increased need for a new store of value in countries with unstable currencies. Aswath Damodoran, professor of finance at New York University’s Stern School of Business, believes that cryptocurrencies such as bitcoin will eventually replace gold as a store of value and may someday be as important as actual paper currencies. He told CNBC, “Cryptocurrencies have taken the role of gold at least for younger investors because they don’t trust paper currencies.”
But bitcoin also has its share of skeptics. In a recent interview with CNBC, J.P. Morgan CEO Jamie Dimon expressed that bitcoin is a “fraud.” Comparing bitcoin to the tulip mania of the 1600s, Dimon said that bitcoin is “not a real thing” and that “[c]urrencies have legal support. It will blow up.” Despite Dimon’s negative comments, it should also be noted that his firm, J.P. Morgan, has been developing its own blockchain built on the ethereum network. J.P. Morgan is also a member of the Enterprise Ethereum Alliance. (We’ll talk more about ethereum below.)
Challenges of bitcoin
With the rise in popularity of bitcoin as a means of payment, the current system as it exists has had trouble with the number of transactions moving through the network, leading to increased transaction fees. The size of the blocks that make up the actual transactions is limited to one megabyte, which has led to a delay in processing transactions. More recently, a dispute over how to cope with increasing adoption emerged in the bitcoin community. On August 1, a “fork” took place and a new currency—bitcoin cash—evolved. Bitcoin cash is essentially a clone of the existing bitcoin blockchain, but it has an increased block size of 8 megabytes. Those who owned bitcoin prior to the split now own an equal amount of bitcoin and bitcoin cash.
Still, a major critique regarding wide mass acceptance of bitcoin as a form of payment is its extreme volatility. While major paper currencies such as the dollar and the euro experience swings in performance, the volatility for bitcoin is roughly 30 times higher than typical foreign exchange markets, meaning it can surge—and plummet—quickly.
Recent news surrounding China’s forced shutdown of several bitcoin exchanges led to a bout of increased volatility and panic selling for bitcoin. According to the New York Times, regulators were growing concerned with the potential risks that cryptocurrencies could have on China’s financial system. The news led to a steep drop in the price of bitcoin, evidence that regulatory involvement with cryptocurrencies will continue to have a major impact on pricing volatility moving forward.
Despite these challenges, supporters note that we are still quite early in bitcoin adoption; they believe that as acceptance increases, and regulatory involvement is better defined, the pricing volatility will ultimately level out.
Ethereum, ICOs, and other cryptocurrencies
One of the main holdups to the staying power of bitcoin could be—in the simplest of terms—its limitations. Bitcoin was designed with limited flexibility on purpose, so that it can deliver robust security. The currency has essentially become a sophisticated store of value or a way to exchange payments—but that’s mostly it. As a result, it’s quite challenging for third parties to develop applications on top of the bitcoin blockchain. That’s where ethereum comes in.
Ethereum, now the world’s second-largest cryptocurrency, was developed a few years back by Vitalik Buterin. Now 23, Buterin got his start in bitcoin development but wanted to create a more sophisticated and flexible blockchain. Buterin’s genius is evident in his cult following in the cryptocurrency space.
Like bitcoin, ethereum has its own blockchain, yet it has the ability for programmers to build applications that run on top of it. These applications use “smart contracts” that can be considered a form of programmable money. If someone wants to engage in a more complicated transaction—such as a house purchase or a business acquisition—they could do so with ethereum, without needing a trusted third party, such as a real estate agent or a lawyer, to complete the deal.
Buterin envisions ethereum as “the world computer” in a future where the centralized applications of today that rely on trusted third parties are built in a decentralized manner on ethereum. In a report he wrote for R3, a financial innovation consortium, Buterin compared his creation to “the smartphone of blockchains.” He called ethereum “a universal platform where, whatever you want to build, you can just build it as an ‘app,’ and [e]thereum users will be able to benefit from it immediately without downloading any new special software.”
Ethereum also allows for the creation of “tokens” for applications built on its network. These tokens have been distributed to the public in a new form of fund-raising known as an Initial Coin Offering, or ICO. The tokens themselves don’t typically offer any sort of equity in a particular project, yet they allow individuals to speculate on the future adoption of these systems.
The explosion in popularity of these ICOs has been mind-blowing, with at least several projects launching every week, some with barely any sort of developed business model, and the SEC is taking notice. William Mougayar, a venture advisor and expert in ICOs, put it best when he expressed concern about their growing interest to bitcoin news site CoinDesk: “Yes, I want the ICO party to continue, but I’m seeing participants that are just there for the ride,” he wrote. “I’m seeing companies and ideas getting ICO-funded on a wing and prayer chance of being successful. . . . When the party gets overcrowded and unwanted visitors want it louder and bigger, events can turn to the unpredictable.”
As integrity, security, and volatility continue to plague the networks that keep them operational, cryptocurrencies still have a tough road ahead. Despite this, major progress has been made to create more secure environments that help facilitate the exchange of digital currencies. With more widespread adoption and continued funding into the space, there are endless possibilities as to how cryptocurrencies and various forms of the blockchain could affect the world as we know it.
This article is intended strictly for educational purposes only and is not a recommendation for or against cryptocurrency.
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Authored by Chris Stuart, senior investment research analyst, at Commonwealth Financial Network®.
© 2017 Commonwealth Financial Network®