What Are Digital Currencies — And What Do They Mean For Gold?
Guild Investment Management
June 22, 2017
Bitcoin is in the news, once again driven by a price spike that makes speculators and would-be speculators start counting their unhatched chickens. This time, the granddaddy digital currency has competitors — “altcoins” — which are also attracting attention. Ripple, ether, dash, monero, and hundreds of other currencies have sprung up (as of this writing, a total of 888, with a combined market capitalization of about $115 billion). Some promise technical refinements and improvements to the bitcoin system; others offer institutionally friendly features that leverage bitcoin-derived technologies for broader application in contracts and transfers.
All the competitors have their proponents. While some are clearly more serious contenders than others, at the end of the day, disagreement is heated even among technical experts and non-experts who chase windfalls in digital currencies. While the excitement lasts, there will be enough stories of overnight digital currency millionaires to keep the process going, but eventually the music will stop. (Of course, speculation can be fun — as long as you recognize it for what it is.)
Digital Currencies Are Here To Stay
While picking winners and losers in the rapidly growing field of digital currencies is very complex, digital currencies as a whole are doing something for which there is demand. While they share some characteristics with other assets, they combine those with unique characteristics of their own, and therefore they will appeal to users and speculators who want those characteristics. That means that they will continue to exist (even if some governments decide they shouldn’t), so at some point after the dust settles, intelligent speculators, and even investors, will need to decide whether digital currency is an asset class in which they want to hold some of their wealth.
Bitcoin was the model for competing digital currencies for good reason. It came up with elegant solutions to fundamental problems of exchange, which we’ll describe below. Other digital currencies, while differing in technical details, share bitcoin’s solutions in broad strokes. Understanding the technical details is not as important as understanding the basic nature of what digital currencies are trying to achieve, and how they achieve it. With that clear view, speculators and investors can make the essential decision of whether participation in this new asset class aligns with their personal goals and risk appetite — or whether they should ignore it entirely.
The first thing to realize about bitcoin is that the entire system is rooted in a desire to remove financial intermediaries, and allow people transacting business to make their exchange directly with one another. Bitcoin is anarchist money. It isn’t created by a central authority, it isn’t backed by a central authority, and transactions are not confirmed by a central authority. Indeed, the bitcoin system sets out to remove the need for any “central authority” — whether that’s a government, a bank, or any “trusted intermediary.”
Some readers may immediately think, “There’s an asset like that already — it’s gold.” In the contemporary economy, gold is the asset whose ownership is at bottom a vote of “no confidence” in central authorities and the stability that they create — or at least a hedge against their failure.
What bitcoin sought to do (and what its anonymous inventor largely succeeded in doing) was to create an asset that would, like gold, be independent of governments and banking systems — but that existed only digitally, and thus had a host of other characteristics that are desirable in a digitally connected world.
Gold has mass. It takes up space. It’s difficult to divide so that it can be used in exchange. It requires physical-world vigilance and security to prevent theft. It has to be carried and physically exchanged in order to conduct transactions, which could be inconvenient and dangerous. Using third parties to perform any of these functions exposes the owner of gold to the risk of theft and fraud.
Bitcoin, on the other hand, takes up no space, and can be exchanged instantly over any distance. While it can be stolen, that theft can only occur on the edges of the bitcoin system, where it interacts with the established financial world. As it is constructed, within itself, the bitcoin system is impervious to theft and fraud (with one important caveat, which we’ll mention below). A bitcoin wallet — really nothing more than a set of cryptographic keys giving you the power to allocate bitcoins from your address to some other address — in cold storage, unconnected to the internet, is completely secure.
In short, bitcoin set out to be digital gold for the digital age. Will it succeed?
How Bitcoin Works
The mechanics of digital currencies are complex in their actual implementation, but the broad structure is not difficult to understand.
In order to remove the need for financial intermediaries, any digital currency system has to solve two problems: the problem of identity and the problem of ownership.
The current global financial system also solves these problems. Central authorities — banks, governments, and courts — keep exhaustive accounts of financial assets and of the ownership of those assets, tying those accounts to identity records maintained by other authorities. When you withdraw money from your bank, the bank has a system to confirm your identity — relying on many other expansive and intrusive identity-confirmation systems within government. Then the bank has to verify your ownership of the money you’re withdrawing — using a complex system of proprietary ledgers and record-keeping as well as the proprietary communications systems connecting all these records. The system functions smoothly, and that smoothness hides the complexity of intermediary structures, not to mention hiding the costs these intermediary systems impose on users.
Bitcoin, on the other hand, solves the identity and ownership problems with math and algorithms. It secures ownership through cryptography. Only the possessor of the correct cryptographic key can spend the bitcoins associated with a certain address, and while the possession of that key can be verified by anyone, the key itself is never revealed to anyone. (If readers want to delve into the mechanics of public/private key cryptography, it’s an interesting and challenging subject area.) The central role of cryptography in almost all digital currencies has led to them being dubbed “cryptocurrencies.” For now, these cryptographic keys are so robust that no existing computer technology is even theoretically capable of compromising them.
These cryptographic technologies existed long before bitcoin. Bitcoin’s real innovation was this: it created an elegant system for the maintenance of a public, universally agreed-upon ledger of bitcoin ownership, that is maintained by a distributed network of computing nodes rather than by any single, proprietary institution.
Again, the technical details of how bitcoin accomplishes this goal are abstruse. The bottom line is that every bitcoin transaction that has ever occurred is included in a ledger called the “blockchain,” and the blockchain itself is not held by any central institution, but exists in thousands of independent “nodes” around the world. These nodes compete with one another to verify new transactions being added to the blockchain, and winners are rewarded with newly created bitcoins. The competition involves a race to solve extraordinarily difficult mathematical puzzles. When a new, valid block is added to the blockchain, it propagates among all nodes from peer to peer and is adopted as the basis for work starting on the next block. (To fraudulently rewrite or alter the blockchain, or introduce bogus transactions, would require an amount of computing power that’s far beyond anything currently available.) Thus the system maintains a universally agreed-upon ledger describing the ownership of every bitcoin in existence — without the need for any central authorities or intermediaries.
Every digital currency solves these problems with an approach similar to that used by bitcoin. They use cryptography to solve the identity problem, and a distributed ledger (some form of blockchain) to solve the ownership problem.
Digital Currencies: Are They What They Seem?
Digital currency creators set out to make digital gold — an asset that, like gold, needs no central authorities to back it, or to its certify ownership; but unlike gold, takes up no space, can’t be stolen, and can be instantly transmitted anywhere in the world. Did they succeed?
Yes and no. Here are some skeptical thoughts on potential cryptocurrency weaknesses — questions we think speculators and investors should ask themselves as they decide whether they eventually want to hold some of their wealth in the form of digital currency.
First, digital currencies claim to do away with intermediaries. But do they? Although we’ve sketched an extremely high-level view of how digital currencies operate, a real understanding of these systems requires a lot of intellectual sweat — and possibly, for deep comprehension, a decent grasp of several fields of mathematics and computer science. Therefore, a real-world user has two options: acquire the detailed, precise knowledge of how the systems operate — or trust the understanding of a third party, whether a friend or an advisor acting in some formal capacity.
Personally, we would not want to hold assets about which we or a trusted advisor don’t have deep understanding. So any normal person who doesn’t have the time or inclination to become an amateur computer scientist is relying not on the bitcoin system’s supposedly robust independence, but on some trusted authority who facilitates their interaction with the bitcoin system. Despite bitcoin’s theoretical security, for almost all investors its real security will be tied to intermediaries whose trustworthiness they must judge. Sounds rather like we’re back to square one.
Even in a bitcoin world, real-life users will depend on the trustworthiness of other actors in the financial system. So trustworthy intermediaries create value, and will continue to create value. And as unforeseen troubles occur for cryptocurrencies, that truth will, we believe, become more apparent. Of course, while physical gold in one’s personal possession may present risks, those risks are much more easily comprehended and mitigated than the risks associated with complex and novel computer networks.
A second trouble with digital currencies is privacy. Astute readers may have reflected on the public nature of the bitcoin blockchain. This is noteworthy: every bitcoin transaction that has ever occurred is preserved in the blockchain, publicly available and held in its entirety in every node. Those transactions are identified with bitcoin addresses, which are simply long alphanumeric strings — not names. Still, data mining — especially using artificial intelligence and machine learning — may well be able to find patterns in the blockchain and marry those discoveries with external data to tie transactions to real-world identities. (Intelligence agencies are undoubtedly already working on this. This is not idle speculation; worries about privacy have led to the creation of several bitcoin alternatives. Those alternatives, though, end up creating problems and weaknesses of their own.)
This privacy issue is something that gives us pause when we contemplate the proposed expansion of the blockchain technology beyond cryptocurrencies. Several successful platforms are bringing blockchain to the world of business transactions and contracts, promising to reap the benefits of decentralization and digitization in reduced costs and increased efficiency.
We think that privacy concerns here, too, may eventually provoke a backlash as consumers realize that blockchain technology permanently memorializes their activities in a public database that is pseudonymous, but not necessarily impervious to attempts to extract personal data. And of course, the risk of exposure of personal data doesn’t just concern those who are fearful of government prying, or those who are engaged in illegal activities. Countless commercial transactions must remain private to safeguard businesses against the unfair advantage their competitors would have if, for example, they had detailed information about who their suppliers were. All of that is the kind of information that could be revealed through a public blockchain. (In a subsequent article, we’ll explore the promises and potential problems of blockchain technology as a way to smooth exchanges and reduce transaction costs entirely outside the world of cryptocurrencies.)
A third potential weakness is technological. We noted above that both of the central pillars of digital currencies — cryptographic identity and blockchain construction — rely on mathematical problems. Those problems need to be either impossible (in the case of cryptographic identity) or extremely difficult, time-consuming, and costly (in the case of blockchain construction). With current computer technology, all is well: the unsolvable is unsolvable, and the extremely difficult is extremely difficult.
But there’s a new technology coming: quantum computing. The inflection in computing power that quantum computing inaugurates could quite possibly break all existing cryptocurrencies. Indeed, it could/will break all existing cryptography. We don’t know when that moment will arrive. Perhaps it’ll be like fusion power — always 30 years in the future. But the consensus of computer scientists is shifting, and many now believe that functional quantum computers are only five to ten years away. Quantum encryption will likely arise as a response, but the shift could occasion imponderable risk and volatility. With such an impending potential destruction of the foundations of digital currencies within long-term view, the question is, can digital currencies be more than a gamble?
All of these considerations could be summed up in one observation: it is essential for investors, as well as for intelligent speculators, to be ruthless in realistically assessing their own ignorance. The saying that “pride goeth before a fall” is nowhere more applicable than here. The apparent simplicity and straightforwardness of digital currencies masks complexities which create risks that are not trivial to understand and quantify. If we ourselves lack the technical expertise to understand and quantify these risks, we have to rely on others whom we trust. Does that reliance cut completely against the cryptocurrency grain?
Gold, Bitcoin, and Artificial Intelligence
Recently we offered some thoughts about the imminent arrival of artificial intelligence (AI) and machine learning, and commented on the “black box” nature of this revolution. With machine learning, we’ll have extremely functional automated systems that can offer no account of their behavior — there will be no real answer to the question, “Why did it do that?” This is simply what happens when artificial neural networks pass the threshold of complexity that they’re passing, and begin to program themselves rather than being programmed by humans.
For most people, bitcoin and other cryptocurrencies will always be black boxes. We noted a few potential weaknesses — but we are not experts, and other weaknesses may well exist in these systems that will not manifest until a major failure occurs. This is part of the problem with complex systems that function as black boxes: the only way to find out when they’ll break, if they’re intractably complex, is to use them until they do break. And then it’s too late – for some who make the mistake, if not for the people who learn from your mistake. Most investors, when they reflect, are not eager to become everyone else’s cautionary tale.
So while cryptocurrencies are technologically, culturally, and politically fascinating, in our view they are at this stage only vehicles for speculation, not investment. We realize, however, that the tempting prospect of outsized gains and the mythic accounts of bitcoin billionaires will inexorably pull in many speculators.
Still, we don’t believe that cryptocurrencies have yet demonstrated success in their quest to be the new “digital gold.” For all its drawbacks, and even though we can’t store it on a flash drive, we still prefer analog gold as a hedge against the malfeasance and irresponsibility of government.
Investment implications: Digital currencies are not investments. In our view, unless you have significant technical expertise, they are rank speculation. Since they marry some desirable characteristics of gold and of virtual assets, they will probably continue to exist — but we believe that it is impossible to determine which of the nearly 1,000 currently existing digital currencies will survive in the medium term. Longer term, there are significant questions around privacy, public comprehensibility, and the potential for quantum computing to defeat the difficult mathematical problems on which cryptocurrencies are based. For all these reasons, we think cryptocurrencies are interesting to study, and may be fun to trade — but are not investments, and in the long run will not supersede the need for trusted intermediaries in the financial system. We believe that most investors who want to hedge against the malfeasance of government and the vicissitudes of monetary policy should keep doing it the way they’ve been doing it for 5,000 years — with gold.
Guild Investment Management
June 28, 2017
Last week we wrote a simple introduction to digital currencies, describing the motivation of their creators, the technologies that underlie them, and some of the pitfalls that may be waiting for speculators. A lot of readers found the piece helpful.
Bitcoin and other digital currencies were designed as forms of “digital gold” that would meld characteristics of physical gold with those of electronic money. They may or may not ever become viable media for storing and exchanging value. For now, they remain highly speculative, highly volatile, and subject to a variety of risks that are nearly impossible to evaluate. Some of those risks are existential and could lead to the collapse of digital currency systems, either because of regulatory crackdown, or because of a technical failure from unexpected advances in computing technology. We concluded that, for now at least, digital currencies are for intelligent and careful speculators who have some idea what they’re getting into — but definitely not for investors.
With all that said, some of the most interesting things about digital currencies are not the currencies themselves, but the technologies that underlie them. We’re not kidding ourselves; the current rapid appreciation of bitcoin, ether, and several other digital currencies is much more exciting than the underlying technologies. Still, those technologies may ultimately prove to be more influential on the global economy and the global financial system than the currencies they were created to support.
The Technologies That Make Bitcoin Work
As we mentioned last week, bitcoin rests on two key technological innovations: public/private key encryption and the blockchain. Public/private key encryption has been around since 1976; the blockchain was an innovation contributed by bitcoin’s anonymous inventor when he wrote the white paper that launched the currency in 2008.
In public/private key encryption (also called asymmetric encryption), every user has a private key which only they possess, and a public key which is known by the recipient of their communication. You encrypt a message using your private key and your recipient’s public key. They can decrypt the message using their private key and your public key. The critical thing is that if you just have someone’s public key, it’s impossible to fake a message coming from that person. The system relies on the application of some brilliant mathematics — a function that is simple to solve in one direction, but impossible to “reverse engineer.”
So asymmetric encryption solves one basic problem of digital transactions: proving the identity of the person making the transaction in a purely mathematical way — one that doesn’t rely on any manual human intervention or evaluation. (This is a much more secure way to confirm identity than a login/password confirmation, for example, and less cumbersome than some other attempts at more robust authentication. Indeed, it’s instantaneous and in principle unbreakable.)
Bitcoin married asymmetric encryption to another technology: the blockchain, which is really just one example of what could be called distributed ledger technology, or DLT. DLT is simply a record of transactions that is not held and maintained by a single, central agent. Instead, it is held simultaneously by many “nodes” of a network who have a system in place to reach a consensus about valid transactions and add those transaction records to the agreed-upon ledger.
Bitcoin’s blockchain incentivizes this process by setting up a verification race among the nodes, and rewarding the winners with newly minted bitcoins (the only way the currency can come into existence). Bitcoin’s ledger is fully public, and the system is set up to prevent malicious actors from inserting fraudulent transactions into the ledger. But in itself, DLT doesn’t require such a “verification race,” as we’ll describe below. The most important characteristic of DLT is that it is held simultaneously in an agreed-upon form by many different transaction participants — and thus it can allow transactions to proceed without laborious cross-checking verification against individually maintained databases.
Since DLT requires the secure authentication provided by asymmetric encryption, we’ll just roll them together. Any time we refer to “DLT” we mean the combination of encryption and distributed ledgers that bitcoin ushered in.
Moving Beyond Bitcoin
The bitcoin system was set up to facilitate the exchange of bitcoins. However, it quickly became apparent to observers that DLT could secure, streamline, and transform any exchange — not just exchanges of digital currency.
All economic exchanges revolve around the verification of identity and ownership, and in the past, those problems were solved through the presence of centralized records and trusted authorities in the exchange process. DLT suddenly created the prospect of “exchange infrastructures” where mathematical algorithms could take the place of those centralized records and trusted authorities — and get the job done a lot cheaper and faster.
It helped that this new potential exchange infrastructure was emerging at the same time as artificial intelligence and the internet of things — the beginning of a world where machines could be interacting and transacting with one another at the speed of a semiconductor.
Make no mistake: there are a lot of hurdles to overcome before DLT starts to take over the “infrastructures of exchange” in earnest. The hurdles aren’t just technological; they’re psychological and regulatory. Most financial exchanges are highly regulated, and the use of these technologies will require regulatory buy-in. Still, they will be adopted more quickly in some areas than in others; and in many areas where regulators will drag their feet, they will ultimately acquiesce because of cost savings.
So what are some of the areas where bitcoin-derived technologies can really shake things up?
Industries Facing Disruption
To our mind, the most immediate application of DLT is in the sharing economy and social commerce. DLT could cause the sharing economy to accelerate rapidly — to the detriment of incumbents and the advantage of innovators.
At the core of the sharing economy and of social commerce is the management of reputation by buyers and sellers. AirBnB is a prime example: the functioning of this platform depends on reliable social credentials. Safety is a key concern; both guests and hosts want to know that the person they’re interacting with has a track record of honesty and straightforwardness — that the people and accommodations involved are what they seem to be. This is one primary reason, for example, that female travelers, on the whole, are less willing to use home-sharing platforms to find accommodations. AirBnB has fairly robust systems in place to ensure the identity of people on the platform, but there is still a period of negotiation and direct communication between guest and host where each has to get an intuitive sense of the other before going forward. While usually smooth, this process can often take a day or more. Such transactional friction makes the system incrementally less attractive than traditional hotel accommodation in spite of any economic savings.
Another example from the world of social commerce is Yelp [NASDAQ: YELP]. Yelp is a platform where users can review businesses. Identity has been problematic on this platform in both directions — ensuring that reviews are neither fraudulently generated by businesses to artificially boost their ratings, nor fraudulently generated by bad actors to artificially reduce a competitor’s rating.
What DLT technology suggests is the possibility of a “social blockchain” to resolve identity issues. Remember that the fundamental characteristic of a distributed ledger is that it is verified and agreed upon by all stakeholders, and that once an entry has been made, it can’t be modified. A social blockchain would aggregate user behavior and transactions across multiple platforms. In YELP’s case, for example, DLT could ensure that a reviewer was a bona fide patron of a particular business before permitting a review to be added to that business’ “ledger” of reviews.
In AirBnB’s case, the entire review history of prospective guests and hosts would be instantly available — not just from AirBnB, but from other social commerce transactions as well, giving users a much greater sense of security. While AirBnB is gradually taking market share from more traditional forms of travel accommodation, removing some of the transactional friction through the use of a social blockchain could accelerate that process — and potentially help business travelers more rapidly identify shared accommodations that are suitable to their needs.
The construction of a social blockchain could ultimately resolve many of the inconsistencies and weaknesses of the existing reputation management systems that social commerce platforms depend on and help them make even faster inroads into traditional business models.
How Broader DLT Use Will Differ From the Bitcoin Blockchain
This use-case highlights a critical way in which DLT, as it is more broadly applied, will differ from the bitcoin blockchain model. Bitcoin’s blockchain is designed to be public. As we noted last week, this is a key strength and also a key weakness. Because bitcoin sought to remove the need for any trusted intermediaries, it needed to come up with a way to have a consensus public ledger that could be verified by anyone. Broader DLT applications will not necessarily be public. While anyone can run a bitcoin node on their home computer, other DLT uses will involve a limited number of stakeholders who are permissioned to access and use the database. The “social blockchain,” for example, could permission a particular restricted set of users, social commerce businesses, and financial entities to make changes to the ledger.
This restricted, or private, blockchain will characterize most applications of DLT outside the bitcoin universe, and will smooth the way to regulatory approval of DLT uses in areas where privacy is important — for example, in medical and financial applications.
Other Applications of DLT
DLT could also be applied in many financial settings. One where the case for DLT is especially strong would be in property titles. As it is, an entire industry — title insurance — has grown up around the need to investigate property titles before real estate transactions can occur, to make sure there are no issues or encumbrances, and to insure transacting parties against potential problems. Most of the work in title insurance is manual legwork across a wide variety of potentially incomplete and inconsistent databases maintained by many financial and government entities. In developed economies, this process is laborious enough — but in many developing economies, existing property title systems are so fragmented and disorganized that property transaction costs can become extremely high. In Brazil, for example, transaction costs in real estate sales are estimated to average 12–14% of the total value of the transaction. We don’t have figures for India, but we suspect they are even worse.
A distributed ledger of property title data would solve most of these problems. Particularly in developing market economies which could leap-frog legacy systems and adopt DLT directly, real estate transactions and financing could become much smoother and easier. In India, for example, such a system could indirectly offer a significant boost to GDP growth by facilitating property sales and development.
DLT is also likely to offer significant back-office savings in various parts of the financial industry by smoothing and accelerating the process of clearing and settling a variety of market transactions. The Australian Stock Exchange is already beginning to experiment with using DLT as it upgrades its clearing and settlement systems.
Finally, DLT may see use in the “internet of things” (IoT). We can imagine a case, for example, where smart meter technology and a distributed ledger are used to facilitate micropayments directly between homes that are producing excess electricity from their solar panels, and their immediate neighbors who need that electricity — without involving the central utility electricity distributor at all. In the IoT, such micropayments could disintermediate many economic actors, but only if instantaneous transactions are possible. DLT can facilitate such transactions by removing the need for human evaluation and review.
To sum up, digital currencies may or may not last as a challenge to traditional asset classes. However, the technologies that underlie bitcoin — the combination of asymmetric encryption and distributed ledgers — are already being explored far beyond the digital currency world. In some industries they will facilitate cost savings — and in others they will be more radically disruptive.
Investment implications: For now, there are no direct investment opportunities associated with the wider deployment of distributed ledger technology. We think that DLT will have its first big impact in social commerce, where it is less likely to hit regulatory roadblocks. Look for the arrival of a “social blockchain” which will make social commerce credentials portable across a wide variety of sharing economy platforms, and could accelerate the penetration of those platforms into traditional markets. Eventually, DLT will lead to significant cost savings in many parts of the financial ecosystem, and could disrupt some specific industries severely, such as title insurance, and could be used to spark economic growth in parts of the developing world. Finally, DLT could help accelerate the decentralized operation of the internet of things by facilitating instant micropayments. Watch the development of this technology more to help you understand the evolving shape of these parts of the U.S. and global economy.
Digital Currency “ICOs” and the Regulators
July 11, 2017
Two weeks ago, we wrote an introduction to digital currencies in which we pointed out how fast these new instruments have proliferated. Nearly a thousand are currently available — and almost a hundred more have been listed on coinmarketcap.com than when we ran the article.
As we’ve discussed in recent weeks, these various forms of “gold for the digital age” take the basic innovations of bitcoin — encryption and a decentralized ledger system — and modify them to add desired features, such as improved privacy or better transaction processing speeds. So far, bitcoin is still the largest, with a market cap of about $39 billion as we write — but the next largest competitor, ether, has gone from a $700 million market cap to a $19 billion market cap since January 1 of this year. Ether has risen on the strength of its underlying platform, which is designed to facilitate the execution of electronic contractual agreements. Among the hundreds of other “alt coins,” there are certainly many with advantages that will be compelling, although most will be “zeroes.”
New coin launches are proving to be interesting in their own right — particularly in their wider ultimate implications for financial markets. So far this year, new coins have raised more than $1 billion. Many investors in bitcoin and ether are buying new coins at their launch, or “initial coin offering” (ICO) using their existing cryptocurrency stash — a kind of diversification. And of course, ICOs exist completely outside the regulatory framework that governs the initial public offering of stock in newly listed public companies.
In our previous coverage of digital currencies, we have pointed out some of their potential pitfalls for would-be investors and speculators. For example, unexpected technological developments that could threaten digital currencies’ cryptographic foundations; or the need of most users to interact with the world of digital currencies through a system of intermediaries which may not be as secure from fraud as the pure technical design of these instruments would suggest. There is also the specter of internal disagreements leading to “forks” in which currencies split into rival versions in response to some technical challenge or problem. (Ether has already weathered one of these, with its platform splitting into ethereum and ethereum classic. Bitcoin itself is nearing such a moment, with rival camps unable to agree on an approach that will speed transactions.) These growing pains will result in volatility, as if there weren’t already enough of that for digital currency speculators.
The rise of prominent ICOs, and the first stirrings of digital currency hedge funds, suggests to us another issue on the horizon. Digital currencies are above all, as we observed two weeks ago, a gauntlet thrown down in front of government and financial regulators. Regulators’ responses thus far have been either hesitant or permissive. As digital currencies become more prominent — as the news flows, transaction volumes, market capitalizations, and hedge fund activities grow — regulators around the world will become less sanguine about the existential challenge being made to their power. How will the communities of the various cryptocurrency systems respond? Will they accommodate — or will they entrench?
We do not know how this, the most basic cryptocurrency conflict, will play out — but speculators should be cautious and aware of the regulatory mood. We believe that cryptocurrencies will be able to survive regulation, since evading it has been part of their core raison d’être. But the process in which they accommodate themselves to a regulatory presence, or fail to do so, will shape their future — and determine if they will become more predictable virtual commodities, or remain a “wild west,” with the excitement, freedom, and risk that that entails.
Certainly, cryptocurrencies will make for interesting times.
Investment implications: As we have noted in our previous coverage of cryptocurrencies, we don’t believe that they’re investments at this stage — the risks and uncertainties are too large. Speculators should be comfortable with those risks and uncertainties. Some level of technical expertise is necessary for intelligent speculation. Speculators should also monitor the regulatory atmosphere carefully, since regulators’ attention, no matter what the eventual outcome, could cause severe volatility, or even the collapse of coin ecosystems.
The Bitcoin “Fork”: What You Need to Know
August 3, 2017
Bitcoin’s wild gyrations have this year become even wilder, driven largely by an ongoing “civil war” within the community of coders and miners who make up the cryptocurrency’s ecosystem.
So what’s the nature of this civil war, what are the stakes, and what might the consequences be? On the surface, the conflict is pragmatic; underneath, it reveals two divergent visions of what bitcoin is and what its purpose should be.
The central issue is the speed at which the bitcoin network is able to handle transactions. Readers may be aware that one of the two fundamental technologies underlying bitcoin is the blockchain, a public distributed ledger of bitcoin transactions. Bitcoin “miners” compete to solve fiendishly difficult mathematical problems, which validate bitcoin transactions, and they are rewarded for their investment in dedicated computers and electricity with transaction fees and newly minted bitcoins. Together, the miners permit the entire bitcoin ecosystem to reach consensus on what transactions should be added to the ledger.
The current bitcoin software is constructed so that the mathematical problems gradually increase in difficulty. The consequence is that as computer power is added to the network, the time it takes to validate a new “page” (or “block”) of transactions and add it to the ledger stays the same — about ten minutes.
Does Bitcoin Need to Accelerate Transactions?
Each block takes ten minutes to be verified and added to the blockchain. Though it may be surprising for some observers to learn, bitcoin as it stands is a relatively slow and expensive affair, compared to the speed and cost of mainstream financial transactions (such as credit cards). Visa’s [NYSE: V] network can process 1600 transactions per second globally — the bitcoin network processes about six.
The original architect of bitcoin, the pseudonymous Satoshi Nakamoto, set things up this way knowing that it would eventually be a problem — but in the early days, the original implementation served to entice miners to invest in the technology that supported the expanding network. Now, though, the problem is coming to a head as use of the digital currency has dramatically increased.
So does it matter that bitcoin is currently so slow? That depends on what you think bitcoin should be able to do. If you think bitcoin should primarily serve as a functional currency that you can use to buy a latte at Starbucks, it matters a lot. On the other hand, if you think bitcoin should primarily be a store of value to protect your assets against the predations of taxation, inflation, or appropriation, or a tool for conducting transactions of which governments disapprove, it doesn’t matter much at all.
Bitcoin Faces the Forks
Thus the conflict is revealing a philosophical schism among bitcoin users and adherents. How do such conflicts get resolved? Ultimately, the same way everything in bitcoin gets resolved: by consensus.
In the end, bitcoin is software that specifies how the blockchain is constructed. It is open-source software, so any user is free to modify it in any way they see fit. However, it would be pointless for a miner to alter it in a way that rewarded themselves, because unless a majority of the network’s computing power agrees with their new criterion for a valid block, the block would be rejected by the network and all the effort they expended in mining it would be wasted.
That’s a lot of effort. Bitcoin “mining” is now an industrial enterprise. In the early days, anyone could set up a node on their PC and mine bitcoins. Nowadays, the validation process is so difficult and the competition is so fierce that miners are constructing factory-sized operations in remote parts of China, situated directly adjacent to hydroelectric power sources to minimize electricity costs. (For an interesting peek inside the world of Chinese bitcoin mining, have a look at this article.)
Although some in the bitcoin universe don’t mind if the status quo is maintained, and don’t care if bitcoin transactions get accelerated, many users and most miners are eager for a solution.
The trouble is, users and miners have different solutions in mind. Users want a solution that will minimize transaction expenses; miners want a solution that will maximize them. Therefore there are different solutions being proposed. They’re all variations on a theme: expanding the maximum size of a block. Exactly how this is achieved will result in different rewards for different participants in the bitcoin system.
The bitcoin market has been gyrating because in one way or another, down the road, there has loomed the prospect of a “fork” — that is, that two incompatible versions of the bitcoin software will start operating, and consequently, the one bitcoin blockchain will split in two. (The currency’s most recent dramatic rally occurred because an imminent fork had been avoided.)
The first such fork in bitcoin’s history just occurred. It split bitcoin into two different cryptocurrencies — bitcoin and a new cryptocurrency called “bitcoin cash.”. Anyone holding bitcoins before the split would now owns equal numbers of bitcoin cash. (We should note that the fate of your bitcoins could vary depending on whether you held them in your own system, or on an exchange; few exchanges have so far recognized the new currency, so those who held their bitcoins on those exchanges are out of luck. If bitcoin cash gains traction, most exchanges should eventually distribute the new coins to those who held bitcoin before the fork. Transactions occurring near the time of a fork could also be problematic and could lead to lost bitcoins; this happened to some users when ethereum weathered a fork in 2016.)
“Bitcoin cash” simply ramped the maximum size of a block in a way that will speed transactions up to about 50 per second. So far the new currency is holding some value although it’s extremely volatile; that may change as more exchanges start trading it and more holders are able to sell.
This doesn’t end the matter, though, as further forks are possible in the future if participants in the original bitcoin network decide to tackle the transaction speed issue in other ways. Another potential fork looms in November.
Look At It Like a Spin-off
Bitcoin speculators should look at the whole thing as a spin-off. The current bitcoin is the parent company. Owners of bitcoins own stock in that company. After a spin-off, current shareholders will then own the same number of shares in the original company and in the spin. But the fate of each company will then be independent. And the lack of clarity could offer an opportunity to disruptive competitors to step in and take market share.
After any fork, the behavior of the new coins that arise from the split will be difficult to predict. Although holders of bitcoin who now also hold bitcoin cash have come out ahead, future forks could even precipitate a collapse in bitcoin and the rise of a rival, such as ether, which is already nipping at bitcoin’s heels in terms of market capitalization.
Does that mean that you should diversify your digital currency holdings ahead of another potential intra-bitcoin struggle that may emerge this fall? If you have been on the sidelines, and you want to buy in, should you buy bitcoin, bitcoin cash, or both? That, gentle readers, we will leave up to you.
Investment implications: Current holders of bitcoins should evaluate where their credentials are stored and consider whether they want to hold their bitcoins locally or in a virtual wallet. Speculators who are considering entering bitcoin should watch the news carefully for information about disruptive events surrounding a potential fork. Speculators may also consider diversifying into other coins in the run-up to a bitcoin fork. We stress again that at this juncture, we consider digital currencies to be extremely risky but interesting speculative opportunities — not investments.
About Guild Investment Management
Founded in 1971 by Monty Guild, Guild is an SEC-registered investment advisor dedicated to helping our clients achieve their investment goals and objectives while minimizing their exposure to unnecessary risks in the global markets. Guild manages investment portfolios for high net worth global investors located in various countries, and we manage money for retirement accounts, trusts, corporate accounts, foundations, and other tax-exempt entities. We also publish a weekly Market Commentary to help our clients and subscribers keep abreast of important developments in the global economic, social, political, geopolitical, and technological trends that shape the current investing environment.
During the summer of 2017, we published several articles in our Commentary on the phenomenon of digital currencies such as bitcoin, their underlying technologies, and their significance, risks, and opportunities. This white paper reproduces those articles for interested readers.