Cryptocurrency

INTRODUCTION Cryptocurrency, an encrypted, peer-to-peer network for facilitating digital barter, is a technology developed eight years ago. Bitcoin originated with the white paper that was published in 2008 under the pseudonym “Satoshi Nakamoto.” It was published via a mailing list for cryptography and has a similar appearance to an academic paper. The creators’ original motivation behind Bitcoin was to develop a cash-like payment system that permitted electronic transactions but that also included many of the advantageous characteristics of physical cash. To understand the specific features of physical monetary units and the desire to develop digital cash, we will begin our analysis by considering a simple cash transaction. Bitcoin began operating in January 2009 and is the first decentralised cryptocurrency, with the second cryptocurrency, Namecoin, not emerging until more than two years later in April 2011. Today, there are hundreds of cryptocurrencies with market value that are being traded, and thousands of cryptocurrencies that have existed at some point. The common element of these different cryptocurrency systems is the public ledger (‘blockchain’) that is shared between network participants and the use of native tokens as a way to incentivise participants for running the network in the absence of a central authority. However, there are significant differences between some cryptocurrencies with regards to the level of innovation displayed. Bitcoin, the world‟s most common and well known cryptocurrency, has been increasing in popularity. It has the same basic structure as it did when created in 2008, but repeat instances of the world market changing has created a new demand for cryptocurrencies much greater than its initial showing. By using a cryptocurrency, users are able to exchange value digitally without third party oversight. Cryptocurrency works on the theory of solving encryption algorithms to create unique hashes that are finite in number. Combined with a network of computers verifying transactions, users are able to exchange hashes as if exchanging physical currency. There is a finite number of bitcoin that will ever be generated, preventing an overabundance and ensuring its rarity. Water, despite its requirement as a life giving material, is generally accepted as being free or of little cost because it is so abundant. If water was rare, it would be more valuable than diamonds. Value exists for bitcoin because its users have trust that if they accept it as payment, they could use it elsewhere to purchase something they want or need. As long as the users maintain this faith, the valued object can be anything. Bitcoin‟s value exists in its ecosystem much in the same way that wampum, a seashell, was the currency of the land for Native Americans. (Kelly, 2014). Bitcoin does not have intrinsic value like gold in that it cannot be used to make physical objects like jewelry that have value. Nevertheless, value continues to exist due to trust and acceptance. Current legal and financial structures are not designed with a technology like this in mind. Financial institutions are built off of much older forms of currency. In some ways, it is comparative to the computing industry. The baseline of computing still relies on transmitting and processing 1‟s and 0‟s, providing only two dimensions of input. Yet all of our current technology uses this technologically archaic system due to adoption, cultivation, and lack of need for newer systems. If cryptocurrencies became the global norm for transactions, long standing systems for trade would need to be completely reformed to deal with this type of competition. For this reason, cryptocurrencies could possibly be the single most disruptive technology to global financial and economic systems. BitPay, the largest bitcoin processor in the world, has recently seen transaction rate grow 110% in the past 12 months. (DeVries, 2016). CYPTOCURRENCIES A number of cryptocurrencies have emerged that, while borrowing some concepts from Bitcoin, provide novel and innovative features that offer substantive differences. These can include the introduction of new consensus mechanisms (e.g., proof-of-stake) as well as decentralised computing platforms with ‘smart contract’ capabilities that provide substantially different functionality and enable nonmonetary use cases. These ‘cryptocurrency and blockchain innovations’ can be grouped into two categories: new (public) blockchain systems that feature their own blockchain (e.g., Ethereum, Peercoin, Zcash), and dApps/Other that exist on additional layers built on top of existing blockchain systems (e.g., Counterparty, Augur). The combined market capitalisation (i.e., market price multiplied by the number of existing currency units) of all cryptocurrencies has increased more than threefold since early 2016 and has reached $27 billion in April 2017 . A relatively low, but not insignificant share of value is allocated to duplication (i.e., ‘altcoins’), while a growing share has been apportioned to innovative cryptocurrencies (‘cryptocurrency and blockchain innovations’). As of April 2017, the following cryptocurrencies are the largest after bitcoin in terms of market capitalisation: ETHEREUM (ETH) Decentralised computing platform which features its own Turing-complete programming language. The blockchain records scripts or contracts that are run and executed by every participating node, and are activated through payments with the native Cryptocurrency ‘ether’. Officially launched in 2015, Ethereum has attracted significant interest from many developers and institutional actors. As of April 2017, the following cryptocurrencies are the largest after bitcoin in terms of market capitalisation: DASH Privacy-focused cryptocurrency launched in early 2014 that has recently experienced a significant increase in market value since the beginning of 2017. In contrast to most other cryptocurrencies, block rewards are being equally shared between miners and ‘masternodes’, with 10% of revenues going to the ‘treasury’ to fund development, community projects and marketing. MONERO (XMR) Cryptocurrency system that aims to provide anonymous digital cash using ring signatures, confidential transactions and stealth addresses to obfuscate the origin, transaction amount and destination of transacted coins. Launched in 2014, it saw a substantial increase in market value in 2016. RIPPLE (XRP) Only cryptocurrency in this list that does not have a blockchain but instead uses a ‘global consensus ledger’. The Ripple protocol is used by institutional actors such as large banks and money service businesses. A function of the native token XRP is to serve as a bridge currency between national currency pairs that are rarely traded, and to prevent spam attacks. LITECOIN (LTC) Litecoin was launched in 2011 and is considered to be the ‘silver’ to bitcoin’s ‘gold’ due to its more plentiful total supply of 84 million LTC. It borrows the main concepts from bitcoin but has altered some key parameters (e.g., the mining algorithm is based on Scrypt instead of bitcoin’s SHA-265). Although bitcoin remains the dominant cryptocurrency in terms of market capitalisation, other cryptocurrencies are increasingly cutting into bitcoin’s historically dominant market cap share: while bitcoin’s market capitalisation accounted for 86% of the total cryptocurrency market in March 2015, it has dropped to 72% as of March 2017. Ether (ETH), the native cryptocurrency of the Ethereum network, has established itself as the second-largest cryptocurrency. The combined ‘other cryptocurrency’ category has doubled its share of the total market capitalisation from 3% in 2015 to 6% in 2017. Privacy-focused cryptocurrencies DASH and monero (XMR) have become increasingly popular and currently constitute a combined 4% of the total cryptocurrency market capitalisation. It shows that both DASH and monero have experienced the most significant growth in terms of price in recent months. While monero’s price already began skyrocketing in the summer of 2016, the price of DASH has increased exponentially since December 2016. The price of ether has also recovered since a series of attacks on the Ethereum ecosystem, starting with the DAO hack in June 2016, and increased 8x since its 2016 low of less than $7 in December. All listed cryptocurrencies have increased their market value in this time window. (Hileman, 2017). OUTLOOK As with any fundamental innovation, the true potential of blockchain technology will become apparent only many years, or possibly decades, after it becomes generally adopted. Forecasting the areas in which blockchain technology will be used to the greatest effect is therefore not possible. We nevertheless would like to mention a few areas where blockchain technology serves as an infrastructure platform that facilitates a variety of promising applications. CRYPTOASSETS The most apparent application is Bitcoin as an asset. It is likely that cryptoassets such as Bitcoin will emerge as their own asset class and thus have the potential to develop into an interesting investment and diversification instrument. Bitcoin itself could over time assume a similar role as gold. Moreover, the potential for trading securities on a public blockchain is large. So-called colored coins can be traded on the Bitcoin (or similar) Blockchain and used in smart contracts, as described below. COLORED COINS A colored coin is a promise of payment that is linked to a Bitcoin transaction. This promise is possible because the communication protocol of the Bitcoin network allows additional information to be tied to a transaction. For example, promises for the delivery of an ounce of gold or a dividend payment can be added to a Bitcoin transaction and represented on the Bitcoin Blockchain. Any of these promises are of course subject to issuer risks and require some extent of trust. This is in sharp contrast to native cryptoassets such as Bitcoin units. SMART CONTRACTS Smart contracts are self-executing contracts. They can be used to stipulate that a Bitcoin payment will be executed only when a certain condition is met. The Ethereum network is currently the leader in the field of smart contracts. Similar to Bitcoin, it is based on blockchain technology and provides a native cryptoasset, called Ether. In contrast to Bitcoin, Ethereum provides a more flexible scripting language and is able to track contractual states. Potential applications include but are not limited to e-voting systems, identity management and decentralized organization, and various forms of fundraising (e.g., initial coin offerings). DATA INTEGRITY Another application for public blockchains is the potential to monitor data files. We havevalready shown how fingerprints of block candidates play an important role in the Bitcoin network. The same technology can be used to produce fingerprints for all kinds of data files and then store them in a blockchain. The entry of a fingerprint into a blockchain ensures that any manipulation attempt will become apparent because any change to the data file will lead to a completely different hash value. Because it is very difficult to change a blockchain retroactively, a fingerprint can serve as proof that a specific data file existed at a specific point in time and ensures the integrity of the data. RISKS Much like any other key innovation, blockchain technology introduces some risks. The following sections will consider some of these risks. As we mentioned in Section 3, we would like to note that this list is non-exhaustive. FORKS The Bitcoin protocol can be altered if the network participants, or at least a sufficient number of them, agree on the suggested modification. It can happen (and in fact has happened) that a blockchain splits because various groups cannot agree about a modification. A split that persists is referred to as a “fork.” The two best-known examples of persistent splits are the Bitcoin Cash fork and Ethereum’s ideological dissent, which resulted in the split to Ethereum and Ethereum Classic. ENERGY WASTAGE Proof-of-work mining is expensive, as it uses a great deal of energy. There are those that criticize Bitcoin and assert that a centralized accounting system is more efficient because consensus can be attained without the allocation of massive amounts of computational power. From our perspective, however, the situation is not so clear-cut. Centralized payment systems are also expensive. Besides infrastructure and operating costs, one would have to calculate the explicit and implicit costs of a central bank. Salary costs should be counted among the explicit costs and the possibility of fraud in the currency monopoly among the implicit costs. Moreover, many cryptoassets use alternative consensus protocols, which do not (solely) rely on computational resources. BITCOIN PRICE VOLATILITY The price of Bitcoin is highly volatile. This leads us to the question of whether the rigid predetermined supply of Bitcoin is a desirable monetary policy in the sense that it leads to a stable currency. The answer is no because the price of Bitcoin also depends on aggregate demand. If a constant supply of money meets a fluctuating aggregate demand, the result is fluctuating prices. In government-run fiat currency systems, the central bank aims to adjust the money supply in response to changes in aggregate demand for money in order to stabilize the price level. In particular, the Federal Reserve System has been explicitly founded “to provide an elastic currency” to mitigate the price fluctuations that arise from changes in the aggregate demand for the U.S. dollar. Since such a mechanism is absent in the current Bitcoin protocol, it is very likely that the Bitcoin unit will display much higher short-term price fluctuations than many government-run fiat currency units. (Berentsen and Schär, 2018) OPPORTUNITIES Cryptocurrency is in a unique position as a forerunner in a possibly transformative technology to long standing financial systems. By its very nature, it is able to fill gaps in current financial technologies and be able to help solve traditional banking problems by being a peer-to-peer system. Napster, another peer-to-peer system, transformed the music industry by cutting out the middle man. Transformative technologies start by solving a specific problem in an industry. For instance, cryptocurrencies are poised to help remediate the problems related to unbanked consumers. Significant portions of the population in developing countries are unbanked. In Latin America, 60% of 600 million inhabitants have no access to bank accounts. Bitcoin’s technology allows for individuals to exchange currency without needing a third trusted party, like a bank, to oversee the transaction. All that is needed to use Bitcoin is a mobile phone, which 70% of Latin Americans do have access to. Due to bitcoin’s ad-hoc networking capability, two users can trade bitcoin with each other by scanning QR codes displayed on their phones printed out by the application. This is a truly unique solution to a problem that has existed for many years for some people. This would invariably increase as the user base grows, so the demand for better cryptocurrency network and applications will come to the forefront. There is an enormous market for potential developers to create these applications, as this technology could affect any industry that relies on a trusted third-party clearing system. Any developers who increase usability through application and GUI improvements to bitcoin would be very successful. Bitcoin’s progression into becoming a transformative technology is driven by its ability to solve long standing problems, combined with a supportive and growing community of developers and users. Businesses are beginning to see the value in using cryptocurrencies for international transactions, especially when transactions need to occur quickly in response to an emergency. Cryptocurrencies are solely positioned to solve this problem thanks to the speed and ease of transaction in the peer-to-peer system. Money can be wired internationally, but typically arriving days after being sent and not for the full amount. The transaction can be hit with any number of unexplained fees as it crosses borders, making it difficult to send the correct amount to another business. A good example of this type of emergency need is an online company who is suffering from a denial-of-service attack and is looking to get immediate protection from a network security company. In this scenario, speed is of transaction is of the essence, for every minute that the company’s website is down, profits are being lost. Cryptocurrency has a major advantage over traditional currencies thanks to its agility in making fast peer-to-peer transactions, especially in international business-to business scenarios. Internet marketplaces have been thriving and are true contenders to traditional brick-and-mortar stores. Amazon.com has grown to a degree that seems almost unexpected. They have even begun to hire “on-demand” delivery drivers, who use their own personally owned vehicle to deliver standard packages. This type of growth shows an attempt to further tighten control of the company’s logistics costs, which expand exponentially with increased business. Ebay.com already uses a paying system that is similar to Bitcoin called PayPal, and has been very successful in using it to facilitate all purchases made on its site. Silk Road was another example of a thriving online market, albeit it‟s very illegal nature. It connected buyers and sellers who mostly used bitcoin to complete transactions. This marketplace showed how a digital currency can connect buyers and sellers without much interference by presiding governments and still succeed. Online shopping is thriving, and bitcoin is poised to extend its reach with efficient and easy payments for both vendors and customers. General purpose online shopping for individuals accounted for nearly 23 percent of transactions processed by Bitpay in the second quarter of 2015. Cryptocurrency has the advantage over traditional card-based for the vendor in that it eliminates those fees. International laws regarding taxation have been passed recently, creating validity for cryptocurrency as a mainstream device. Laws regarding the taxation of cryptocurrencies are required before digital currency could be considered a truly valid form of transactions. Towards the end of 2015, the European Court of Justice announced that it viewed bitcoin transactions as exempt from value-added tax. Steps like this will significantly increase cryptocurrency flow. Some users would refuse to use currency without knowing how it would affect their tax statements, regardless of what positive light in which they are viewed. One of Bitcoin’s largest opportunities is that it can also act as a sort of commodity, similar to gold. The value of gold can spike considerably whenever an event threatens the balance of the global market, as we have seen with the Brexit vote. The precious metal saw an increase in value to a two-year high as investors became uncertain as to how the markets would react to the vote, using it as a safe haven. The commodity market is a widely accepted form of trade worldwide, and cryptocurrency has seemingly begun to mimic the characteristics of gold. Gold has been a long standing holder of value, and that is based on the universal acceptance and trust of its value. Cryptocurrencies could potentially become a big player in the commodity market. They have a unique attribute of being purchased through a direct online mechanism, which creates easy entry for buyers. If bitcoin continues to be a valid refuge for inflating currencies, it will gain validity to investors and push deeper into becoming more mainstream. THREATS Bitcoin has quite a few hurdles to clear for user acceptance to become widespread. The value fluctuations that plague cryptocurrencies puts doubt in users, as well as investors. Ultimately a limiting factor in cryptocurrency is general acceptance. Value fluctuations reduce trust that a consumer’s value would be retained on a day to day basis, limiting faith in the currencies overall worth. The lack of central ownership of cryptocurrencies means that any attempt to remediate this marketing problem using advertisements could theoretically help the investing company’s competition. This is not an ideal situation for a marketing plan. Cryptocurrencies have also seen fraud and theft, generally due to faulty system setups by exchange companies. These hacks generally make the news, and can easily convince the layman that they are unsafe locations to put their money. There is also a large gap in laws that cover the use of cryptocurrency. As long as cryptocurrencies remain in an area not generally covered by law, user acceptance will be limited. User’s need to trust that any transactions using cryptocurrencies are legal and binding. Markets and governments are slow to react to the new technology. Ultimately, all of these factors limit consumer’s trust in bitcoin and cryptocurrency. This lack of trust leads to issues with investors as well. The dead pool of failed startups has increased to 24, mostly citing „security‟ as the main reason for closure. This metric could be considered a watermark for future investors to consider before investing in bitcoin. The Mt Gox and DAO hack shows how inattentive organization can not only lose millions of dollars‟ worth of digital currency, but can drop the value significantly. New startups now know that a haphazard and unplanned launch is ill-advised at best, and new market entry will be limited. This could ultimately hurt bitcoin, as development of better software is important to improve security and user acceptance. As obvious of a concern as it may seem, security implementation and fixes are both generally slow to adapt for any new technology. Even the DAO hack exploit was documented as a potential problem weeks before the attack. One of the issues with security is that the decentralized nature prevents a unified effort to completely secure every server that runs the code. A unified front in the realm of cryptocurrency may need to rise before the peer-to-peer network would become truly secured. A standards committee similar to ANSI, the American National Standards Institute, may need to be appointed for cryptocurrencies to develop security standards beyond the bitcoin application requirements. This type of regulation could only be implemented at the cost of the freedom of peer-to-peer networks, and may cause independent miners to exit the market. There are also competitors to cryptocurrency that are attempting to provide an alternative to digital currency. Apple is one of the main competitors with their product ApplePay. They are levering their infrastructure and hardware to give users the ability to charge their debit or credit cards associated to their iTunes account with their phones. Traditional credit card companies like Visa and MasterCard are happily joining ApplePay‟s infrastructure as are allowed to keep their fees. Bitcoin will always have a difficult time competing with these household names. PayPal has been very successful as the eBay exchanging system, and could potentially be moved into mobile payment. Companies like Apple, Google, and Amazon have entire marketing budgets with a foothold in the mobile application market, giving them a huge advantage over Bitcoin‟s comparatively small time players. Mobile consumers want to be able to buy things with phones directly, and bitcoin would have a hard time rallying together as a community to beat out competitors. Another serious threat to cryptocurrency is the maze of US regulations that would need to be traversed before mainstream user acceptance. The US government has yet to even classify what type of asset bitcoin is, which will prevent most market participants from adopting cryptocurrency-based business models. Cryptocurrency could be labeled as either a security, capital asset, commodity, or a currency, and each would have a different effect on how bitcoin is adopted. International views of bitcoin vary by country, but seem to be viewed positively based on Bitpay‟s assessment of transactions. In Europe, transactions have reached an all-time high at 102,221 per quarter, which may be the cause regulations being passed regarding bitcoin and cryptocurrency. Bitcoin transaction have become exempt from value added tax by the European Court of Justice, effectively recognizing it as a legitimate means of payment in Europe. This simply means that bitcoin transaction will not be taxed in Europe. While great news for European bitcoin users, other major markets are still missing crucial legislation regarding bitcoin taxation. Legislation in the United States could negatively affect how bitcoin transactions are processed, delivering a severe blow to legitimacy as a currency. (DeVries, 2016). REFERENCES Berentsen A., Schär F. (2018). A Short Introduction to the World of Cryptocurrencies, St. Louis: Federal Reserve Bank of St. Louis Review. DeVries, P. (2016). An Analysis of Cryptocurrency, Bitcoin, and the Future, https://www.researchgate.net/publication. Hileman G., Rauchs M. (2017). Global Cryptocurrency Benchmarking Study, Cambridge: Cambridge Centre for Alternative Finance. Kelly, B. (2014). The Bitcoin Big Bang: How Alternative Currencies Are About to Change the World.