Days of currency future?

Despite his advancing years, Marketwatch has always fancied himself as being pretty aware on the technology front.  But he has to admit he has found the whole area of cryptocurrency a challenge for him.  Even the application of liquid brain food has been difficult.

But it might just be that this technology is be getting respectable and shedding its image of drug deals and money laundering by organised crime.  But first, some history.

Probably the best known currency is Bitcoin.  Its name has become synonymous with the wider cryptocurrency market.  It first surfaced in late 2008 when two computer programmers, Satoshi Nakamoto and Marti Malmi registered a new domain, Bitcoin.org.  To this day, nobody is quite sure who these two people are.

Together with a group of volunteers they produced a paper which laid out principles of Bitcoin, an electronic payment system that would eliminate the need for any central authority while ensuring secure, verifiable transactions.  In short, the document described a new form of currency, one that allowed for fully trusted payments on the web, that is, they require a minimal amount or even no trust between parties.

In other words, the system allowed two users who didn’t know or trust each other to exchange money in the same way they could pass cash back and forth.  The system also allowed users to confirm messages, transactions and data using a tool called public key encryption, eliminating any need to disclose their identities to transaction partners or third parties.

Bitcoins aren’t printed, like dollars, they’re produced by computers all around the world using free software and held electronically in programs called wallets.  The smallest unit of a Bitcoin is called a satoshi.  It is one hundred millionth of a Bitcoin (0.00000001).  This enables micro-transactions that traditional electronic money cannot perform.

Generally the term “Bitcoin” has two possible interpretations.  There’s Bitcoin the token, which refers to the keys to a unit of the digital currency that users own and trade.  A Bitcoin token is held in a Bitcoin wallet that is identified by a string of numbers and letters such as “1A1zP1eP5QGefi2DMPTfTL5SLmv7DivfNa.”  When someone wants to send you Bitcoin, that person will send it to your particular, public wallet address, and you will access it via your private keys.

Then there’s Bitcoin the protocol, a distributed ledger that maintains the balances of all token trading.  These ledgers are massive files stored on thousands of computers around the world.  The network records each transaction onto these ledgers and then propagates them to all of the other ledgers on the network. Once all of the networks agree that they have recorded all of the correct information, including additional data added to a transaction that allows the network to store data immutably, the network permanently confirms the transaction.

Bitcoin can be used to pay for things electronically, if both parties are willing.  In that sense it’s like a conventional currency, which can also be traded digitally using ledgers owned by centralized banks.  Unlike payment services such as PayPal or credit cards, however, once you send a Bitcoin, the transaction is irreversible; it cannot be called back.

Another attribute of Bitcoin that takes away the need for central banks is that its supply is tightly controlled by the underlying algorithm.  With conventional currencies, central banks can issue as many currency units as they want and can attempt to manipulate a currency’s value relative to others.  Holders of the currency, especially citizens with little alternative, bear the cost.

With Bitcoin, a small number of new coins trickle out every hour, and will continue to do so at a diminishing rate until a maximum of 21 million has been reached.  This makes Bitcoin more attractive as an asset: in theory, if demand grows and the supply remains the same, the value will increase.

So, in that case, is it an asset in which you invest, or is a currency which you can use as a method of payment?  The short answer is, it’s both.  As we all know, currencies have a value when compared with each other.  For example, today the Australian dollar is worth US$0.74.  These values fluctuate but dramatic movements are limited to a few cents.  Compare that with the following chart comparing the value of Bitcoin against the US$ over the past 6 years.

Bitcoin Chart

By any measure, this is a volatile performance and one not seen in conventional currencies.  So, it’s a currency but behaves like a high-risk asset.

And Bitcoin was the best-performing asset last year.  So what is going on?  Is this another Bitcoin bubble, as seen at the end of 2017, or has something fundamentally changed?

The popping of the 2017 bubble, which led Bitcoin to crash 83 per cent by Dec 7, 2018, from its peak just under a year earlier, can be traced to several forces.

First, after almost 10 years of keeping the benchmark US Federal Reserve funds rate at close to zero, the United States Federal Reserve hiked interest rates repeatedly in 2018, almost doubling the rate over the year to 2.4%.  It also shrank its balance sheet, which further tightened monetary policy.

As a result, several risk assets took a hit, including stocks, bonds, gold and most of all, Bitcoin.  When the Fed stopped raising rates last year and resumed expanding its balance sheet, risk assets turned up again, most of all, Bitcoin.

Second, crypto exchanges had some serious security issues.  In January 2018, the Japanese exchange Coincheck was hacked and some US$500 million (S$672 million) worth of crypto assets stolen.  Then in June 2018, there was another hack, this time at the South Korean crypto exchange Coinrail, in which about US$40 million worth of crypto assets disappeared.

These incidents scared off many investors and almost certainly accelerated Bitcoin’s decline.

Third, there were no easy pathways for mainstream investors to invest in Bitcoin. Banks would not be custodians of it, and few broker-dealers were offering crypto assets.

Several financial celebrities at the time, including The Vanguard Group founder John Bogle, JPMorgan chief executive Jamie Dimon and legendary investor Warren Buffett, had pooh-poohed Bitcoin.

But this year, it is different.

In the wake of the Covid-19 outbreak, the US Federal Reserve is stepping on the monetary accelerator as never before.  US federal debt is close to 100 per cent of gross domestic product, and much of it could end up being monetised.

Moreover, the Fed has signalled that it plans to keep interest rates at near zero till at least 2023.

Nor is the Fed the only central bank on a money-printing binge.  The European Central Bank and the Bank of Japan are running negative interest rates.  The Bank of England might soon follow.

Looking at the exponentially growing supply of currencies and the potential for their debasement, as well as higher inflation, Bitcoin investors believe they are sitting on the ultimate scarce and most pristine reserve asset – better even than gold, which is not as supply-constrained, nor as easy to store, verify or transfer.

But perhaps most significantly, Bitcoin has started to go mainstream.  Along with other crypto assets, it is available on an increasing number of online trading platforms.  Some brokerages have started to offer Bitcoin.

In August, one of the world’s largest money managers, Fidelity Investments, announced that it would launch a Bitcoin fund, which will open the way for family offices, investment advisers and institutions to invest in the cryptocurrency.

Last month, online payment company PayPal announced that it will soon enable its customers to buy and sell Bitcoin and other crypto assets on its platform.

In November, Mr Dimon repeated his opposition to cryptocurrencies.  He, and others, believe that governments will ultimately more heavily regulate it, saying that oversight is inevitable for something so large.

Caveat emptor (let the buyer beware).

Bearing in mind the festive season is on us, Marketwatch defers to his dear wife who, among other things, is a bubbles lady.  Push the boat out with a bottle or two of Piper Heidsieck.  Or, if you prefer Australian, sample the delights of Chandon, a fine drop.  Then, on the other hand, there is the wonderful sparkling Shiraz, a family favourite for Christmas Day.  There are plenty of different ones on offer but our favourite has always been the Seppelt.

But above all, my best wishes to you and your family for a happy and safe Christmas.

We will talk again in 2021.

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