The publication of a new book -- Paul Vigna and Michael Casey’s The Age of Cryptocurrency -- brought Bitcoin to our attention again, and highlighted the disruptive potential of cryptocurrencies.
Bitcoin is a cybercurrency; like so-called fiat currencies it lacks any tie to hard, real-world assets such as precious metals. But unlike government-sponsored fiat currencies, its value is not supported (or manipulated) by any central state authority -- or indeed by any financial intermediary.
To understand how such a form of currency can work, it’s helpful to think of money as a system of tokens which are a universally recognized medium of exchange, as well as a system of ledgers recording the ownership of those tokens. As soon as monetary exchange passed beyond the direct physical exchange of coins or other tangible tokens, the ledgers recording ownership took on critical importance. Significantly, those ledgers are all proprietary information possessed by banks and other financial intermediaries, and exchanged among themselves under various circumstances and always at a cost. Mistrust and counterparty risk were mitigated by the development of this system, which we could broadly describe as banking.
Banks and other financial institutions therefore function as indispensable intermediaries in the circulation of money through the economy, by virtue of their control of the ledger-keeping function. The use of a credit card to buy a cup of coffee, although it seems simple, involves a long string of transactions through various intermediaries, who all take a piece of the action.
How Bitcoin Differs From the Banking Model
Bitcoin solves the problem of the ledger system that is needed to mitigate mistrust and counterparty risk -- and it solves it in a completely different way than the present banking system.
All Bitcoin transactions are recorded in a single public ledger, called the blockchain. The blockchain records the assignment of Bitcoin balances to Bitcoin “addresses.” To own a Bitcoin means to possess the password that permits the Bitcoins associated with a given address to be transferred to another address. The integrity of the blockchain is guaranteed not by a central authority but by the distributed effort of competing verifiers. Those verifiers are rewarded for their effort -- which becomes exponentially more difficult as the blockchain grows larger -- with the creation of new Bitcoins according to a definite and unalterable algorithm.
When Bitcoins are exchanged, there are no intermediaries -- just the transfer of ownership from one Bitcoin address to another, and the verification of the transfer by distributed computing. Think of it as the peer-to-peer model of AirBnB applied to a monetary system.
The distributed model also ensures that there are thousands of actors maintaining the integrity of the blockchain as well as the core software, which is all entirely open-source and open to scrutiny. In spite of reports of hacks and thefts, all have been incidental to the Bitcoin ecosystem, and have not represented fundamental structural weaknesses.
This is not to say that there may not be other cryptocurrencies yet to emerge that improve on Bitcoin in some functional aspect. We simply note that the disruptive influence of cryptocurrencies -- which basically disintermediate the entire existing financial ecosystem -- has hardly even begun to manifest itself. We do not believe this disintermediation is imminent, and we do not believe that cryptocurrencies will completely replace either fiat currencies or tangible monies such as precious metals. But we do believe that cryptocurrencies will become a major, disruptive presence in global finance -- and we are watching carefully. Over the next several years, as global central banks continue their all-out war on deflation, cryptocurrencies may gradually rise in prominence as an alternative form of money that, like gold, is insulated from the macro policy goals of governments.
What is attractive about cryptocurrencies such as Bitcoin? They use a different model to solve the same problems tackled by the traditional banking system -- but they have a few characteristics that may make them attractive.
- Anonymity. Although every Bitcoin transaction is recorded forever in the blockchain, making a direct connection between an individual and a particular Bitcoin wallet is next to impossible except for all but the most determined law enforcement agencies (and extremely difficult and time-consuming even for them). No intermediaries are tracking exchanges or compiling data about counterparties and their transactions. Obviously this is appealing to both legitimate users and those who are engaging in illegal activities.
- Cost. With no intermediaries, transactions are instant and free. No actors stand between counterparties to shave off transaction costs -- and the distributed system deals with counterparty risk.
- Convenience. Since Bitcoins exist only in cyberspace as information, and transactions are unmonitored by any state actors, transporting them from one jurisdiction to another is easier than with any other currency.
- Independence. Bitcoins exist completely apart from the financial ecosystem of fiat currencies in which institutional actors such as governments and central banks can manipulate currency values.
In short, cryptocurrencies combine some of the most attractive characteristics of fiat currencies and tangible monies such as precious metals. Of course, they also have significant risks and dangers -- they are young and unstable, and they face potential legal hurdles from governments seeking to obstruct their use. This is why we remain observers rather than participants, although we are watching the development of cryptocurrencies with close interest.
Investment implications: None, for now -- we are simply aware of the incremental arrival of fundamentally disruptive cryptocurrencies and are staying abreast of ongoing developments.
DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer