What's With Bitcoin's Recent Surge?

Guild Investment Management |

Bitcoin, the virtual “cryptocurrency,” has been in the news again. Bitcoin’s value has fluctuated wildly over the past several years, which is one of the obvious factors keeping it from wider adoption as a real medium of exchange (imagine getting on a plane to a foreign destination with little idea of the worth your currency will have when you disembark). We’ve noticed that the intensity of Bitcoin news coverage is closely related to its current price action, and the spate of new stories has indeed corresponded with another parabolic move up above $400 that started in October.

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The coverage has been higher-profile. Last week’s Economist featured an article on one of the key technologies underlying Bitcoin -- the “blockchain,” which we explain below. Any time a speculative vehicle offers potential rewards of the kind Bitcoin does (a 64 percent return in the last month), there will be new investors looking at it. We thought it worthwhile to reprint some of our observations and reasons to be cautious about Bitcoin itself, as well as its underlying technologies.

Bitcoin Basics

Here’s a refresher on Bitcoin.

Bitcoin is a cryptocurrency -- a form of digital money that proponents hope will get all the middlemen out of financial transactions and permit the parties to an exchange (even ones who do not know or trust one another) to conduct that exchange directly between themselves. If you think about who all those middlemen are, you realize that most of the financial ecosystem consists of middlemen: some state (governments who manage fiat currencies) and some private (everyone from small insurance brokerages to giant multinational institutions that provide a complete range of financial services from commercial banking to investment banking and asset management).

Bitcoin and the Promise of “Digital Trust”

Financial mediation arises because of the messiness of human relationships: we need to interact with people we don’t necessarily know and can’t necessarily trust. The intermediary stands between the parties of an exchange, making guarantees to each side and lubricating the gears of commerce. Without intermediaries, we’d be reduced to barter — and the robust, complex modern economy with all the benefits it provides would be unthinkable. Of course, intermediaries are themselves not immune from the same messiness. Banks fail; fraudulent people inhabit and occasionally co-opt whole institutions; public financial policies can have disastrous consequences. There is ultimately nowhere to find total security and total safety. And likewise, there is nowhere to escape from the fees claimed by those intermediaries out of the capital flowing through the global financial system -- unless, that is, humans could somehow be removed from the equation.

That’s what bitcoin proposes to do -- reduce the risk of fraud and the expense of transactions by replacing the middlemen with a suite of cold, hard technological tools.That way, you can still have the fluidity of a modern financial system, but without the risks and with far lower costs. “Digital trust at a fraction of the price!”

Core Bitcoin Technologies

Bitcoin relies on two core technologies: the blockchain and public key encryption. Both are ways to eliminate the risk of fraud in transactions. Both of them have been noticed as potentially transformative technologies in their own right. Even if Bitcoin itself ends up as a footnote, some analysts argue, these technologies may find broader applications anywhere “digital trust” could be applied to remove fallible human intermediaries -- for example, in banks, clearing houses, or public institutions.

The Blockchain

The blockchain is a ledger like that in a bank. Banks have private ledgers whose accuracy is guaranteed by the bank itself, legislators, third-party auditors, and market discipline -- and the bank profits by possessing this proprietary information.   But Bitcoin’s blockchain is public. In it, every transaction is recorded: “Bitcoin address X assigns 5 Bitcoins to Bitcoin address Y.” The blockchain is distributed, held in its entirety in countless network “nodes.” The distribution of millions of those nodes makes it theoretically impossible to corrupt or game the blockchain, since they would all have to agree (but more about that below).

Public Key Encryption

The other key Bitcoin technology is public key encryption. This is a way to send secure messages from one person to another, which cannot be intercepted by a third party in between. Public key encryption needs two “keys” (long chains of numbers and letters) to unlock a secure communication. One is your public key, which everyone, including the person sending something to you, knows -- it’s for encrypting. The other is your private key, known only to you. Your private key, and only your private key, can “unlock” (decrypt) a message sent using your public key. These keys are generated in pairs by a mathematical algorithm. Again, the mathematics are abstruse -- but suffice it to say that with a public key in hand, no computer that currently exists could “reverse engineer” the private key (but more about that below).

What Are the Dangers?

Together with the Economist, we see the applicability of Bitcoin’s technologies to a variety of situations where a “public ledger” could replace a private one and disintermediate the ledger-keepers. These technologies will work, will find niches where they shine, and will be disruptive.

We also see that the revolutionary character of these technologies shouldn’t be overstated. We say this for two reasons.

First, the “human factor” will never be eliminated. These technologies, in theory, replace fallible or malign human actors with an algorithmic system. Yet humans are involved in this system at every stage -- and some of them will be seeking ways to exploit it. Wherever these technologies are deployed in real life, they will be “intersecting” with real people. And in the cracks between the human world and the pure mathematics of the algorithms, there will be opportunities for fraud, theft, and deception.

For example, you need your private keys to send secure messages. As beautiful as this encryption system is -- and as resistant to “brute force” hacking attacks -- you must store your private keys somewhere. Where will it be? In a “virtual wallet.” And where will that virtual wallet live? Perhaps on your computer -- where it will be vulnerable to viruses, keyloggers (a malicious virus which records all a user’s key strokes and sends them to a hacker), and other cyber-threats. Perhaps on your mobile device -- where besides those threats, you have the risk of a lost phone. Perhaps written on paper or in some other location not connected to the Internet -- in which case it will be like cash, vulnerable to theft by any old-fashioned, low-tech thief.

Second, and perhaps more importantly, even the theoretical invulnerability of these technologies is ultimately a matter of technological hubris. The integrity of a blockchain is compromised at the moment a single actor has 51 percent of all the computing power deployed in support of the network (and potentially compromised well before that point). Radical technological innovation has been known to occur in human history -- who is to say when a computing revolution (such as quantum computing) might not suddenly make the blockchain’s computational integrity a thing of the past? (Our recent coverage of Alphabet’s [NASDAQ: GOOG] long-term investment in quantum computing should give pause to anyone who thinks quantum computing is pure science fiction.) If businesses and governments everywhere became dependent on blockchain technology, wouldn’t the possessor of an effective quantum computing system have every motivation to use it clandestinely for nefarious purposes?

And as far as encryption goes, the current public key standard relies on the mathematical intractability of factoring very large integers. But again, discoveries and innovations have been known to occur from time to time in the mathematical sciences. When will someone “break” public key encryption with a transformative development in the underlying mathematics? We don’t know.

When we contemplate an architecture of “digital trust” with such distant but conceivably catastrophic threats, it begins to look less robust to us. We will not be alone in this analysis, which we are confident is also being discussed at high levels in the cybersecurity industry and in the national security establishment.

Is “Digital Trust” Really More Robust?

These technologies are critically reliant on a few technical and mathematical elements whose integrity looks unassailable -- for now. That reliance on a few pillars, someday, may make it look far less secure than it now seems in theory. The “messiness” of the world’s welter of fiat currencies and countless intermediators may begin to look more secure -- a chaotic system with surprising resilience that economic analyst Nassim Nicholas Taleb describes as “antifragile.” More opportunity for malfeasance -- but spread over more “critical elements.”

Investment implications: The basic technologies behind Bitcoin -- the blockchain and public key encryption -- are powerful and will prove useful in many industries where trust is an issue between cooperating parties. However, we think that potential pitfalls of these technologies will mean that those who need assurance of security will never rely on them entirely. There will always be a critical role for human intermediaries.

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

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