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‘C’ Is For Crypto-currency

What are cryptocurrencies and how have they become so valuable?

Photo Credit : Shutterstock

When it first hit the e-waves on 3 January 2009, no significant value was attached to it. Interest was merely tertiary. It was barely used to trade or transfer value. Merchants did not understand this new exchange mechanism.  Governments, too, were unconcerned about the implications on the economy. Fiat money was in their control.

Nearly a decade later, however, after a “no-man” going by the pseudonym of Satoshi Nakamoto wrote a white paper on blockchain and released one of its applications in a cryptocurrency ‘bitcoin’, the technology has spawned a multibillion dollar empire of “virtual” currencies. In other words, ‘money’. Not real. But virtual. Existing in computer nodes and wallets across the globe.

At the last reckoning, the combined value of virtual currencies has soared to $793 billion — and growing (from next to nothing a decennial ago). Cryptos added about $210 billion in market value in the last two weeks, and now their worth has ballooned to about 34 per cent of Indian equity at $2,320 billion.

Putting that further in perspective, the stocks listed on the Indian bourses generate billions of dollars in profits, with their value derived from the underlying assets they own, such as land or plants and machinery.

Cryptocurrencies, though, operate in a different realm. They live only in computers and computer codes, digital bits and bytes in machine-readable language devised for hard disks, decentralised computers, which means any such device connected to the global network. No central authority governs virtual currencies. None determines their value. Sure, they are mined (or decoded and deciphered) to generate coins for the miners. But, no interest accrues or is earned, no income is generated by itself.

Yet, they now command enormous market value. Investors and speculators across the world are scrambling over one another to be in or a part of the bitcoin action. A fortnight ago, a massive frenzied bidding war took prices of cryptos to stratospheric heights. In fact, other high-flying cryptocurrencies like ripple, ethereum, bitcoincash, cordano, litecoin, stellar, nem, iota, dash, monero have seen similar and higher price action. Besides all these crypto currencies have their own identies and logos. (See graphs: Flying Without Wings)

Bitcoin hit $19,909 apiece (Rs 12.74 lakh). Shortly after, a huge sell-off saw the price of a bitcoin crash to $10,000 (Rs 6.4 lakh) in a matter of days. It has, of course, bounced up now to $14,982 (Rs 9.58 lakh), again in less than a week.

Moreover, considering the price of a bitcoin a year ago, when it was just $968 (Rs 61,952), means that it has risen a whopping 15 times in a year. Such a frenzy is rarely seen for a new phenomenon in the currency world. Does bitcoins and other cryptos really have value? Do they offer an alternative option to the fiat currency?

Complex Cryptos
Legendary investors such as Warren Buffett are sceptical about the idea. Buffett recently noted that you can’t value bitcoin because it’s not a value-generating asset. Also, Nobel Prize winner Robert Schiller noted in a recent TV interview that “the value of bitcoin is exceptionally ambiguous”.

Why, then, is there such demand for the “currency of virtualness”? Will demand boost it further? Is this a fad of the new millennium or does it mark a real breakthrough in de-centralising currencies? Does this constitute a revolution in technology or is it merely a brewing pot of uncertainty lurking in the virtualness of cyber space?

The answers to this lie in uses of cryptocurrency. For instance, some of these new coin offerings could be used against or backed by alternative assets like gold or commodities. Venezuela is looking at issuing a $5.9 billion cryptocurrency backed by oil assets.

Several hundred variations and currencies have since seen the ‘light of day’ (or should that be ‘depths of cyber space’?). In fact, when we went to print, 1,384 virtual currencies clamoured for attention. Virtual currencies are being added to the roster almost every other day. And each of these perhaps undermines the existing cryptocurrencies and can disrupt the technology or the concept or even prices.

This will certainly make the world of cryptocurrencies more complex. How can you know which one has value? 
Each crypto can have its own market or niche focus area in markets they choose to serve. Many of them have been offered through the ICO route, that is, the initial coin offering route (similar to an initial public offer or an IPO), with a thesis on the type of technology and the number of coins that can be mined. Bitcoin, for instance, has a limit of 21 million coins, the last of which will be mined in 2140. As of now, there are about 16 million bitcoins that have been mined, but it is estimated that out of that, there are only about 5 million bitcoins in circulation, which gives the currency a sort of scarcity premium in market parlance. Other cryptos may have different limits to how much can be mined.

In some cases, due to this scarcity and increasingly widespread acceptance with merchant establishments, there is no denying that bitcoin is becoming more mainstream; and is finding some of its value. Blockchain and cryptocurrency enthusiasts are quite optimistic that bitcoins will do well the next year despite the year-end volatility.

Major exchanges such as The Chicago Board Options Exchange (Cboe) and CME have also introduced bitcoin futures, which provides another main stream push for the virtual currency by which institutional investors who shied away from the virtual currency exchanges can now invest or buy them for clients.

Says Raj Chowdhury, MD, HashCash Consultants, “Institutional investors have found a way to buy into bitcoins without actually getting locked into the virtual currency, through the futures markets. This means, bitcoins are receiving more mainstream attention. Bitcoin could go up to $40,000 purely on the basis of demand and supply.”

Cryptos And Speculation
Several press releases of The Reserve Bank of India have warned about the pitfalls of investing in bitcoins. In the first such release in December 2016, the RBI warned about the safety and security of exchanges (See box: ‘RBI Cautions’).

It seems that, at present, plenty of speculation has built up in bitcoins, largely because of a liquidity gush in the global economy. However, Chowdhury dismisses this claim about speculation. “If you say that bitcoin is speculation, then let me ask you what is not speculation? If you look at the real valuation of companies, you would not find a single company that is not overvalued. Have you ever questioned that the common stocks that you are buying even if a company files for bankruptcy, common stockholders are speculating on the secondary market; that is what is going on. So, speculation is all over.”

But, what is peculiar to bitcoin is that people say that there is no underlying asset. Proponents of blockchain say that it is a distributed ledger, where thousands of servers are holding the bitcoin ledger. So, people are holding the ledger, which accounts for the bitcoins that are mined. Besides, there are miners who solve the cryptography to mine new coins. Says Chowdhury: “Bitcoin miners have to get a transaction fee that goes to the miner. The ledger is immutable and nobody can tamper with it. You can never change the ledger, you can never remove any blocks from the transaction ledger.” This is what makes blockchain unique and tamper-proof.

If you want to add a blockchain to the bitcoin blockchain, you have to get the permission of the network. But, there are many nodes that will not allow you to change the data in the sequence block, hence your only recourse if you want new coins is to mine for bitcoins and generate new algorithms, which are linked to the old blockchain. Once you link the hash of the previous block to the next block in the chain, you have to link the previous block to the next block in the chain. One cannot tamper or change the blocks.

Legalising Cryptocurrencies
Another thing that is driving the value of bitcoins is that more people are beginning to use bitcoins. Japan has legalised it as a currency, while more merchant establishments are open to the idea of accepting payments in bitcoins. As more people ask or consider bitcoins as payments, the more its usage will grow in the market, driving new demand for the currency — and perhaps even higher prices.

“The more people use bitcoins, the more the value it can have, and that is probably driving its price,” says Rajesh Dhuddu, SVP, Quatro and Nasscom Blockchain Council chair. “One, supply is limited. Currently, there are 16 million bitcoins. Of that, 64 per cent has never been used, and will never be. That is because they are lying with somebody, and that somebody may not even know that they have bitcoins,” he adds.

In the early days, it is estimated that when people started dealing with this new currency they stored it in some hard-drives, which are since lost, or some of them were simply not interested. Says Dhuddu: “The person who invented bitcoins is said to have 1 million bitcoins. So, like that, there are different people holding bitcoins; perhaps they are not interested in dealing with bitcoins. It is like some scientists who don’t patent their inventions, while others do.”

Chowdhury also agrees that bitcoin value is due to its wider acceptance. “Sure, bitcoin is a like piece of code, but then, when others are willing to accept it, it has value. What is money anyway, it is a piece of paper that has some value to it because others are willing to accept it. And if merchants start accepting bitcoins, it has value. If you are able to liquidate it against something else, it has value.”

Cracking The Code
In order to understand why cryptocurrencies are now becoming more mainstream, it is essential to know the real technology behind it. The key underlying principle behind the bitcoin technology is blockchain technology. What is blockchain? Chowdhury explains that “blockchain is a way of a network to deterministically establish that a transfer has happened from one party to another. There was nothing else in the world before blockchain that could have done this. So, if you are sending something of value to me, the network can establish that a transfer has taken place without the need for a third party, an in-between. For instance, if you had to transfer money to me before, your HDFC Bank had to transfer to my ICICI Bank. But, that is no longer required because the network can deterministically do that henceforth.”

Cryptocurrency is a result of cryptography, which encrypts documents to make them unhackable. “Cryptography is a form of communication which is how I can make my communication reliable and authentic even in the presence of people who will go to any lengths to make it unreliable,” explains Dhuddu. “So, you are working with a large set of people where there will be several bad elements who try to work against you. From here, came cryptocurrency. Several aspects like secured hash alorigthms, consensus mechanism, linking everything from the genesis to the last transaction on the network gives bitcoins an immutability. So, once you write something on a blockchain, you can’t change it.” The old transaction can never be made null and void. So, because of this, the cost of manipulation is higher than the reward.

Bitcoin is a coin on that blockchain technology. As a technology, blockchain allows you to transfer assets from one entity to another, which is why it is billed as a revolutionary technology. For example, let us assume you are sending me $1. You can take a picture of the dollar and e-mail it to me. But will that transfer the money to me, not really. Because both you and me have a copy of the dollar. So, the essential issue of transferability is not addressed. In blockchain, the network will establish that I have sent that $1 just like an e-mail, without the need of the bank, and that will also establish trust in the network.

In fact, banks are also using the blockchain technology to speed up cross-border trade finance. There are three pillars of banking, one of documents, exchange of funds, exchange of messages. All three can be revolutionised by blockchain as all of these are transferable.

“We did a trade finance transaction between Emirates NBD and ICICI Bank in which we transferred trade documents such as purchase orders, letter of credit, bills of lading, customs documents which is involved in bank guarantees, invoice discounting, pre-shipment loans, which are trade finance activities. So, we exchanged these documents over a private blockchain and exchanged trade finance documents, transaction messages, which triggered actual fund transfer between the core banking systems. It was moved through fiat currency only, but the messages went through the blockchain, which executed the transfer,” explains Chowdhury.

With this, banks benefitted through moving the documents in real-time and being able to establish that these are authentic documents far better than the conventional way of sending the documents, which can be fake. In a blockchain transaction, there are no forgeries. This eliminates fraud, and helps in moving documents in real time, which typically takes 60 days. Besides, no third party is required to control the documents.

Value Of The Virtual Alchemy
Tomorrow’s world will look very different. So, it is of little surprise then that many entities and groups of individuals are launching their own cryptocurrencies. Whether all these will have value — and how much — in a few years remains to be seen, but suffice it to say that cryptocurrencies are disrupting how we do peer-to-peer transactions.

Bitcoin investors, though, need to tread carefully. Even while there seems to be a short-term demand-supply mismatch and the newness of the technology can drive prices higher, in the longer run, bitcoin prices will reflect in the economic value they can create or the transaction costs it can lower.

On the other hand, while bitcoins and other cryptocurrencies have invincibility, the underlying technology is still prone to risks. New cryptos run the risk of technology changes and inexperienced backers. Besides, the risks of reliance on a digital exchange remains. In the past, hackers have run down cryptocurrency exchanges.

In contrast to fiat currencies, virtual currencies have not displayed any kind of stability. And it is too early to say if they have the capacity to exhibit the kind of accepted stability, which is demanded of currencies. At the moment, investors are hoarding the virtual currencies, and this hoarding is driving speculation and the price rise.

There are other drawbacks such as lack of centralised authority, because of which there is no grievance redressal mechanism. If your account is hacked or you lose the bitkeys, you can lose all your savings.

Another issue dogging bitcoin and cryptocurrency investing in India is that many people who are buying it do not own an account in the cryptocurrency ledger. Instead, they have an account with an exchange, which, in turn, has an account with others sources, and so on. Hence, it works like a multi-level account, which poses a high counterparty risk. If you hold direct bitcoins in the ledger, that should work, but if you own it in other places, then safety can be an issue.

“There are no limits to the number of cryptocurrencies that can come up in the future. So, if you see the current appreciation, it is nothing more than madness,” says freelance trainer and author of Riding the Roller Coaster – Lessons from Financial Market Cycles We Repeatedly Forge Amit Trivedi. “Historically, manias started with the promise of changing the world. Blockchain, the underlying technology, has the promise of changing the world. People who have invested early may make money in bitcoins. But the larger number of people who come in late, may not be so lucky.”  

Pitfalls of Virtual Currencies

RBI cautioned investors of dealing  in bitcoins and other virtual currencies (VC) way back in December  2013. Here are some of the risks the Apex Bank mentions:

>>VCs  are in digital form and are thus stored in digital/electronic media  called e-wallets. Therefore, they are prone to losses arising out of  hacking, loss of password, compromise of access credentials, malware  attack, etc. Since they are not created by or traded through any  authorised central registry or agency, the loss of the e-wallet could  result in the permanent loss of the VCs held in them.

>>Payments  by VCs, such as bitcoins, take place on a peer-to-peer basis without an  authorised central agency, which regulates such payments. As such,  there is no established framework for recourse to customer problems /  disputes / charge backs, etc.

>>There is no underlying or  backing of any asset for VCs. Their value seems to be a matter of  speculation. Huge volatility in the value of VCs has been noticed in the  recent past. Thus, the users are exposed to potential losses on account  of such volatility in value.

>>It is reported that VCs, such  as Bitcoins, are being traded on exchange platforms set up in various  jurisdictions whose legal status is also unclear. Hence, the traders of  VCs on such platforms are exposed to legal as well as financial risks.

>>There  have been several media reports of the usage of VCs, including  bitcoins, for illicit and illegal activities in several jurisdictions.  The absence of information of counterparties in such peer-to-peer  anonymous/ pseudonymous systems could subject the users to unintentional  breaches of anti-money laundering and combating the financing of  terrorism laws.

The basics of bitcoin

>>What is a bitcoin?

Bitcoin is  the first cryptocurrency. It is a digital currency, created  electronically and held in computers. It is a decentralised ecosystem,  and is not controlled by any single entity. Bitcoins cannot be printed.  They are mined through computers by solving mathematical problems.

>>How different is bitcoin from normal currencies?
Bitcoin  is not controlled by any centralised authority or a bank. It is an  electronic currency in the hands of the people, produced by the people  who are in the network and who mine bitcoins, and/or maintain the  ledgers. Anyone can join the community of bitcoin miners. It also acts  as payment processor as you can transfer bitcoins easily to other  accounts.

>>Who created Bitcoin?

Satoshi Nakamoto created  the blockchain technology and mooted the idea of bitcoins. Essentially,  bitcoins were created to be easily transferred electronically with low  transaction fees.

>>What are the salient features of bitcoins?

A  bitcoin network is not owned by a single group or central authority.  The computers that mine and process the transactions become a part of  the network working together as a seamless whole. Bitcoin is an  anonymous system as one gets a digital address not linked to names,  addresses, or other personal information. But bitcoins store details of  transactions that happened in a blockchain. You can transfer bitcoins  instantly, but once transferred, they are gone out of your account for  good.