CRYPTOCURRENCY
Rise of the new money
On January 3, 2009, a programer (or programers) working under the pseudonym Satoshi Nakamoto launched something remarkable: a new form of money, a digital cryptocurrency called Bitcoin. The idea was that Bitcoin would be completely independent of outside forces—no banks, no governments. It would be a distributed method of wealth that required no trusted third party to verify transfers or hold money. Supply was limited, to combat inflation. A simple idea done with clever math.
Cryptocurrencies run on a peer-to-peer system. Transactions take place between two parties without intermediaries, verified by horribly involved calculations. This math is based on public-key cryptography; put very simply, each transaction is verified by the completion of a series of cryptographic puzzles, and added to the blockchain. The blockchain is the ledger, which is distributed and checked by the network. To reward those who do the hard work of maintaining the ledger, they are paid in coins—as you “mine,” you run the network.
The math may be complex, and the concept big, but in use, it’s fairly easy. Create a wallet with public and private cryptographic keys, and you can buy and transfer coins. At first glance, there’s one clear problem: no collateral at all. Bitcoin is built on sand and trust, yet it works….
Enthusiastic early adopters got the Bitcoin gears turning, but the initial value of the coins was negligible and negotiable, and they were traded between friends. The first cited proper purchase was in May 2010, for two pizzas, at a cost of 10,000 coins.
In July 2010, a Bitcoin was worth eight cents. By early 2011, it achieved parity with the dollar. Early this year, it reached parity with gold. Since then, it has gone well beyond that. As we type this, a Bitcoin is worth $4,159. Those pizzas cost the equivalent of over $41 million today. While that quick calculation was being made, Bitcoin jumped to $4,202, and then back to $4,130. Valuable, but also terribly volatile. There have been some spectacular slumps along the way, the value halving or worse a number of times.
Money is trust, and to be worth anything, it must be transferable to goods or other currencies. At first, you would have to talk a merchant into accepting it; now, Bitcoin has reached a turning point, depending on where you are in the world. It is not fully integrated with the banking system, or even legal tender, yet it can be spent.
The United States Department of the Treasury classifies cryptocurrencies as virtual currencies, and therefore not under its remit; however, their generation counts as money transmitters. Last year, a federal judge ruled that Bitcoins are “funds within the plain meaning of the term.” So, it is money. In China, individuals can trade in Bitcoins, but the banks cannot.
Elsewhere in the world, it ranges from being completely illegal to being widely accepted as money. Generally, it is treated as “private money,” not legal tender, but is still wealth, and subject to the same taxation. One acid test for money is whether you can pay your taxes with it. That next step has been taken. From April this year, Japan started counting Bitcoin as legal tender. Russia, Germany, and others reportedly have plans for similar steps. Bitcoin is on the verge of going fully legit. Full government approval inevitably leads to regulations at some point, or attempts, anyway.
FINANCIAL STABILITY
Until legislation fully catches up with cryptocurrencies, you are operating largely outside the traditional financial framework, and therefore the legal protection of the central banks and governments. You are pretty much on your own if things go wrong. Don’t panic, though; Bitcoin has amassed enough adherents to be respectably stable.
Another acid test for money is whether you can swap it for other money, preferably the green folding kind. To do this, you need to go to a Bitcoin exchange. There are some 64 of these worldwide, and levels of security, privacy, and control vary. Over the years, a number have had their security breached, gone bankrupt, or, in at least one case, simply disappeared with all the funds. This is where that democratic and distributed— and hence loosely regulated—aspect of cryptocurrencies can look worryingly fragile. Some research is recommended before you start making large transactions. Scary? A little, but the cowboys are rapidly being weeded out.
The days of these unregulated exchanges may well be numbered, anyway. Becoming legal tender opens the way for the traditional financial institutions to start trading in Bitcoin. Increasingly, it is becoming yet another cog in the wheels of international business. This summer, the Swiss bank Falcon added Bitcoins to its accounts—customers can now buy and hold them in their own accounts. At the end of August, this was expanded to Ether, Litecoin, and Bitcoin Cash, too. Amazon, Apple, and Google are all working on integrating Bitcoin services. Widespread adoption is coming quickly.
Meanwhile, there are more than a few technical problems to deal with. The increasingly technical complexity of transactions has begun to drag. Currently, a Bitcoin transaction takes about 20 minutes to process; occasionally, an hour or more. On smaller deals, merchants often ignore this, and take the payment on trust—if you are buying a fancy new watch, you’ll probably have to wait.
This, along with the attendant meager results when mining, has helped spark a bit of a civil war in the Bitcoin camp, which led to it being split in two. A clone of Bitcoin was created—Bitcoin Cash—which altered the math to allow for much faster transitions. A software update is also due this fall—Segwit2x—aimed at addressing the speed issue as well. This is also causing conniptions, and a second split is in the air. Changes to the underlying code have huge effects on the whole edifice.
The decentralized nature of Bitcoin was designed to ensure no single failure would have much impact, and no single player could dictate terms. That has been eroded considerably now; huge swathes of the
network run in large data centers. Salcido Enterprises is building a data center in North Washington that will consume 7.5MW of hydro-electric power. Going further up the scale, in Xinjiang province in China, a major player called Bitmain is building a data center that will consume up to 135MW of power, and Bitcoin mining will be its main job. Bitcoin has come a long way from its hobbyist roots.
Bitcoin has an intrinsic limit of 21 million coins, which is expected to be more or less reached by around 2040, although it’ll take a lot longer to mine the very last block. What happens then could be awkward. By this point, the complexity of the blockchain will be considerable, and there will be no new coins to pay for running things. Transaction fees at some point look inevitable.
As a cryptocurrency “matures,” it increasingly falls under the control of those with the computing power to run it. Control over the supposed democratic and distributed currency gathers around the big data centers and the exchanges. It’s an old story: The “kids” come along with something cool, and the “suits” take it away, commercialize it, and sell it back. Man. However, digital money’s full integration into mainstream financial markets is hampered by its very nature. The markets like centralized exchanges and institutions, and don’t like volatile currencies.
VOLATILE VALUE
Rapid changes in value are not too much of an issue when ordering pizza, but a corporation making a big international payment won’t like to see percentage swings in value of the currency used over the minutes or hours it takes to verify a payment, which could be millions of dollars either way.
The central concept of the blockchain is proven, though. A number of currencies have been created that cannot be mined, but concentrate on the business of transfers. They launch with a fixed number of tokens. The biggest of these is Ripple, currently worth over $6.1 billion. The aim is similar to Bitcoin: seamless and easy transfers of any currency to anywhere else, with no third-party fees or involvement. It positions itself as a complement to, not a rival of, Bitcoin. Transactions go through in seconds, which alleviates the problem of the currency’s value bouncing around too much. It’s designed specifically with banks and business in mind, citing better security and scalability than Bitcoin and its ilk. You can trade in these business-orientated cryptocurrencies on the exchanges,