A Primer on Cryptocurrencies

Within the last couple of weeks, Facebook’s burgeoning cryptocurrency Libra has taken a couple of major hits. Among the most noteworthy was a comment by JP Morgan Chase CEO Jamie Dimon who said, “it will never happen.”  I’d like to focus this month’s blogpost on cryptocurrencies in general.

What are Cryptocurrencies and Where Did They Originate?

Cryptocurrencies are digital or virtual-based mediums of exchange that use cryptographical functions to conduct financial transactions. They are used by private individuals or groups as a means of purchasing goods and services in a more secure and accessible way. Cryptocurrency is highly fraud-proof due to its cryptographical nature, making it very difficult to counterfeit. Because it is not regulated by a central agency, cryptocurrency is virtually immune to government interference and manipulation. Its decentralized nature ensures individual ownership, inhibiting outside entities such as banks from taking control.

The beginnings of cryptocurrency date back to the early 80s when a cryptographer named David Chaum generated an anonymous electronic currency known as ecash. Chaum, called the forefather of cryptocurrency, states that “…individuals should control their own digital lives, and to do so, peer-to-peer networks are necessary.” He believed that the privacy of users conducting online transactions should be protected, hence the cryptographical design.

Basically, cryptography describes the construction and analysis of protocols that hinder third parties from gaining access to private messages or information. The origins of the word trace back to the Greek word kryptos meaning “hidden” or “secret” and graphein meaning “to write”. Along with ecommerce and digital currencies, cryptography assists with military communications, healthcare information, computer passwords and a lot more.

Chaum’s creation has sparked thousands of subsequent variations of cryptocurrency. The most prominent and valuable of those is one which I’m sure you’ve all heard of – Bitcoin. A man by the name of Satoshi Nakamoto was the brains behind Bitcoin, opening it to the public in January of 2009. Bitcoin has provided lower fraud risks for buyers, elimination of third parties and an overall safer ecosystem for users.

Pros and Cons of Cryptocurrency

When the ripple effects of the Great Recession in 2008 were felt all over the world, banks and financial institutions had to be bailed out by their governments, essentially dropping the burden on the taxpayers. Many viewed the modern financial system as deeply flawed. Distrust and dissatisfaction with these banks and institutions led to the desire for an alternative currency. This was right around the time Bitcoin was introduced.

Cryptocurrencies possess a variety of positive features that have helped them grow in popularity over recent years. Some of the unique qualities that distinguish them from other forms of currency are their transparency, portability, and untraceable nature.

Let’s look again at Bitcoin for example. Bitcoin uses a decentralized open ledger called a blockchain which is the record-keeping technology that makes up the very existence of cryptocurrency. With blockchain, transactions occur across a peer-to-peer network in which participants can confirm transactions without the need for a central clearing authority. These transactions are available for verification to anyone at any point in time.

Unlike tangible money, cryptocurrency can be carried around in very large quantities on a memory card making it extremely portable and easy to use. While it is possible to carry billions of dollars on these drives, it is not advisable. Another reason why people enjoy using cryptocurrency is that it is untraceable. You don’t have to fear outside organizations monitoring or interfering with your source of funds and it gives you the freedom to buy and sell as you please without worry of bureaucratic intrusion.

Individual ownership makes cryptocurrency safe to use and eliminates the concern of identity theft because the transactions are made independent of the identities of the parties making them.

As a result of economic shifts in price and the printing of excess money by the government, all traditional currency experiences inflation. Since Bitcoin and other cryptocurrencies have a limited number of coins or tokens, they are not very susceptible to this. Bitcoin was programmed to have only 21 million minable Bitcoins and the last of them are expected to be mined around 2050 due to a heavy increase in population.

Before jumping the gun, let's look at some of the unfavorable aspects of this fascinating form of currency.

Cryptocurrency can pose challenging obstacles that make it difficult to comprehend, especially for those who aren’t very tech-savvy. Lack of knowledge tends to make people mistrustful of virtual currency and many businesses refuse to accept it as a form of payment because they would have to provide education for employees to understand its concept.

“If you don’t believe it or don’t get it, I don’t have the time to try to convince you, sorry.” – Satoshi Nakamoto

Another disadvantage of cryptocurrencies is that they cannot be retrieved if they are lost. The optimal way to keep them secure is to store them on a drive that is disconnected from the internet. The reason is because they are encrypted for security purposes and the encryption identifies the currency, but not the owner of it. The ones in possession of the codes are those who own the currency and this anonymity feature means that stolen coins are lost.

In an article from CoinTelegraph, a blockchain analytics firm called Chainalysis reported that 8.1% of crypto assets are involved in illicit activities along with 2.7% by darknet markets. Cryptocurrencies cannot, for the most part, be traced. I say “for the most part” because it’s true that most wallets operate anonymously, and in the cases of criminal activity, it’s difficult to pinpoint who is initiating transactions and moving wealth around, but tracing transactions to the traditional banking system is possible.

Investigators first need to find the address which is like an account number. If a wallet can be identified, then every transaction ever made is permanently recorded in the blockchain. Once they match the wallet with the suspected criminal, they can view every single transaction made and they will have the ability to inquire further into their network and learn about all wallets they have used in any other transactions. Law enforcement has been utilizing this resource to track bad actors in the crypto-world.

Are Cryptocurrencies Necessary?

It’s clear that cryptocurrencies offer many distinctive qualities that you wouldn’t otherwise find in traditional forms of currency – some good, some bad.

Economists along with digital innovators seem to be split on the role that cryptocurrencies and blockchain play in our financial system.

Money has always played a critical role in society. It serves as a measure, exchange and store of value. It has greatly impacted trade and boosted economic growth around the globe. The invention of money was during a time when digital assets weren’t even thought of. Today, with the creation of the internet and its seemingly infinite abilities, we are looking to transition to the creation of value in digital assets.

In both domestic and international currency markets, fiat money is directly dependent on the actions of governments. Cryptocurrencies can serve as a stronger alternative and a stable store of value. In countries with weak currency and high inflation, cryptocurrency can be very valuable due to its basis on a distributed global ledger in which no country or government has the authority to control its price.

“Many people in underdeveloped economics see cryptocurrency’s universal access and fairness as a first step to achieving greater rule of law and protected property rights.  This is one of the reasons we expect to see crypto’s global adoption start in 2ndand 3rd world economies, principally because they receive a higher immediate marginal value from pursuing a fair and just system” -Eric Kovalak, Hedge Fund Manager and CEO of Vellum Capital

Cryptocurrency is especially useful in aiding business transactions. Whether you’re using a bank, credit card, PayPal or other intermediary, cryptocurrency can cut out the third party and facilitate a much more efficient and direct transfer of funds while also avoiding transfer fees that you would likely have to pay in a situation of third-party involvement.

Whether cryptocurrency is necessary to better the economy and our way of life is not clear-cut, although there are many good arguments in favor of it. In forming an opinion on this subject, it’s important to consider both sides, for and against. The best way is to do some of your own research!

What Does the Future Hold for Cryptocurrencies?

Cryptocurrencies remain a highly speculative asset. Even though they are still in early development, they have great potential to change and improve ecommerce as we know it.

In the market, cryptocurrency can be extremely volatile. It all depends on supply and demand and the more people using it, the higher its price goes. In 2017, the value of a single Bitcoin rose all the way up to $20,000 and then took a dive down to $4,000. This year, it has gone from below $4,000 to above $13,000.

Though cryptocurrency has experienced these fluctuations, there is another interesting perspective to look at – the Sharpe Ratio. This ratio helps investors understand the return on an investment compared to its risk. In this chart, you can see how Bitcoin compares to other investments such as stocks, gold, and oil. Bitcoin leads above the rest and has maintained a Sharpe ratio of close to 3.00 and beyond in the last several years. This number is considered excellent among investors and it shows that Bitcoin has a very good return relative to its risk.

People conduct business in Bitcoin at roughly $800 million per day. Big companies like Facebook and Microsoft along with private companies are beginning to see great potential in cryptocurrencies and the amount of revenue they can generate. From time to time, cryptocurrency value soars, so getting involved and educating yourself about it can serve as a good investment.

What are your thoughts on cryptocurrencies? Do the pros outweigh the cons or vice versa?

Sources Used:

What Are Cryptocurrencies: The Basics

What is Cryptocurrency – How it Works, History & Bitcoin Alternatives

The Future of Cryptocurrency in 2019 and Beyond

Do We Really Need Cryptocurrency? – A Modern Exploration of Money

The Role of Cryptocurrencies in Future Society