Cryptocurrencies are a confidence trick, but in fairness, all currencies are a confidence trick. The US dollar, British pound, and the Euro all depend on nothing more than market confidence for their value. The extent to which a currency works effectively is a function of a range of factors and this report sets out to determine whether cryptocurrencies represent a serious alternative to the established fiat currencies and tests some the claims made on behalf of cryptocurrencies by their proponents. So what are cyptocurrencies in business and why are they relevant?
The future role that cryptocurrencies play will be less important than the technology upon which they are based. Blockchain and distributed ledger technology (DLT) offer far greater potential and will deliver far greater impact.
Why do cryptocurrencies matter for business?
There are no reliable means to forecast the growth of the cryptocurrency market as there is no rational basis for the valuations of the leading cryptocurrencies. The chaotic nature of the cryptocurrency market is demonstrated by the following points:
- With rare exceptions, all cryptocurrencies track the price of bitcoin very closely even though many are completely unrelated in terms of their technology, form, and function.
- The degree of fluctuation in prices remains very high.
- The underlying technical challenges faced by bitcoin and many of its rivals place their long-term future in doubt.
Given these issues, there is no way to provide a credible prediction as to the likely future value of cryptocurrencies, despite the press being awash with confident promises of stratospheric price rises.
The cryptocurrency market is dominated by bitcoin, with a little over 40% of the market, followed by Ethereum (18%) and Ripple (8%).
The sheer weight of investment in bitcoin lends some assurance that it will maintain its place at the pinnacle of the cryptocurrency market. However, in the coming 24 months bitcoin will face at least one existential crisis in order to deliver the scalability enhancements that it needs in order to survive, and there is good reason to believe that the currency will go through at least one more “hard fork” as happened with the creation of Bitcoin Cash, meaning holders of bitcoin will find themselves in possession of both bitcoin, and its replacement. At this point, it is likely that the original bitcoin will see a sharp decline in value, as users switch to the improved variant.
What are the big themes around cryptocurrencies?
One of the key features of cryptocurrencies is that they are decentralized, in that there is no single central authority that approves transactions. This is achieved by using a consensus mechanism that calls on participating nodes in the network to approve transactions – on the basis that once over 50% of the nodes in a network have approved a transaction it is effectively immutable. However, having a large number of transaction approvers means that transactions will inevitably take longer to be approved and this places a limit on the number of transactions that a given blockchain can process.
There is a range of ways in which scalability can be improved. One is to limit the number of transaction coordinators to a small set of “approved” parties – which is the approach taken by Ripple and most private blockchain platforms like Hyperledger – but this comes at the cost of adding a degree of centralization. The other approach is to process transactions “off-chain” which involves an additional protocol layer in which the parties to a set of transactions place a certain amount of currency into a digital escrow – in the form of an on-chain transaction – and then conduct any number of transactions between themselves without posting these to the main blockchain. Once a period of time has elapsed, or when both parties agree, another transaction is posted to the main blockchain which transfers the locked funds to the parties according to the final balance arrived at in their off-chain interactions.
Transition away from power intensive consensus mechanisms
Both bitcoin and Ethereum rely on a consensus mechanism that uses a proof of work (POW) algorithm to determine who gets the right to approve a block of transactions. A POW algorithm represents a competition, in which anyone wishing to create a new block on the blockchain must compete with other participants to solve a mathematical challenge. The complexity of the challenge is designed to ensure that it takes a certain amount of time (on average) to solve. The nature of the challenge is such that it requires enormous amounts of processing time and power to solve – which means that a massive amount of resource is expended by every participant in the network. There are other mechanisms that select transaction approvers using a proof of stake (POS) algorithm, that doesn’t rely on participants solving a computing- and energy-intensive problem.
Speculation vs application
For cryptocurrencies to live up to their name, they need to be applied in a meaningful way as a means of value exchange rather than as a speculative instrument. While it is impossible to establish a precise figure, we estimate that fewer than 1 in 100 bitcoin transactions are to complete a value exchange rather than simply being an investment/divestment action. As the hype that surrounds cryptocurrencies falls off, the price of cryptocurrencies will decline but may also eventually become more stable, making it more attractive and usable as a genuine means of exchange.
The blockchain lobotomy heals
Over the coming 12 months we expect the absurd levels of hype surrounding both cryptocurrencies specifically, and blockchain technology more generally, to fall into steep decline. As we enter what one firm calls “the trough of disillusionment” but which we prefer to call “the cavern of common sense” the real inherent value of blockchain and distributed ledger technology will become apparent. As people come to understand that blockchain technology is not possessed of magical properties, clearer eyes will be able to evaluate and compare different offerings. When this time comes, bitcoin’s dominance will be severely challenged as technically better protocols are compared against it.
Adoption by central banks
Central banks have taken a sceptical view of cryptocurrencies for a number of reasons. The first reason that is often cited by proponents of cryptocurrencies is that, by definition, a central bank is going to see a decentralized currency as a threat. It is certainly true that central banks rely on their ability to influence the economy by controlling the money supply, so there is a political component to the debate around bitcoin (free market libertarians are willing to pay a price to be free of the shackles of government regulation and oversight). On the other hand, there are those that view an unregulated Wild West as anathema.
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Most central banks are exploring blockchain and distributed ledger technology and a few are flirting with the idea of minting “e-Fiat” currency, but these projects often founder for lack of any clear idea as to what purpose e-Fiat would serve.
The fintech revolution gathers pace
A lot of the criticisms of the financial sector have merit; our financial systems are indeed sluggish, expensive, and inefficient. A blend of poor management, little or no market incentive to change and a deeply ingrained dislike of their customers has led to a banking sector that is ripe for disruption. Combine this parlous state of affairs with new technologies that allow small organizations to scale-up rapidly and inexpensively (the cloud), reach clients in new and more accessible ways (mobile), and deliver better and more tailored services (AI) and you have the ingredients for a wholesale revolution. The fintech revolution is more than simply a marketing bandwagon; it enables challenger banks to displace the behemoths and, while crypto-currencies are only likely to play a passing role in this revolution, for many organizations it will have acted as a catalyst.
Existing banking apps modernised
The primary reason for cost and delay in existing financial systems is not the fact that they don’t use blockchain technology as the underlying transaction protocol. Indeed, compared to mainstream transaction processing systems, blockchain is slow and expensive. The reason for the inefficiencies that beset existing financial systems is that they tend to be old, complex, and the result of many years of modifications, mergers, and “fixes” to implement new regulations. The emergence of non-traditional payment processors like PayPal is in large measure a consequence of this. One of the reasons PayPal is able to offer money transfer services at a lower cost than traditional institutions is that PayPal doesn’t live with a legacy of decades-old banking applications. Within individual regulatory environments, banks are already implementing fast payment services so that payments between banks within a given geography are near-instant and, while cross-border payments only account for a tiny proportion of transactions, payment processing providers (including Ripple) are all moving to offer high velocity/low-cost international payment processing and banks are either opting to make use of shared payment processing platforms or to build their own.
China is coming to the party
The Chinese government has a clear agenda to establish China as a technology leader, and the domains of cryptocurrencies, and blockchain generally, are a point of focus. A number of the most interesting new projects – Binance, Neo, Ontology – are China-backed, and China boasts 75% of the worlds bitcoin mining capacity.
Regulators are fumbling to categorize cryptocurrencies
Cryptocurrencies cannot be classified as “currencies” in the true sense of the word. They are a new financial instrument that shares some of the characteristics of currencies, commodities, and securities. In the context of financial regulation (money laundering laws, know your customer obligations, etc.) cryptocurrencies can be viewed as currency in that they’re a store of value that can be readily be transferred.
In the context of speculation and price fluctuation, they share some of the characteristics of commodities, while in the context of fundraising they are very closely aligned with securities.
Initial coin offerings will be regulated in the same way as securities
Much of the regulation that surrounds securities is designed to protect investors from fraud and to ensure that all investors have access to the same information about a security, to prevent insiders exploiting their privileged knowledge at the expense of other investors. Many of the fundraising events in which projects mint a new “coin” and sell it through an initial coin offering (ICO) offer next to no security to investors when it comes to likely return; indeed, with a significant number of the ICOs we’ve analyzed, there appears to have been no attempt to show any relationship between the value of the tokens and the performance of the project.
In some cases, ICO documents have sought to evade scrutiny by very clearly stating that their token has no inherent value, while on the other hand hinting at tremendous potential returns. The regulations that govern IPOs, which require any statement about future value to be properly backed up and the risks clearly outlined, will certainly be applied to ICOs in the future.
Cryptocurrency exchanges will be subject to regulation
Cryptocurrency exchanges are an essential component of the ecosystem. They are how cryptocurrencies are bought, and – just as important – they are how cryptocurrencies can be converted into a currency that can actually be used to complete a commercial transaction. The early exchanges began as hobby projects: MtGox (the first big exchange to collapse) was famously little more than a hobby-project written in a web scripting language which grew beyond all expectations. These exchanges have been the subject of massive losses – hundreds of millions of dollars in value – often as a result of pitifully poor design and implementation. There are also serious concerns (serious enough for the US Department of Justice to launch a criminal investigation) that exchanges are involved in the manipulation of prices.
What is the history of cryptocurrencies?
- 1983: David Chaum publishes a paper (“Blind signatures for untraceable payments”) which described a new way of storing money – eCash. The system worked by enabling banks to issue electronic cash to users, by providing them with a signed token. The digital cash could then be spent at retailers who were participating in the scheme.
- 1990: David Chaum forms DigiCash to commercialise eCash, raising $10m to fund development.
- 1995: The Mark Twain bank in Missouri implemented eCash as part of a three-year trial which was shelved in 1998 after only 5000 people signed up.
- 1997: Several European banks (including Credit Suisse, Deutsche Bank, and Posten Bank) began trialling eCash.
- 1997: HashCash – a proof of work system, designed to limit email spam and denial of service attacks was proposed by Adam Back.
- 1998: eCash went bankrupt 2008 The domain name bitcoin.org was registered in August A paper “Bitcoin: A Peer-to-Peer Electronic Cash System” credited to Satoshi Nakamoto was posted to a cryptography mailing list in October
- 2009: On 3 January 2009, the bitcoin network came into existence. The first block was mined by Satoshi Nakamoto
- New Liberty Standard offers to buy and sell bitcoin at a rate of 1309 BTC to the dollar in October
- 2010: First bitcoin transactions took place including a famous 10,000BTC transaction to have a Pizza delivered in February First hike in bitcoin’s value sees BTC rise from $0.008 to $0.08 – a tenfold increase in July Mt Gox launched as a cryptocurrency exchange in July
- On 8 August, someone exploited a weakness in the bitcoin software to create 92 billion bitcoin. The software was fixed and the bitcoin chain reverted to the block that was at the top of the chain immediately before the malicious code was executed
- 2011: Mt Gox sold in March to Mark Karpeles a French software developer living in Japan Mt Gox hacked – losing a large number of bitcoins in June
- Mt Gox private keys to the MtGox hot wallet stolen in September – resulting in the loss of over half a million bitcoin over the course of 3 years
- New cryptocurrencies emerge including Litecoin (In October) Bitcoin’s market cap broke past $1Bn in November
- 2013: Thailand bans bitcoin in July 2014 Mt Gox files for bankruptcy reporting the effective loss of over 650,000 bitcoins
- 2015: The first Ethereum block was created
- 2016: Ethereum’s DAO (Digital Autonomous Organisation) was hacked leading to a hard fork and the creation of Ethereum Classic
- $72 million worth of bitcoin was stolen from Bitfinex, a bitcoin exchange. This was the second-largest theft of bitcoin, with 120,000 units of bitcoin stolen, about 0.75% of all bitcoin then in circulation. Bitconnect launches its initial coin offering – Promising returns of 1% / day this scheme soon ran into trouble after it began to appear as if the organisation was simply operating a Ponzi scheme
- 2017: Beginning of the ICO craze with the number of cryptocurrencies passing 1000 Cryptocurrency market cap exceeds 100bn in June Bitcoin splits into Bitcoin and Bitcoin Cash in August
- 2018: Samsung announces it is manufacturing chips to mine cryptocurrencies Coincheck, one of Japan’s biggest cryptocurrency exchanges, losses $534m in the largest cyber heist ever
- South Korea’s Government expresses concerns over cryptocurrency trading, hinting at a ban in January
- Egypt’s Grand Mufti Shawki Allam, the highest official of religious law, declared trading on bitcoin as “forbidden” in Islam. In a strongly worded fatwa (religious edict), Allam said the cryptocurrency risks “fraudulence, lack of knowledge, and cheating”.
- Marshall Islands announce plans to launch the first legal tender cryptocurrency, pegged to the dollar in February.
- In the same month Gibraltar, relaxed home of online gambling, announces plans to provide a regulatory framework for ICOs.
- This was followed by the announcement that Lloyds Banking Group, which includes Lloyds Bank, Halifax, Bank of Scotland, and MBNA, had banned customers from using credit cards to buy cryptocurrencies
- Lloyds Banking Group bans customers from using credit cards to buy cryptocurrencies.
- Sweden’s central bank launched a project which “aims to investigate the legal and technical conditions for the Riksbank to be able to issue an E-krona.” The decision on whether the bank will issue an E-krona will be taken after the end of the project, probably in 2019
- In March Google announced a ban on cryptocurrency advertising on one hand, while detailing plans to develop blockchain technology for its Google Cloud Platform on the other
- In April John Pfeffer, a partner at London-based Pfeffer Capital, said that bitcoin could hit $700,000 and replace gold (The Independent), and that the entire network could one day be worth more than $6 trillion this was followed by the collapse of Ifan and Pincoin – two initial coin offerings run by the same organisation having allegedly stolen $660million In May
- Goldman Sachs was reported to be looking into opening a bitcoin trading desk, while in the same month it was also reported that the US Department of Justice has launched a criminal investigation into whether the price of bitcoin and other crypto-assets are being manipulated.
This article was produced in association with GlobalData Thematic research. More details here about how to access in-depth reports and detailed thematic scorecard rankings.