Bitcoin and Blockchains – what are they?

Bitcoin (BTC) have continued their meteoric rise in price this week, smashing through $16,000 per coin just a week after surpassing $10,000 for the first time – and gaining plenty of media attention in the process. This is thought to have accrued on the back of speculation about the impact of a launch of futures contracts for the digital currency. This would increase the availability of investing in Bitcoin for a broader set of the investing public.

It would seem that interest in Bitcoin grows exponentially with prices. Given recent moves, we have received a number of questions on what we think of digital currencies. We believe investors should separate out Bitcoin – the internet based ‘crypto ‘currency’ – from the underlying technology registering their change of ownership – the blockchain. Too often, we get the impression that investors believe they are investing in the future benefits arising from blockchain applications when they buy bitcoins.

It is the technology itself and not the crypto currency that is the true innovation, having particular use in financial services (fund, bond and equity settlement), transportation (shipping records) and health (think fully digitised individual NHS records). In reality, we do not fully know all future uses, but we suspect that nearly every industry’s record keeping could be transformed by the blockchain in some way.

Before we dive deeper into the underlying technology, we should review price action over the past week and in 2017 as a whole.

Bitcoin started the year at $997.69 and has since skyrocketed to $16,000, a gain of over 16x as speculative interest in the fledgling currency has grown around the world.

In the past 36 hours, prices have moved through $12,000, $13,000, $14,000 and finally breaking $16k in a seemingly relentless near 30% surge.

Each $1,000 psychological increment appears easier to pass as prices rise.

Here is the history:

• ? $0000 - $1000: 1789 days
• ? $1000- $2000: 1271 days
• ? $2000- $3000: 23 days
• ? $3000- $4000: 62 days
• ? $4000- $5000: 61 days
• ? $5000- $6000: 8 days
• ? $6000- $7000: 13 days
• ? $7000- $8000: 14 days
• ? $8000- $9000: 9 days
• ? $9000-$10000: 2 days
• ? $10000-$11000: 1 day
• ? $11000-$12000: 6 days
• ? $12,000-$13,000: 17 hours
• ? $13,000-$14,000: 4 hours
• ? $14,000-$15,000: 10 hours
• ? $15,000-$16,000: 7 hours

In pure market capitalisation terms (number of units x price), Bitcoin is now worth around $250 billion. If it were a company, it would already be nearly as big as Wal-Mart, the 12th largest firm on the S&P500 Index.

What is behind the strong rally?

It would seem that prices are responding to news of the imminent launch of trading in Bitcoin futures. Such a step has the potential to increase not only the ease at which investors can access Bitcoins (financialisation) but also raise levels of demand.

The Chicago Board of Options Exchange (CBOE) will begin trading Bitcoin futures this Sunday (10th December) and rival Chicago Mercantile Exchange (CME) follows a week behind (18 December).

NASDAQ (technology trading) plans to launch its own futures market in the summer of next year, while Japan’s Tokyo Financial Exchange may follow suit after that.

Bloomberg even reported that brokerage houses like TD Ameritrade and Ally Invest might offer Bitcoin futures trades to their clients. Even J.P. Morgan Chase may follow suit, despite CEO Jamie Dimon’s infamous views on the digital currency (he said he would fire any employee involved in Bitcoin trading).

What is all the fuss about and what is the difference between Bitcoin and the blockchain?

Bitcoin itself could be thought of as a digital code or token that can be used as a person-to-person (called P2P or Peer-to-Peer) version of electronic cash, where 1BTC would be equivalent to say 1GBP.

No middleman is required at any stage of the transaction, so one might question the need for a current account at a bank, or an investment platform to hold their pension or ISA on.

But given how the BTC protocol was set up, it might be better to think of Bitcoin as a digital version of gold. Like gold, Bitcoin supply is ‘finite’ and limited to 21 million bitcoins. Given the extreme levels of daily volatility in Bitcoin, we would be hard pressed to say it has much utility as a form of cash, or even as a long-term store of value like gold (at least there is a real physical asset with the precious metal).

We think investors should not confuse being able to purchase BTC as the same as being invested in the more promising blockchain technology.

Blockchain can essentially be thought of as a giant electronic database or ledger of digital records (blocks).

The difference is that it is ‘distributed’ or shared between all relevant users over the internet. The Blockchain can only be modified through the consensus of a majority of the users within the system. Once a record has been entered, information cannot be erased, thereby retaining a verifiable record of every single transaction ever made.

When one thinks about the technology in these terms, it becomes much easier to see its value for a multitude of different industries.

Custodian bank State Street believes one early use is likely to be for post-trade confirmations. The firm expects that the blockchain could transform how financial transactions are recorded, reconciled and reported. This could lead to reduced error rates and large cost savings.

This week, the Australian Stock Exchange (ASX) said it would adopt the blockchain to manage the clearing and settlement of equities. While one of the UK’s leading mutual fund settlement agents, Calastone, said it would begin migrating fund settlement over to the blockchain method of distributed ledgers in 2019.

However, there are significant uses for the technology in other areas, as any two parties could exchange information within seconds, all without the need for 3rd party verification.

Medical and NHS records, voting and legal documents like land registry could all end up using a blockchain. Any and all digital transaction would leave a ‘fingerprint’, which would generate a full audit trail for every digital record in history, all without comprising personal privacy.

New digital currencies

Since Satoshi Nakamoto (pseudonym? But no one really knows) released the first white paper (click to follow link to the paper) in 2008 outlining what would later become the blockchain, the digital currency world has expanded well beyond BTC to over 1,000 new variants issued by ICO (Initial Coin Offering – a bit like the IPO of a company on the stock market – a capital raising mechanism).

We would caution investors to think carefully before entering the next ‘gold rush’ ICO in the hope of it being the next BTC to emerge.

We believe there are a number of linguistic clues or potential red flags people should be aware of.

• ? Be wary of ‘technical innovation’ – BTC is essentially software, meaning new innovations are easily copied or assimilated across other coins, leaving any advantage a temporary distortion at best. If an ICO touts such, then purely betting on technological development rarely ends well.
• ? ‘Smart Contracts’, from a marketing perspective sound interesting. If an ICO states they will make them usable, easy or accessible, then one has to ask whether this relates to education programmes or a ‘breakthrough’ that could easily be ignored or lept over with the next such breakthrough.
• ? Legally enforceable smart contracts: Legal does not really apply to software contracts. Either the software executes a contract or it doesn’t – pretty binary, leaving little for lawyers to argue over.
• ? If ICOs mention ‘storage’ of things like data, pictures, fingerprints, etc. it suggests that someone lacks any real blockchain network programming experience. It simply costs too much to store data on the blockchain itself and is slow/inefficient compared to something like an SQL database.
• ? Language around ‘decentralised search engines’ that might rival Google or Bing is worrying. Search engines by their nature require centralised indexing to efficiently deliver results.
• ? Blockchain enabled advertising exchanges should raise questions about how they would handle ad auctions, linkages to end websites, payment gateways (and their security) and placement of ads on things like YouTube.
• ? Use of the term ‘micro-payments’ suggests someone does not understand the computational and storage requirements to process such transactions, which might mean the processing cost could eventually exceed the payment itself as volume increases.
• ? Anything touting ‘community control’ where individuals can vote on aspects of management is by definition not a business but more a social project.
• ? Mentions of ‘distributed computing’ should be avoided. Running computing in this manner has not proven to be cost effective, so merging the blockchain with it is problematic, like giving your nightmare a migraine.

Summary

Digital currencies should be seen in their proper context, as a natural extension of the ongoing computing revolution.

The movement of analogue signals to digital formed the genesis of the internet and now the almost pervasive mobile computing platform we use today.

We have transformed shopping (Amazon), auctions (eBay), marketing (online adverts, SMS text alerts), healthcare (electronic patient 15 records), news (real-time global coverage), watching TV (instant streaming media from a vast worldwide library) and a whole host of other business innovations that were not possible just a decade ago.

So why are people so surprised that we have reimagined one of the most fundamental things: money?

The blockchain could prove revolutionary to new and existing industries in ways we do not yet understand. Early research suggests that firms are beginning to adopt blockchain technology, and the results look promising in terms of reducing costs and increasing efficiency.

It is no wonder that people are excited for the future of the technology and this may explain some of the exponential rise in prices over the past few years.

This new technology should not be feared, nor should it be blindly embraced under a cloud of flashy buzzwords for the potential to make a quick profit. Investors should seek to separate buying/investing (gambling might be more accurate) in BTC or a cryptocurrency derivative from that of the blockchain.

As for the rise in the value of Bitcoins as presented in the chart at the beginning, we would like to close this article with two observations.

Firstly, there is no intrinsic value in Bitcoins as is the case with traditional currencies, which are backed by the taxation power of the issuing nations. Neither is there some form of future income stream which could be discounted to compute a fair present value, as is the case with real world investments.

Secondly, the chart displays quite graphically all the hallmarks of an investment mania. Historically, the resulting bubble has always deflated and a quick internet search will generate a myriad of article drawing parallels to previous mania and bubbles like this one: https://bloom.bg/2kxurBt.

In summary, there is very little doubt that this bubble will deflate at some point. When this will be is a different question, but Paddypower’s spoof below reminds all of us who were around during the Dotcom mania of 1999/2000 that we have been here before.

This should not be seen as a recommendation to invest and the value of your investments can go down as well as up and you may get back less than you originally invested.