Bitcoin, Blockchain, and the Cryptocurrency Model: What Might the Future Hold?

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Written by J. Cannon Carr, Jr., Kevin Keeney, Roger A. Sheffield, CFA on January 11, 2018

Over the past year, the concept of cryptocurrencies—digital money backed by algorithms for security, verification, and record keeping—exploded into the mainstream. Bitcoin is the most famous cryptocurrency today, but Wikipedia lists over 1300 digital currencies—a number which seems to be growing by the month.

Cryptocurrencies were certainly the speculative investment darlings of 2017. On the humorous side, during the Christmas Holidays, we heard neighbors, supermarket cashiers, and Uber drivers talking about them, with authority. On the more serious side, businesses and national governments are beginning to explore them and their underlying technologies.

What is speculative hype, and what is here to stay? With this report, we offer our assessment of Bitcoin, digital currencies, and something called the blockchain. We draw upon our experience analyzing emerging companies, computing algorithms, and technologies over the past 25+ years.

THE BOTTOM LINE

Our message here is twofold:

  • The concept of digital currencies is an important innovation, but it will take time for them to catch up to the current hype. How quickly or broadly they gain traction will be determined by their ubiquity, stability, security, and scalability. This is how we believe effectiveness of currencies should be judged. Current versions do not have these characteristics, in our view.
  • The underlying technology (blockchain) is a game-changer. Conceptually, it helps address the issue of counterfeiting and duplicity, an inherent problem in the digital world. Blockchain’s application is not limited to monetary transactions; it can work for financial services, intellectual property, medical records, etc.

Regarding Bitcoin specifically, it is revolutionary in concept. It introduced blockchain, and a decentralized “peer-to-peer” digital payment system. That said, we are already seeing chinks in its armor, and “next-gen” digital currencies are emerging. Cryptocurrencies will continue to evolve, but it will take time before they broadly replace major currencies.

Importantly, we point out that Bitcoin depends on blockchain, but blockchain does not depend on Bitcoin. Blockchain applications have potential to grow well beyond currency markets, and we believe its development will be equivalent to the period of the Internet in the 1990s. Will it disrupt traditional businesses like banking and healthcare? Or will traditional players effectively integrate the new technology? The genie is out of the bottle, as they say, and its path will be fascinating.

In the rest of this commentary, we will use a Q&A format to cover this complex subject.

WHAT IS BITCOIN? WHERE DID IT COME FROM?

Bitcoin, like any cryptocurrency, is a form of digital cash. It does not represent an actual coin in the sense that we would think of money. Instead, as Bitcoin’s founders originally said, a digital coin is “a chain of digital signatures” derived from unique electronic identifiers and algorithms.

During the global financial crises of 2008-09, an unknown individual or organization, going by the public name of Satoshi Nakamoto, published a paper which described a process for exchanging digital cash. That process encompassed an anonymous yet secure financial transaction that eliminated the need for financial intermediaries (banks and credit card companies) to secure the integrity of the transaction. Exhibit 1 offers a great summary of the thinking behind it.

What’s fascinating is that, after publishing to the public domain, Satoshi disappeared into anonymity and has never been heard from again.  This remains the case despite a massive and ongoing hunt to ferret out his/her/their identity.  The software protocol however has enabled, literally, the development of more than a thousand competing digital currencies from around the world.

HOW DO YOU USE BITCOIN? IS IT LEGITIMATE?

Bitcoin is designed to facilitate commerce over the Internet. Without getting technical, you use Bitcoin by:

  • Installing a Bitcoin “wallet” on your computer or mobile device, which in turn creates a Bitcoin digital address; the wallet also contains a private key that proves ownership yet preserves anonymity of the owner;
  • Converting any currency into Bitcoins through various digital exchanges or brokers;
  • Sharing your Bitcoin digital address with any parties to conduct transactions;
  • Relying on a digital record (the blockchain) that is created after each transaction; the blockchain incorporates the private key to authenticate the transaction and determines the new digital balances among the parties.

An entire infrastructure of service providers is emerging to assist users with purchase, storage, and sale of cryptocurrencies like Bitcoin. The system is notably unregulated, in what is the equivalent of the Wild West during the 1800s. Key players in this infrastructure are people called “miners” who use complex computing algorithms to decrypt the coded information, confirm transactions, and post them to the blockchain.

Incidentally, successful miners are rewarded in newly minted Bitcoins. Currently, there are perhaps 15 million Bitcoin in circulation, with the limit expected to be 21 million. Owners can own fractional coins.

Bitcoins can be used for purchases (not widespread yet, but there is growing interest as the infrastructure builds out), but most attention centers around Bitcoin as an investment. It is highly speculative, as the price movement famously attests. Lack of liquidity has created big volatility, but the presence of trading/futures exchanges may help facilitate trading. So far, major institutions have not yet entered the market; some hedge funds have, either betting on rising prices or betting that they will fall. In our view, those who own it “are big believers in the revolution” and those who bet against it call it “the biggest bubble of our lifetime.”

WHY IS THE BLOCKCHAIN IMPORTANT TO BITCOIN?

A technology called the blockchain is key to understanding how Bitcoin works.

The blockchain is a decentralized electronic ledger that stores data related to transactions. We’ve heard it referred to as “the scaffolding that can hold any data” for permanent, authentic documentation.

For Bitcoin, it represents a public record of every Bitcoin transaction that has occurred throughout the life of that digital currency. When a transaction occurs, the addresses of the sending and receiving parties are recorded in the blockchain along with the amount of Bitcoin that was transferred. Cryptography algorithms are used by the miners mentioned above to ensure that the transaction is valid and that previous transactions cannot be modified.

It is important to note that only the transfer of Bitcoin is recorded in the blockchain. What the Bitcoin was exchanged for in terms of goods or services is not recorded. For example, if you agreed to buy a car from your neighbor with Bitcoin, the blockchain will show the amount of Bitcoin being sent to your neighbor’s digital address, but there is no record of what you received for the Bitcoin.

THE BENEFITS AND RISKS OF BITCOIN

Proponents of Bitcoin see great potential benefits, including:

  • Security in a digital world where authenticity is difficult to guarantee
  • An efficient and direct global medium of exchange to replace national currencies or separate payment systems
  • Removal of “middle man” players (extra costs) and government/central bank manipulation (devaluations, policy errors, even confiscation)
  • Anonymity in a digital transaction, all while ensuring the underlying exchange is authentic

There are of course weaknesses to Bitcoin—from unstable values to lack of regulation; from lack of ubiquity to high transaction fees; from abuses of the system to criminal activity. We anticipate that many of these major obstacles will be addressed over time by new currencies. We are not there yet though.

Particular to Bitcoin, there are a few emerging weaknesses that may in fact limit its success. Consider, for example, that:

  • There’s no intrinsic value to the currency, and no underlying financial or institutional support for the currency. The lack of intrinsic value lends instability to Bitcoin, limiting its effectiveness in payments and saving. And undiscovered security issues have the potential to instantaneously wipe out any perceived value without the protection of governing bodies.
  • Energy costs are massive. Anecdotal estimates are that Bitcoin’s mining network involves 10 million trillion calculations per second, driving annual electricity consumption roughly equal to that of Ireland. These costs could imply a natural limit to calculations.
  • Miners are beginning to pool together to share energy costs, which drives consolidation of miners and pushes out smaller players. This undermines the integrity of the decentralized system. A powerful miner could bribe others to influence verification.

Finally, and ironically, criminal activity can and has occurred in this emerging network. There are stories of hacking attacks and stolen assets from currency exchanges or brokers in what can be described as the perfect crime. And once digital currencies are stolen, there is no one to turn to for recovery.  If you lose your password or electronic access to your account, you are out of luck. And storage of digital currencies is a challenge: you want to be sure your computer hard drive is safe in case your computer goes down.

THE REAL STORY: WHY IS BLOCKCHAIN A GAME CHANGER?

The reason blockchain is a game changer is because it begins to solve the intractable problem of authenticity in the digital world. Without some means of protecting original source material (whether a contract, a transaction, a digital product, a unique identifier), content on the Internet is at risk of forgery, manipulation, or theft.

As a public, secure, decentralized ledger of an event or information, blockchain’s goal is to create a permanent, tamper-proof record. For this reason, its application goes well beyond digital currencies. Since it’s in the early stages of development, we are still learning its weaknesses. Lack of oversight could certainly allow for misuse, or for human error (coding, mismanagement, etc.). Plus, as “blocks” in the chain get bigger and more complex, what kind of supercomputer will be required to run them? In reality, the blockchain technology will likely evolve through applications.

Here are but a few examples of possible application of the blockchain technology:

  • Financial Institutions: A common question is whether blockchain will remove the role of a middle man like banks in the payments system. There are many start-ups gunning to support direct payments outside the banking system. That said, in many respects, blockchain offers clear opportunities to large banking centers, who have resources to make large investments here. It is too early to predict winners and losers, but our view is that global banks have the time and resources to incorporate blockchain technology into services like credit cards, mortgages, international settlements, etc. The implications can be quite meaningful—think of how blockchain could help credit reporting and avoid breaches like that of Equifax.
  • Legal: Blockchain technology could be applied to the chain of custody associated with physical evidence used within our justice system. The blockchain may also prove useful in the ownership and management of intellectual property, patents, and copyrights.
  • Government and Health Documentation: Blockchain technology may help secure distribution of birth certificates, licenses or medical history in the general population.
  • Medical: In light of the ongoing worldwide opioid addiction issues, drug manufacturers and pharmacies expend significant resources to document and track the manufacture and distribution of controlled substances. Blockchain technology could be used to consolidate and secure the transfer of controlled medications throughout the distribution chain. For example, the blockchain would record that 100 units of some medicine was shipped to a distribution center. This data would be visible to users of the technology, but no single individual could go in and modify past events to misdirect drugs from the supply chain.
  • Manufacturing: The infamous “$100 screw” used on a military fighter jet is often used as an example of government inefficiency and waste. A significant portion of the cost of critical parts is in the complexity of documenting and certifying each step of the manufacturing process. Blockchain could be used to build systems for tracking parts that impact public safety (such as aviation or nuclear power).
  • Food Safety: As we become more aware of what goes into our food chain, consumers have looked for certifications around the ingredients and methods used in food production. “Farm to table” certifications (e.g. organic or antibiotic free) could be built off of blockchain technologies.

These examples only scratch the surface of the potential applications. We believe that blockchain technologies will be applied to both existing and new businesses to drive efficiency and innovation.

There is much more to bitcoin and blockchain than we cover in this article. For more information, we find that www.coindesk.com offers helpful current education about the blockchain and digital currencies. The original paper introducing Bitcoin (summarized in Exhibit 1) offers the conceptual and technical features of the Bitcoin network. There are, of course, many other sources available to learn about digital currencies and the blockchain, some of which may be promotional but informative nonetheless.

Exhibit 1: Summary of the Original Bitcoin White Paper

Bitcoin Summary

Source: Bitcoin is More than Digital Gold

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