Bitcoin: An exhilarating but risky diversion

Bitcoin's value has halved in the last month, but many still hope crypto-currencies and their blockchain technologies have a future - including one Auckland company that has just raised $100 million to build a global blockchain services marketplace. Bernard Hickey reports on whether Bitcoin is a bubble and 'blockchain' is real.

There’s a saying in financial markets that when the bus-boy starts talking enthusiastically about the stock market then that’s the time to get out. It’s also when markets become irrationally exuberant that the weirdest and newest assets get wheeled out to become fresh fodder for speculation.

Before the great crash of 1929, the value of land titles to swamps and sand dunes in Florida quadrupled in a year, and then crashed. Single tulip bulbs traded for today’s equivalent of hundreds of thousands of dollars in Holland in the 1630s, before collapsing. Shares in London’s South Sea Company were worth millions of pounds in today’s money in 1719, until they weren’t in 1720.

We’ve been here before and here we are again. Earlier this month a taxi driver asked me if I thought he should buy bitcoin, and then whether these initial coin offerings or ICOs he was hearing about were a real thing. My initial thought was to tell him buying bitcoin was akin to buying a lotto ticket as an investment strategy and that ICOs were like buying a futures contract on vapour-ware. Instead, I suggested he should be prepared to lose all of any investment and to do an awful lot of research before putting any money into anything.

It may seem unfair to compare bitcoin to Florida swamp titles or black tulip futures, but there are plenty of parallels and the claims of Bitcoin fanboys and the enthusiasm for other crypto-currency investment vehicles certainly need challenging. It is an asset class essentially based on an as-yet unrealised aspiration: that a decentralised and unregulated digital currency has real value and could be used as both a medium of exchange and a store of value across the world.

The dream is that bitcoin and the ‘blockchain’ technique underneath digital currencies will replace the fiat currencies backed by central banks and governments and circumvent the payment systems currently dominated by banks and credit card companies. If realised, it would represent the biggest change in the way commerce and the global economy has operated in centuries.

Some mad moments in December

For a moment, it seemed as if the promise might be realised sooner than some had thought. Japan revised its banking laws in March to formally recognise bitcoin and other such currencies as legal tender. Japan’s Financial Services Agency then licensed 11 bitcoin exchanges to operate in Japan in September. Investors there and in Korea and China piled in with the hope that Japan’s official approval would be the first of many to legitimise what had been an anarchic, unregulated sector beset by fraud, hacking, criminality and massively volatile prices.

Bitcoin and other digital currencies such as ethereum and ripple hit the mainstream in late 2017 as their prices first surged through August, September and October, before exploding through late November and early December. Bitcoin hit a peak of NZ$27,912 on December 17, having been just NZ$1,121 a year earlier. A series of ICOs rippled through the market, with investors pledging real money or bitcoin for tokens in new digital currencies such as ethereum that were being offered by start-ups.

Then came the crash. Bitcoin’s value almost halved to just NZ$14,400 by late-January as reports emerged that Korea planned to ban bitcoin and other virtual currency exchanges and as China cracked down on both the ‘mining’ and use of bitcoin. China is particularly concerned about the use of bitcoin and other virtual currencies for money laundering and to move money out of China and past its strict capital controls.

However, these virtual currencies are not going away in a hurry and the values of bitcoin and ethereum remain more than ten times what they were a year ago. In fact, these virtual currencies are continuing to multiply as a growing ecosystem of startups hunt for the holy grails of seamless and cheap transactions with currencies that can be both stores of value and mediums of exchange. They see trillions of dollars of value in creating transactional systems that are disconnected from any one Government and able to disrupt the interconnecting networks run by banks and credit card companies. The prize is huge and the risk-takers are unrelenting.

So what is needed for these virtual currencies to succeed?

Virtual currencies will not truly cross over into the mainstream for consumers and investors until they have legitimacy and stability. That’s why the legal recognition by Japan was so important and why the banning of bitcoin exchanges and transactions in Korea and China was also crucial.

Ultimately, consumers want to know they have some official or large organisation standing behind a transaction or a store of wealth to guarantee or protect them. They also want widespread adoption by retailers and banks, and they want to know any currency is not too volatile.

Currently, central banks and Governments stand behind currencies that are based on legal and constitutional structures built up over hundreds of years. There are often legal, economic, military and democratic powers underpinning the assumptions we make about the value and use of a currency. Governments and banks used to guarantee they would exchange the currency for a hard asset such as gold. The removal of the convertibility of the US dollar for gold by Richard Nixon in 1971 ended that assumption, but there are still conventions and assumptions about Government bonds being repaid and big banks not being allowed to collapse that underpin stable currencies. Ultimately, the US dollar is the most traded and stored currency in the world because America is still the most powerful country in the world with the most potent military and biggest economy.

Bitcoin and others will struggle to win that legitimacy unless major countries adopt them as a virtual currency that they stand behind, or the existing currencies evaporate in Zimbabwean style collapses that leave virtual currencies as the only alternative. Neither options seem likely any time soon.

New Zealand’s banks still don’t accept bitcoin and regularly shut down accounts that are used to buy and sell bitcoin on exchanges both here and overseas. They worry virtual currencies are being used for illegal means and will open them up to prosecution under tough new laws to stop money laundering and make them ‘know your customer’ (KYC). Very few retailers accept bitcoin in New Zealand and slow processing times mean it can take up to 12 hours for a bitcoin transaction to be confirmed, which had made it unusable for the small transactions over the counter and online that make up a modern economy.

But there is plenty of action still going on around virtual currencies and the use of the blockchain and ICOs here in New Zealand.

What do our officials think?

The Financial Markets Authority issued advice to investors in late October about how crypto-currency services needed to register with a dispute resolution scheme, become a registered financial services provider and comply with the Financial Markets Conduct Act. It also advised any companies planning an ICO to talk to the FMA first to see whether it was officially seen as a financial product like a listed security that needed to be regulated with official product disclosures, trustees and a licensed supervisor.

The FMA also warned it was concerned about the accuracy of statements made by a 19-year-old Aucklander, Ashutosh Sharma, in November about his plan to raise NZ$220 million through an ICO for a Trade Me-style e-commerce site called Sell My Good. Sharma cancelled the ICO a week after the FMA warning.

The Reserve Bank is also taking a look at cryptocurrencies and how the central and others might use blockchain-type systems for transactions independent of the private banking system. The bank published an analytical note on crypto-currencies in November that said it was considering the feasibility of issuing its own digital currency. It said then it did not want to regulate other currencies and did not see them as a threat to the financial stability of New Zealand’s banks. Essentially, it was open to the idea, but not enthusiastic.

Reserve Bank Governor Grant Spencer was openly skeptical about the boom in crypto-currency values in December.

“It looks remarkably like a bubble forming to me. We’ve seen them in the past. Over the centuries, we’ve seen bubbles, and this appears to be a bit of a classic case,” Spencer said in a television interview.

Spencer didn’t see a future for bitcoin, but was open to the idea of officially-backed digital currencies that would be widely available and stable.

“I think they are part of the future, but not the sort that we see in bitcoin. Bitcoin is very much like gold. It’s mined, it has a fixed quantity and the price is very volatile,” he said.

“I think a cryptocurrency that has a more stable value will be the sort of cryptocurrency that’s more useful for the future. To be a useful currency, it has to have a stable value in terms of facilitating payments, as opposed to just a speculative instrument, like gold or bitcoin.”

There is a future in blockchain

Many banks and regulators agree with Spencer that the future for digital currencies is around using the blockchain system to make payment systems more efficient and reliable, and potentially create new competition for banks.

But such blockchain systems are more likely to be successful and widely accepted with the backing and involvement of central banks, regulators and large institutions, including banks and major companies. The current wild west of unregulated currencies won’t cut it with regular consumers and investors.

Global banks are already cooperating to create their own blockchain systems, while New Zealand and other more cashless societies such as Sweden and Norway could create new virtual currencies to shut down the money laundering and tax evasion possible with the current systems that use cash and bank accounts.

Start-ups providing services in the blockchain economy are forging ahead with capital raising and development plans, including in New Zealand.

Centrality, an Auckland-based venture with 75 people across Auckland, London and Melbourne, raised $15 million in crypto-currency in an ICO in October. It then raised a further $100 million in under six minutes on January 17 through what it called a Token Generating Event, whereby new virtual tokens were exchanged for crypto-currency. These tokens can then be used on Centrality’s platform to buy software and other blockchain-type services.

“The completion of our token main sale will enable us to accelerate platform development and scale our venture model into new international markets,” said a thrilled Aaron McDonald, CEO of Centrality, on the day of the fresh capital raising.

In the end, bitcoin and its rivals will struggle to replace actual currencies, but the era of digital currencies backed and run by large organisations and central banks is not far away.

In decades to come, the bitcoin bubble will be seen as an exhilarating diversion from the main game – the development of blockchain technologies for cheaper and more reliable transactions and contracts that circumvent banks and credit card companies.

My taxi driver may in time be paid using these technologies.

Know the lingo

Bitcoin – a virtual currency system invented by a group of anonymous software developers led by the fictional ‘Satoshi Nakamoto’ in 2009. They agreed rules and a system of computer-powered cryptography that meant transactions were recorded identically on ‘ledgers’ on a network of computers. The rules and currency are not guaranteed or regulated by any one Government and the identity of bitcoin owners and the nature of the transactions is not recorded on any central server. That makes it a perfect money laundering vehicle for drug dealers and gun runners, or for those needing to keep their activities secret from a corrupt Government.

Bitcoin ‘mining’ - ‘Miners’ earn bitcoin by running the servers needed to do the complicated cryptography calculations for bitcoin transactions on the ‘blockchain’. Most of the miners now use cheap Chinese electricity in massive server farms to ‘create’ new bitcoins. Bitcoin’s creators designed the system to halve the number of bitcoins that could be mined every four years. That limits the total number of bitcoin to just under 21 million and at current mining rates the last bitcoin is due to be ‘mined’ around 2040. Bitcoin’s creators were worried about the unlimited nature of today’s fiat currencies and the risk that Governments would deflate away their currencies by unlimited money printing. Around 16.8 million bitcoin had been ‘mined’ by January 2018. However, other new virtual currencies have been created to compete with bitcoin, including ethereum, litecoin, dash and ripple.

The ‘blockchain’ – This is the computing protocol used to create the decentralised digital ledger needed to record the encrypted transactions with bitcoin and other virtual currencies. It is the ‘system’ of cryptography of ‘blocks’ of code that identify transactions and their owners, but doesn’t record that information in one place or allow it to be reverse engineered or changed retrospectively. It allows people to transact and create binding contracts in a peer to peer way without the need for an intermediary such as a bank or a credit card company or some sort of Governmental registry.

ICO – An Initial Coin Offering or ICO is a lot like an Initial Public Offering (IPO), but instead of shares in the new business being offered for cash, new ‘coins’ or ‘tokens’ in a new type of currency or service are issued in exchange for either cash or other forms of virtual currency. Start-ups creating services that use or build virtual currencies often use ICOs.