An introduction to the Cryptocurrency sector

  • By Tom Cleveland

  • September 28, 2018
  • 8:45 pm BST

It may seem difficult to believe today, but, as far back as 2008, the word “cryptocurrency” had yet to creep into the public lexicon. In one short decade, the growth and expansion witnessed in this investment/payment sector has been nothing short of phenomenal. Its progenitor, Bitcoin, weathered attacks from both banks and regulators, and, although the attacks continue across the globe in different forms, the concept of a new type of digital currency has gained a permanent foothold within the financial services arena.

What primarily started as a dream of software programmers and anti-banking zealots has finally gained the respect of the investment world, as investors took note and rushed to add crypto positions to their respective portfolios. Millions have been won and lost to date, since timing has been crucial for success. It has been called the most volatile asset class in history. The cryptocurrency market is very unique in how it operates and can be traded, but many investors to their detriment have ignored its risk components, which are at the top end of the risk pyramid. The objective of this piece and the ones that follow is to provide a basic education of every moving part of this industry and its risk profile.

To be forewarned is to be forearmed! An introduction to these various “moving parts” follows:

Cryptocurrency: Digital currencies are not new. We have been using them for decades on the Internet, at ATMs, and at Point-of-Sale terminals. A “cryptocurrency”, like Bitcoin for example, uses cryptography in a special way to deliver its exchange of value. One brief online definition states that, “A cryptocurrency is a digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank”. You need not know more than this in order to use it for payment transactions. Investment and trading considerations, however, are numerous regarding liquidity, volatility, and the viability of your chosen exchange or broker, which by the way are generally unregulated.

Bitcoin: Historians have traced the beginnings of cryptocurrency development back to 1983, but the first cryptocurrency to actually go live in 2009 was Bitcoin. The name of “Satoshi Nakamoto” is noted as the founder, although many believe it was a group effort under this pseudonym. Regulators and banks were not pleased with the decentralized and anonymous aspects of the system. Their attacks, however, were unsuccessful in stopping the crypto revolution. Fast forward to today, and you have over 1,100 crypto coin systems in existence, each with its own distinguishing factors and valuations. The major competitors of Bitcoin are Ethereum, Litecoin, and Ripple, to name only a few. There are physical coins, but ultimately your account and coins relate to an address. How big is Bitcoin today? There are 17.3 million coins in circulation, which translates to a market cap of $113 billion, anything but shabby. The maximum limit for mined coins, however, is 21 million. With supply fixed, demand spikes will cause volatility.

Initial Coin Offerings (ICOs): Following the crash, venture capital firms all but exited the market to lick their wounds. New capital went to existing investments, making it extremely difficult and expensive to raise seed capital in the traditional manner. Where there is a vacuum, market forces will fill it with another solution. In stepped ICOs, a derivation on the cryptocurrency theme, but one that could offer a quick, but unregulated, path to a capital raise. Consider this one quote: “ICOs are turning my own profession of venture capital on its head. For the first time ever, capital raised through ICOs eclipsed VC money in Q1 2017, and this gap will only continue to increase.” Roughly $4 billion was raised in 2017 via ICOs, but fraud has also been rampant. Bad business plans, poor management teams, and fraud have yielded a 90% failure rate.

Blockchain Technology: We could get very technical here, but a more simplistic description of Blockchain is that, “It is a secure transaction ledger database that is shared by all parties participating in an established, distributed network of computers. It records and stores every transaction that occurs in the network, essentially eliminating the need for “trusted” third parties such as payment processors.” Buyers and sellers deal directly with one another. It is a decentralized system. You will not find a Bank of England or the Fed in control of all monetary proceedings, making anonymity and freedom from government intervention key characteristics of the system. As a result, many nefarious types, i.e., drug runners, arms dealers, money launderers, and Russian oligarchs, have exported capital via these private channels. Cryptocurrencies do not own the patent for Blockchain technology, but valuations can be positively impacted when IBM, other consulting firms, or banks tout the value of this technology going forward.

Exchanges/Brokers: Crypto exchanges are not regulated, but 88% of them want regulation and are preparing for it. Crypto exchanges are not that different than your traditional stock exchange. The firm’s digital platform acts as an intermediary, matching up buyers with sellers, using their respective fiat currency or alternative cryptocurrency. There is no central exchange, but Coindesk publishes consolidated data for all systems in its reporting network. A sign of growth is that nearly every major trading country has an exchange. In the United States, three examples are Coinbase, GDAS, and Kraken. The latter firm attempts to offer tighter spreads and deals in 17 cryptocurrencies to distinguish itself from the pack, but that scheme implies more risk, as well. A brokerage community has also developed that can offer more convenience at a price, using the “market-maker” back-office approach. Early stage firms focused more on operational details and not security, due to thin margins. Consequently, hackers have stolen millions from unprepared exchanges and brokers. Mt. Gox, an early stage exchange, was forced into bankruptcy after Bitcoins valued at $473 million vanished. From an investment perspective, one analyst correctly noted that, “Investing in the blockchain wave is akin to investing in the Internet in the mid-nineties”. Bitcoin topped out at $17,600 per coin last December, but has since collapsed to the $6,500 range. The asset-bubble burst for all other coin systems, as well.

Mining/Miners: Once again, we are in total “Geekville”, when it comes to discussing this topic. Suffice it to say that, “Mining is the process by which transactions are verified and added to the public ledger, known as the block chain, and also the means through which new coins are released.” Anyone with the necessary equipment, software protocols, and major utility budgets can become a “Miner”, who creates new coins in the blockchain system and collects a fee or retains the coins for future turnover. Is it easy to do? Take it from the experts, “Cryptocurrency mining is painstaking, expensive, and only sporadically rewarding. Nonetheless, mining has a magnetic draw for many investors interested in cryptocurrency.” Crypto systems also have block limits, as for how many coins can be mined over a period of time. Bitcoin, for example, is within 3.7 million of its final limit. Be careful investing in this space. There have been several incidences of fraud, where crooks raised seed capital for mining, but exited stage left with the cash.

Merchant Acceptance: How can you use your cryptocoin tokens to buy things at the point of sale (POS)? There is another subset of the industry that may create an electronic “wallet” to facilitate buying and selling transactions, as well as another group of entities that focus on signing up merchants for eventual acceptance online. Acceptance is becoming more common for Bitcoin and other large systems, but it is not ubiquitous. Coinbase currently touts that, “48,000 businesses trust Coinbase to integrate Bitcoin payments.” This number is a far cry from the 50 million merchants that accept major payment cards, one reason why cryptocurrencies will never become major players at the POS. Recording blockchain transactions also requires a great deal of electronic time and effort, and at the end of the day, cryptocurrencies do not have intrinsic value, as do fiat currencies. Supply/Demand dynamics prevent cryptocurrencies from being a reliable store of value. Volatility and exchange rate risk are ever present.

Regulation: New developments, especially in the financial services arena, take a decade on average before regulators and lawmakers catch up to create new laws and assign responsibility for protecting the public at large. Cryptocurrencies have generally been ahead of this legislative curve, but regulators have been more proactive this time around. Is Bitcoin a currency or a security? How should gains and losses be treated under local tax law? What protections exist for consumers? Every jurisdiction on the planet is dealing with these questions now. ICOs appear to fall under security protection regulations, which could stop this section of the industry in its tracks. Governments, like Russia and China, have waffled back and forth from acceptance to outright bans. No one expects the drama to die down anytime soon.

Crypto Fraud: The popularity gained by cryptocurrencies over the past few years has not gone unnoticed by the criminal element of our society. It is a given that crooks will flock to where crowds have formed, especially if the attention getter is a financial service. It is unfortunate, but organized crime has attacked every element of the crypto value chain. Each “moving part” is susceptible in its own way to compromise and theft. Blockchain technology espouses a “hack-free” environment, but risk pervades each operating entity in the network, due to its own security shortcomings. Exchanges, miners, ICOs, and external support components have already tallied losses in the hundreds of millions of U.S. Dollars. Theft within an exchange environment is a real issue. Due diligence is paramount when choosing a crypto exchange partner.

As the industry continues to evolve, there will surely be more additions to this list, and the risk dynamics of each component and the industry at large will surely change, as well. In the pieces that follow, we will expand upon each of these “moving parts”.