Cryptocurrencies may be the next major step in the internet's evolution, but they are also of a frightening level of complexity that makes the recent news flow difficult to assess and challenging for potential investors.
Recent headlines have focused on the surge, and subsequent retreat, of the price of bitcoin, as well as on the rush of new cryptocurrencies to the market. Investors not already in the bitcoin market naturally wonder whether they should get in now or whether they've missed the boat. And business owners naturally must wonder whether they should establish a way to be paid in cryptocurrency in order to get ahead of a potentially changing payments landscape.
But the rise of cryptocurrencies has implications for industries outside of the financial realm. While the future is difficult to predict, a good place to start is a grounding in the fundamentals of cryptocurrencies. Here's a primer to get you up to speed:
What are they?
Simply put, cryptocurrencies are digital currencies that exist only online and operate using peer-to-peer technology. Unlike fiat currencies — issued and backed by a country — they have no paper version and no central bank controlling their supply.
They can, however be used much like any other currency: as payment or an investment. They can be purchased on certain exchanges or directly online on various platforms, and purchased in small fractions of a coin, meaning they can theoretically be used to make small purchases as well as larger ones. In the case of bitcoin, there is a limit of 21 million coins that can ever be produced, which appeals to investors as it puts a hard cap on potential inflation.
But while bitcoin is the largest cryptocurrency, it is just one of many. However, only a few — such as Etherium, Ripple, Dash and Litecoin — have achieved notable penetration.
“There are some 1,500 cryptocurrencies out there today, I'm sure many of which are not really steeped in well-vetted technology," says Dan Perlin, managing director of Payments, Processors and IT Services at RBC Capital Markets in Baltimore. “What happens in that regard is it creates an enormous amount of volatility."
While cryptocurrencies are intriguing in their own right, there is more excitement surrounding the network that powers them, known as blockchain. Bitcoin was the first use of blockchain technology, but the two are not the same. Rather, blockchain is a constantly growing system of encrypted ledgers, which are all linked and are widely distributed among many users.
Changes made to any block require changes to previous blocks and any alterations leave a record, making the chain all but impossible to hack.
While investor focus may be on the potential for cryptocurrencies as alternative investments or payment systems, it's the potential of the blockchain that could end up being more transformative, says Perlin.
“There are really two schools of thought here," he says. “There's one of stored value where you're actually able to take this cryptocurrency as an alternative to fiat currencies… But when you go deeper into this, what you find is that the protocols being developed, meaning the purposes of these things, is where the real value can be accrued."
Where do they come from?
Unlike fiat currencies, cryptocurrencies are not issued by a central bank. Instead, they are 'mined', a term which defines the process involved in producing them. Miners donate time and computer power to help verify cryptocurrency transactions and add them to the blockchain. In return, they are rewarded with new coins. The process requires specific hardware and uses an enormous amount of power, which makes the process expensive.
Mining issues will likely be solved over time by new technological innovations, such as the Lightning Network, says San Francisco-based RBC Capital Markets analyst Mitch Steves. The technology works as a payment protocol that can be layered on top of a cryptocurrency blockchain to speed up transaction times and use less energy.
“Lightning Network technology already works so it's just a matter of time," says Steves.
What are the benefits?
By using the decentralized blockchain technology, cryptocurrency transactions need no intermediary, which can make transactions cheaper and means no, one authority can cancel or interfere with a transaction.
For instance, a person wanting to send money internationally or to buy a product would normally require an intermediary to convert the currency from one to the other, with fees charged for the conversion, as well as for the transaction. There could also be delays, depending on how the funds are transferred.
With a cryptocurrency such as bitcoin, the transactions take a few minutes at most, with a single transaction fee. It can also be initiated from anywhere in the world using an internet connection. For businesses, this may present the prospect of cheap, nearly instantaneous transactions, that can cross borders seamlessly revolutionizing the global payments and remittances industry.
“The costs individuals incur when sending money using money transfer services, are pretty high. The alternatives available today are going to be potentially very disruptive to that space, cryptocurrencies can do it faster, cheaper and with a similar level, if not greater level of security associated with it," says Perlin.
Blockchain is also anonymous and has never been hacked, says Steves. The distributed ledger means that evidence of every transaction is replicated on each computer on the chain. If even a few of these were hacked, there were still be records showing the correct transaction details.
What are the risks?
While the possibilities of cryptocurrencies are undeniable, there are also plenty of risks to consider, both as an investment and a transaction currency.
Firstly, the decentralised nature of cryptocurrencies comes with a downside as the lack of government backing means no government protection. As such, this could mean the authorities have little incentive to track down and punish the criminal activity, says Steves.
Whilst the blockchain itself has never been hacked, there have been instances of theft from exchanges that buy and sell cryptocurrencies. In January, hackers stole around US$530 million worth of cryptocurrency from Coincheck exchange in Japan, according to Reuters.
Also potentially vulnerable, are the digital wallets customers use to store cryptocurrencies. According to Steves, a weak point in the security is the set of codes or 'keys' used to access the wallet. If the codes are stolen — through the hacking of a storage device, like a smartphone on which they're stored, for example — a digital wallet could be drained.
“We see this as a significant risk going forward as more and more hackers attempt to steal and unwind wallets that are not secure," he says.
Another factor which may be contributing to the recent decline in bitcoin value, is the risk of government action. While it would be unlikely for countries to completely shut down a cryptocurrency, they could make trading illegal, says Steves. Worries that China and South Korea would do just that surfaced in January, spurring a selloff in bitcoin. There could be other levels of regulation put in place as governments try to track down taxable currency flows and potential criminal activities.
For many, the recent decline in prices of some cryptocurrencies, (Bitcoin has lost more than half of its value since December), makes them more compelling as investments.
But in terms of long-term potential upside, Perlin says it's difficult at this point to get a handle on the potential value embedded in the blockchain protocols, which makes picking winners a challenge.
“Determining the value of any of these (cryptocurrencies) is very much predicated on what are the protocols they're building. There’s a huge amount of effort and work required to determine that, and that's why in many instances the investment today is particularly hard to get to," he says. “I would say it's very early days."
What does the future hold?
While the cryptocurrency space may be new at the moment, many merchants already accept bitcoin worldwide - and blockchain has the potential to impact multiple industries, says Perlin.
In addition to global remittances, the decentralised nature of blockchain opens up the possibility of overhauling the identity industry, with the potential for customer specifics being stored in an authenticated, distributed database that could be managed by the consumer and shared with any business and authority they wish.
“IDs being in the hands and control of the individual, as opposed to some governing body I think is going to be a huge shift, and identification inside organizations is also a costly process," he says.
It could equally impact any industry that uses loyalty programs or contracts. Perlin also sees potential disruption in insurance, as well as trust-based businesses, such as tracking the provenance of precious materials.
Steves predicts a $10-trillion cryptocurrency market over the next 15 years or so — more than a tenfold increase — based on a rough calculation of one-third of approximately $30 billion combined value of current offshore accounts and gold; current stores of value which cryptocurrencies could begin to replace.
Key to this, he says, is continued advancement in the cryptocurrencies themselves; additional applications and faster transactions at lower costs.
As to whether a cryptocurrency will be the world's dominant currency, “It's unclear," Steves says, "but there will be a few coins worth many trillions of dollars."