Bitcoin made a name for itself – and amassed a following – primarily because it was innovative and a first mover.

Bitcoin first attracted those who were dissatisfied with the monetary policies adopted by the major central banks and monetary authorities which, after the financial crisis of 2008, saw fit to push the money-creation pedal to the floor and create huge amounts of new money out of thin air with such programmes as ‘quantitative easing’, zero interest rate policies and gargantuan bond buying.

As emergency measures, these policies were necessary to revive the major economies and to avert deflation but money creation – much like morphine injected during a medical emergency – soon became a bad habit and, today, 10 years after the crisis, are still with us.

ICO

Very soon after its launch as an open-source software in 2009, Bitcoin attracted speculators who figured that, with time, it would rise in value primarily because supply is supposed to be limited to 21 million bitcoins.  And they were proved right.

Bitcoin then led to the creation of many other cryptocurrency systems, with coins such as ethers, monero, cardano, litecoin and iota.

Initial Coin Offerings (ICO) have become very popular, attracting investors, many of whom either had made money on Bitcoin or had missed Bitcoin but were trying to make sure they were going to be among the first on a new bandwagon.  Regulators are now taking a closer look at these ICO.

Bitcoin is not a productive asset, in the sense that it does not entitle its holders to a cash flow except the sales price one expects to eventually get when it is sold.  Miners, who expend huge computer power (electricity) to gain the right to attach new blocks of bitcoin transactions to the blockchain – like attaching wagons to a train – do earn money from mining and transaction fees, but this money is like a fee for operating the system rather than from holding bitcoins.

Gold is also considered a non-productive asset, even though it does have some industrial and other uses – gold teeth give their wearers a certain character – and can be rented out.  Importantly, though, gold enjoys a track record running for millennia, which Bitcoin does not.  With one bitcoin you can today replace a jaw of rotten teeth, but if you have to place a bet as to its value in 10 years’ time, where would you place your money, in gold or a bitcoin?

I ask this because while the demand for bitcoins and other cryptocurrencies is necessarily limited by the financial resources of potential buyers, the supply of new crypto­currencies is essentially infinite since anyone with some financial resources and technical savvy can today set up a blockchain or similar system and come up with one’s own cryptocurrency.  This demand-supply imbalance means that, in the long term, the value of bitcoin or any other cryptocurrency is probably zero.

In the short term, though, a cryptocurrency can have value and enjoy a quoted price on an exchange.

The purpose of this article is to provide readers with an investment framework within which to think about and evaluate cryptocurrencies and their future.

Technology and popularity

A cryptocurrency’s value is driven by various factors.  These include the degree of innovation, the security of the system, whether it is useful in transactions, how easy it is to store the cryptocurrency, whether you can make anonymous payments, how it is marketed, the costs of making payments or receiving coins from others, and how many new coins are created.  But, most of all, value is driven by the technology used and the popularity of the cryptocurrency.

Bitcoin itself is fast losing its lustre because its innovation bang is eroding, the technology is no longer cutting-edge, it is difficult to upgrade the technology due to the need to reach consensus (though there is disagreement on who should vote) and payments are being monitored by the authorities and investors, including hedge funds (thus dwindling its attraction to make illegal payments).

At a seminar in Toronto, someone told me that the monero is now the currency of choice to make shady anonymous payments; its promoters at getmonero.org state that transactions are “secure, private and untraceable”.  (A statement like this is a perfect red flag for the police.)

Bitcoin transfers have also slowed down, the capacity of the system to make transactions is limited, transactions are getting costly (users are often charged much higher fees for the privilege of jumping the queue) and mining is taking too much computing power.

This last factor led to the oligopolisation of mining by a few very large computer warehouses located in areas enjoying cheap electricity, such as certain states in the US and China.  Morgan Stanley, the US investment bank, recently stated that Bitcoin’s “use by online merchants is virtually zero and shrinking”, according to Bloomberg Businessweek (January 8, 2016).

Bitcoin is not a productive asset, in the sense that it does not entitle its holders to a cash flow except the sales price one expects to eventually get when it is sold

What Bitcoin has going for it now is the popularity it gained by being the first mover in this field and this popularity in turn brings with it what are called ‘network effects’.

Network effects are benefits an asset gains from being at the centre of a network of suppliers and consumers.  We see new Bitcoin exchanges cropping up every day.  Information is available and we now read articles about Bitcoin by journalists looking for a subject to write about, by people who are interested and by miners who have invested in computer plants.  We see Bitcoin ATMs.  We see some major corporations accepting bitcoins in payment for real goods and services.  Networks also give potential buyers a sense of comfort, and a sense of safety from being part of a crowd.

Innovation

While new investors are busy opening accounts at exchanges and buying bitcoins from others, however, we know that there are many other cryptocurrencies which are based on superior blockchain technology, such as on Ethereum, the system on which ether coins are based, which is claimed to be able to codify, decentralise, secure and trade just about any data, asset or token.

Ethereum is now available to anyone via ‘Ethereum Blockchain as a Service’ (EBaaS) on Microsoft Azzure and makes it possible to create a cloud-based blockchain for private or public use. (Technical problems were reported early this year, though, including overcharging for transactions and problems with synchronising new nodes to the blockchain.)  There is disagreement as to whether ethers can be produced indefinitely or are technically limited to around 100 million; considering this, one wonders how their price is now around $1,300.

Iota is a crytocurrency based on the IOTA system, launched in 2015, which is also an open-source distributed ledger but uses Directed Acyclic Graph (DAG) (known as the ‘tangle’) which one can think of as being a generalised blockchain, that is, the blockchain is but one specific case of DAG.  Transactions are free, the capacity of the system to handle transactions is said to be unlimited and no miners are involved since each user has to confirm two prior transactions.

Companies are also now trying to come up with their own ‘currency’ to be able to pay suppliers rather than using hard dollars and euros.  Just recently, Eastman Kodak announced that it will be launching the KODAKcoin to pay photographers for image rights.  On the announcement, early this January, its shares, which had been languishing around $3, more than doubled.  On January 10, they closed at $10.70.

New systems are being invented every month and most of the recent ones facilitate the use of what are called ‘smart contracts’.  Smart contracts are digital contracts which can be tracked, are irreversible and do not require third-party confirmation.  They are automatic: think of them as buying a chocolate bar from a vending machine as soon as you drop the coin rather than having to go to a shopkeeper.

The big thing which came out of Bitcoin is not the cryptocurrency itself but the blockchain and the blockchain’s rapid improvements as well as the emergence of parallel and alternative technologies to power distributed ledgers (where all users have copies of past transactions) and fast, easy transfers of money and other data.

But a technological edge is difficult to protect.  A technological advantage can only be retained via patents or trade secrets.  The latter often move out with the next top employee terminated.  Most patents, on the other hand, depend on the enforcement of legal rights in a geographical region, such as the EU or the US but are difficult, expensive, and sometimes impossible to protect in other regions, such as China.  Furthermore, once the details of a patent are published, it is quite often not too difficult for the technically savvy to find some alternative method to achieve the same objective or even improve upon it, thus skirting around the patent.  We see this often and thus the many legal wars between technology companies to protect their patent and fight patent infringement.

As always, the key word in IT is evolution.  A new technology renders the previous one obsolete.  One needs only recall the old Personal Digital Assistants (PDAs) and their innovative apps.  Nobody uses them anymore and they were soon supplanted by today’s smartphones.  What’s the value of your old Psion Organiser today?

As to popularity, this too needs protecting.  Since Bitcoin and other cryptocurrencies do not have a central authority to ensure that the system is secure, and lay down and enforce the rules, and since many national police forces are under-resourced and have more than enough serious crimes and pickles on their plate, fraudsters and other criminals tend to disappear into the digital netherworld with their ill-gotten gains.  Victims therefore have very little and often no recourse. One big fraud and informed holders will sell to new buyers who are unaware of the fraud.

Ecurrencies

We are now also seeing various efforts by the monetary authorities to use blockchain and similar new technologies to turn normal fiat currencies into electronic currencies.  Russia recently announced plans to turn the rouble into an electronic currency and it has been rumoured the Bank of England has similar plans for sterling.  Venezuela is planning some sort of ecurrency linked to oil.

Since the prefix ‘crypto’ means ‘hidden’ or ‘secret’, it would be obviously wrong to call such currencies ‘cryptocurrencies’ since these would be official currencies in electronic form.  Transfers would actually be less hidden than if one used cash since central banks and other authorities would obviously be able to track them.

When (rather than if) these ecurrencies develop, and since most transactions in bitcoins and other cryptocurrencies can now be tracked, who would want to convert good euros and dollars into volatile bitcoins to effect payments? Ecurrency systems are likely to be more secure than cryptocurrencies’ permissionless networks and would probably be transmitted cheaply.  And if you’re doubting whether fiat currencies will hold their value in the long term (they normally do not)why not buy productive assets with your money, or even gold?

Finally, Malta’s blockchain initiative is commendable because strategically, where emerging technology is concerned, the country which first comes up with a body of regulation which balances equitably the rights of users and suppliers is likely to attract business.  And this would be especially so keeping in mind that acceptance of business in Malta will open European markets to these regulated companies.

Paul Azzopardi has worked as a financial and investment adviser and manager for many years.  He is the author of Behavioural Technical Analysis and other books.  The views expressed here are entirely his own and not necessarily those of companies he is associated with.  He can be contacted on email@paulvazzopardi.com.

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