While the possibilities of cryptocurrencies are undeniable, there are also plenty of risks to consider. Read this primer to get up to speed.
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:
1. 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.
However, they can 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's really two school of thoughts 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."
2. Where do they come from?
Unlike fiat currencies, cryptocurrencies are not issued by a central bank. Instead, they are mined, a term which reflects the amount of work involved in producing them. Miners donate time and computer power to help verify cryptocurrency transactions and add them to the blockchain. For doing so, they are rewarded with new coins. The process requires special hardware and uses a significant 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 already works so it's just a matter of time," says Steves.
3. 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 to family or to buy a product would normally require an intermediary to convert the currency from one to the other, with fees being 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 transaction would 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, and it could revolutionize the global payments and remittances industry.
“The cost with which individuals send money using money transfer services, are pretty high. The alternatives that exist today look to be something that are going to be potentially very disruptive to that space in that (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, as the distributed ledger means that evidence of any transaction is replicated on every computer on the chain. If even a few of these were hacked, there will still be records showing the correct transaction details.
4. 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 decentralized nature of cryptocurrencies comes with a downside as the lack of government backing means no government protection. Steves says this could mean the government has no incentive to track down the criminal in the event of a theft.
And while the blockchain itself has not 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 smartphone on which they're stored, for instance — a digital wallet could be drained.
“We think this is a significant risk going forward as more and more hackers attempt to steal and unwind wallets that are not secure," he says.
Another risk which may be contributing to the recent decline in bitcoin value, is the risk of government action. While countries would not likely be able 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 those (cryptocurrencies) is very much predicated off of what are the protocols they're building. That's a huge amount of effort and work to determine that, and that's why in many instances the investment today is very hard to get to," he says. “I would say it's very early days."
5. 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 decentralized 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 area, and identification inside of organizations is also a costly process," he says.
It could also impact any industry that uses loyalty programs or contracts. Perlin also sees potential disruption in insurance, as well as trust-based businesses, such as the tracking the provenance of precious materials.
Steves is also reluctant to make any predictions around any particular cryptocurrency, citing the many risks, though he believes the space in general has the potential for enormous growth.
His bull case is for a $10-trillion market over the next 15 years or so — more than a tenfold increase — based on a rough calculation of one-third of the 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; to add applications and transact faster 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."