Notes on investing

The Future of Cryptocurrencies

The introduction of Bitcoin in 2008 as a new decentralized electronic cash system that uses peer-to-peer networking to prevent double payments marked the birth of cryptocurrencies. Bitcoin has since been joined by a large number of new entrants vying to become the most widely accepted cryptocurrency.  What does the future hold for cryptocurrencies?

Cryptocurrency defined

Cryptocurrency is a digital asset designed to be used as a medium of exchange which uses cryptography to secure financial transactions, control the creation of additional units, and verify the transfer of assets.

Cryptocurrencies uses blockchain technology, which is essentially a distributed ledger system, that serves as a public financial transaction database. It is blockchain technology that provides the features of decentralization, transparency, and immutability.

Cryptocurrencies are called such because they are entries that secured by strong cryptography. They are not secured by people or by trust, but by the mathematics of cryptography.

Decentralization

An important feature of cryptocurrencies is that it is not controlled by a central authority. Their decentralized nature makes them relatively insusceptible to government control and interference.

A Bitcoin-like cryptocurrency system consists of a network of peers, where each peer has a record of the complete history of all transactions, and therefore of the balance of every account. Each transaction is signed by the originators private key and broadcast to all peers in the network.

Immutability

Whilst a transaction is added almost immediately to the network, it remains pending until it is confirmed. Once confirmed, it cannot be reversed, and becomes part of an immutable record of historical transactions. With Bitcoin, only so-called “miners” can confirm transactions, by solving a hash function (called “proof-of-work”). The miners are rewarded in Bitcoins, and in fact that’s the only way to create Bitcoin.

In other words, cryptocurrencies basically are entries in a decentralized database that can only be added to the database if specific conditions are met, and cannot be altered after the fact.

Disintermediation

Cryptocurrencies can be sent directly between two participants using a private and public key. These transfers can be done with minimal processing fees, allowing users to avoid the steep fees charged by traditional financial institutions.

With the basic characteristics of cryptocurrencies under the belt, we can consider the economic and other features of cryptocurrencies which may affect their future viability and performance.

Product life cycle

In terms of the typical industry life cycle, cryptocurrencies are in the growth phase, that is seeing increasing interest and acceptance of the concept, with numerous new entrants in the market, each emphasizing some or other aspect more than the others.

Sooner or later, the industry will reach the consolidation or shakeout stage, in which the less successful cryptocurrencies will fall into disuse. As growth to maturity stages of the personal and internet industries have shown, the winners in the end are not necessarily the first starters off the block.

Competition and value

Cryptocurrencies are digital tokens with no inherent value, and are simply worth what people are prepared to pay for them. For cryptocurrencies to become widely used, they have to gain widespread acceptance by both merchants and consumers as a medium of exchange.

In other words, the rules of supply and demand apply. An increase in the number of competitors and resultant supply of cryptocurrencies can be expected to push down prices, until some equilibrium is reached.

Security

The security of your holding of cryptocurrencies is only as good as your ability to protect your private key from loss or misappropriation. Furthermore, being essentially unsupervised internet-based digital systems, cryptocurrencies remain susceptible to hacking attacks and fraudulent activities.

Government regulation and oversight

Whilst some countries have shown a positive attitude towards cryptocurrencies, others are still deliberating on what regulations to put in place. The list of countries that have placed restrictions on the use of Bitcoin and other cryptocurrencies, or banned its use altogether keeps getting longer.

Central supervision of a country’s currency and banking system enables the enaction of monetary policy, and allows for regulation to counter tax evasion and money laundering. Peer-to-peer cryptocurrencies, unrelated to any government, pose a threat to authorities to execute these regulatory functions effectively.

Anonymity and criminal activities

Cryptocurrencies such as Bitcoin can be used to anonymously conduct transactions between account holders anywhere in the world, making it attractive to criminals and money launderers. Even cryptocurrency-friendly countries, such as the US, require exchanges and payment processors to adhere to regulations regarding reporting, registration and record keeping. As cryptocurrencies become more prevalent, the more government regulation and oversight they are likely to attract.

Volatility and risk

The following price chart comparing Bitcoin and Ethereum price action for the last few years indicate that the euphoria at the end of 2017 has subsided, and that cryptocurrency movements tend to follow its other.

Cryptocurrencies are trading at prices which are significantly more volatile than most currencies and stock market indices, as the following daily %change chart for Bitcoin and Ethereum indicates. Both traders and investors should recognize the increased risk entailed by such volatility.

In the last few years, cryptocurrencies have become an established part of the financial marketplace, but traders and investors need to heed the significant risks that are associated with such currencies.

 

Further reading

Blockchain is not a magic bullet for security. Can it be trusted?

 

 

Image by Pete Linforth from Pixabay