Focus on Cryptocurrencies

There has been a great deal of coverage recently about Bitcoin, “blockchain” and other elements of cryptocurrencies. This raises many questions about what these things are, how they work and whether or not investors should consider them as part of their portfolios.

Conventional currency

To understand what a cryptocurrency is, we first need to look at more conventional currencies, and then consider the differences.

If you look at a £5 note, written on the side that has the Queen’s head are the words, “I promise to pay the bearer on demand the sum of five pounds”. This harks back to how cash as we understand it today, evolved. An individual would trade for goods with gold often being used as a commonly accepted payment.

Simplifying history somewhat, rather than carrying gold around all of the time, people would place it with someone who had sufficient means to keep it safe; an early form of bank. That “bank” would give the depositor a receipt confirming how much gold had been deposited.

These receipts had to be fairly durable, and difficult to forge. This enabled traders to pay for goods with receipts rather than bits of gold. The gold stayed in safe storage and people exchanged bits of paper instead.

It was a relatively short step from this to an official form of money governed by a central bank. The central bank would hold huge amounts of gold to act as collateral for the receipts/ cash that was flowing around in trade.

Over time, the “gold standard” as it was called, became obsolete as the central bank was able to print new money should it need to and everyone (in most countries) had sufficient trust in the currency for it to be widely accepted as a form of payment. This sort of money is known as fiat money, taken from the Latin “fieri” meaning arbitrarily decided or chosen by decree.

Jump forward in time a little further and the vast majority of money is not in paper cash form, but in numbers held on computer: salaries transferred, bills paid, and savings all held on electronic accounts with the understanding that the currency is backed by the central bank.

Central bank power

This puts central banks in a position of both great responsibility and great power. As well as controlling how much cash is printed, they act as the lender of last resort, i.e. the bank that lends to all the commercial banks.

The Bank of England can increase or reduce the interest it charges commercial banks in order to discourage or encourage borrowing and spending respectively. By working with government policymakers, the Bank of England can help to guide the country through economic ups and downs, as we have seen in the lowering of interest rates and electronic printing of money (i.e. “quantitative easing”) since the financial crisis 10 years ago.

The key point for an investor is that, as well as an economic guardian, the Bank of England also oversees the value of the pound.

Cryptocurrencies - outside of central bank control

Cryptocurrencies don’t have a central bank or an underlying asset. They are, in effect, just a number on a computer screen that, in theory, anyone can buy with dollars, pounds, euros or whatever.

If enough people want to buy them, then their value will rise, if not, it will fall. There is no central bank to step in and try to influence the cryptocurrency’s value.

This is also seen as one of the major advantages of a cryptocurrency: its value cannot be influenced or interfered with (depending on your perspective) by any national authority such as a central bank.

So who does control it?

From this point on, the article will address the points to Bitcoin as that is the best-known of the numerous cryptocurrencies.

Bitcoin is run as a peer-to-peer network that everyone can contribute to, but no one owns. Software programmers can download the coding that supports the exchange of Bitcoins and offer improvements. There are thousands of contributors these days, all of whom have fairly equal status in that they all hold the same software and contribute to the same network.

Think of it like the Internet; anyone can use it, but no one owns it out-right. There are lots of different software types being used on the Internet, the most efficient and successful such as HTML or PERL are widely adopted because they work fairly well in delivering websites and services. But neither of them changes the basic structure or existence of the Internet itself, and both of them are “open source”, i.e. freely available to anyone to use as they wish without restriction.

Who created Bitcoin?

The person accredited with creating Bitcoin is referred to as Satoshi Nakamoto, though the veracity of that name and the person’s true identity are clouded in mystery. According to Bitcoin.org, Nakamoto came up with a Bitcoin specification and proof of concept in 2009, before “leaving the project in 2010 without revealing much about himself”. Since then, much as has been the case with Sir Tim Berners-Lee’s invention, the World Wide Web, countless developers have descended on Bitcoin to bring it to where it is today.

Blockchain security

This might lead one to question the security of such a system, but it is this very trait that affords cryptocurrencies such a relatively high level of security.

Imagine you have a shopping list held online. On its own, it’s vulnerable to hackers and other ne’er-do-wells. Such people might break through the security barriers and mess around with your shopping list.

To prevent this, you could have everyone in your family keep an online copy of the shopping list in completely different locations on the Internet. The different shopping lists can be compared against each other so that if a lorry-load of marzipan suddenly appears on one of the lists, then that is obviously a result of unwelcome interference. It is removed and the shopping lists all tally.

In short, it’s simple for a hacker to corrupt one or two versions of the shopping list, but the more copies of the shopping list there are, the harder it is to corrupt all of them consistently and thereby overcome the process in which the different shopping lists are compared and corrected.

With Bitcoin, the ledger of every transaction that has taken place is recorded and that record, the ledger, is duplicated thousands of times across Bitcoin users the world over, making it far more trouble than it’s worth for a hacker to try to corrupt. This ledger history and comparison system is referred to as “Blockchain”.

A user’s place in the network

Users get hold of Bitcoins by installing an application (i.e. computer programme) on their phones or computers, or by creating an account online. This application is called a “Wallet” for obvious reasons.

The wallets have been created by the computer programmers mentioned above. They are free to download and access.

A typical installation process takes a couple of minutes, requires an email address, password (measured for how difficult it would be for someone to guess) and a PIN code (i.e. four-digit identification number).

Once that’s done, the user can upload fiat money (pounds, dollars, euros etc.) to the wallet and use that to buy Bitcoins from another wallet owner whom they know has Bitcoins to sell, or through an exchange.

It takes an average of 10 minutes for the purchase (or sale) of Bitcoins to be confirmed as this allows time for various other copies of the Blockchain to confirm that they’ve recorded the transaction, making it difficult to reverse i.e. cheat the system.

What’s in it for the software providers?

To begin with, Bitcoins, after that, fees.

The system is set up so that the people who provide software services either in the form of wallets, exchanges or online storage, can earn the odd Bitcoin here and there once they’ve delivered a prescribed amount of service. This process is called mining (you can probably guess why).

As the system matures, and increasing numbers of “miners” contribute, it becomes more difficult to earn Bitcoins through this process. That’s deliberate as it offered a greater incentive to contribute when the system was embryonic and in need of software support.

The miners can, however, continue to earn fees by charging for their services, though competition is steep and that has helped to keep fees down to date.

In theory fees could be avoided altogether by users writing the software to create their own wallets, or by finding someone with whom they can trade and avoid most of the online services that the contributors provide. But that would mean being a computer software engineer and partaking in the equivalent of a private trade which might not be at as favourable a price as one that might have been achieved by using an exchange.

How many Bitcoins will be produced?

The maximum number will be 21 million, but with the current number in circulation close to 17 million, and the rate at which they are being added having slowed (as was intended from the original design), it is likely to be years before the maximum is reached.

Before then, Bitcoins can be divided down to 0.00000001 of a Bitcoin. At the time of writing, that equates to around one millionth of a US cent, in theory affording this cryptocurrency plenty of scope to deal with rising value.

But cryptocurrencies are not invulnerable

There is potential weakness in the exchanges where people deposit money and trade Bitcoins. Hackers have managed to break through the security systems of these exchanges and steal money or Bitcoins.

The most notorious instance was that of “Mt. Gox” from which $460m disappeared in 2014, sending the company into bankruptcy. While there was clearly some nefarious activity involved, the slapdash running of the company played a big part in its demise.

These exchanges have the equivalent assets and responsibilities of banks, so their security systems need to be just as robust. Mt. Gox was something of a wake-up call for cryptocurrency exchanges, and has led to improved security.

Down the back of the sofa

However, the most common form of loss, according to bitcoin.org, is that of people losing or forgetting their wallet details. Once that happens, there is no way that anyone can spend or sell the Bitcoins that are in the given wallet, so they effectively drop out of circulation permanently.

Why is Bitcoin so highly valued?

Bitcoin’s original value was based on its inherent quality of being international and out of the reach of central banks. It created a currency by the people, of the people and that had been predicted in the 1997 book “The Sovereign Individual”, by William Rees-Mogg and James Dale Davidson.

This initial attraction was overtaken by momentum in 2017 as more and more people saw the stratospheric rise of Bitcoin’s equivalent value in dollars, leading to a rush of people buying Bitcoins in the hope of multiplying their assets.

To say that this was a high risk strategy is a colossal understatement. Previous sharp rises along similar lines have included the housing bubble of 2007, internet bubble of 2001, the stock market bubble of 1929, the Mississippi property bubble of 1721, and the Tulip bubble of 1637.

But there is at least one difference between most of those rises and that of Bitcoin: the cryptocurrency’s rise has been far quicker and steeper.

While it might be tempting to regret having missed out on the value created out of thin air for holding such an asset, a similar thought could be applied to not betting on the winner of the 4.30pm at Catterick.

Sure enough, the risks of buying such a stratospherically rising asset proved to be a high-risk strategy to say the least. The dollar value of Bitcoin plummeted by more than 50% in the early part of 2018.

What are the risks?

Putting aside the sharp fall in dollar value of Bitcoin, cryptocurrencies have a number of vulnerabilities.

Firstly, they are fairly embryonic at the moment, so sharp movements in value are bound to occur, both down as well as up.

What’s more, as China demonstrated in September 2017, a country could ban the use of cryptocurrencies. At the moment this is easier for autocracies to implement, but that could change if cryptocurrencies lead to tax avoidance or evasion.

Should this happen, then it would not take a great stretch of the imagination to conceive of leading economic nations getting together to restrict the use of cryptocurrencies.

One organic restriction that has already begun is that of competition. The other cryptocurrencies being developed include Ethereum, Ripple, Litecoin, Dash, NEM, Monero and Zcash. As with all developing offerings, some will blossom or specialise, others will merge or fail.

Conclusion

So cryptocurrencies are just forms of money that only exist on computers. In this way, they are like most of the money that everyone deals with on a daily basis.

They are not subject to government interference, but are not immune to it, and that poses a huge potential risk to valuations and integrity.

Some people will have done very well out of Bitcoin if they bought at the right point and sold similarly. But without intrinsic value or the ability to project future growth, cryptocurrencies have a long way to go before they feature in our investment considerations.

The financial crisis ought to remain fresh in investors’ minds. In his excellent book on what happened, “The Big Short”, Michael Lewis related the story of a fund manager visiting regions of the US to see if there was a housing bubble. On one occasion he met a pole dancer who had borrowed money to buy four houses and a condominium. She was able to do this because house prices were rising very quickly, hence she felt she could always refinance. She was wrong.

In a post on Bloomberg just before the price of Bitcoin slumped from $17,000 high, Macro Strategist Mark Cudmore told of a pole-dancing instructor who was “focusing more of her time informing people how to ‘invest’ in Bitcoin”. He went on to quote her breathtakingly naïve claim, “The good thing is when it goes down, you can buy some more, and you know it’s going to go up at some point”.

She would have done well to read “The Big Short” not to mention the first sentence of our “Important information” below.

Wealth Investment Office
May 2018

Important Information

Forecasts of future performance are not a reliable guide to actual results in the future, neither is past performance a reliable guide to future performance.

The value of investments, and the income from them, may fall as well as rise and cannot be guaranteed. Any views expressed are our in-house views as at May 2018. Investment markets and conditions can change rapidly and the views expressed should not be taken as statements of fact nor relied upon when making investment decisions. This document may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) without our prior written consent.

Lloyds Bank plc. Registered Office: 25 Gresham Street, London EC2V 7HN. Registered in England and Wales, number 2065. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority under number 119278.

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