When it comes to any finance-related questions, I am fair game, and those questions usually span the spectrum, from what I think about Warren Buffett (or why I don’t agree with everything he says) to whether tech stocks are in a bubble (a perennial question for worry warts). In the last few months, though, I have noticed that I have been getting more and more questions about crypto currencies, especially Bitcoin and Ether, and whether the price surges we have seen in these currencies are merited. While I have an old post on bitcoin
, I have generally held back from talking about crypto currencies in this blog or in my other teaching for two reasons. First, I find that any conversation about bitcoin quickly devolves into an argument rather than a discussion, since both proponents and critics tend to hold strong views on its use (or uselessness). Second, I find that some of the technical underpinnings of bitcoin, ether and other cryptocurrencies are beyond my limited understanding of block chains and technology and I risk saying something incredibly ill informed. While both reasons still persist, I am going to throw caution to the winds and put down my thoughts about the rise, the mechanics and the future, at least as I see it, of crypto currencies in this post.
The Market Boom
Any discussion of crypto currencies has to start with the recognition that the experiment is still young. Satoshi Nakamoto's paper on bitcoin was made public in October 2008 and implemented as open source in January 2009. Less than ten years later, the market capitalization of bitcoin alone is in excess of $40 billion and the success story, at least in terms of bitcoin as an investment, can be seen in the graph below:
The initial rise could have been a flash in the pan, a fad attracting speculators, but in the last two years, Bitcoin seems to have found new fans, as can be seen below:
Bitcoin's success, at least in the financial markets, has attracted a host of competitors, with Ethereum (Ether) being the most successful. Ether's rise in market price, since its introduction in 2015 has been even more precipitous that Bitcoin's, though it has pulled back in recent weeks:
The list of crypto currencies gets added to, by the day, with a complete list available here
, with the market caps of each (in US dollars) listed. At least from a market perspective, there is no doubting the fact that crypto currencies have arrived, and enriched a lot of people along the way.
While the crypto currencies emphasize their differences, the most successful ones share a base architecture, the block chain. A block chain is a shared digital ledger of transactions in an asset where the validation of transactions is decentralized. I know that sounds mystical, but the picture below (using bitcoin to illustrate) should provide a better sense of what's involved:
The key features of a block chain are:
- Decentralized verification: The validation and verification of a transaction is sourced to members, called miners in the crypto currency world. Verification usually involves trying different algorithms (hashes) to find the unique one that matches the transaction block, and the successful miner is rewarded, currently with the crypto currency. At least, as I understand it, this process requires more brute force (powerful processors trying different algorithms before you find a match) than intellectual firepower.
- Complete and open records: Every transaction, once validated and verified, is converted into a block of data that is recorded in the block chain ledger, which is accessible to everyone in the network. If you are worried about privacy, the transaction records do not include personal data but take the form of encrypted data (hashes).
- Incorruptible: A block chain, once recorded and shared, cannot be changed since those changes are visible to everyone in the network and are quickly tagged as fraudulent. Thus, the ledger, once created, becomes almost incorruptible.
In effect, a block chain is a digital intermediation process where transactions are checked by members of the network, and recorded, and once that is done, cannot be altered fraudulently. As you can see from its description, the block chain technology is about far more than crypto currencies. It can be used to record transactions in any asset, from securities in financial markets to physical assets like houses, and do so in a way that replaces the existing intermediaries with decentralized models. It should come as no surprise that banks and stock exchanges, which make the bulk of their money from intermediation, not only see block chains as a threat to their existence but have been early investors in the technology, hoping to co-opt it to their own needs.
The Currency Question
If you define success as a rise in market capitalization and popular interest, crypto currencies have clearly succeeded, perhaps more quickly than its original proponents ever expected it to. But the long term success of any crypto currency has to answer a different question, which is whether it is a "good" currency. Harking back to Money 101, you measure a currency's standing by looking at how well it delivers on its three purposes:
- Unit of account: A key role for a currency is to operate as a unit of account, allowing you to value not just assets and liabilities, but also goods and services. To be effective as a unit of account, a currency has to be fungible (one unit of the currency is identical to any other unit), divisible and countable.
- Medium of exchange: Currencies exist to make transactions possible, and this is best accomplished if the currency in question is easily accessible and transportable, and is accepted by buyers and sellers as legal tender. The latter will occur only if people trust that the currency will maintain its value and if transactions costs are low.
- Store of value: To the extent that you hold some or all of your wealth in a currency, you want to feel secure about leaving it in that currency, knowing that it will not lose its buying power while stored.
Given these requirements, you can see why there are no perfect currencies and why every currency has to measured on a continuum from good to bad. Broadly speaking, currencies can take one of three forms, a physical asset (gold, silver, diamonds, shells), a fiat currency (usually taking the form of paper and coins, backed by a government) and crypto currencies. Gold's long tenure as a currency can be attributed to its strength as a store of value, arising from its natural scarcity and durability, though it falls short