Cryptocurrencies may be the next big thing in the evolution of the internet, but they also have 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 rise and subsequent fall in the price of bitcoin, as well as the rush of new cryptocurrencies onto the market. Investors who are not yet in the bitcoin market are naturally wondering if they should jump in now or if they have missed the boat. And business owners should naturally be asking themselves whether they should establish a cryptocurrency payment method to stay ahead of a potentially changing payment landscape.
But the rise of cryptocurrencies has implications for industries outside of finance. Although the future is difficult to predict, a good place to start is with the basics of cryptocurrencies. here’s an introduction to get you up to speed:
1. what are they?
In a nutshell, cryptocurrencies are digital currencies that only exist online and work on peer-to-peer technology. Unlike fiat currencies, which are issued and backed by a country, they do not have a paper version or a central bank to control their supply.
However, they can be used like any other currency: as a payment or as an investment. they can be bought on certain exchanges or directly online on various platforms, and can be bought in small fractions of a coin, meaning that they can theoretically be used to make small and large purchases. In the case of bitcoin, there is a cap of 21 million coins that can 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 about 1,500 cryptocurrencies out there today, and I’m sure a lot of them aren’t really steeped in well-vetted technology,” says dan perlin, general manager of payments, processors and it services at rbc capital markets in baltimore. “What happens in that sense is that 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 the blockchain. bitcoin was the first use of blockchain technology, but the two are not the same. rather, blockchain is an ever-growing system of encrypted ledgers, which are all linked and widely distributed among many users.
changes made to any block require changes to previous blocks and any alteration leaves a log, making the chain almost impossible to hack. While investors’ focus may be on the potential of cryptocurrencies as alternative investments or payment systems, it’s the potential of blockchain that could end up being more transformative, says perlin.
“There are really two schools of thought here,” he says. “there’s a stored value one where you can actually take this cryptocurrency as an alternative to fiat currencies… but when you dig into this, what you find is that the protocols that are being developed, i.e. the purposes of these things, that’s where you can accumulate real value.”
2. where do they come from?
Unlike fiat currencies, cryptocurrencies are not issued by a central bank. instead, they are mined, a term that reflects the amount of work involved in producing them. miners donate time and computing 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, making the process expensive.
Mining problems are likely to be solved over time by new technological innovations, such as the lightning network, says mitch steves, san francisco-based rbc capital markets analyst. the technology works as a payment protocol that can be overlaid on a cryptocurrency blockchain to speed up transaction times and use less energy.
“lightning network is up and running, so it’s only a matter of time,” says steves.
3. what are the benefits?
Using decentralized blockchain technology, cryptocurrency transactions do not need intermediaries, which can make transactions cheaper and means that no authority can cancel or interfere with a transaction.
For example, a person wanting to send money internationally to their family or purchase a product would typically need a middleman to convert currency from one currency to another, and fees would be 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 like bitcoin, the transaction would take a few minutes at most, with a single transaction fee. It can also be started from anywhere in the world using an internet connection. For businesses, this may present the prospect of cheap, near-instantaneous transactions that can seamlessly cross borders, and could revolutionize the global payments and remittances industry.
“the cost with which people send money using money transfer services is quite high. the alternatives that exist today seem like something that is going to be potentially very disruptive to that space where they (cryptocurrency) can do it faster, cheaper and with a similar level if not a higher level of security associated with it says perlin.
The blockchain is also anonymous and has never been hacked, Steves says, as the distributed ledger means evidence of any transaction is replicated to every computer on the chain. even if some of these were hacked, there will still be logs showing the correct transaction details.
4. what are the risks?
While the possibilities of cryptocurrencies are undeniable, there are also many risks to consider, both as an investment and as a transaction currency.
First of all, the decentralized nature of cryptocurrencies has a downside, as the lack of government backing means there is no government protection. Steves says this could mean the government has no incentive to track down the criminal in the event of theft.
And while the blockchain itself has not been hacked, there have been cases of theft from exchanges that buy and sell cryptocurrencies. In January, hackers stole around $530 million in cryptocurrency from check exchanges in Japan, according to Reuters.
Also potentially vulnerable are digital wallets that customers use to store cryptocurrency. According to Steves, a security weakness is the set of codes or ‘keys’ used to access the wallet. if the codes are stolen, for example through hacking of a smartphone in which they are stored, a digital wallet could be emptied.
“We think this is a significant risk in the future, as more and more hackers try to steal and crack wallets that are not secure,” he says.
Another risk that may be contributing to the recent decline in the value of bitcoin is the risk of government action. While countries may not be able to completely shut down a cryptocurrency, they could make trading illegal, Steves says. Concerns that China and South Korea were doing exactly that surfaced in January, triggering a Bitcoin sell-off. There could be other levels of regulation put in place as governments try to track taxable currency flows and potential criminal activity.
for many, the recent drop in the prices of some cryptocurrencies (bitcoin has lost more than half its value since December) makes them more attractive as investments.
but in terms of long-term upside potential, perlin says it’s difficult at the moment to control the potential value embedded in blockchain protocols, making picking winners challenging.
“determining the value of any of those (cryptocurrencies) relies heavily on the protocols they are building. that’s a lot of effort and work to figure that out, and that’s why, in many cases, current investment is very hard to come by,” he says. “I’d say it’s too early.”
5. what does the future hold?
While the cryptocurrency space may be new at the moment, bitcoin is already accepted by many merchants around the world, 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-specific details to be stored in an authenticated distributed database that could be managed by the consumer and shared with any company and authority they wish.
“identifications are in the hands and control of the individual, as opposed to some governing body, I think it will be a huge area, and identification within organizations is also an expensive process,” he says.
It could also affect any sector that uses loyalty programs or contracts. perlin also sees potential disruption to insurance as well as trust-based businesses such as tracking the provenance of precious materials.
steves is also reluctant to make predictions about any particular cryptocurrency, citing the many risks, although he believes the space as a whole has the potential for enormous growth.
his bull case is for a $10 trillion market over the next 15 years or so (an increase of more than ten times) based on a rough estimate of one-third of the roughly $30 billion combined value of offshore accounts current and gold, current stores of value that cryptocurrencies could begin to replace.
The key to this, he says, is continued advancement in cryptocurrencies themselves; to add apps and transact faster at lower costs.
As for whether a cryptocurrency will be the world’s dominant currency, “it’s not clear,” Steves says, “but there will be some multi-trillion dollar worth of coins.”