In a nutshell: digital and cryptocurrencies

What is it?

In our last ‘in a nutshell’, we discussed that blockchain is a secure way of quickly processing data. This makes it an ideal way to process money and has given rise to digital and cryptocurrencies.

Just to get the terminology right, a ‘cryptocurrency’ is a privately produced form of currency, of which Bitcoin is by far the largest, whilst a ‘digital currency’ is an electronic form of an existing currency such as dollars and sterling (more on this later).

Bitcoin was originally conceived by a guy pseudonymously known as Satoshi Nakamoto as a form of currency that could trade quickly and securely on a blockchain. This original idea went nowhere for several years until a company called Blockstream became the main promoter and developer.

The key idea behind Bitcoin was that it could become a mainstream currency with all the qualities of a normal currency but with a fixed level of supply – there will only ever be 21 million Bitcoins. This is seen as an important factor by Bitcoin advocates in the face of the ever-rising money supply of regular currencies which effectively devalues them over time.

Of course, this idea caught on and other cryptocurrencies soon became available. Today, there are about 5,000, from 0x to ZKSwap. Not all cryptocurrencies are the same. The second largest one, Ethereum, for instance, is less secure than Bitcoin but significantly more versatile for commercial applications.

Whilst the original idea was to create an alternative currency, Bitcoin’s status is ambiguous. The value of Bitcoin against regular currencies has been wildly volatile, making it unsuitable to qualify as a stable medium of exchange*. It has been subjected to wild speculation and can be considered a ‘Wild West’ asset with some optionality on the prospect it may one day be widely accepted (and thus more highly valued). Remember that any gains on cryptocurrencies are subject to capital gains tax in the UK.

Whilst many buy Bitcoin as a way of rebelling against mainstream finance, the fact is that large financial companies are key players; AXA, the French insurer, was the company that launched Blockstream off the ground and Mastercard has investments in most of the Bitcoin exchanges and businesses (and holds patents in this area).

In almost every country, central banks have the monopoly on issuing the official currency. The development of these new cryptocurrencies, and Bitcoin in particular, raises the possibility of the loss of control of monetary policy for the banks and, in response, financial regulators have started to impose controls and restrictions to prevent their broad adoption. The Governor of The Bank of England recently said the people who invest in cryptocurrencies should be “prepared to lose all their money”.

At the same time, 85% of the world’s central banks – including the UK – are looking at creating digital versions of the official currency with the first, China’s e-RMB, soon be launched. These new currencies are called ‘central bank digital currencies’ or CBDCs.

In economics, Hayek’s principle of choice states that “good money drives out bad” which some have held as the basis whereby the new state-issued digital currencies may undermine and herald the demise of private cryptocurrencies.

What is it good for?

The fixed-supply nature of (many) cryptocurrencies offers the potential for a stable, virtual currency that could be a secure and efficient form of exchange.

Once universally accepted, the faster transaction speeds could materially improve company cashflows and allow for greater and cheaper cash transfers too – the largest Bitcoin transaction was for a value of $1.1bn and cost about $0.68.
Is it bad?

There are two key problems: valuation and security.

In terms of valuation, the problem with cryptocurrencies is that there is no fundamental value to them, no income, no financial backing, no utility (gold, for instance, can be made into jewellery) and thus difficult to value, indeed many are worthless. This problem of valuation – we have heard estimates from $0 to $1m per Bitcoin – is reflected in the highly-volatile performance of the price which, in itself, reduces the odds that it will be widely adopted as a currency.

The security problem arises in trying to mix the legitimacy of a cryptocurrency with the freedoms of blockchain. Cryptocurrencies are unregulated and anonymous and, as such, have been used for wholesale money laundering, ransomware payments, fraud and other criminal activities (the largest contributor to Bitcoin coding was employed by a company that was funded by Jeffrey Epstein).

Here are some other considerations:

• Ownership is very concentrated – there are 200 million crypto users worldwide, but 2% of the accounts own 95% of the digital assets; more than 70% of Bitcoin addresses have less than 0.01 Bitcoin, which opens the way for price manipulation.
• Bitcoin mining, to produce the code for trading, requires massive energy consumption and it currently consumes the equivalent to half the UK’s electricity supply.
• Nobody owns or manages Bitcoin; there is no contract or binding arrangement and there is nothing to stop more than 21 million coins being issued which could destabilise the whole ecosystem.

Do we invest in them?

No.

We are not adverse to the idea, however, these assets are only worth what the next buyer is willing to pay, and we cannot in all honesty say we are able to value them (and therefore what the next buyer is likely to pay) at this stage.

Different cryptocurrencies move in and out of favour which significantly moves their prices but, as yet, we have no real way of anticipating these trends.

Once central banks or states begin to issue digital currencies we will certainly examine if they provide advantages over the ‘paper’ currencies in terms of potential benefits for our clients in speedier settlement and lower costs.

DIY?

We can understand if people want to get involved for a flutter – we are not recommending it and would heed the Bank of England Governor’s advice that you must be prepared to lose all you spend on cryptocurrencies – but if you must, the way to do it is by using one of the larger apps or websites which act as electronic wallets. They charge around 1.5% to buy or sell (on top of the 0.5% spread) and 4% for debit card payments.

The cost of a Bitcoin is currently around £26,700 but they allow you to buy small fractions (up to 8 decimal places) of a single Bitcoin called a Satoshi, after the creator.

Once purchased, the Bitcoin wallet will have both a private key (like a password) and a public Bitcoin address. The private key (usually a 12-word passphrase) is what you use to access your public bitcoin address and get into the bitcoin network to buy or sell. With the private key, you can access your cryptocurrency wallet from anywhere – if you lose your ‘wallet’, you can use this passphrase to recover it.

There may be funds of cryptocurrencies available in the UK in the next few months, but the managers are struggling to get approvals to create a regulated fund of an unregulated asset.

*Postscript: You might have seen that El Salvador has made Bitcoin its legal tender. Just bear in mind that the country already operates outside the bounds of normal finance as 70% of the population does not have a bank account and 20% of the country’s GDP comes from payments sent by Salvadorans living abroad back to the country.