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Introduction to Bitcoins and Cryptocurrencies Part 2: Looking deeper


 

 

 

 

 

 

 

By Avinash Shenoy, UK


This article has taken into consideration valuable reader feedback and aims to build on this to cover areas such as looking more in-depth at what cryptocurrencies are, examining what their value is and explore the topic of a growing Bubble within the cryptocurrency universe.


Looking Deeper into Cryptocurrencies

The most the widely known cryptocurrency, Bitcoin, was born in 2009. Its creation was through the efforts of an unknown person(s) or group known as Satoshi Nakamoto. Before 2009 there were many attempts at Digital Money Systems which had mixed success due to their centralised nature. What Satoshi achieved was to create a Digital Cash System comparable to a Peer-to-Peer File sharing network something that had no central authority, a genuinely decentralised Digital Cash System.

To understand the differences between Digital Money (also known as E-Money) and Digital Cash systems such as Bitcoin here is a link to an interesting infographic. In this illustration, they highlight Kenya’s ‘M-Pesa’. This mobile phone-based money transfer system is comparable to India's ‘Paytm’.


Critical Factors in a Cryptocurrency System:

Decentralisation: In any payment network you need transactions, accounts and balances. A ledger is used to record these activities. However, in the digital world, this gets more complicated as an unscrupulous individual could make unlimited copies of a cryptocurrency and send it out. It is known as the ‘Double Spending Problem’. What made this problem more interesting is that in a centralised system a central server could perform the role of the record keeper. In a decentralised network, this could not be the case.

To solve this problem, Satoshi Nakamoto came up with an elegant solution: he/she/they merely gave the ledger to everybody in the network and made it completely transparent! These ‘decentralised ledgers’ are on the computer of every Peer in the system and are known as the ‘Blockchain’.

Miners: After the creation of a successful distributed ledger system, the question of how to keep consensus about the records without a central authority became important. To solve this issue miners and mining come into the picture. (For this example Bitcoin mining will be used).

The job of the miners is to solve complex mathematical problems usually using specialised computers which have collected a several hundred Bitcoin transactions at regular intervals called a ‘Block’. When the miner has found the solution, he/she broadcasts it to the network, who then check its validity, whether the sender has a right to spend the Bitcoin and upon sufficient approval, the transaction gets added to the Blockchain. The miner who solved the Block receives 12.5 Bitcoin (currently) as a reward for participating in this process.

The process of mining is one of ensuring that a transaction is confirmed by the network and added to the Blockchain. It is the final and crucial piece of the puzzle in avoiding the ‘Double Spending Problem’.

The following image depicts the transaction process beautifully:



Source: (Blockgeeks, 2016)

 

For a those who want a further insight into Bitcoin and cryptocurrencies, ‘The Princeton Bitcoin Textbook’ (Complete First Draft) by Arvind Narayanan et al is available download online for free (Narayanan, 2016). There is also 11-week online course provided by the same team from Princeton University, currently at no cost to you through Coursera.  You can find it here: https://www.coursera.org/learn/cryptocurrency


Intrinsic Value and Cryptocurrencies?

When investing in anything, it is good to have an understanding of why they are valued. Otherwise, why participate at all?

The value of traditional currencies, for example, the USD can be determined by means such as exchange rates, value of treasury notes and foreign exchange reserves.

When we consider precious metals such as gold it has value as a commodity including areas such as science, technology, jewellery and investment.

However, where cryptocurrencies derive their value is an area of hot debate within the economic, financial and technological communities. This discussion stems from the fact that while the value of currencies and precious metals is apparent, it is not so much with cryptocurrencies such as Bitcoin.

Taking Bitcoin as our example, the three primary arguments surrounding the value of it are the underlying technology, that is, the Blockchain, the potential that it is a ‘store of value’ and its utility as a medium of exchange.

It is clear that the value of the underlying technology is never in dispute. Various industries all over the world are currently integrating multiple Blockchain technologies into their systems for the benefits they provide.

In a CNBC interview the CEO for Citadel, the hedge fund firm, Keith Griffin said, "Blockchain's a very interesting technology that will have some very profound applications for society over the years to come" but added, "I think what is happening is people confuse bitcoin with blockchain." (Cheng, 2017)

However, when it comes to acting like a medium of exchange or a store of value, it is proving rather difficult at this stage to see its value as this comment by the CEO of Goldman Sachs Group Inc. Lloyd Blankfein succinctly puts it “Something that moves up and down 20 percent in a day doesn’t feel like a currency, doesn’t feel like a store of value.” (Campbell, 2017).

A similar viewpoint by the Co-Founder of PayPal, Max Levchin, was expressed when he said that Blockchain technology was revolutionary and will form an essential role in many industries. However, with regards to Bitcoin, he was unsure of its long-term stability and whether it is a good investment (Buck, 2017).

The assertions made by the various captains of industry are correct. For example, Bitcoin and other cryptocurrencies are notorious for wild fluctuations in price due to many factors, not least due to the unregulated nature of the industry.

It seems that if we remove the Blockchain technology aspect, the cryptocurrency itself is purely a speculative asset with no real economic basis.

So all we can say that the only real value when investing in Bitcoin or any other cryptocurrency at the moment for the average person is purely the speculative element. That is the fact that people buy it in the hope that it will rise in value and then they can sell it to others at a premium.


Talk of a 'Bubble':

The price of Bitcoin has gone from around $900 at the start of 2017 to just over $12,500 at the time of writing. The rise in price has sparked concerns in the cryptocurrency community and Governments around the world that we may be experiencing a Bubble. This Bubble is said to be similar to the one experienced before the DotCom and the more recent Housing crash.

Surprisingly, one of the thing that both the vocal enthusiasts and the sceptics of cryptocurrencies such as Bitcoin can agree upon is that we are in Bubble territory.

The difference seems to be the attitudes towards this Bubble.

The first being a positive attitude towards the Bubble and that it will cause disruption when it pops. The hope is that once this happens, the bad players will be weeded out leaving the favourable currencies to flourish afterwards. The second attitude is a more sceptical attitude towards cryptocurrencies in general with a call for more regulation or outright bans on them.

A couple of notable quotes on the Bubble are:

Michael Novogratz, the former Fortress hedge fund manager, said "I think this [crypto] is going to be the biggest bubble of our lifetimes by a longshot," and "To be fair, this is a bubble and there's a lot of fraud mixed in. We look at tons of projects. And some get funded, and they literally look like Ponzi's. There's a lot of froth and fraud in something that's exciting as this." (Evelyn Cheng, 2017)

And,

The CEO of Credit Suisse, Tidjane Thiam suggests people were buying Bitcoin for no other reason than to profit and observed that this was "the very definition of speculation and the very definition of a bubble." (Browne, 2017)
For an investor, if we are in a Bubble it is crucial to be aware of which stage we are maybe in because it could inform his or her investment decision.

Below is a diagram representing the Main Stages in a Bubble designed by Dr Jean-Paul Rodrigue of Hofstra University. 

 

Source: (Jean-Paul Rodrigue, 2009)

It describes four key stages:

1. The Stealth Phase: This is where the early adopters take advantage of investment opportunities.

2. The Awareness Phase: During this phase, more investors start entering the market as word of it gets around and the value slowly rises.

3. The Mania Phase: It is during this stage when the Bubble starts to expand. With media and word of mouth attention drawing in investors looking to make quick money, it is a period of hype, exponential growth with a feeling of guaranteed profits and that prices can only keep on increasing.

4. The Blow off Phase: Finally we move from mania to panic-selling. During this period prices plummet as investors lose confidence very quickly and off-load their assets.

According to the financial publication, Motley Fool, Bitcoin is in the Mania Phase. (Smith, 2017). Also, The Telegraph has described the Bitcoin surge as being in the ‘Pre-Crash Mania Phase.’ (Scott, 2017).

After taking the rate of growth over the past year and the opinions from principal sources, a yellow star and a green arrow have been placed in the above diagram to indicate where we may be in this Bubble.

The only question remains: When will this Bubble pop and enter the Blow off Phase?


Final Impression

The world of cryptocurrencies Is a fast moving a dynamic one. This article has attempted to address some of the essential questions that further build on part 1 of this article. However, these two article’s have just started to scratch the surface of the Universe of cryptocurrencies.

Having taken a more in-depth look at what a cryptocurrency is, we can see that it is more complicated than just a simple vehicle for transfer of value such as Digital Money.

The question of the value of cryptocurrencies demonstrated that once you strip away the underlying Blockchain technology, it for the moment has a predominantly speculative purpose. People, seem to value them purely as a means to profit.

Finally, an exploration of the topic of the phenomenon of the Bubble and where we sit within the model designed by Dr Jean-Paul Rodrigue. It would seem we are in the somewhere in the Mania Phase of the model. The real question raised by the parabolic rise in Bitcoin price and the mania surrounding cryptocurrencies is: when we will see the Bubble pop?



References

Blockgeeks. (2016). What is Cryptocurrency: Everything You Need To Know [Ultimate Guide]. Retrieved December 03, 2017, from https://blockgeeks.com: https://blockgeeks.com/guides/what-is-cryptocurrency/

Browne, R (2017, November 2). Banks are staying away from bitcoin 'bubble' due to money laundering, Credit Suisse CEO says. Retrieved December 02, 2017, from https://www.cnbc.com: https://www.cnbc.com/2017/11/02/credit-suisse-ceo-banks-staying-away-from-bitcoin-bubble.html

Buck, J (2017, December 05). PayPal Co-founder Says Blockchain Good, Bitcoin Not So Sure. Retrieved December 05, 2017, from https://cointelegraph.com: https://cointelegraph.com/news/paypal-co-founder-says-blockchain-good-bitcoin-not-so-sure

Campbell, D (2017, November 30). Blankfein Says It’s Too Soon for a Bitcoin Strategy. Retrieved December 01, 2017, from https://www.bloomberg.com: https://www.bloomberg.com/news/articles/2017-11-30/blankfein-says-too-soon-for-bitcoin-strategy-as-volatility-jumps

Cheng, E (2017, November 27). Billionaire hedge fund manager Ken Griffin says bitcoin has 'elements of the tulip bulb mania'. Retrieved December 05, 2017, from https://www.cnbc.com/: https://www.cnbc.com/2017/11/27/citadels-griffin-says-bitcoin-has-elements-of-the-tulip-bulb-mania.html

Evelyn Cheng, T K (2017, November 28). Novogratz: Cryptocurrencies like bitcoin are ‘going to be the biggest bubble of our lifetimes’. Retrieved December 05, 2017, from https://www.cnbc.com: https://www.cnbc.com/amp/2017/11/28/novogratz-cryptocurrencies-are-going-to-be-the-biggest-bubble-of-our-lifetimes.html

Jean-Paul Rodrigue, C C (2009, May 18). Stages in a Bubble. (Routledge) Retrieved December 02, 2017, from https://people.hofstra.edu: https://people.hofstra.edu/geotrans/eng/ch7en/conc7en/stages_in_a_bubble.html

Narayanan, A (2016). https://freedom-to-tinker.com. Retrieved December 04, 2017, from https://freedom-to-tinker.com/2016/02/09/the-princeton-bitcoin-textbook-is-now-freely-available/

Scott, P (2017, December 01). If this Bitcoin surge is a bubble, we're in the pre-crash mania phase. Retrieved December 01, 2017, from http://www.telegraph.co.uk: http://www.telegraph.co.uk/technology/2017/11/30/bitcoin-surge-bubble-pre-crash-mania-phase/

Smith, M (2017, November 30). Bitcoin Soars to New Highs With No Sign of the Bubble Bursting. Retrieved December 02, 2017, from https://www.fool.ca: https://www.fool.ca/2017/11/30/bitcoin-soars-to-new-highs-with-no-sign-of-the-bubble-bursting/

 

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Comment on this article

  • Naresh, Mangalore

    Mon, Dec 11 2017

    Hi, Nice article. Covers important topics.

    DisAgree Agree [5] Reply Report Abuse

  • Avinash Shenoy, UK

    Mon, Dec 11 2017

    Dear Naresh,

    Thank you for your valuable feedback.

    Best Wishes,
    Avinash

    DisAgree Agree [3] Reply Report Abuse

  • Avinash Shenoy, UK

    Mon, Dec 11 2017

    Hello Naresh,

    I appreciate your support.

    Best Regards,
    Avinash

    DisAgree Agree Reply Report Abuse

  • Muktar, Mangalore

    Mon, Dec 11 2017

    What is your view on Ripple... Does it have good future ...Though some people claim it as bankers coin... But I don't think so... Though price is not rising as anticipated it is one coin which is more stable and which is making lot of news ...And with real life time application unlike other coins

    DisAgree Agree [2] Reply Report Abuse

  • Avinash Shenoy, UK

    Mon, Dec 11 2017

    Dear Muktar,

    Thank you for your this interesting question.

    I am inclined to agree with your assertions that it is one of the few cryptocurrencies that have practical, real-world applications.

    The reason why it is called a Bankers coin is that the nature of the underlying technology makes it an amazing for cheaper cross-border transactions: https://www.influencive.com/amex-ripple-partner

    It is a very stable coin, and news sources suggest that overtime its price will rise slowly because a significant portion is now in escrow: https://www.cryptocoinsnews.com/ripple-price-leaps-13-company-escrows-55-billion-xrp/

    Best Wishes,

    Avinash

    DisAgree Agree [4] Reply Report Abuse

  • Avinash Shenoy, UK

    Mon, Dec 11 2017

    Dear Dr Kamath,

    Thank you for your valuable comments.

    As you have raised critical questions I will do my best to answer your points for the benefit of everybody:

    1. The Finance Minister Arun Jaitley recently said India does not recognise Bitcoin as legal tender. It is my understanding that a group has been appointed to decide on how to move forward with the regulation of the currency. The Bubble I discussed in this article has world Governments issuing similar statements at this time.

    2. You are correct that individual cryptocurrencies can be used for illegal activities due to the properties they possess. Specific cryptocurrencies, such as Monero, do exhibit a more significant potential threat in that they are untraceable. However, even untraceable cryptocurrencies must be "cashed out" at some point to be truly useful, at which point, they, in a sense, reveal themselves. Until cryptocurrencies supersede fiat (i.e. INR, USD, GBP) altogether, cash will continue to be the preferred method of payment for nefarious activities.

    3. With regards to this point, I am not sure whether you mean trouble in accessing the funds or with the tax man? Addressing both regardless-

    a) Exchanging cryptocurrencies has been made as simple as going to an ATM or trading the cryptocurrency for cash in the street (e.g. using https://localbitcoins.net/places/581430/india-india/) and through Cryptocurrency exchanges directly into your bank account depending on where you live in the world!

    b) With regards to the taxman, it depends on the country and the regulations they have imposed. For example, in the USA the IRS is now going after people as studies have shown a tiny percentage have declared their trading profits.
    India I assume will go down the similar route of taxation (possibly hefty one) as opposed to an outright ban on cryptocurrencies. Then again the incumbent Government has used some dramatic means to protect its monetary interests!

    Hope this helps.

    Best Wishes,
    Avinash

    DisAgree [1] Agree [9] Reply Report Abuse

  • Dr.S.Kamath, Mumbai

    Mon, Dec 11 2017

    Nice article
    But the most important aspect which has not been touched up is
    1. Govt of India has warned the Citizens not to buy Bitcoins
    2. Most importantly this could be used for all illegal transactions like Drug trafficking and thus bound to be supporting sinful activities
    3. After you buy when you go to redeem back into cash that time you are likely to be running into trouble

    DisAgree [6] Agree [6] Reply Report Abuse

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