DECODING CURRENCIES

DECODING CURRENCIES FROM GOLD TO PAPER TO E-MONEY

BITCOIN, THE BLOCKCHAIN, AND CRYPTOCURRENCIES HAVE RAPIDLY RISEN UP THE WATCH LIST OF THE INVESTOR COMMUNITY IN 2017. I WOULD HAZARD A GUESS THAT THE QUESTION OF WHETHER OR NOT “BITCOIN IS IN A BUBBLE” IS RIGHT UP THERE WITH “WHO WILL RISE VICTORIOUS OUT OF THE ANC’S DECEMBER ELECTIVE CONFERENCE?” ON THE LIST OF KNOWN UNKNOWNS. ZAIN WILSON I N V E S T M E N T A N A LY S T, MACROSOLUTIONS

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A WORLD ON EDGE 2018

DECODING CURRENCIES FROM GOLD TO PAPER TO E-MONEY continued...

BIT COIN AS A DIGITAL PAY ME N T S Y S T E M o understand the disparity in opinions around bitcoin and its fellow cryptocurrencies, we need to understand the potential technological revolution they bring, the problems they are purporting to solve and what underpins their value proposition – commercial or otherwise.

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Bitcoin was created as an alternative means of digital payment and as a new digital currency. As you stand, you likely have several forms of digital payment systems accessible within your immediate reach – in your wallet, a credit or debit card issued by your bank; on your mobile phone, a banking app and any number of payment applications; and on your laptop, desktop or tablet device, access through your browser to your online banking portal through which you may make direct payments, purchases or transfers. While the technology used varies, all forms of digital payments refer to any non-cash transaction where there is a transfer of actual value. These applications and services are essentially user interfaces aimed at providing improved convenience and ease of execution of payment, without jeopardising security for either party in a transaction. All forms of digital payments are built on the same underlying local and international banking infrastructure, which is conferred with the responsibility of keeping a living record (or centralised ledger) of all individuals’ and institutions’ monetary assets. This ensures the legitimacy of every transaction, without which, buying and selling goods and services would be virtually impossible without physical cash, as there would be little basis for trust between the payer and recipient. The simple interfaces we use daily belie the elaborate network required. In any one transaction there is the owner of the digital payment interface (for instance, PayPal), the payee’s bank (Capitec) and the recipient’s bank (FNB). The banks, as gatekeepers of the “ledger”, remain embedded in the chain, while the number of other intermediaries can easily go upwards of five

(imagine an online payment through PayPal using a credit card for an international purchase). As an alternative form of digital payment, bitcoin's unique commercial value proposition is that it tackles the same desire for convenience and ease of execution, but also does the job of the banking network in verifying and keeping record of the living “ledger”. It replaces the complex international banking network without jeopardising the validity and security of individuals’ and institutions’ ledgers and the related transactions. This cuts out numerous middlemen and reduces costs, while also leveraging off the larger and broader network to reach parts of the world traditional financial networks cannot easily reach, or that are not financially viable. BIT CO IN AS A DI GITAL CU RR E N CY Bitcoin goes a step further than just offering a broader and cheaper payment service. It also acts as its own separate currency. Payment interfaces like PayPal, ApplePay, Visa and FNB process, record and validate transactions in US dollars, euros, rands or other government-issued currencies (fiat money). Bitcoin, on the other hand, provides the same service in… erm, bitcoins. The debate around governmentissued fiat money has been around since its first use in China around 1 000 AD. Before that, money was commodity based – initially rare stones, shells, grain and livestock and later almost exclusively gold and silver. These commodities either possessed a use outside of acting as money or had a degree of rarity, and could be assigned some “intrinsic value”. Fiat money emerged as it reduced the cost and difficulty of storing and moving money (imagine having all of your savings as a silo of wheat that has an expiry date!). Through time, different regions around the world adopted “hard” fiat money, linking the ratio of the paper money to a fixed amount of a physical commodity to underpin its value. This solved the problems of portability and storage, while promising that it could be exchanged for the physical commodity on demand. Without exception, each of these experiences ended in the fiat money being inconvertible into the promised quantity of the

IT REPLACES THE COMPLEX INTERNATIONAL BANKING NETWORK WITHOUT JEOPARDISING THE VALIDITY AND SECURITY OF INDIVIDUALS’ AND INSTITUTIONS’ LEDGERS AND THE RELATED TRANSACTIONS

DECODING CURRENCIES

commodity − often as governments were tempted to simply create new money (to finance wars and expansions). Each fiat money regime inevitably collapsed and ended in periods of high inflation as the money rapidly devalued (debasement), eventually to be re-pegged at a new, more appropriate, ratio to the chosen commodity. As such, governments have fluctuated between “hard” fiat money (pegged to a commodity) and “soft” unpegged fiat money, with its value effectively reliant on the widespread trust of the users. Which system is preferable, each with its own flaws and advantages, is a shifting debate of ideology shaped by the most recent crisis. Examples of this destruction in trust continue to this day in Argentina, Venezuela, and our neighbour, Zimbabwe. In all cases, the preferred alternative currency of choice to which these broken paper money economies resort has been the US dollar, benefiting from its role at the centre of global finance. As the world’s reserve currency, the US dollar exhibits the favourable feature of having the broadest network of use.

TRAITS OF MONEY

The global financial crisis further highlighted some of the vulnerabilities within the global fiat money and banking system, keeping a few ardent believers calling for the return to some form of hard fiat or commodity-based monetary system. It is no coincidence that bitcoin was launched in August 2008, in the midst of the crisis. Built into its design is a limited amount of bitcoins that can be created over time − controlling the supply of the digital currency, to be capped at 21 million bitcoins by 2040. The limited supply eliminates the ability of individual governments and the banking network to simply create new money, while the fact that each bitcoin is an easy-to-store and a transferable digital code makes it more appealing than a clunky piece of metal. Whether or not bitcoin or other cryptocurrencies supplant our rands and US dollars is far more difficult to assess compared to the commercial value of a digital payment system, given that the usefulness of any form of non-commodity money is reliant on the trust in it and a sufficiently large network of users.

PREFERRED MONEY TRAIT

COMMODITY (GOLD)

Secure (Difficult to counterfeit)

HIGH

HIGH

HIGH

HIGH

Durable

HIGH

HIGH

LOW

HIGH

Divisible

HIGH

MODERATE

MODERATE

HIGH

Transactable & Portable

HIGH

MODERATE

HIGH

HIGH

LOW

HIGH

LOW

HIGH

LOW

HIGH

HIGH

LOW

LOW

Sovereign (Government Issued) Scarce Non-monetary Use

STABLE AND PREDICTABLE SUPPLY

F I AT (RANDS)

C RY P T O (BITCOIN)

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(17 November 2017) – a growth rate of 80% per year. With it, the market capitalisation has gone from just over US$9 billion to US$121 billion. If the market capitalisation of bitcoin continues to grow at the rate it has since 2014, it would be the size of global GDP by 2028. For this to be fundamentally justified, bitcoin would have to become the globally accepted reserve currency − as the value of money as a medium of exchange cannot exceed the value of transactions it is used for. (Sources: www.blockchain.com, www. coinmarketcap.com)

BIT COIN , T HE BU BBLE The question of whether or not bitcoin is in a bubble relates to the price of bitcoin in fiat currency terms (US dollars) − analogous to whether or not the South African rand might be “cheap” or “expensive”. Given that bitcoin, the asset, is closer to a currency than an equity or a bond, one consequence of a possible bubble would be that the continued use of bitcoin as money is closely tied to the stability of its price. While shares can sustain periods of large drawdowns (as long as the underlying businesses do not go bust), excessive volatility and a collapse in the price of a currency can perpetuate vicious cycles, driving away those that use it as a means of exchange.

02. Everyone around you is talking about it… –

You hear more and more anecdotal stories of friends, or acquaintances who have “invested” in bitcoin and made a quick buck, paying for their next holiday, with a guarantee that the price can only go up.

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Google trends reveal that the popularity of “blockchain” and “cryptocurrency” as search topics has increased by a multiple of 17 times over the past four years. By comparison, another disruptive technology,

There are plenty of signs that bitcoin and the broader cryptocurrency market are in the midst of a bubble: 01. The extent and pace of the increase in price, and with it the market capitalisation, has been astronomical. –

The US dollar price of bitcoin is up from US$747/BTC at the start of 2014 to US$7 300/BTC as I write

BITCOIN MARKET CAP IN US DOLLARS (BILLIONS) A S AT 1 5 N O V E M B E R 2 0 1 7 $130 000 $120 000 $110 000 $100 000 $90 000 $80 000 $70 000 $60 000 $50 000 $40 000 $30 000 $20 000 $10 000 $0 January14

Source: Blockchain.com

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January15

July15

January16

July16

January 17

July17

2014

THE US DOLLAR PRICE OF BITCOIN WAS US$747

NOW THE US DOLLAR PRICE OF BITCOIN IS US$7 300

80%

GROWTH RATE PER YEAR

DECODING CURRENCIES

GOOGLE TRENDS: E-MONEY AND UBER LEVEL OF INTEREST FOR A KEYWORD PHRASE R E L AT I V E T O T O TA L S E A R C H V O L U M E 120 100

80

60 40 20

0 January 14

July 14

January 15

BITCOIN (WORLDWIDE)

July 15

January 16

BLOCKCHAIN (WORLDWIDE)

July 16

CRYPTOCURRENCY (WORLDWIDE)

January 17

July 17

UBER (WORLDWIDE)

Source: Google, to 12 November 2017

Uber, is lagging behind with an increase of only 10 times (see the chart above).

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The volume of transactions performed via bitcoin (payments of bitcoin from one user to the next) compared with the high volume of trade on bitcoin exchanges (those buying and selling bitcoin with fiat currencies) also gives an indication of the users of the digital payment system relative to the investors and speculators in the digital money.

–

A more stable and functioning currency needs a foundation of active users (those using the currency as money), with the traders and speculators being secondary and acting to grease the wheels and keep the system efficient.

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Measuring the use of borrowing to fund speculative activity is impossible, given the unregulated nature of cryptocurrencies.

03. There is a sudden proliferation of “expert” opinions and articles on the subject − this one included! 04. The market for the asset is dominated by speculators, and with it, the use of borrowing to fund their activity. –

While there is no easy way to measure how many people have quit their day jobs and registered bitcoin trading operations in their garages, the extreme price volatility and sensitivity of the bitcoin and other cryptocurrencies to news and events suggest the role of speculators in driving the price is high.

B I T C O I N E S T I M AT E D T R A D E V O L U M E A S A P E R C E N TA G E O F TRANSACTION VOLUME (USD) 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% January 14

July 14

Source: Blockchain.com

January 15

July 15

January 16

July 16

January 17

July 17

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05. There is belief in a new paradigm and that “this time is different”. –

The potential of new and disruptive technologies is notoriously difficult to measure, part of which makes them ripe for speculative bubbles. Some truly are transformative, while others fade.

–

As belief in the technology and possibilities that come with it spread, new markets, businesses and micro-economies are rapidly created around the new technology. While many of these are legitimate businesses (still tied to the success of the underlying technology), others don’t stack up quite as well under a critical eye.

–

One measure of the growing micro-economy is the number of newly issued cryptocurrencies – currently totalling 1 2931 ! This is many times more than the roughly 185 sovereign states in the world − a decent proxy for the number of independent fiat currencies. On top of that, there are exchanges, wallet providers, detailed research, data and analytic providers and, not least, the new applications of the technologies, which are attracting increasingly larger amounts of funding.

06. Some of the “smart money” is beginning to take profits. This is by no means a comprehensive analysis of bitcoin and the world of cryptocurrencies. Nor are we experts on technology – there are many more potential applications not discussed here, as well as some features I have not explored. Instead, what I have attempted to do is frame a better understanding of what cryptocurrencies are and, by drawing some lessons from history, highlight some of the opportunities and risks:

1 www.coinmarketcap.com

01. As a form of digital payment, bitcoin is underpinned by a viable value proposition. Although not enabling completely free transactions, it presents an alternative form of digital payment, which will find niche markets for transactions that are uneconomical for current payment systems. This opportunity is large, and meaningful. –

However, this is not a commoditised market – the software on bitcoin is open source, it is free for anyone to copy and attempt to improve upon. Thus, the only true advantage bitcoin has over its peers is the larger network of users it has already established.

–

For bitcoin to maintain its lead and remain ahead of its competing cryptocurrencies and the alternative technologies used by traditional payment providers, it would have to continuously improve upon its technology and offering.

02. Bitcoin as a digital currency is slightly more complex. The success of any currency depends on some failure or discontent in the currency that precedes it, and a build-up in trust and usage via a strong network in the new currency. 03. The argument that bitcoin, the digital money, has no intrinsic value is misguided in that it is no different from other forms of fiat money. Whether or not there is trust and a large enough network of users, is a more appropriate question for a currency to be legitimate. The two greatest obstacles to expanding this network are the uncertainty around regulation from governments, and the high volatility in the price of bitcoin, which can dissuade an everyday mom and pop user. 04. Bitcoin, and the cryptocurrency craze more broadly, exhibit definite signs of a bubble. While the technology is potentially disruptive, the balance of speculators to real users appears unstable.

ONE MEASURE OF THE GROWING MICRO-ECONOMY IS THE NUMBER OF NEWLY ISSUED CRYPTOCURRENCIES – CURRENTLY TOTALLING 1 293!

DECODING CURRENCIES

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W HAT DOE S T HI S ME AN FO R Y OU R FU ND S ? While there are a few cryptocurrency exchange traded funds (ETFs), futures and even dedicated mutual funds (investing ONLY in cryptocurrencies) in the US, regulation remains an obstacle globally. For instance, it is not clear whether cryptocurrencies are considered currencies or commodities, and what the respective tax implications would be on any profits. Currently in South Africa, lack of regulatory direction leaves cryptocurrencies as un-investible for our funds and, as such, MacroSolutions does not have any exposure.

In addition to the regulatory uncertainty, the highly competitive market in which cryptocurrencies operate and absence of intellectual property protection, weaken the competitive edge of any one cryptocurrency over the next, while valuation remains distorted by the amount of speculators active in each currency. For now, this would exclude bitcoin and other cryptocurrencies from being considered as an appropriate investment opportunity. Exciting and interesting, but speculative is a more appropriate space. |