What is Cryptocurrency? – Beginner Guide

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What is Cryptocurrency? – Beginner Guide Introduction to Cryptocurrency Cryptocurrencies have soared in popularity since 2008, with more than 1,000 in existence today and an aggregate value greater than the market capitalization of IBM. But we are highly doubtful whether they will ever become mainstream currencies. The need for companies and individuals to pay tax…

What is Cryptocurrency? – Beginner Guide Introduction to Cryptocurrency Cryptocurrencies have soared in popularity since 2008, with more than 1,000 in existence today and an aggregate value greater than the market capitalization of IBM. But we are highly doubtful whether they will ever become mainstream currencies. The need for companies and individuals to pay tax receipts in government-issued currency, and the potentially unlimited crypto-money supply, pose significant barriers to widespread adoption. We think the sharp rise in crypto-currency valuations in recent months is a speculative bubble. “Virtual currencies, perhaps most notably Bitcoin, have captured the imagination of some, struck fear among others, and confused the heck out of the rest of us.” – Thomas Carper, US-Senator What is a Cryptocurrency? Most of us are familiar with using digital currencies.

Ever since IBM released their 3651 controller and 3663 checkout terminals in 1973, the role of digital currency has grown, pushing the bounds of mobility, convenience, and security. Debit and credit cards, automated teller machines, point-of-sale chip and pin and contactless technology, the rise of e-commerce, and new peer-to-peer payment methods like Venmo and Square, have all promoted the use of digital currency as an alternative to traditional cash and checks.

But in recent years, interest has grown in a new type of currency – cryptocurrency. Seeking to satisfy the demand of individuals looking for a digital platform to transact securely, anonymously, and outside of government influence, since 2008 the volume and usage of cryptocurrency has exploded. At of the end of September 2017, Coin- marketcap – a cryptocurrency market tracker – lists over 1,100 cryptocurrencies that trade in over 5,500 markets worldwide and with an aggregate value approaching USD 150bn; more than the market capitalization of IBM and McDonald’s. The most prominent, Bitcoin, accounts for just under half of this. So what is cryptocurrency, and why would one use it? Under development in some form or another since 1983 (see timeline), cryptocurrencies are digitally coded scripts that attempt to replicate the government-backed currencies we use today. However, while transactions in government-backed currencies are tracked by central clearing houses or banks, cryptocurrency transactions are tracked by blockchain, a publically-viewable, digital ledger.

The backbone of the cryptocurrency network is made up of ‘miners’: individuals or syndicates who use highly-efficient networks of computers to solve complex mathematical sequences in exchange for transaction fees and, in some cases, newly created cryptocurrency. This distributed, rather than centralized, set-up creates a number of advantages over government-backed currencies. First, by allowing transactions to be made directly between two parties, rather than through an intermediary, blockchain could make transacting quicker and cheaper. Second, raising funding in cryptocurrencies is also more straightforward than through a traditional initial public offering (IPO). This has helped spur growth in the initial coin offering (ICO) market. Finally, the pseudonymous nature of cryptocurrencies (the accounts transacting are known but the owners are not) and non-governmental nature of the currencies, means that cryptocurrencies have also gained traction among people concerned about privacy, among those politically opposed to government management of currencies, and as a medium of exchange on the online black market. “It is that narrative of human development under which we now have other fights to fight, and I would say in the realm of Bitcoin it is mainly the separation of money and state.

” – Erik Voorhees, cryptocurrency entrepreneur Will they ever become true currencies? Although cryptocurrencies, and the underlying blockchain technology, have advantages that have spurred their growth, we are doubtful that cryptocurrencies will ever become mainstream currencies. Currencies have two basic roles, which cryptocurrencies lack. Timeline 1983: Berkeley programmer David Chum invented Blind Signature technology – an untraceable payment system that separated a person’s identity from their transaction.

Late 1980s: Self-proclaimed libertarian anarchist group ‘Cypherpunks’ outline some mainstays of modern cryptocurrency (pseudo- anonymous protection of identity, proof-of- work systems, private/public-key encryption and separation from government-backed cur- rency) in their memorandum The Crypto Anarchist Manifesto.

1997: Adam Beck introduces first successful proof-of-work algorithm, such algorithms would become an important means of controlling the money supply of a given cryptocurrency. 1997: Wei Dei – another member of the Cypherpunks and a researcher for Microsoft released B-money, indulging the concepts of decentralization and digital contracts. 2004: Hal Finney – a computer scientist and Cypherpunk – developed the first successful reusable proof-of-work (RPOW) protocol based on Beck’s earlier work. RPOW allowed users to transfer digital tokens by destroying and creating tokens during each transfer. This process constituted the first proof-of-work digital cash system.

2004: Nick Szabo – a computer scientist and cryptographer – launched a protocol that merged Wei Dei’s concept of decentralization and Hal Finney’s RPOW to create Bit Gold, the cryptocurrency that served as the predecessor to Bitcoin. 2009: The first popularized cryptocurrency – Bitcoin – is launched following the release of a paper titled, Bitcoin: A Peer-to-Peer Electronic Cash System, by someone writing under the pseudonym Satoshi Nakamoto.

Failing as a medium of exchange – why crypto-currencies will never be used for a majority of transactions The first and most important role of a currency is to act as a widely accepted medium of exchange. Currencies in themselves have no natural value – gold, for instance, is naturally as worthless as paper 9 , sea shells, or wooden sticks (all of which have been used as currencies). Currencies only have value when they can buy things that are useful. In this regard, government backed currencies carry a huge advantage. Governments set taxes, and tax is the largest single payment in almost any economy. In developed economies over a third of all economic activity that takes place in a year is paid to the government as tax. As such, people will always demand government-backed currencies because they are useful for paying taxes. One of the earliest government-backed paper currencies was that of the Chin dynasty of northern China.

In 1192 the Chin Emperor decreed that certain taxes (previously paid in copper coin) must instead be paid in paper currency. This created a demand for the paper currency, giving it a value 10 . In theory, a company could receive a crypto-currency for goods sold. But it would then need to pay corporation tax, payroll tax and sales taxes in government-backed currency.

And the company would be taking an exchange rate risk. If the government-backed currency rose in value against the crypto-currency the company would be at risk of significant loss. Equally, if a company decided to start paying staff costs (on average 70% of costs in a developed economy) in bitcoins, the firm would be expecting its staff to take on an exchange rate risk. This is unlikely to be acceptable to most employees. Staff also need to pay tax in government-backed currency.

This does not stop crypto-currencies from being accepted as a limited form of medium of exchange (see “the currency of crime”). But if governments refuse to accept crypto-currencies for tax payments, the single most important transaction in an economy, that significantly reduces demand for crypto-currencies. Governments are highly unlikely to ever take this step. Governments generally prefer taxes to be raised in the same currency as their liabilities, and also generally prefer to issue liabilities in the same currency that they can control if necessary. This makes it highly unlikely that crypto-currencies could ever be used for a majority of transactions in an economy. Failing as a store of value – why crypto-currencies will never be used as a store of value The second role of a currency is to act as a store of value. People need to believe that what their cash can buy today, their cash will buy tomorrow.

In order to maintain the store of value, central banks take a lot of trouble to keep a currency’s value roughly stable (i.e. control inflation). This is done by making sure that the supply of currency generally matches the demand for a currency.

If the balance is maintained the currency will broadly keep its store of value. An individual crypto-currency cannot achieve this balance, which explains their volatility. Crypto-currency supply cannot go down.

A fall in demand for a specific crypto-currency will therefore cause that crypto-currency’s value to collapse as supply outstrips demand. For context, Bitcoin’s collapse in value in early September was worse than the collapse in the value of the German mark at the start of the Weimar hyperinflation 11 . To be sure, this is nothing to do with the immaturity of the market.

Singapore’s cash and demand deposits are about USD134bn, not much more than Bitcoin (at $4500 per unit Bitcoin’s total value is about USD74bn). But Singapore’s dollar is a very stable store of value, because the Monetary Authority of Singapore spends a lot of time and effort making it a stable store of value. Bitcoin’s value gyrates wildly because its supply cannot be readily changed. The store of value of a crypto-currency is further damaged by tax risks.

Holding a currency generally has a different tax treatment to holding an asset. If a British subject holds pounds sterling, the recent rise in the value of the pound against the dollar generates no tax liability. However, if the government considers Bitcoin as an asset (rather than a currency) then a rise in Bitcoin’s value against sterling could create a capital gains tax liability. And if there is uncertainty about where tax liabilities may arise, or whether they would be incurred, it is likely to undermine peoples’ belief in the currency as a store of value 12 . While the supply of individual crypto-currencies cannot be readily changed, the supply of crypto-currencies overall can be infinitely increased.

Crypto-currencies have few barriers to entry. Anyone who wants to set up a new crypto-currency can do so.

This means that while there may be limits on how much of an individual cryptocurrency can be created, there are no limits on how many different crypto-currencies can be created. The possibility of limitless supply of different crypto-currencies creates the risk of further collapses in value. If a new crypto-currency were created which is easier to “mine,” and which allows more transactions to take place more quickly, demand for that cryptocurrency might naturally increase.

Existing crypto-currencies would likely see demand fall; a crypto-currency that has been superseded by a new crypto-currency with superior technology has little value. As the supply of existing crypto-currencies cannot fall to match the decline in demand, the result would be a collapse in the value of existing crypto-currencies. A good example of this are New York City taxi medallions, which were previously seen as a “store of value” due their limited supply, providing the right to earn cash flow from riders. Their value has plunged in recent years following the advent of ride-hailing apps.

Sarah Granger. Cryptocurrency “While it’s still fairly new and unstable relative to the gold standard, cryptocurrency is definitely gaining traction and will most certainly have more normalized uses in the next few years. Right now, in particular, it’s increasing in popularity with the post-election market uncertainty. The key will be in making it easy for large-scale adoption (as with anything involving crypto) including developing safeguards and protections for buyers/investors.

I expect that within two years, we’ll be in a place where people can shove their money under the virtual mattress through cryptocurrency, and they’ll know that wherever they go, that money will be there.” – Sarah Granger, Author, and Speaker. The currency of crime? While crypto-currencies will almost certainly never be used for a majority of transactions in an economy, they could conceivably be used for some purchases. The possible role of crypto-currencies in illegal transactions is interesting. It could be argued that greater banking regulation and transparency along with more sophisticated attempts to identify money laundering have reduced the supply of government-backed money to the illegal economy. If this is so, then it is entirely in line with historical precedent that those operating in the illegal economy will seek to create their own alternatives to government-backed money, and crypto-currencies could fill that role. The problem with crypto-currencies as criminal-currencies is that the criminal economy is not a closed economy. The desire to, at some stage, transfer money or assets between the illegal and legal economies would mean that there would have to be a conversion rate between crypto-currencies and government-backed currencies.

This would fluctuate with the effectiveness of law enforcement, the demand for illegal goods and services from otherwise law-abiding citizens, and possibly with the penalties for crime. This would make for an uncertain store of value, in a way that a cash-based criminal economy does not.

Are crypto-currency prices a bubble? What are bubbles? The term “bubble” is a bit like the term “recession”– a word that is much used in the media but does not have a formal definition in economics. A bubble is assumed to occur when asset prices cannot be explained by fundamentals. However, there has to be more to a bubble than pricing alone. Fundamentally-based models are not entirely accurate, and so a price may appear to deviate from fundamentals and not be a bubble. Deviating from fundamental value must be a necessary condition, but not a sufficient condition for a bubble. Bubbles nearly always occur when there is something new, or relatively new in the economy. Change, by definition, creates uncertainty about the future.

The tulips of the seventeenth century were new and exotic (to Europeans). The joint stock companies of the Mississippi and South Sea bubbles in the eighteenth century were relatively new financial structures. The 1920s saw mass entertainment (radio and cinema) and mass transport (cars). The dot com bubble had the internet. A constant theme of bubbles is the ability of speculators to shout that dreaded cry “this time it’s different.” Logical arguments against the bubble can then be disregarded as speculators declare that the doubters simply do not understand that the world has changed. The problem with this theory is that the world never changes that much.

A second characteristic of bubbles is that there must be a delay in expected real-world (rather than asset-market) returns. If an asset promised a real-world return in a short space of time, any failure to deliver would undermine the asset price. The great thing about the tulip bulb speculation was that the purchaser had to wait until the bulbs had grown in order to be able to see what flowers had been purchased. The Mississippi and South Sea bubbles both depended on fabulous wealth from far distant colonies and trade that was supposed materialize in a few years. The dot com bubble promised future wealth, and in the meantime nothing as vulgar as earnings need be considered. Of course there were asset price gains to be realized immediately in each bubble, but the underlying value story could not materialize for some time. In the later stages of a bubble there is normally a mix of buyers in the market.

There are those who still believe in the potential real- world profit at some distant point in the future, and there are those that are likely to be investors who are buying purely in anticipation of a rising asset price, without any reference to future profit.

Such investors are not looking to future value, they are hoping that they can get out before the bubble bursts. In the Mississippi Bubble in 1720, the promoter (Law) complained that people were trying to convert shares into gold for speculative gain, rather than holding on in the expectation of future returns (which never materialized). The South Sea bubble in the United Kingdom in 1720 saw similar speculation – not just in the South Sea company, but in the hundreds of imitator companies that were launched at the same time. When there was a regulatory attack on such companies, the speculative owners of stock were forced to sell earlier than anticipated. These stocks had been bought on margin, meaning that the owners were looking entirely for speculative short-term gain and not for longer- term value. The regulatory tightening precipitated a sudden collapse in price.

Are crypto-currency prices a bubble? Fig. 1: Traditional databases run on master- replica architecture Applying the aforementioned characteristics to cryptocurrency prices, they demonstrate most of the characteristics of a bubble.

Cryptocurrencies are relatively new. The real world benefits are said to take years to materialize, even among evangelists. And the relatively high volume of cryptocurrency turnover, against limited real- world use, suggests that many buyers are seeking speculative gain, never intending to use cryptocurrencies to make a real-world transaction. The remaining characteristic – fundamental value – is the most difficult to assess, since unlike in government-backed currencies, no crypto-currency has an economy behind it.

But with each of the other characteristics of typical bubbles in evidence, a twentyfold increase in bitcoin prices in just two years, and an absence of any fundamental economic backing, cryptocurrency prices are almost certainly a bubble. What is Blockchain? While we are doubtful whether cryptocurrencies will ever become a mainstream means of exchange, the underlying technology, blockchain, is likely to have a significant impact in industries ranging from finance to manufacturing, healthcare, and utilities. We estimate that blockchain could add as much as USD 300-400bn of economic value globally by 2027. Imagine UBS analysts were asked to write this research paper in a single master document.

In such a scenario, only one analyst would be able to work at a time. A shared platform would improve efficiency, allowing multiple analysts to work on their respective segments in a single master document, with changes made visible in real-time. This is a gross oversimplification of blockchain technology, but helps explain the concept. Blockchain is essentially a distributed database, which is shared and continuously reconciled.

Traditional databases are run on a master-replica architecture (see Fig. 1), where a trusted party alone can update the master copy, while replica databases mirror the transactions updated in the master database. Traditional databases are cumbersome and require huge investments in back-offices to reconcile and verify the validity of transactions. Fig.

2: Every transaction needs to be verified by all the users in distributed databases like blockchain In contrast, with distributed databases, or ledgers, under a blockchain, every user in the system has a copy of the database (see Fig. 2). This structure reduces costs – individual users do not need to rely on a central party or intermediary, it improves security – any potential change to the database has to be verified by the majority of users using cryptography, and it makes the system more robust – there is no central party at risk of cyber-attack or malfunction. How does it work? Put simply, every 10 minutes or so, all users are required to approve all the transactions (called blocks) done on the network, using cryptography (or hash values), and record them in a chronological order (chain). The term block-chain refers to this block of transactions recorded in a ledger through an immutable chain (see Fig. 3).

Fig. 3: An example of hash values in blockchain transactions Security is improved by the use of hash values – strings of letters and numbers which transform data through mathematical transformation. If an individual user were to make any changes, the hash function would return a totally different hash value, demonstrating that the record has been altered. This helps prevent any malign user from altering past transactions, making the network immutable.

To summarize the key advantages of a blockchain network: • Disintermediation: Blockchain makes the centralized server less relevant. This allows peer-to-peer transactions with less oversight or intermediation of a third party, while still not exposing the system to counterparty risks.

• Security: The cryptographic nature of blockchain transactions makes the network more secure than traditional databases. Hash values prevent any maligned user from altering the transactions. • Resilience: In addition to its immutability, blockchain networks are resilient as they do not have a central point of failure. Also, given the encrypted and chain nature of the data blocks, any potential damage to the data would not affect records of historical transactions. • Lower costs: By eliminating or reducing the reliance of intermediates and associated costs, blockchain networks can significantly reduce transaction costs.

The ability to monitor transactions in real-time, for example, can reduce the effort needed to reconcile dispute resolutions. Fig. 4: How blockchain networks work Here the Recent Popular Cryptocurrency Bitcoin The one and only, the first and most famous cryptocurrency. Bitcoin serves as a digital gold standard in the whole cryptocurrency-industry, is used as a global means of payment and is the de-facto currency of cyber-crime like darknet markets or ransomware. After seven years in existence, Bitcoin‘s price has increased from zero to more than 650 Dollar, and its transaction volume reached more than 200.000 daily transactions. There is not much more to say: Bitcoin is here to stay.

Ethereum The brainchild of young crypto-genius Vitalik Buterin has ascended to the second place in the hierarchy of cryptocurrencies. Other than Bitcoin its blockchain does not only validate a set of accounts and balances but of so-called states.

This means that Ethereum can not only process transactions but complex contracts and programs. This flexibility makes Ethereum the perfect instrument for blockchain -application. But it comes at a cost. After the Hack of the DAO – an Ethereum based smart contract – the developers decided to do a hard fork without consensus, which resulted in the emerge of Ethereum Classic.

Besides this, there are several clones of Ethereum, and Ethereum itself is a host of several Tokens like DigixDAO and Augur. This makes Ethereum more a family of cryptocurrencies than a single currency.

Ripple Maybe the less popular – or most hated – project in the cryptocurrency community is Ripple. While Ripple has a native cryptocurrency – XRP – it is more about a network to process IOUs than the cryptocurrency itself. XRP, the currency, doesn‘t serve as a medium to store and exchange value, but more as a token to protect the network against spam. Ripple Labs created every XRP-token, the company running the Ripple network, and is distributed by them on will.

For this reason, Ripple is often called pre-mined in the community and dissed as no real cryptocurrency, and XRP is not considered as a good store of value. Banks, however, seem to like Ripple. At least they adopt the system with an increasing pace. Litecoin Litecoin was one of the first cryptocurrencies after Bitcoin and tagged as the silver to the digital gold bitcoin.

Faster than bitcoin, with a larger amount of token and a new mining algorithm, Litecoin was a real innovation, perfectly tailored to be the smaller brother of bitcoin. “It facilitated the emerge of several other cryptocurrencies which used its codebase but made it, even more, lighter“. Examples are Dogecoin or Feathercoin. While Litecoin failed to find a real use case and lost its second place after bitcoin, it is still actively developed and traded and is hoarded as a backup if Bitcoin fails. Monero Monero is the most prominent example of the cryptonite algorithm.

This algorithm was invented to add the privacy features Bitcoin is missing. If you use Bitcoin, every transaction is documented in the blockchain and the trail of transactions can be followed. With the introduction of a concept called ring-signatures, the cryptonite algorithm was able to cut through that trail.

The first implementation of cryptonite, Bytecoin, was heavily premined and thus rejected by the community. Monero was the first non-premined clone of bytecoin and raised a lot of awareness. There are several other incarnations of cryptonote with their own little improvements, but none of it did ever achieve the same popularity as Monero. Monero‘s popularity peaked in summer 2016 when some darknetmarkets decided to accept it as a currency.

This resulted in a steady increase in the price, while the actual usage of Monero seems to remain disappointingly small. Besides those, there are hundreds of cryptocurrencies of several families.

Most of them are nothing more than attempts to reach investors and quickly make money, but a lot of them promise playgrounds to test innovations in cryptocurrency-technology. .

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