Talking to clients about cryptocurrencies

What are the principles behind the digital cash and what does its growing popularity mean for investments?
by Tim Green

Cryptocurrency, which uses a cryptograph (the process of converting legible information into an almost uncrackable code) for security, making it difficult to counterfeit, is not issued by any central bank or authority. It was technically created in 2008, but there are still some teething issues with using it in daily life. 

In January 2018, the North American Bitcoin Conference, without a trace of irony, confirmed it would not let people pay for tickets with cryptocurrency. The organiser said this was because of transaction fees exceeding US$30 at certain times of day. 

These fees come into play when demand to use the network upon which cryptocurrency transactions take place exceeds its capacity. The higher the fee, the more likely it is that a transaction will make it to its destination. 

The conference’s refusal to accept cryptocurrency payments is just one crazy story among the many thousands from the world of digital cash. But it neatly reflects a fundamental problem with the technology: it’s almost impossible to use cryptocurrency to actually pay for stuff.

Bitcoin by numbers

3,413 – The number of days since the first block creation 

£156bn –  The value of blocks mined to date 

94.73% – The amount of bitcoin engagement with male user
Source: Coin Dance
Of course, this major flaw has not halted the rise of cryptocurrency in the current decade. The price of bitcoin – the most well-known cryptocurrency – has soared, but it has experienced volatility along the way. In 2010 it was trading at US$1. By December 2017 it had reached its all-time high of nearly US$20,000, and on the date of publication of this article, it was at US$9,288.87. Thanks to its phenomenal rise in value, many investors now consider cryptocurrencies as an asset class that could help to diversify a portfolio.
How cryptocurrencies work To understand how cryptocurrencies work, it helps to know how we have arrived at this point. In the physical world, cash is straightforward. For example, John has a pound. He gives it to Jane. Now, Jane has the pound and John doesn’t. No intermediary is needed to manage the process.

In the digital world, this transactional set-up is hard to replicate. When John gives Jane a digital item (a Word document or an MP3 file, say), John still has it. Both of them can copy it as many times as they like. 

This is why, when we send money online, we do it through intermediaries like card schemes, which debit and credit vast electronic ledgers and keep a record of every transaction. Cryptocurrencies eliminate the need for an intermediary by creating a blockchain. This is a universal ledger that every user can access. 

Users make payments via a bitcoin wallet such as Coinbase or Electrum. In reality, these wallets don’t hold bitcoins. Instead, they maintain a bitcoin address (a string of 34 letters and numbers). When a person validates a transaction with a private key, the system debits his or her account, and credits another.  

Every transaction is included in a ‘block’ (hence blockchain), which is processed by miners  – they are members of the general public, who validate and timestamp transactions, and add them to the blockchain using their computer. Their reward for doing the work is to unlock more bitcoins. Anyone can do it, though the amount of processing power needed to mine is now so great that many individuals have been priced out.

The blockchain set-up is simultaneously very public and highly private. It records all transactions and makes those records publicly accessible, but the actual identity of the participants is hidden. Crucially, no single entity controls the blockchain. It’s an open source project managed by a community of people that care enough to do the work. The result? There’s no identifiable intermediary like a bank or a card company, which works in a client's favour if they wish to keep their financial transactions hidden from scrutiny. 

The anonymity guaranteed by cryptocurrencies has proved attractive for many of its early adopters, although not always entirely for legitimate reasons. It has been widely reported that using the dark web (a specific collection of websites that exist on an encrypted network and cannot be found by using traditional search engines), criminals such as drug dealers can trade anonymously using cryptocurrencies. The darker side of the world of cryptocurrencies is something advisers should bear in mind, should clients express an interest in investing in this new asset class (see table at the end of the article for a snapshot of pros and cons).
Cryptocurrencies’ consThere are many types of cryptocurrency, but the dominant one is bitcoin. Its wild fluctuation has made some people very rich. Notable winners include the Winklevoss twins (who helped launch Facebook). They were early investors in bitcoin and owned around US$1bn worth by December 2017. But this volatility is also one of the reasons why some investment advisers warn against it.

Garry White ACSI, chief investment commentator at Charles Stanley, echoes this point: “Bitcoin is not something we would recommend. It’s like the National Lottery. Yes, you could possibly win a lot of money, but you probably won’t. In the end, I expect the retail punters will lose out in this area as they nearly always do.”

So, besides price fluctuation, why is there such scepticism around bitcoin and the many other cryptocurrencies that exist (CoinMarketCap lists almost 900 of them as of May 2018)? Garry believes there are structural flaws. “Any investment vehicle has a track record of a return over time or is a reliable store of value. Bitcoin is neither,” he says.

However, there are many more conversation points to have with a client before they make a decision on whether to invest in cryptocurrency or not:
1. Cryptocurrency isn’t really currencyHardly anyone ever spends bitcoin. Why would they when the price keeps rising? Also, cryptocurrency is not good at scaling transactions. Experts say it takes ten minutes to clear and settle one bitcoin transaction. Visa and Mastercard can do more than 5,000 a second. But, for an investor, this won't really make a difference, if they're planning to just buy a bulk of bitcoin and not spend it. 
2. It is easy to lose or steal bitcoinsWhile it’s almost impossible to counterfeit bitcoin, they are easy to lose or steal. Most owners trust third parties to look after their reserve. But this can go wrong. Witness the Mt. Gox bitcoin exchange. When it collapsed in 2014, it was handling over 70% of bitcoin transactions worldwide. It later confirmed 850,000 bitcoins worth US$450m had been lost. Although it subsequently ‘found’ 200,000 bitcoins, how they were ‘lost’ and where they went is still very much a point of conversation, with ongoing legal battles with the Tokyo based bitcoin exchange. The firm has blamed hackers for its loss, pointing to a security flaw. 

Bitcoins can be stolen by hackers through a user’s private safe keys – sometimes the only information a hacker will need is your email and phone number. The major security flaw is due to the Signaling System 7, which allows phone networks to connect with each other. However, it also allows hackers to intercept authentication messages for a person’s bitcoin wallet. 
3. The world of cryptocurrencies is dominated by crime and money launderingA 2017 study, titled Sex, drugs and bitcoin, by Sydney University, finds that 44% of bitcoin transactions and 25% of all users are associated with illegal activity. This is why regulators are increasing their scrutiny of bitcoin. 

South Korea has moved first, passing a law that says bitcoin owners have to identify themselves. In the UK, Action Fraud said crimes linked to bitcoin rose from 320 in 2016 to 999 in 2017. The UK government is now looking at applying EU anti-money-laundering rules in relation to cryptocurrency. 

These concerns spread to the United States too, as US Treasury Secretary Steven Mnuchin told the World Economic Forum in January 2018, in Davos, Switzerland. “My number one focus on cryptocurrencies, whether that be digital currencies or bitcoin or other things, is that we want to make sure that they’re not used for illicit activities … we encourage fintech and we encourage innovation, but we want to make sure all of our financial markets are safe,” he said.
4. It is hard to bequeathFor investors, it is sensible to think about the future of their investment, and a fundamental requirement of any investment vehicle is the ability to bequeath it to someone after you pass away. This is another bitcoin flaw – for two reasons. First, owners have to give loved ones access to the keys to their digital wallets. Most bitcoin users are young, and they don’t think to, just like a young person may not have written a will before a certain age. Second, the laws that guide asset transfer do not yet apply in the cryptocurrency space. 
5. A small cabal ‘owns’ bitcoinFor all the libertarian ideals of bitcoin enthusiasts, the truth is that most coins are in the hands of a small group of super-owners. Indeed, reports say 1,000 people may hold 40% of the supply. Clearly, these owners have the ability to manipulate the price, making it unstable.

Despite the concentration of bitcoin ownership noted above, no single entity controls the currency. This means that, in a crisis, there is no one to defend it. 

In a talk for CISI TV, money expert Tim Jones CBE argues that this is a potential disaster, labeling it ‘crypto anarchy’. He explains that a fundamental element of the human condition is that when a society has over-concentrated power, dissent will ensue. With no bank or institution monitoring cryptocurrency transactions, a certain amount of privacy is given to the user.

Some might see this lack of central oversight – a kind of democratisation of finance – as a good thing, but it also has its flaws. “Cryptocurrency is backed by nothing,” says Jones. “Fresh air. Not an asset in sight. So who is going to pull the policy lever when the sellers exceed the buyers? There’s nothing there. There’s no entity to decide anything.” 

Jones explains the relatively simple business model of bitcoin too, stating that if there are more buyers than sellers, the price of bitcoin goes up, but adds that if you liquidated all of them, no one really knows what the price would be, so your cryptocurrency’s actual value is unknown. 
Is blockchain a better investment bet?Clearly, there are many compelling reasons for investors to avoid cryptocurrency. But what about the blockchain technology that underpins it? Blockchains can provide a trustworthy framework with no middlemen for transferring anything valuable. Not just money, but contracts, ownership deeds, votes and more. 

This is an area that many investment professionals are examining closely. They are aware of the growing consensus in technology circles that blockchain technology could change the world. There are already intriguing real-world case studies. For example, Walmart and IBM are working on a project that applies blockchain technology to food safety. In the pilot, they found that they could cut the time it took to trace a package of mangoes from the farm to the store to just two seconds – from weeks. 

If cryptocurrencies don’t evolve into genuine investment opportunities, maybe blockchain-related assets will. However, there are already signs of hype in this space too. In December, the unprofitable US drinks company Long Island Iced Tea Corp changed its name to Long Blockchain Corp. Its shares rose by 289%.

Meanwhile, there has been an explosion of initial coin offerings (ICOs) that sell tokens based on a company’s blockchain as an alternative to share certificates. The attraction for issuers is that ICOs can reach a global market of buyers. They can be viewed more like crowdfunding than a share sale. However, ICOs occupy a legal grey area, and regulators are watching.

Garry is not impressed. “Lots of companies are pivoting in this way – trying to cash in on the interest in the blockchain. And there are so many ICOs already. The world needs fewer coins, not more. I would urge everyone to be very cautious.”
Pros Cons
Cryptocurrencies are transparent. Using bitcoin and blockchain, all transactions are recorded and monitored, and can’t be changed. No organisation or person can manipulate it Cryptocurrency, in particular, bitcoin is associated with illegal activity. According to a study by the Sydney University, 44% of bitcoin transactions and 25% of all users are associated with unlawful activity
Cryptocurrencies are portable, and unlike cash, can be transported easily Currently, cryptocurrency isn’t really a ‘currency’, as no one really spends bitcoin
There is a potential for big returns  – if a person had invested US$1,000 in bitcoin in 2013, it would be worth over US$400,000 today Cryptocurrencies can be lost or stolen relatively easy through hackers. As it’s still a comparatively new technology, the security hasn’t been refined yet
A user has full control over their funds. Using cryptocurrency takes away the need for a bank or institution as the platform it uses is decentralised, cutting out the third party, which works in a client's favour if they wish to keep their financial transactions hidden from scrutiny

It’s hard to bequeath. The laws that guide asset transfer do not yet apply in the cryptocurrency space. In order to pass cryptocurrency on, the deceased would have to give their ‘key’ to their loved one

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Published: 09 May 2018
  • The Review
  • cyber crime
  • cryptocurrency
  • Bitcoin

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