Abacus: The Growing Economic Sector of Cryptocurrencies

Last week, my roommate and I were lying outside on a beautiful day in Northeast Canada, wondering about how we’re going to afford to buy a 6-pack of PBR for the night’s activities. This is when he asks me to co-invest with him in something called Ethereum; the goal of course being to make a ton of cash, quickly. Naturally, I have no idea what Ethereum is, but he refers to it as “the next Bitcoin, but better.”

I’ve heard small mentions of Bitcoin, a digital payment system run and used by a bunch of software geeks, right? A deeper look into both Ethereum and Bitcoin resulted into a 4-hour binge research session of every Cryptocurrency on the market. Cryptocurrencies are essentially a non-traditional asset that can be used as a medium of exchange, i.e. a digital currency that works directly between two individuals (called peer-to-peer, or P2P for short). What makes this new payment system so valuable is the technology it runs off of: Blockchain. Bitcoin transactions are recorded by a decentralized group of Blockchain “Miners.” These miners basically record proof-of-transactions (in electronic nodes called Blocks) in between online individuals who pay each other in these types of currencies, and these transactions are then broadcasted across the entire network, for everyone to see. People are rewarded for mining these transactions in the form of Bitcoin, or whatever digital currency they are mining.

This is essentially the same as having a trusted third party, for example PayPal, verify a peer-to-peer transaction online. But PayPal is a centralized third party that oversees the interaction, while Bitcoin’s blockchain technology allows enough transparency throughout the interactive network that it is a completely decentralized payment system. The important implication of this: It is a safe and secure way to complete online interactions without a centralized third party, like a bank, involved in it. Instead, transactions take place between users directly, and everyone can see who paid who, and when, and how much was exchanged for what, so that no one can cheat the system.

Therefore, Cryptocurrencies are a digital payment system wherein individuals can exchange anything in any market with no regulation or centralized intermediary, all via code. This currency for the online platform can create, as Morgan Peck writes for a Wired.com article, “a new economy in which anyone can participate on their own terms.” This decentralized global network can reduce costs, remove barriers to entry, and get rid of online market failures, while still being a transparent and trustworthy payment system with no censorship. That last sentence wasn’t entirely original, check out Ethereum Co-founder Vitalik Buterin explain this system, and his Ethereum application, in 3 minutes below:

While the goal of decentralized global currencies is to challenge monetary theory and create a new economy in which third party intermediaries are no longer needed, Cryptocurrencies are currently just a non-traditional monetary asset in a very bullish market. The best returns in the first half of this year, across all assets, have been Bitcoin and Ethereum, here’s the performance year-to-date for these currencies vs. traditional assets:

It’s probably fair to argue that these super high returns are from the currencies being traded in a thinly regulated and highly emotional market, with exceptionally high volume and liquidity. In addition to this, as my roommate can attest to, a lot of global attention has been placed on these new types of currencies, meaning a lot of investors have heard about them. As a result, Bitcoin and Ethereum and many other currencies are being bought and bought and bought, by millions of investors, with no centralized system, and market momentum has driven the returns in this market through the roof.

Of course, positive volatility can only come with negative volatility. For example, just last week Ethereum experienced what is known as a “Flash Crash”, in which the price dropped from just over $300 to 10 cents, in just a matter of seconds, on one exchange, after a large multimillion dollar sell order was placed. The huge sale also triggered over 800 stop-loss orders, continuing to push the price down. The goal is to create a large global economy based off of decentralized digital currency, but right now the market is so small that one investor can manipulate a market this easily, especially with no regulations. The price quickly rebounded to just over $300 again, but not before thousands of investors lost tons of money, and thousands of investors made tons of money when they bought the currency down near 10 cents. This anecdote only explains the high risk inherent with this type of asset, despite the possibility of a global turn to cryptocurrencies.

It’s incredibly easy to buy Cryptocurrencies online. Yesterday, I went on Coinbase.com, made an account in like 3 minutes, and then bought 10 bucks worth of Bitcoin, which amounted to a breathtaking 0.00385409 Bitcoins! Digital currencies are liquid and trading in high volumes, despite their nontraditional origins, and are bringing about super high returns for investors who like to speculate. However, Cryptocurrencies have a high potential to grow into a major economy by challenging current monetary theory, but only if enough people start to trust/put faith into the currency like they do with federally backed monies.

But, the long term investment horizon for cryptocurrencies involve many barriers to becoming a major economic sector. Three key problems outlined by Sean Williams in an article for The Motley Fool (paraphrased by me):

1.)  Anonymity is its enemy: It’s use of completely anonymous and decentralized transactions allow the possibility for criminals and terrorists to use certain digital currencies to fund their activities. There are literally almost no safety protocols put in place to deal with this possibility, and placing them there take away benefits of using the currency in the first place

2.)  Security is a problem: If these digital currency systems don’t remain decentralized, they become easy prey to hackers. For example, if they run out of miners who don’t want to keep the system running for rewards anymore, they are forced into centralization, which creates these security issues.

3.)  Few understand cryptocurrencies: Very few people know what/how these are or how they work, and of course decentralized digital currency will not continue to grow if it doesn’t become more easily available to more people.