Bitcoin: boon or bubble?

These days, newspapers and websites are full of stories about cryptocurrencies, virtual currencies, and bitcoins. Confused? Here is a ‘guide for the perplexed.'

By SHLOMO MAITAL
January 20, 2018 18:51
 A coin representing the bitcoin cryptocurrency is seen on computer circuit boards in this illustrat

A coin representing the bitcoin cryptocurrency is seen on computer circuit boards in this illustrative picture. (photo credit: REUTERS)

 
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What are virtual currencies and cryptocurrencies?
A virtual currency is money, used as a means of payment and created, transferred, stored and traded digitally. Cryptocurrency is kind of virtual currency that uses encryption − coding, readable only to authorized persons who possess “keys” to the code – used to control the creation of new money and to secure the transfer of existing money against theft and fraud.

Bitcoin is the first and still leading cryptocurrency. It was launched in 2009 – with a value of five cents per coin – and since then, there have been growing numbers of copycats. According to Wikipedia, there are at least 34 such currencies – litecoin, swiftcoin, namecoin, ether, ubiq, etc. – and only one has ceased operations.

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What is bitcoin?
WHAT IS THE BLOCKCHAIN TECHNOLOGY BEHIND CRYPTOCURRENCIES LIKE BITCOIN AND ETHEREUM? (REUTERS)

Bitcoin is the leading cryptocurrency. Writing in the TechCrunch website, Florian Graillot explains: “Bitcoin was the first use of the blockchain [explained below], and the most famous one. Its founder developed this technology to process money transfers and to solve many cryptocurrency issues. Instead of having a central bank that regulates money, and banks that validate financial transactions, Bitcoin relies on the blockchain.”

Bitcoin got off to a rocky start. In 2013, to buy one bitcoin, you needed to go to a drugstore and use a MoneyGram to wire the dollar value of a bitcoin to a cryptocurrency exchange. Proponents then tried to make things easier by setting up bitcoin ATMs (automatic teller machines). At the time each bitcoin cost $140. Today a bitcoin is worth about $16,000 and the process is far simpler. It is all done online. Incidentally, there are now three bitcoin ATMs in Tel Aviv.

The shekel value of each bitcoin today is about 56,000 shekels. There are some 17 million bitcoins now in circulation, worth at current prices about $272 billion (950 billion shekels). This is just a drop in the bucket, compared to the US money supply of $13.7 trillion (the broad definition of money, including various sorts of deposits).

There actually exists a physical bitcoin. The most popular version has a big B in the center, ringed by the somewhat pompous Latin slogan “libertas, veritas, equitas” (freedom, truth, equality). The real bitcoin, of course, is not physical but digital.

What is blockchain technology and how is it related to bitcoin?

In our daily lives, highly advanced technologies lurk behind the devices we use. Few of us need or want to understand them deeply. We simply want speed, convenience, connectivity, and friendliness. The best technologies are the ones that are most invisible.

Blockchain is one of those technologies. It makes bitcoin possible. At a Swiss- Israel Innovation Workshop where I spoke last year, in Lucerne, a speaker casually mentioned that the next world-changing technology is called “blockchain.” So far he has been proven correct.

In the blockchain, information is stored in blocks that record all transactions ever done through the network. Hence, it helps validate both the existence of assets to be traded and who owns them. With chains of “blocks” or transactions, you don’t need a middleman (e.g. a bank) to organize buying and selling. It is done instead by a network of buyers and sellers; the blockchain technology enables secure transactions without fraud.

The term “blockchain” was coined by an anonymous person or group of persons using the name “Satoshi Nakamoto” in 2011. To this day the identity of this group remains obscure. It is not known whether the name “Satoshi Nakamoto” is real or a pseudonym, nor whether it represents one person or a group. Nor do I understand why the group chooses to remain anonymous.

Today, blockchain enables online buyand- sell transactions without financial intermediaries such as banks, with full anonymity and security (encryption). Formally, blockchain is a person to person “ledger” or register that records deals done in terms of cryptocurrencies and operates with no central authority or banker.

Blockchain is thus a trusted impersonal mediator, which helps confirm transactions to the rest of the network. For example, bitcoin users use the blockchain to prevent attempts to re-spend coins that have already been spent elsewhere, just as banks clear checks and subtract funds from one account and add them to another..

Blockchain is a disruptive technology – a game-changing matchmaker that brings together those who want to sell something with those who want to buy it. It undercuts huge established existing players (stock exchanges, banks, etc.), who make money by charging for their services as intermediaries. Instead, blockchain technology enables smaller players and start-ups to compete, by creating value for customers.

Harvard Business Review claimed earlier this year that blockchain is a “foundation technology” because it “has the potential to create new foundations for our economic and social systems.” Like so many other Internet technologies, it eliminates conventional middlemen, giving access to global markets to anyone with an Internet connection.

Banks create conventional money, mostly in checking accounts, under the supervision and regulation of central banks. Who creates the supply of bitcoin?
Bitcoin “miners” and how they “mine” for bitcoins is a story. “Mining” is the process of adding records, i.e. bitcoins, to Bitcoin’s public ledger (blockchain) for people to buy. This is done by a “mining rig” – a single computer system that makes the necessary computations for “mining.” These computations are purposely very difficult and costly to perform, limiting the new supply of bitcoins and preserving its value.

Mining is intentionally set up to be so costly and difficult that the number of blocks processed each day by miners remains steady. This is similar to how central banks stabilize credit creation by controlling bank reserves. Individual blocks of bitcoins created by miners must contain proof of work to be considered valid. The resulting scarce supply, relative to demand, partly explains bitcoin’s soaring price.

Conventional money is created when commercial banks expand their lending by making loans. A loan is simply the creation of a checking account with money in it. Central banks limit credit and money creation by requiring banks to hold reserves (liquid assets) to back the credit they give.

With cryptocurrency, such as bitcoin, “miners” leverage computer power to solve complex cryptographic problems (the proof of work). Every time a problem is cracked, a block of bitcoins is added to the chain and all the transactions it includes are thus validated.

Bitcoin miners are paid a “subsidy” for the newly created coins they mine. In this way, new coins are distributed in a decen-tralized manner, without a central bank.

Mining for bitcoins is like mining other commodities − it requires much effort and it makes new currency available at a rate that is not unlike the rate at which silver and gold are extracted from the ground.

Why are some experts worried about cryptocurrencies? Why has bitcoin risen in value so steeply?

On Dec. 1, 2016, each bitcoin was worth $220.46. A year later, on Dec. 1, 2017, each bitcoin sold for $16,179. If you invested $100 in bitcoins a year ago, your investment today is worth $7,300. If you bought a bitcoin on day 1 (2009), it is worth 320,000 times more today. No other widely traded asset can match this. No wonder thousands or millions want to get on the bitcoin bandwagon.

Why the steep rise? Is it a bubble? Of course it is. The bubble is generated by enormous demand, relative to limited supply. But why the demand?

It is the usual feedback loop – the value of bitcoins rises, leading to demand, leading to further rises… and a powerful growth loop that pulls amateur investors in globally, fueled by the ease of investing in them.

Very little demand for bitcoin is fueled by actual purchase of goods and services. Most of it is “store of value” demand – investors who want to protect their money and make a high return on it. A herd mentality has developed and such bubbles rarely end well.

The website CoinMarketCap claims all 20 of the leading cryptocurrencies are rising steeply. Bitcoin is not the only star. Litecoin rose the most, by 40% in one week in mid-December.

According to Bloomberg BusinessWeek, a thousand “whales” (the one thousand holders of large amounts of bitcoins) can move the market – send prices plummeting when they sell, or soaring when they buy. Some 40% of bitcoins are held by the whales, who know each other and can coordinate buying and selling. Bitcoins are not a security, so it is not illegal for a group to push up the price together and then dump the coins for a profit. So far, they have not done this.

Writing in The New York Times, Kevin Roose asks, “You know what’s more popular than stable monetary instruments? Casinos! People like to gamble!” Bitcoin, fed by social media, has attracted a bevy of get-rich-quick speculators. They hope to sell before the crash. But I would not count on it.

Is there a bitcoin industry?

There are many businesses set up to profit from niche positions in the bitcoin industry. Coinbase.com was at the top of Apple’s download rankings of applications. Coinbase makes it easy to trade bitcoin, litecoin and other cryptocurrencies. The venerable Chicago Board of Trade Global Markets Exchange now enables trading in bitcoin futures – buying and selling bitcoin for future delivery, a month, six months or a year hence. The volatility of bitcoins make them attractive for such trades.

Is Israel involved in bitcoin?

How could it not be! In Israel, a company called Natural Resources Holdings announced in October that it was switching out of iron and gold mining and entering the bitcoin mining business. Its shares soared. From November 10 to mid-December, its share price rose twentyfold. This alacritous shift is not unlike a potato grower announcing he will now “grow” fairytales.

ACCORDING TO the daily Haaretz, Natural Resource Holdings bought a Canadian cryptocurrency “miner” start-up and, as a result, in a single month, November, “mined” 390 bitcoins with its four server farms, worth today over $6 million. It is interesting that bitcoin mining requires huge amounts of electricity to feed the server farms – but power is cheap in Canada, giving the acquired Canadian start-up an advantage.

On December 15, an Israeli real estate developer, Hanan Mor, publicly traded on the Tel Aviv Stock Exchange, said it would start accepting bitcoins as payment for apartments in its Ir Yamim 10 project in Netanya. According to the daily Haaretz, it is the first time that an Israeli company agreed to accept payment in bitcoin. Nevertheless, there is a catch – there is a ceiling of 10 bitcoins, or no more than a quarter of the apartment’s price, payable in the cryptocurrency.

Are bitcoin and other cryptocurrencies a boon? Or a bubble? They are, of course, both.

Nobel Laureate Robert Shiller, in his 2012 book, “Finance and the Good Society,” insists that the way money is borrowed and loaned can bring huge benefits to society, especially when human creativity innovates this huge industry. At the same time, avaricious “whales” in the financial services industry can through greed create catastrophes, like the 2008 financial collapse.

Central banks have been very late in awakening to the cryptocurrency industry, Bank of Israel among them. In the US, the Securities and Exchange Commission (SEC) has just begun to investigate initial cryptocurrency offerings. In Israel, Shmuel Hauser, chair of the Israel Securities Authority, has discussed with Ittai Ben-Zeev, CEO of the Tel Aviv Stock Exchange, whether to exclude bitcoin mining businesses from the TASE stock price indexes – because inclusion confers confidence and respectability.

In recent months there was a wave of highly publicized cyber-hostage attacks. In these, scoundrels hacked into a computer system, changed the password, then demanded ransom money in return for releasing the password. Often they demanded payment in bitcoins – because it is hard to track and hard to identify its owner.

Like nearly all financial innovations, the bitcoin boom is both a boon and a bubble. It is a boon, because it makes it possible for a great many people and businesses to engage in global transactions, without having access to banks, credit ratings, credit cards and checking accounts. It is a bubble because a great many people, who have seen the value of bitcoins soar, want to climb on board the “greed train” and make money – thus inflating the value of each bitcoin to unrealistic levels.

Sooner or later this bubble will burst, the party will end, and, as usual, the winners will be the whales, who sell first, and the losers will be ordinary, unsophisticated investors who sell their holdings close to the bottom.

The writer is senior research fellow at the S. Neaman Institute, Technion and blogs at www.timnovate.wordpress.com

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