The Crazy? Potential of Cryptocurrency: Part 2

This will be the first post of a series which I will call Disruption? and part 2 of a two part introduction on the potential of cryptocurrency and more specifically Bitcoin. Find part 1 here.

Here, in this series, I will be able to voice my thoughts on the potential of new technologies and their relevance in our day to day lives. This will include all sorts of stuff related to FinTech and Markets, Medical Technology or other exciting services that I stumble upon.

Continuing from the previous post:

How can it change our world?

For this section of discussion I am going to target a rather niche area of Bitcoin and I will tackle other cryptocurrencies later on. A lot of the other advantages that can be related to an already developed economy can be found online but here I wanted to focus on economic development and access to finance through Bitcoin.

One of the great things about Bitcoin is that it is borderless. This means that it can operate seamlessly to basically anywhere that has access to the internet. Michael J. Casey and Paul Vigna’s discussion on Bitcoin’s potential in accessing Emerging Market Economies (EMEs) or underdeveloped countries appears to be attractive. Although I recognise that EMEs already have heavy development, it’s more of a case of accessing the rural areas that might be left untouched by Foreign Direct Investment (FDI).

Let’s talk potential before we dive into some of the obvious objections I am sure are already swirling in your heads. Here are some of the possible advantages:

  1. Bypassing political barriers to development
  2. Cutting international transaction costs
  3. Accessing the ‘unbanked’

Bypassing political barriers to development
A great number of people still live without access to basic necessities and a greater number don’t have access to the finance required to reach a certain level of economic development. We can define this development as an advancement in the social and economic prospects of an economy. A lot of these barriers have to do with a lack of infrastructure and investment along with the issue of politics. Casey and Vigna go into detail about Afghan women’s limited access to technology, the internet and finance.

How does Bitcoin bypass these barriers? It does not do it alone. The limited access mentioned above is aided by initiatives that promote the use of technology. In Casey and Vigna’s case, they discuss Roya Mahboob’s work with the Women’s Annex. This provided the necessary exposure for female school students in Afghanistan to access this technology. This subsequently allows access to Bitcoin.

Why is Bitcoin so important though? It provides access to finance. Many of these school students that Casey and Vigna talked about were ‘unbanked’ meaning that they did not have a bank account. This meant there was a lacking component of finance even if you were educated on the topic. This has wide implications on a lot of economic development and I encourage you to read Abhijit V. Banerjee and Esther Duflo’s book Poor Economics, to understand why a lack of access to finance is such a drastic barrier to development.

Hence, Bitcoin allows for access to finance without the need for traditional routes such as established banks and so forth that might be slowed down by the bureaucracy of politics. We can bypass the political limitations such as discrimination against gender to allow for economic development to occur through micro-financing which is also discussed in Banerjee and Duflo’s book. The empowerment of women is one strong example that was discussed in Casey and Vigna’s book along with issues to do with low income, low investment and low savings — the elements of a vicious poverty cycle.

Cutting international transaction costs
Another great component, as we have discussed, is the reduced transaction costs. Without the need to go through multiple foreign exchanges or clearing houses or banks, we can transfer Bitcoin directly, across borders, without the need to pay many fees.

This means that money, unhindered by additional costs, can get to the people we want to get it to with less hassle. The only hindrance, and it is a big one, is how we can get these people to access the necessary equipment required to make this work. The requirement for internet, a mobile device and some technical know-how are all necessary requirements and I’ll discuss this below.

Accessing the ‘unbanked’
I quickly ran over the issue of banking above when talking about some of the advantages of Bitcoin’s borderless access. The issue with a lot of EMEs and underdeveloped countries, especially in rural areas is to do with the lack of investment due to risk. What do I mean by this? Big financial institutions such as your JP Morgans, your Goldman Sachs, your HSBCs and Barclays do not really want to invest a lot of money into setting up financial institutions in areas that may not provide returns.

This is no doubt an oversimplification but due to the lack of financial knowledge present in these areas, due to the lack of infrastructure and potential for investment and the real possibility that many people would be unable to repay their loans due to external factors such as health and so on, it would not be worth it for these big institutions to come into these areas to conduct business. Their initial investment into the area in setting up the brick and mortar banks might not lead to many returns.

Hence, in many of these places, you can find stand-alone businesses for finance that charge absurd interest rates on the loans that they give out. This is also because of the risk associated with giving a loan to these ‘entrepreneurs’.

So how does Bitcoin circumvent this issue? Bitcoin simply does not require all of these brick and mortar institutions to facilitate transaction. It’s simple because it only needs access to the internet and some technology, albeit a barrier in itself. So, as with Casey and Vigna’s example of Afghan people’s lack of access to banks, Bitcoin might be another possibility for people to access finance and credit.

Now having discussed the possible advantages with respect to EMEs and underdeveloped countries, let’s dive into the possible barriers:

  1. Issues of regulation
  2. Cost of maintaining the network
  3. Issues of education and accessibility

Issues of regulation and conversion
This downside is going to be a big hindrance if these payment systems do not get the support they need. I’ll break this part down into two parts, changing money, such as Dollars ($) and Pounds (£), into Bitcoin and changing Bitcoin into money.

Money to Bitcoin:
Currently, we can trade Bitcoin pretty freely in most economies. Governments around the world are mostly open to the prospect of Bitcoin. Some are much more restrictive than others but as shown by the map below, most countries are okay with it:

The issue with Bitcoin that people are most worried about is its use for illicit activities that we mentioned before, like purchasing contraband on the dark web or laundering drug money. So, as we speak, a lot of regulation, especially in the USA, appears to be coming up in attempts to counter Bitcoin and cryptocurrency. This is one barrier that might get in the way as for adoption, the regulators and the system must be favourable to one another.

Bitcoin to money:
The use of wallets and exchanges as a medium to convert Bitcoin to fiat currencies is also of concern due to many banks and financial institutions worried about the origins of the money. As highlighted by the illicit activities that Bitcoin is notoriously affiliated with, large corporations do not want to potentially damage their reputation if they end up handling ‘black’ money.

The regulation imposed by banks on themselves also are a big part of this issue of conversion. Many articles have been written about the struggle of ‘cashing out’ as financiers are worried about involvement in a very grey area. Here is an article by the FT on Bitcoin investor’s struggles of cashing out. So for remittance payments using Bitcoin, especially with respect to our EMEs and underdeveloped countries, the issue of regulation might prove to be a barrier. However, relative to traditional networks, there might still be a strong attraction to the use of Bitcoin over already established financial institutions due to its relative accessibility.

Cost of maintaining the network
The cost of maintenance, especially in underdeveloped countries may be a concern. It is, in fact, already a growing concern in developed countries due to the increasing costs of transactions!

Further, with reduced revenues from mining, the network would only become weaker as miners divert their computing power to another cryptocurrency which would be more profitable. This chart shows the revenue change for Bitcoin:

As shown above, reduction in revenues are evident from the price correction of Bitcoin amongst other things such as the need to invest exponentially more computational power into the system to break even.

Bitcoin is only as good as what you put in, so with less computers on the network, it could be less secure, have possible gaps in security or fall prey to a monopoly in computing power which might dictate the system.

Is this of any concern to those who just want to utilise Bitcoin as a payment system i.e. just using a device to receive and send Bitcoin? The issues of security that span worldwide may hinder Bitcoin as a payment platform. Further, the increasing difficulty of mining and completing transactions has increased the transaction time and increased the costs creating another barrier to adoption. This increased difficulty is shown below:

Here, we can recognise the recently sharp increase in difficulty of mining bitcoin in the last year. In 2018 alone, the difficulty has jumped nearly 2 million relative units! This means that those people who want to access Bitcoin through an underdeveloped country might not have the level of infrastructure to complete transactions in a viable amount of time such as good internet speeds or good hardware.

However, relative to traditional routes such as brick and mortar banking, Bitcoin definitely has an advantage in terms of what conditions are required as Bitcoin requires less i.e. internet and a computer compared to an actual bank, to have an impact. So we can take this barrier as relatively minor. For more on bitcoin transactions click here. This point is open to discussion as the extent of the impact we are talking about is relative to the people who require this access to finance.

Issues of education and accessibility
On a more practical level and with reference to our discussion on EMEs and underdeveloped countries, there is a necessary requirement to convert Bitcoin into currency at this early stage. Unless it is universally accepted, which is not the case at this time, Bitcoin would be worthless without being able to convert it.

This presents two issues: another set of regulations to face in another country and access to technology to obtain Bitcoin. The first one is self-explanatory, a country might not accept Bitcoin or the use of Bitcoin. The second one is applicable in EMEs and underdeveloped countries because many people might not have access to a mobile device and/or the internet.

This is a big barrier to the function of Bitcoin I had originally proposed — utilising Bitcoin as a tool for micro-finance and development. It could be solved, however, if we provide the necessary education required in understanding these systems — that runs against the issue of initial investment as well. In the long run, with this initial investment, it might make sense to use Bitcoin as a payment rail due to the potentially lower costs but at the moment the key issue of access to the necessary conditions required is a large obstacle to overcome.

Hence, relative to traditional financial institutions, it might be more accessible as, aforementioned, you simply don’t need as much to complete a transaction on the Bitcoin network! This paper talks about the difference in accessibility in more detail and why traditional methods, burdened by bureaucracy such as requiring passports, personal details and so on, make Bitcoin more attractive.

In actual fact, it appears that a lot of people in these EMEs and underdeveloped countries already have some knowledge of Bitcoin according to the paper linked. This makes the outlook more optimistic despite the barriers.

Will it change our world?

Having written these points on the disruptive potential of Bitcoin with regards to EMEs and underdeveloped countries, I believe it has the ability to access these markets if they have the necessary tools to respond.

However, I’m going to go through a few issues before concluding on the potential of blockchain and not simply Bitcoin. This is a consensus shared by many but the following technical insight might provide more substance as to why such a conclusion is a very plausible one. Here are the things I will discuss:

  1. Bitcoin’s deviated purpose
  2. The rise of alternative cryptocurrency
  3. The rise of the blockchain technology

Bitcoin’s deviated purpose
As of now, Bitcoin should not be mistaken for its intended purpose. It is much more likely that it is used as a digital asset and a store of wealth. Credit Suisse dives into more depth with this analysis in their 2018 report but here is a simple explanation of what is happening.

The use of cold storage is on the rise. This means the amount of Bitcoin taken off the network to be stored is increasing. Cold storage ensures the safety of your Bitcoin because it is off the network, when connected again it will sync. This safety means that Bitcoin can be stored, like gold, as an assurance for wealth if the price does not vary too wildly (ironic right?).

What does this do? It restricts the supply of an already restricted Bitcoin. The limit of Bitcoins is set at 21 million by Satoshi Nakamoto (the anonymous founder) but with people taking Bitcoin off the network, this supply is effectively reduced at a given price point. Further to this, our discussion on the identity problem has already shown the amount of Bitcoins lost due to the inability to access Bitcoins previously mined. This reduces the effective supply even further.

In terms of economics, an increased hype around Bitcoin most likely leads to an increased demand for Bitcoin. Coupled with the limited supply and increase in difficulty for mining these Bitcoins, the price skyrockets ceteris paribus (all other things equal).

This does two thing: increases difficulty of access due to high costs whilst making it less attractive compared to cheaper alternatives ultimately making people switch.

This means that Bitcoin, as a payment device would be less favourable compared to traditional forms of payment. This hinders our transaction ability by limiting the actual amount of Bitcoins in circulation (despite how we can divide one Bitcoin into many pieces). This is evident through a comparison below:

Comparing the market price, we can take this as an indicator for popularity, to the confirmed number of transactions per day, we can see that even with a large increase in market price, transactions still maintain a steady level. This might confirm the analysis of Bitcoin’s being utilised as a store of wealth which explains the rising popularity but not an equivalent rise in the number of transactions.

For Bitcoin to change our payment systems, we require a wide-spread adoption of the currency and the payment rails upon which it is based. Due to the inefficiencies of the Blocks that it produces, limited by its 1MB block size — this means that less transactions can fit into our books in the village, think of it as a page limit — it seems unlikely that we would favour a seemingly much more secure system over our supposedly faster one.

The rise of alternative cryptocurrency
Having focused a lot on Bitcoin, it would be hard-pressed not to recognise the rise of alternative cryptocurrencies. Popular coins such as Ether from Ethereum and Ripple are all alternatives to the popular Bitcoin. In actual fact, a lot of these alternative cryptocurrencies utilise innovative technology that attempts to resolve some of Bitcoin’s flaws. I don’t think I am as knowledgeable about this topic but it is my belief that these ‘alt-coins’ have faster transaction times with lower costs as of now.

Further to that, Ethereum is open-source which means people can create software on top of its blockchain. This allows for further benefits such as smart-contracts which are self-executing. An example of a smart-contract is a self-executing mortgage payment which ensures that mortgages are paid if there are sufficient funds in the accounts. The use of blockchain in this way allows for much more innovative projects than simply a cryptocurrency which augments rather than replaces.

The rise of blockchain technology
Perhaps the most important takeaway from Bitcoin’s meteoric rise is an increase in interest in the blockchain. The potential use of these ledgers and immutable histories is vast. They range from use in intellectual property rights to finance and real-estate and I intend to go over these potential disruptive concepts in a future post.

So will it change anything?
I think Bitcoin on its own won’t be as disruptive as once thought. The technology behind it and the rise of other alt-coins does appear to have a lot of potential in disrupting the market. I think it will be a combination of these cryptocurrencies and blockchain technology that will help us disrupt and aid the EMEs and underdeveloped countries I had discussed.

The question is to what extent? Credit Suisse’s analysis provides a compelling argument to show that medium term disruption is the most likely. Following that, vertical integration but already established payment systems who might choose to integrate this new technology into their architecture appears to be the end-case.

The blockchain and its benefits with a strong emphasis on disintermediation will lead to potential reduction in costs and a more efficient system than the ones utilised by the majority. This new era of FinTech is only in its early stages.

I guess we will have to find out when it happens. For now, all we can do is try to learn about it and be ahead of the curve so when an opportunity comes, we will be prepared for it.

Conclusion

So what’s my opinion on this? I think that Bitcoin’s potential is minute in comparison to the potential of blockchain and its other applications. This should be obvious because blockchain’s applications span much wider than Bitcoin’s.

Right now, it appears that Bitcoin itself is a vehicle for the storage of wealth rather than being utilised as a viable payment system. The direction for Bitcoin appears to be not as certain. With a limitation to the total number of Bitcoins in circulation, coupled with the high amount of computing power that is required to complete these transactions, Bitcoin is becoming less attractive if people are able to find the alternatives.

It might be the case that Bitcoin, with its ‘celebrated’ name, has been used as a speculative tool to get quick money through hobbyists investors yet that is all that is has going for it. The fact that it is the most established does not necessarily mean it has the best infrastructure behind it. Attempts to make it more scalable through initiatives such as Segregated Witness (SegWit) have failed to gain absolute consensus hindering Bitcoin’s ability to be adopted as a mainstream form of payment.

Even though firms are beginning to accept this digital currency, it is likely that newcomers with more efficient technologies that are more adaptable might gain prominence over Bitcoin.

The technology is truly remarkable, however, and as aforementioned, the next post in this Disruption? series will be on the blockchain and new potential services related to it. I will aim to talk about ICOs, Blockchain utility and their market implications. These ideas can all be found in the supplementary material below, Credit Suisse’s analysis being the most detailed.

Hopefully this material is understandable and approachable. Comment and highlight anything that might be wrong or uncertain!

Let’s stay ahead of the curve.

Cedric

This is the second part of this introductory post to my series called Disruption? If you’ve missed out the first part click here to read it.

Here’s the supplementary material you can browse through:

  1. Credit Suisse — Cryptocurrency analysis part one and part two
  2. Cryptocurrency: The future of money? — Michael J. Casey and Paul Vigna
  3. Banking on Bitcoin — Netflix
  4. What is blockchain? — Youtube (One of many videos explaining it)
  5. Cool stuff on stats and other info — Howmuch.net
  6. Cool charts and graphics — Bitcoin.info

Disclaimer — This post is not intended as financial advice.

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