Previously existing only on the fringes of finance or computer science, cryptocurrencies are now being discussed more widely. In the future, banks may not be the only ones making money from making money. Communities, companies and cryptography could become the new moneymakers, which drives new thinking around money, ownership and trade.
It started in 2008 with Bitcoin, the peer-to-peer cryptocurrency and payment system, which was all bit and no coin. Ten years on, the volume and value of new cryptocurrencies launched and traded shows no sign of slowing.
More than 200 coins were issued in 2017, raising $3.8 billion for early stage companies worldwide, according to the tracking website Coinschedule. There have been 195 initial coin offerings (ICOs) so far in 2018, which have raised $6 billion. This time last year, three cryptocurrencies — Bitcoin, Ethereum and Ripple — had a market capitalisation of more than $1 billion. Now there are 28.
Cryptocurrencies challenge fundamental assumptions about where money comes from and how it is raised. They call into question who will make money from money. And set up a power struggle between the old and new money worlds.
ALL BIT AND NO COIN
‘In God we trust’ appears on the reverse of US dollar bills. But who is backing the greenback? Or any other currency for that matter? Who or what do consumers trust when they make or receive payments using a particular currency or payment system?
“Money is all about an asset within a community, it’s just that the communities change,” says David Everett, CEO at Microexpert. “People in the community have to trust each other, or they have to trust that part of the community that underwrites the asset.”
But perhaps that is precisely the point. After the global financial crisis, people lost trust in banks. They were looking for an alternative. Enter the pseudonymous Satoshi Nakamoto, who set out a method for Bitcoin, a peer-to-peer digital cash system. Nakamoto’s trust model and community put faith in computers and code not governments and banks.
Bitcoin did not require banks to either create money or serve as trusted intermediaries in financial transactions. It brought together four concepts: the distributed ledger, cryptography, open source software and a ‘proof of work’ to replace banks. Instead, a decentralised peer-to-peer network of computers resolved a cryptographic problem or ‘proof of work’ to verify each transaction between the members of the network. This also helped to prevent the double-spend problem inherent with digital currencies.
In effect, the system behaved like a crowd-sourced, public, bookkeeping system on the internet, noting transfers of value between participants and adding them to a chain of previous transactions. Bitcoin was born. Its underlying protocol, the Blockchain, has spawned many alt-coins and helped set up
NEW KIDS ON THE BLOCKCHAIN
The cryptocurrency landscape is complex, diverse and dynamic. Proponents see pluses in digital assets that transcend national boundaries. Direct asset transfer with no clearing and settlement makes markets more efficient. The lack of intermediaries also strips out cost and boosts financial inclusion.
The weaknesses of cryptocurrency are the flip sides of its strengths. Agustín Carstens, general manager, Bank of International Settlement (BIS), summarised the drawbacks when he condemned Bitcoin as “a combination of a bubble, a Ponzi scheme and an environmental disaster.”
Volatility currently makes cryptocurrencies an unreliable store of value beyond speculation. They are also not functional enough to be a mass market medium of exchange. The irrevocability of transactions could mean increased risk and fraud. Then there are the environmental concerns. Bitcoin mining now uses more electricity than consumed by Ireland.
The short-term outlook for cryptocurrencies is hampered by the lack of a consistent global approach. For example, the US Commodity Futures Trading Commission (CFTC) regards them as commodities. Iceland and Lebanon see them as electronic currency. In Columbia, Norway, Singapore and South Korea among others, they are not currency. While in Germany, they are financial instruments.
“Regulators, policy makers and tax authorities are all struggling to figure out the best way of regulating and taxing cryptocurrencies,” says John Salmon, partner at law firm Hogan Lovells. “Some jurisdictions, notably China, have completely banned cryptocurrencies. Others are looking to put in place specific legislation and regulation. Most, however, are looking to apply existing rules and regulations.”
It is a similar story around initial coin offerings (ICOs). “Each jurisdiction has its own rules on the particular scenario in which an ICO should be subject to the regulatory regime and many different regulations could apply,” says Salmon. “These rules are often complex in themselves and were not designed for ICOs.”
The legal grey areas, uncertainty and consumer warnings notwithstanding, a regulatory land-grab is underway. A number of countries, including France, Switzerland, the Cayman Islands, Isle of Man and Gibraltar, are known to be drawing up frameworks for formally policing the space to attract business.
This begs the question are ICOs a new way to raise capital and a profound financial innovation? Or just part of the hype around cryptocurrencies?
ICOs, also known as token sales or token generation events, effectively allow companies to pre-sell revenue, rather than take in money in the form of investment. That is to say selling equity, some type of debenture or hold over the company. This echoes ideas in the 1994 paper The IBM Dollar: a proposal for the wider use of ‘target’ currencies by the lateral thinking expert Edward de Bono.
Companies could raise money just as governments do by printing it, thought De Bono. He put forward the idea of private currency as a claim on products or services produced by the issuer rather than the bank. IBM might issue IBM dollars that would be theoretically redeemable for IBM products and services, but also practically tradable for other companies’ monies or for other assets. This is exactly what is happening with ICOs today.
“The ICO proposition is telling about where the future of debt and equity markets are heading,” says Aleks Nowak, CIO, BlockEx, a digital asset exchange platform. “When the regulatory framework catches up and allows more structured products backed by securities, or facilitates shareholding, dividends or revenue shares in projects, it no longer will make sense to do traditional IPOs and equity fundraisers,” he says. There will be an shift in trading venues, but also in settlement processes and how assets move afterwards, he predicts.
The process of doing an ICO is becoming established as way of raising money for digital start-ups but also blue-chip companies. This is fostering greater financial inclusion plus new bottom-up liquidity. “Whether you’re a bus driver or the head of a trading desk for Goldman Sachs, you can get fairly equitable access to our platform — and others like it — where barriers to entry don’t exist,” says Nowak. Traditional investors are also keeping a watching brief. They may not participate immediately but venture capital firms, funds and family offices, who thought they could ignore the ICO market are realising that they can no longer afford to.
“Once the token market becomes regulated, I think tokens are going to become huge. ICOs as one sub-set of that token market are going to become huge as well. They are a genuinely new and interesting way of solving an old problem,” says Dave Birch, director of innovation, Consult Hyperion in conversation with PCM.
Birch advises looking at what is going to be built on top of cryptocurrencies, namely the world of tokens. Cryptocurrencies will act as the base layer. Digital bearer assets or tokens will then be exchanged over a transaction layer with no clearing or settlement. Tokens link the values managed on shared ledgers to the real world. This token economy could yet be a more accurate pointer toward the future of money than the underlying cryptocurrencies, thinks Birch. Thus organisations are advised to develop token strategies and engage with tokenomics.
With the increasing interest in and use of privately-created cryptocurrencies, various central banks are considering the issuance of digital fiat. This central bank digital currency (CBDC) could widen the range of monetary policy instruments available to central banks. It could also promote innovation in payment systems; create alternative finance; boost financial stability and inclusion, and allow the central bank to recapture a portion of seigniorage.
One way to do this is via a decentralised framework resembling privately-created cryptocurrencies. Digital tokens could be transferred from payer to payee after being verified by a cryptographic proof of work and recorded on a distributed ledger. Conversely, a centralised framework would involve individuals and firms having an account with the central bank. All transactions could be validated and processed by the central bank, which administers the currency and payment system in a similar manner to commercial banks today.
“General purpose central bank digital currencies could revolutionise the way money is provided and the role of central banks in the financial system, but these are uncharted waters, with potential risks,” said Benoît Coeuré, BIS, on the publication of a report into CBDC.
Indeed, there are no quick fixes. The Swedish central bank has been investigating the issuance of e-krona as a general means of payment to complement cash since March 2017. In a recent action plan it noted that the changes in the payment market (technical, policy and legal) were of such a nature that it would need to follow developments and work with related issues for several years to come.
Incumbent money is not perfect. There are certain use cases where it is not always convenient. For example, for remote, high-value or cross-border payments. Additionally, few incumbent monies fulfil all economic functions of money equally well. They are not all good mediums of exchange, stores of value and units of account.
The questions asked of money are similar, yet the answers reflect the age. They also reflect the technology of the time and willingness to adopt this. Cryptocurrencies are of their time. They create new alternatives to mainstream money and new liquidity from the bottom up. In so doing, they challenge the traditional state, central and commercial bank monopoly on money creation and how companies raise funds.
However, the cryptocurrency market is a very nascent space. “These are very risky assets to purchase for the most part, because there are a lot of unknown variables in terms of the companies and projects,” summarises Nowak. “We as a company have tied to mitigate that as much as possible, but if there was ever a place where caveat emptor applies, it would be this market,” he says.
There is a pressing need for greater regulatory clarity and legal certainty. But this is easier said than done. Regulators need to balance consumer protection, financial stability and anti-money laundering requirements against new opportunities, efficiencies and potential cost savings. The next 6-12 months could prove telling in the cryptocurrency space.
Meanwhile, the entire legal system is predicated on assessing what people have done and holding them responsible for it. In legal terms, accountability often equates to liability. An essential part of being human is choosing how to act and being held accountable for these actions. So what happens when a machine, an algorithm or cryptography chooses? The decentralised nature of the Blockchain means that it is owned by everyone and by no-one. Who or what is liable?
Satoshi Nakamoto is not often compared to Martin Luther. Yet 600 years ago, the latter nailed his Ninety-Five Theses to the church door in Wittenberg, the established means of starting a scholarly debate. He wanted to reform the church of his own time, but through the ripple effect of history ended up creating the Reformation in Europe.
Similarly with his 2008 paper, Bitcoin: a peer-to-peer electronic cash system, Nakamoto may have been trying to reform the money of his own time. Yet he kick-started a wider debate about what society wants from money. He forced us to acknowledge that there could, and perhaps even should, be alternatives to state, central and commercial bank money.
Alt-coin — Alt = alternative. Any cryptocurrency that is not Bitcoin, for example Dogecoin, Litecoin, Ethereum or Ripple.
Cold storage — Keeping a reserve of cryptocurrency offline for security reasons. This could be a private key written on paper or stored on a USB. Naturally this creates other security concerns if the physical storage method is lost, stolen or otherwise compromised.
Cryptocurrency — A decentralised digital currency that utilises cryptography for security and usually a Blockchain as a ledger to record transactions.
Fork — A fork refers to a change in protocol or when the Blockchain splits into two potential paths forward. A soft fork is backwards compatible, namely the change in protocol creates blocks that are recognised by the old protocol. A hard fork is not backwards compatible.
HODL — Originally a mis-typing of ‘hold’ on an online forum. HODL is a backronym that has come to mean ‘hold on for dear life’ to a cryptocurrency investment, ignoring market sentiments.
ICO — An initial coin offering, also known as a token sale or token generation event, is a way to raise money by selling a new type of coin, virtual currency or token. It is similar to an IPO.
Mining — The process of verifying cryptocurrency transactions by solving a cryptographic proof of work and recording the transaction on a Blockchain or distributed ledger. This generates freshly mined coins.
Smart contracts — A digital programme stored on a Blockchain, which enables the transfer of assets between parties when certain criteria are met.
Whitepaper — This document sets out the commercial and technological details of the project for potential investors prior to the opening of an ICO.