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Cryptocurrencies: 1000 + 1 (Bitcoin) Nights

By Yiannis G. Mostrous, on Dec. 11, 2017

In a 1856 essay, Walter Bagehot included the following sentence: “…but one thing is certain, at particular times a great many stupid people have a great deal of stupid money.” It is the view here that now is one of these times.

Cryptocurrencies are, because of the meteoric rise of bitcoin, the theme du jour in the financial press. Increasingly, people are playing the bitcoin game, to the point that the proverbial taxi driver advice is again in vogue.

There are about 1,000 cryptocurrencies with a market capitalization of around $400 billion. Ten years ago, that figure was zero. This growth rate isn’t likely to be repeated.

At the end of 2013, the entire stock of bitcoins was valued at about $2.6 billion. Four years later, in mid-October 2017, its value was stated to be around $80 billion. And now, a little over a month later, its market capitalization is around $262 billion.

Not long-ago, stories about the right way to flip technology shares were abound. Later we heard stories about flipping houses. Now, those stories, and the most onerous advice, is how to trade bitcoins. Expect the majority of the people rushing to the bitcoin roulette to eventually be burned.

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Breaking Down Bitcoin

The domain bitcoin.org was registered in August 2008, featuring a white paper explaining its existence was published by someone under the pseudonym Nakamoto. According to the paper, the bitcoin concept “is an electronic-payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.”

The urban legend is that the first real world bitcoin transaction was a May 2010 order of two Papa John’s pizzas for 10,000 bitcoins (valuing the bitcoin at the time at around 0.3 cent per coin).

Digital “mining” is how bitcoins are created. Bitcoin’s approach is to perform endless hash calculations to find the “right number” that fits a pre-determined piece of data. In essence, it’s solving a mathematical problem.

A hash is a function that converts an input of letters and numbers into an encrypted output of a fixed length, referred to as a block. A hash is created using an algorithm, and it’ss essential to blockchain management.

When a machine finds the solution, it transmits the solution or block to the rest of the miner machines for verification. Once verification is achieved, the block is added to the blockchain and the process starts again.

At the heart of the bitcoin technology is the SHA-256 algorithm. The SHA (Secure Hash Algorithm) is one of a number of cryptographic hash functions. It was created by the National Security Agency, and it generates an almost unique fixed-size 256-bit (32-byte) hash. In other words, one bitcoin is just 256 ones and zeros.

The reward for mining a block is a defined number of bitcoins, with that number being halved every 210,000 blocks. The initial amount was 50 bitcoins per block, and was halved to 25 bitcoins at the end of November 2012. The current number is 12.5 bitcoins per block, and this will be halved in May 2020.

There have been around 16,727,150 bitcoins mined. The mining process means there can be no more than 21 million ever created, a total that should be reached in 2041. The original miner, probably the creator(s) of the experiment, is thought to have 1,612,800 bitcoins.

The difficulty of mining is also dynamic, with these adjustments designed to keepadjusted to keep block solutions occurring once every 10 minutes. The next adjustment is expected on Dec. 13..

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Price Dynamics

As the price of bitcoin rises, an ever-increasing number of machines are being plugged in to mine them. This makes mining harder and more costly in terms of time requirements, hardware costs, and electricity.

At the same time, the reward for finding each new block diminishes due to the halving of bitcoins per block hashed, as mentioned earlier. So miners pay more for electricity in return for less bitcoins–a not very appealing proposition unless the price of bitcoins climbs indefinitely.

The conventional wisdom seems to be that the capping of bitcoin to 21 million units will cause prices to rise indefinitely and for them to be used widely in the real economy. One should wait and see, as current participants seem to either hoard bitcoins or flip them.

Eventually, people will realize that few people are actually spending their bitcoins and bitcoin isn’t becoming the payment system its creator(s) envisaged. At that point, having bitcoins won’t look so good. That’s when the price fall (i.e., when people are headed for the exits), taking the value of bitcoin to zero.

Bitcoin as a Financial Instrument

Bitcoin transactions use the same technology behind digitally signed and encrypted e-mails, which involves private and public keys. This is where the “crypto” part comes from.

To buy bitcoins, assuming you are not a miner, you have to spend real cash. There are online platforms that facilitate these transactions, ATM machines that serve as a currency exchange and offline schemes that will take your physical money if you’re willing to depart with it. Participating in this game is not recommended.

Speaking of exchanges, until early 2014, one of the biggest bitcoin exchanges was Japan-based Mt. Gox. In February 2014, it suspended trading. It then liquidated after announcing that 850,000 company and customer bitcoins disappeared. At the time, they were valued at $680 million.

A few days ago, the cryptocurrency mining marketplace NiceHash (which was founded in 2014) announced that hackers were able to remove 4,700 bitcoin, a $78 million heist.

It seems that the majority of cryptocurrency owners and traders are retail players. As an aside, bitcoin is taxed in the US as a commodity, not a currency. Furthermore, digital coins have no underlying value. Perhaps this is why the real economy hasn’t exactly run to adopt it.

Our research was unsuccessful in identifying serious institutional players participating in the game. This may change in the future, provided that major investment vehicles are allowed. For now, though, there is an exchange-traded product on Nasdaq Nordic and cleared via Euroclear. But it’s not big.

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