Cryptocurrency: Prepare for Phase II

When bitcoin plunged in value in early 2018 many of us thought that was that. Cryptocurrency – always a dubious asset class – had hyped itself out. Well, think again – second-generation crypto will soon be everywhere we look, writes Victor Hill.

Bitcoin: triumph and tragedy

On 18 August 2008 somebody registered the domain name bitcoin.org. On 31 October 2008 a link to a paper authored by a certain Satoshi Nakamoto entitled Bitcoin: A Peer-to-Peer Electronic Cash System was posted to a cryptography website. Supposedly, Nakamoto then released the software behind bitcoin as open-source code (meaning that anybody could develop it) in January 2009. (But was it he?) The identity of Satoshi Nakamoto remains one of the great mysteries of our time.

After bitcoin was launched it took seven years or so for it to attract attention outside the community of cyber-geeks who understood the sheer originality of the blockchain software technology on which the digital currency relied. Blockchain is a decentralised digital public ledger by means of which the entire history of each “coin” is recorded – not in one place but spread across hundreds of thousands of computers. Consequently, no one user can “see” where that coin has been but they can be confident that its provenance has been verified.

In time, however, speculators piled in, viewing bitcoin as a type of digital gold. In January 2010 one bitcoin traded for $0.06. But around mid-2015 the world’s leading digital currency began to gain value, gathering momentum throughout 2016. By 01 January 2018 each bitcoin was worth $19,498.63. Early enthusiasts – many of whom were by no means professional investors – had become, nominally at least, multi-millionaires.

I was one of those who urged caution. I argued in these pages in November 2017 that, while bitcoin (like other digital currencies) was a medium of exchange it was not a store of value and therefore had no intrinsic worth. The collapse followed the spike. In the first two months of this year bitcoin has been hovering around the $4,000 mark. In terms of the total value of all bitcoin outstanding, that fell from an estimated $230.9 billion in January 2018 to $66.6 billion by the end of December.

Some said bitcoin was the future; others that it was a fraud. Either way, bitcoin and its imitators were branded as volatile and ultimately unregulated. To whom could one complain? For all that, a number of prominent hedge funds continued to show interest. The underlying technology was still proving alluring: IBM (NYSE:IBM), Microsoft (NASDAQ:MSFT) and JP Morgan Chase (NYSE:JPM) have all invested in blockchain technology. Cryptocurrency is made possible by blockchain; but other things could arise from it soon.

The real key is regulation. In July 2017 the SEC in the United States announced that laws governing the trading of securities may also apply to some cryptocurrency transactions; but it failed to provide concrete guidelines. At about the same time, China banned outright Initial Coin Offerings (ICOs) by means of which software start-ups were raising finance in promised digital currency to finance their expansion. Several Asian countries, including China and South Korea, also outlawed cryptocurrency exchanges (where investors can convert crypto into “real” fiat currency).

This all looked like a setback for bitcoin and its peers. But, suddenly, things are moving again…

Facebook and crypto: Like

In May 2018 Facebook (NASDAQ:FB) announced that it was setting up a team to explore the blockchain technology behind bitcoin and to determine how it could be commercialised. The team was to be headed by David Marcus, a former President of PayPal. There are now at least 45 engineers working on this top-secret project and Facebook is still recruiting blockchain experts.

In a report by the New York Times on 28 February the veil was lifted for the first time on what that team has achieved. The NYT claimed that five Facebook employees had briefed the newspaper on condition of strict anonymity since they were subject to confidentiality agreements. Personally, I doubt that the detailed information in the NYT article could have been obtained without Facebook’s say-so (at some level). So here’s what they want you to know.


The company is working on a digital coin that users of Facebook subsidiary WhatsApp will be able to exchange with friends and family instantly. Facebook, apparently, has already held talks with cryptocurrency exchanges. There is speculation that the new cryptocurrency will first be made available in India where WhatsApp has 200 million regular users. Moreover, India receives more remittances from its citizens working overseas than any other country. In 2017 these amounted to $69 billion according to the World Bank.

Let’s not forget that Facebook has about 2.5 billion users across its three messaging platforms – Facebook Messenger, WhatsApp and Instagram. Yes, many of those accounts are corporate and there is much double counting as many individuals have multiple accounts. But that is still about one third of humanity. That gives Mr Zuckerberg’s company a reach beyond the imagination of earlier generations of entrepreneurs. There are more Facebook users than there are Christians in the world – and well more than the number of Muslims. So it is probably fair to say that Facebook (whatever you may think of it on an ethical or societal level) is the most comprehensive network in the history of mankind. If Facebook is really serious about cryptocurrency – then we should reconsider it too.

Messenger services in the crypto vanguard

Telegram is a cloud-based instant messaging and voice-over service developed by Telegram Messenger LLP, a privately held company registered in London founded by Russian mathematicians Pavel Durov and his brother Nikolai Durov. Telegram client apps are available for Android, iOS, Windows Phone, Windows NT, macOS and Linux. Users can send messages and exchange photos, videos, stickers, audio and any kind of file attachments. Telegram has an estimated 300 million users worldwide.

According to the NYT, Telegram is also working on a digital coin which will work with Signal Messenger, an encrypted messaging service that is popular amongst privacy-seeking geeks, developed by super-geek Moxie Marlinspike.

In March 2018 Telegram reportedly raised over a billion dollars via a so-called Initial Coin Offering (ICO). When digital entrepreneurs launch ICOs what they are really doing is selling their own virtual currencies in order to raise money for software they plan to develop. In return for real money, investors receive digital tokens, similar to bitcoin.

Regulators worry that this novel fund-raising method allows start-ups to flout investor protection rules. Financial authorities around the world have been promising to crack down on ICOs, which came out of nowhere in 2017 to become a popular way for start-ups to raise tens of millions of dollars. Interestingly the Swiss authorities, thus far, have proved accommodating – Ethereum was launched there via an ICO in 2014.

Reportedly, two Asian messaging giants – South Korea’s Kakao (KRX:035720)and Japan’s Line – are also working on their own digital coinage. They are playing their cards close to their chests.

The backers of early cryptocurrencies lacked reach but this new generation of messaging giants have the power to propel cryptocurrency into a new phase of its evolution. Facebook and, to a lesser extent, Telegram and other messaging hubs can put digital wallets full of cryptocurrency at the disposal of hundreds of millions – if not billions – of users.

Payment platforms

PayPal (owned by PayPal Holdings (NADAQ:PYPL) having been spun out of eBay (NASDAQ:EBAY) in 2015) is used by over 250 million account holders. One of its subsidiaries, Venmo, (acquired in 2013) has taken off in the United States by making it easier to send payments by mobile phone. In China over one billion people every month use the payment system that operates inside the hugely popular WeChat messaging system which is owned by Tencent (SEHK:700). All of these companies are thought to be working on digital currencies of their own.

Remember that there is a welter of specialist payment platforms out there. For example, Ujo provides automated payment services dedicated to musicians who want to sell rights to their music.

Characteristics of Phase II cryptocurrencies

While using much of the same basic technology (blockchain) the next generation of cryptocurrencies will seek to avoid the errors committed by the developers of bitcoin and other first-generation cryptocurrencies.

Firstly, the NYT thinks that any digital currency that Facebook were to develop could exist on a decentralized network of computers independently from its creators. The same goes for ones developed by messaging networks and payments platforms – in other words such currencies could be used universally. New cryptocurrencies would make it easier to move money between countries, particularly in the developing world where it is harder for ordinary people to open bank accounts and to obtain credit cards.

Second, second-generation cryptocurrencies will do away with the crazy energy-guzzling “mining” process that bitcoin relies on. Facebook’s digital currency will be a stablecoin – that is to say, a digital currency pegged to the US dollar[I] (though its value could vary marginally from the dollar).

According to the website Stable Report there are three types of stablecoin: asset-backed on-chain; asset-backed off-chain; and algorithmic. The first kind would be cryptocurrencies which are backed by other cryptocurrencies. (Which sounds very dodgy to me.) The second type of stablecoin is collateralised by real-world fiat currency such as the US dollar or the euro or by a commodity such as gold. The third type, algorithmic, relies on a combination of algorithms and contracts to maintain price equilibrium. (But would the algorithms work?)

As far as we can tell, Facebook is working on the second type of stablecoin which would be collateralised by greenbacks or by other currencies. This implies that there would be a trusted third party which actually holds a dollar of “real” cash (residing somewhere in the banking system) for every dollar of digital currency in circulation. The question is: would Facebook act as the trusted third party? And what would be the implications of that?

And how much control would Facebook retain over the digital currency? If Facebook is to be responsible for approving every transaction and keeping track of every user, it is not clear why it would need a blockchain system at all, rather than a traditional centralised ledger like PayPal’s. The whole point of blockchain was that it obviated the need for a trusted third party to sit between the two sides of a transaction.

A digital token with a stable value would not be attractive to speculators — the main champions of cryptocurrencies thus far — but it would allow consumers to hold it and pay for things online without worrying about its value fluctuating too much. The NYT reported that some Facebook insiders had suggested that its digital currency will be linked to the value of a basket of foreign currencies rather than just to the US dollar.

On the other hand second-generation cryptocurrencies are likely to face many of the same regulatory and technological hurdles that constrained bitcoin. The absence of a cryptocurrency “central bank” has thus far made them useful to criminals. Further, the designs of the computer networks that manage cryptocurrencies hitherto made it hard to process huge volumes of transactions simultaneously.

A stablecoin known as Basis recently closed last December after just eight months. The New Jersey-based company announced that there was no apparent way around being classified as a security – as opposed to a currency – which would significantly reduce the number of potential buyers. Basis had attracted well-known backers like Andreessen Horowitz of Foundation Capital and Kevin Warsh, a former governor of the US Federal Reserve[ii].

The most high-profile stablecoin to date, Tether, has also been surrounded by controversy. While Tether’s creators say each of its tokens is backed by one US dollar, the company’s refusal to be audited has raised doubts as to whether that is true. Facebook, with more than $40 billion in annual revenue and greater experience in navigating regulatory issues, may have a better chance of making a stablecoin that works.

Meanwhile in Russia and China…

In January it was reported in The Daily Telegraph that Russia’s Central Bank was preparing to replace the US dollar as a reserve currency with…bitcoin[iii]. Supposedly, this will be a bid to circumvent the effect of western sanctions. Sanctions were imposed by most NATO countries on Russia further to its annexation of Crimea in February 2014 – and were then intensified further to the Salisbury poisonings of March 2018. It would also form part of Russia’s plan to reform its state pension system.

Vladislav Ginko, purportedly an economist at the Russian Presidential Academy of National Economy and Public Administration (RANEPA), claimed that the Russian central bank could buy as much as $10 billion of bitcoin as early as February, financed by dumping US Treasuries. However, the Cryptoslate website has cast doubt on Mr Ginko’s credibility. RANEPA is the largest state-funded institute of higher education in Moscow. But apparently, Mr Ginko has tweeted on Russia’s move into bitcoin several times before without showing great insight. In July 2018 he tweeted that Russia would soon move to a cryptorouble. In 2017 he predicted that bitcoin would rise to $2 million. No one has been able to verify his bona fides.

On the other hand there was a spate of more reliable reports in the second half of last year that the People’s Bank of China (PBOC) was preparing to launch its own digital currency. During a March political gathering in Beijing, former central bank chief Zhou Xiaochuan said that any state digital currency must be compatible with financial stability while at the same time protecting consumers. The Digital Currency Research Institute of the PBOC has been hiring people with knowledge and experience of blockchain technology[iv].

According to Fintech News, Yao Qian, head of research at the PBOC said last year that a digital currency could drive down transaction costs, increase the efficiency of monetary policy and extend financial services to rural areas. It would also be easy to trace. (An autocratic government’s dream). He asserted that the development of the digital economy required an electronic currency issued by the central bank – that is to say it would be a state-sponsored digital currency: other non-state digital currencies would presumably be outlawed.

It is likely that such a state-sponsored digital currency would be pegged to the existing fiat currency in the first instance so as to make it less volatile – a stablecoin. There is speculation that such a stablecoin could be adjusted in value periodically in accordance with the consumer price index. In that way, while fiat money might lose its value over time thanks to inflation, the stablecoin would have constant purchasing power. An intriguing idea.

Prepare for the Crypto II bull market

The internet took 30 years to become universal. Blockchain technology is barely 10 years old and has only received the serious attention of investors over the last three years or so. Even if bitcoin bombed in 2018, the number of people with digital wallets, which are capable of storing digital money, has continued to rise.

If a new generation of stablecoins does emerge in the near future, immune from the speculative volatility of bitcoin and the first wave of digital currencies, that development could be a game changer.

In the April edition of the Master Investor magazine (the Show edition – it will be available in hard copy as well as digitally) I’ll explore just how seriously our lives (and pockets) could be impacted. For example, commodity-backed cryptocurrencies could become a smart way for investors to get exposure to gold, copper, Brent crude – whatever – at the click of a mouse.

Not quite as exciting as the bitcoin bubble, perhaps: but it still could change the world.

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Next week I’ll be analysing Mr Hammond’s Spring Statement – to be delivered against a background of kaleidoscopic political uncertainty…No such thing as a dull moment these days…

[i]See Bloomberg, 18 December 2018 at: https://www.bloomberg.com/news/articles/2018-12-21/facebook-is-said-to-develop-stablecoin-for-whatsapp-transfers

[ii]See: https://www.bloomberg.com/news/articles/2018-04-18/a-133-million-bet-on-a-cryptocurrency-designed-to-be-boring

[iii]Daily Telepgraph, 14 Janauary 2019, story by Hasan Chowdhury. Available at: https://www.telegraph.co.uk/technology/2019/01/14/russia-plans-tackle-us-sanctions-bitcoin-investment-says-kremlin/

[iv]See: https://www.fintechnews.org/chinas-3/