Bitcoin has been on a rollercoaster this year – again. Other new cryptocurrencies such as Dogecoin have made their debut, with mixed results. This asset class is a swamp. But investors must understand why cryptocurrency has come about, argues Victor Hill.
A new asset class?
Almost everything I know about cryptocurrency makes me nervous. It is wildly volatile – a billionaire buys on one day – and the price rockets; the same billionaire expresses reservations the next day – and the price tanks. It has no underlying value model. It is a medium of exchange, but is it a store of value? That is yet unclear. It is unregulated. There is no lender of last resort. It encourages speculators to waste vast quantities of electricity – thus belching out more CO2 when we are supposed to be going green – in the process of mining new coins. It is favoured by gangsters, terrorists and blackmailers because it confers anonymity. It has facilitated money-laundering, extortion, drug-dealing and sanctions-busting.
And yet it has stood the test of time – the Bitcoin ledger has been open for trades since 03 January 2009, and there has been a huge volume of trades this year. According to the price-tracking website CoinMarketCap, the cryptocurrency market grew to more than $2.5 trillion by May last year and it has almost certainly grown since then.
This platform tracks the price movements of 5,291 different cryptocurrencies in circulation (Bitcoin being number one); but according to some estimates there are over 8,000 in existence. They vary in make-up; but what they all have in common is that they rely on blockchain technology. A blockchain is essentially a record of transactions stored across network of computers working in parallel which use encryption to verify each other’s identity.
Since the start of this year the value of one Bitcoin has gone from £21,453 to just over £27,000 this morning – but it peaked at £46,881 on 16 April from where it fell back, big time.
The big event for Bitcoin this year was when, on 08 February, Tesla (NASDAQ:TSLA) announced that it had invested $1.5 billion (out its total cash pile of $19 billion) in Bitcoin – and that it would take payment in the digital currency for its cars. The price of Bitcoin soared – though not Tesla’s share price. Many analysts wondered what kind of corporate governance was in play when a technology company speculates on the value of an alternative asset.
It is true that the sort of people who are Elon Musk fans are also the people who dabble in Bitcoin; and that Bitcoin accords with the Tesla and SpaceX futuristic brand image. But the equity markets were unimpressed. In early May, however, Mr Musk tweeted that he was suspending Bitcoin payments because of environmental concerns – that is, the use of fossil fuels to power Bitcoin mining and transactions. In a further twist, Mr Musk tweeted last Sunday (13 June) that the carmaker would resume taking payment in Bitcoin if there is “confirmation of reasonable (~50 per cent) clean energy usage by miners with positive future trend”. (How could he possibly verify that?) This ignited the cryptocurrency price again – it was up by 10 percent. Maybe it should be called Muskcoin.
Other cryptocurrencies have been even more volatile. Ethereum doubled its value in April alone. A stablecoin which is ultimately linked to real-world fiat currencies, this is the cryptocurrency favoured by Goldman Sachs, which opined last month in a report that it could be the digital currency that financial contracts such as interest rate swaps might be booked in. Ripple was up by 50 percent and then fell back again. Dogecoin quadrupled in value before slipping back.
The reasons for the retreat of the cryptocurrencies in May and June was twofold. Firstly, Mr Musk’s change of sentiment; and, secondly, China imposed severe restrictions on the trade of cryptocurrencies. Henceforth, they may not be used as a medium of exchange in China.
Central banks dip their toes in crypto waters
Dozens of central banks have established task forces to look at how state-sponsored cryptocurrencies – known in the trade as central bank digital currencies (CBDCs) – might work. A poll of 66 central banks by the Bank for International Settlements (BIS – sometimes called the central banks’ central bank) last year reported that at least 52 countries were developing their own digital currencies.
Central banks have woken up to the idea that state-sponsored digital currencies could hand them what they have always dreamed of: monetary policy at the click of a mouse. They could regulate the money supply precisely and keep tabs in real-time on fund flows through the financial markets. They could impose negative interest rates by digital means. They would no longer have to print pesky old paper money.
Indeed, the transition to a cashless society is already well underway as we merrily swipe our debit and credit cards – a trend which has accelerated during the pandemic on the grounds of hygiene. Cash withdrawals from ATMs are down 60 percent on pre-pandemic levels. Sweden has become the first nation to have dispensed with cash almost entirely.
But for some people the idea of state-controlled cryptocurrency inspires fear. This would give the state an unprecedented tool to snoop into our private lives. The central bank would know exactly what we spend our money on and where. Some commentators think that is why the Communist Party of China is so keen. China has been steadily building an authoritarian surveillance state with ubiquitous monitoring of social media and facial recognition systems. This is ironic because part of the appeal of the current crop of cryptocurrencies to libertarians has been precisely that they facilitate a commercial domain which is entirely beyond the control of politicians and central bankers.
China has already trialled a digital yuan in about twelve cities which has about 200,000 subscribers. The currency appears on smartphone screens against an ominous silhouette of Chairman Mao. One stated aim is to bypass the Swiftclearing and payments system which is dominated by the USA. By the same token it can subvert domestic payments platforms such as WeChat, Alipay and Tencent as well. Another unstated aim is that the Chinese state will be able to block transactions it does not like.
It is unclear whether the central banks of democratic countries would operate a digital currency beyond the corporate banking sector and in the retail banking sector too. If the Bank of England were to offer digital bank accounts directly to the likes of you and me, that would undermine the deposit-taking ability of retail banks and would cut off an important source of funding for their lending activities. That in turn would undermine the fractional reserve banking model which has been central to the allocation of capital in market economies for over a century. At least until the financial crisis, most new money in the economy was created by private banks lending money to customers – credit creation. The advent of CBDCs might move the task of credit creation back to the state – in effect all new lending would be nationalised, with the banks just acting as credit scoring entities.
On 19 April, during UK Fintech Week, Mr Sunak, the UK Chancellor, announced that the Treasury and the Bank of England would examine the viability of a digital pound sterling for businesses and households. He dubbed the prospective digital currency Britcoin. Some leading City bankers cautiously welcomed the project. Speaking at the TheCityUK virtual annual conference on Tuesday (15 June), Bank of England Governor Andrew Bailey suggested that cryptocurrencies would have to be regulated with tough love. The Banker separately reported that a new EU directive on Markets in Crypto Assets (MiCA) is currently being thrashed out in Brussels.
The most ambitious project to date was the four-year long attempt by Sveriges Riksbank to launch an e-Krona. The main policy conundrum in Sweden was whether the e-Krona should be stored in digital wallets on smartphones or in digital accounts with the country’s banks. Learning lessons from Sweden, the City United Project has come up with a proposal for the development of a digital currency to be used solely for UK financial markets.
If a central bank were to maintain a central ledger of all transactions, then it would potentially know everything that is going on within a given economy – especially when equipped with AI-enhanced data mining tools. Imagine what power would accrue to a hostile country which hacked into that ledger. (The British state does not exactly have an unblemished record when it comes to the management and implementation of IT projects.) And if that treasure trove of data were maintained solely by the central bankers, the politicians might be tempted to wade in, violating the principle of central bank independence.
The model that seems to be developing in China (though it’s still early days) is that there would be a two-tier system, with retail banks providing digital accounts to businesses and individuals by plugging into a central bank-controlled master ledger. If there were currency wars in the age of fiat currency (when countries manipulate their exchange rates for short-term commercial advantage – as China has done over the last decade), then expect digital currency wars to be even more punitive.
Bitcoin becomes official
President Bukele of El Salvador announced on 05 June while addressing a video message to the Bitcoin 2021 Conference in Miami, that he would soon propose a bill to make Bitcoin legal tender for the first time. This, he said, would “allow the financial inclusion of thousands of people who are outside the legal economy. El Salvador’s official currency is the US Dollar – always a sign that a country has a history of failed economic management. About one quarter of El Salvador’s citizens live in the USA. This initiative has been described as stealth de-dollarization. Workers’ remittances from abroad account for over one fifth of the economy. The president thinks that by adopting Bitcoin, foreign remittances will grow further. My hunch is that ordinary Salvadorians who enjoy a GDP per capita of just $8,400 would prefer to receive their remittances in good old greenbacks.
Payment platforms and clearing houses
PayPal (NASDAQ:PYPL) (which was co-founded by Elon Musk back in 1999) allowed users to buy and sell cryptocurrency in January. Several major banks have been weighing up the risks and rewards of offering cryptocurrency services. US Custodian bank State Street (NYSE:STT) has launched a digital finance division which will soon enable clients to borrow and lend crypto assets. State Street is following the example of its competitor BNY Mellon (NYSE:BK). Fidelity International launched its own crypto fund in the summer of last year. A British company called Elliptic has been advising them on compliance issues. Credit card titan Mastercard (NYSE:MA) has announced that it will facilitate payments in selected cryptocurrencies later this year.
To understand what is really going on we must delve deeply into modern computer science – something well beyond my competence, but here goes. Crypto, deriving from the Greek word for hidden or code, refers to the secure way in which blockchain technology is used to record and store ownership and payments anonymously. Each Bitcoin is defined by a sequence of digitally authenticated transactions which originated at that Bitcoin’s creation. Transactions can contain multiple inputs and outputs, allowing bitcoins to be split and combined.
Most buy-sell transactions will have a single input from a larger previous transaction, and one or two outputs: one for the payment, and one returning the change, if any, to the payor. Any difference between the total input and output remains out there in cyberspace – and can be claimed by miners. (If you think visually, as I do, then picture waifs scrambling for dropped pennies on the straw-strewn floor of an 18th century tavern.)
The mining process involves identifying a block that, when hashed twice with an established cryptographic function designed by the US National Security Agency (called SHA-256), yields a positive result. This requires colossal computational power. Cambridge academics have estimated that Bitcoin mining already consumes more energy than Argentina each year.
Apparently, Ethereum and Ravencoin do not require as much energy to mine as Bitcoin. Moreover, British crypto miner, Easy Crypto Hunter, has been building mining computer constellations deep in the British countryside and running them on electric power generated by anaerobic digesters (which burn animal waste to create methane). Farmer Phil Hughes uses manure from his sheep and beef farm in Corwen, Denbighshire to power computers mining cryptocurrency. This could become an increasingly important source of revenue for our hard-pressed farmers – and one which is not dependent on government largesse.
Other crypto miners include Argo Blockchain (LON:ARB), the data centres of which are powered by hydroelectricity in Quebec; and BitRiver, which harnesses hydropower in Russia. Argo Blockchain, DMG Blockchain (CVE:DMGI), Gryphon Digital Mining and Zumo, based in Edinburgh, have all signed up to the Crypto-Climate Accord, which pledges to mine cryptocurrencies only with renewable energy.
Why does crypto exist?
Since the financial crisis of 2008-09 interest rates have been at rock bottom so the opportunity cost of holding conventional currency on deposit is negligible. Central banks have been printing money with gay abandon by means of QE – which now mainly takes the form of hoovering up their own governments’ bonds. And since the arrival of coronavirus in Q1 2020 this has only got worse. The ECB is now the pre-eminent buyer of euro-denominated corporate bonds; the Bank of Japan owns a big slice of the Tokyo stock market.
Then governments have thrown off the shackles of austerity which obtained for a decade (2010-20) and are now spending hand over fist. The Biden administration is pushing the Federal budget deficit to levels unseen since WWII. Signor Draghi, the Italian prime minister (who was President of the ECB for eight years and who should understand economics) is stimulating the Italian economy on an unprecedented scale. The EU Coronavirus Rescue Fund will release €750 billion of new funds over H2 2021.
As I have discussed in these pages in recent months, this tsunami of (conventional) money threatens to unleash the forces of inflation. US producer prices surged by an annualised 6.6 percent in May according to Fox Business. The traditional safe haven for investors in times of inflation is gold. Real estate is also usually considered to be inflation-proof. But it may be that cryptocurrency, the supply of which is fixed, is already emerging as a hedge against inflation. The supply of Bitcoin is finite – the total number of coins in circulation cannot exceed 21 million.
The other point is that cryptocurrency came out of the financial crisis precipitated by the collapse of Lehman Brothers in September 2008. Trust in the post-modern banking system reliant on financial engineering was destroyed forever.
To invest or not invest?
I’m afraid I’m still prejudiced against crypto – though at least I am aware of my prejudices, which are, I hope, in constant evolution. And I’m not qualified to discern which cryptocurrencies are wheat and which are chaff. (Is anybody?) I think, however, that it is reasonable to define cryptocurrencies as a new asset class which is here to stay – though the current crop may well be entirely displaced by state-sponsored CBDCs which will surely emerge in the next 3-5 years. In the meantime, any decent outfit that facilitates, trades and mines cryptocurrency may well be worth a punt.
Edward de Bono, the progenitor of lateral thinking, died on 09 June. (RIP). He made a fortune by jetting around the world in the 1990s telling CEOs of top companies to change their thinking patterns. To his fans, he was a guru. To his detractors, he was a purveyor of three-letter acronyms and management gobbledegook who advanced banalities dressed up as a deep philosophical truth. Some of his profundities included: “A bird is different from an aeroplane – even though both fly through the air”. He advocated corporate brainstorming sessions in which each participant wore a different coloured hat. He urged corporate leaders to correlate their management styles with their conceptual footwear.
He was lionised by the business world and by New Labour. But in the age of the Woke Corporation, when CEOs’ bonuses are calibrated in accordance with their political correctness (what do you think Prince Harry gets paid for?), we shouldn’t be at all surprised.