Has anyone invited you to invest in bitcoin recently? Do you really know what it is? And why did the Chinese ban it?
The future of money
My lead article in the December edition of the Master Investor magazine will be entitled The Future of Money. Not very Christmassy, you might think. But we need to prepare for the New Year 2018 which will be, in my estimation, another momentous one in which the creaking tectonic plates of the global monetary system might suddenly lurch…
For analysts I’ll explain how the international monetary order which obtains at present evolved from the 19th-century Gold Standard via Bretton Woods (1944 – the conference that established the architecture of the post-WWII international monetary system) into a system, after 1971, of purely fiat (sometimes called “paper”) money.
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This post-1971 international monetary order has given rise to the tsunami of debt in which the world is now drowning. This system will, in time, morph into something new. And the key feature of the next-generation international monetary system will be a phenomenon that we have only become aware of in the last few years: cryptocurrencies (of which bitcoin is just the most successful to date).
For retail investors I’ll also explain where these cryptocurrencies are headed. Spoiler alert: they are going to be monopolised by central banks – sooner rather than later…
On the radar
I don’t know about you but my mailbox is filling daily with exhortations from outfits of varying degrees of dubiety not to miss out on the bitcoin revolution. Here’s one email taken at random that I received on 14 November – its title reads: How you could make £100k from “crypto wildfire”. And here’s another received on 15 November: Make lightning-fast returns from “Penny-Cryptos”.
Some of these emails come from the same outfits that were trying to sell me carbon credits two years ago and diamond futures the year before that. I click the delete button. But if even serious investors like my friend Evil Knievil are dabbling in bitcoin then we may need to take a second look.
It should be noted that bitcoin is not just a speculative “commodity” as it is widely used as a means of payment. About 100,000 merchants worldwide accept bitcoin – you can even use bitcoin to pay your parking fines in the city of Zürich! According to research by Cambridge University, there were between 2.9 million and 5.8 million unique owners of a cryptocurrency wallet in 2017, most of whom used bitcoin.
Why have cryptocurrencies emerged?
I was struck by something the Georgian super-banker Lado Gurgenidze told my colleague Swen Lorenz when interviewed for the November edition of the MI Magazine. When asked if he thought cryptocurrencies were here to stay, he replied: I don’t know if there are any clear fundamental reasons for cryptocurrencies to become mainstream, or even to exist…
I agree with him. We do not need cryptocurrencies to buy and sell products across borders – conventional liquid and well-established currencies like US dollars or Japanese yen, euros or even the humble pound sterling will do just fine. Except that all these conventional currencies reside in bank accounts somewhere in the international banking system, the owners of which are ultimately traceable.
So the first reason why bitcoin, Ethereum et al have been invented has been to provide anonymity. This should automatically ring alarm bells. Only criminals, terrorists and spooks seek total anonymity. And it is significant that, as I reported in the June edition of the MI Magazine, hackers have disseminated so-called ransomware by means of cyber-attacks which often require the victim to pay a ransom in bitcoin. (Not that most affected parties, such as the National Health Service back in May, have bitcoin accounts or even know how to acquire bitcoin).
A second more charitable (or libertarian) view would be that cryptocurrencies have been developed in order to enable market participants to buy and sell products without being beholden to the banking system – which, as we know, is controlled by greedy and obnoxious people called bankers. Trading in bitcoin is peer-to-peer: transactions take place between users directly without any intermediary or clearing house and are then verified by the system.
But I take a third Darwinian view: cryptocurrencies have emerged because a technology was developed that made them possible. They will survive to the extent that they are useful and if they are not useful, they will go extinct – or be taken over by state monopolies (just as conventional currency has been).
The technology in question is called blockchain – also called distributed ledger technology. Even if cryptocurrencies turn out to be ephemeral, I contend that blockchain is here to stay.
The strange history of bitcoin
Bitcoin was supposedly developed by a mysterious Japanese computer scientist – or group of specialists – known under the pseudonym of Satoshi Nakamoto. The blockchain technology that drives bitcoin was first revealed to the world in January 2009. This was the first system to resolve the notorious double spending problem inherent in previously envisaged digital currencies. By means of a distributed blockchain database, each unit of digital currency can be spent only once per transaction.
The key idea is that every time someone pays a bitcoin to purchase an item someone else (the seller) acquires that bitcoin. The history of who paid that particular bitcoin and who acquired it is recorded on the distributed ledger for evermore. Imagine that the Pound coin in your pocket contains a microchip on which is recorded every transaction in which it was ever used – plus the identity of all those that have ever owned it. Because the data associated with each bitcoin is stored on the distributed ledger, no one user can trace where each Bitcoin has been (although there are people working on this – see below).
Imagine further that Snook’s Tools PLC is maintaining its accounts on a distributed ledger. I can see into the receivables account and you can see into the cash account. Someone else can see into the capital equipment account, and so on. But none of us can construct the balance sheet or the profit and loss account for Snook’s Tools because we only possess a small part of the total books. We could only do so if we could locate one another and share the information – but we can’t do that because the identity of who holds the complementary information is hidden by super-sophisticated cryptography.
Only the master bookkeeping system can combine the various ledgers to create the final accounts. In the weird world of bitcoin, the central bookkeeping system is called the Hard Fork. New bitcoins can only be “minted” and distributed by the Hard Fork. In November 2017 the Hard Fork controls about one billion bitcoins each one of which had a putative market value yesterday (16 November) of over $7,500 after a week of extreme volatility[i].
Satoshi Nakamoto (“he” is probably not even Japanese) created the domain name bitcoin.org in 2008. He continued to collaborate with other developers until 2010 when he handed over control of the source code to a certain Gavin Andresen, a software developer based in Amherst, Massachusetts. In 2012 Andresen founded the Bitcoin Foundation, the stated mission of which is “to standardize, protect and promote the use of bitcoin cryptographic money for the benefit of users worldwide”. In 2014 Andresen left his software development role to concentrate on his work with the Foundation.
Just to confuse everybody further, on 01 August this year bitcoin split into two derivative digital currencies, the classic Bitcoin (BTC) and Bitcoin Cash (BCH). There even appears to be a third currency – Bitcoin Gold (BTG). So bitcoin is not even one thing.
It is not clear who “runs” bitcoin on a day-to-day basis – or even whether it needs to be managed at all since, once established, the system is decentralised and self-perpetuating. I suppose there must be engineers who maintain the central servers that run the Hard Fork but they might not even know what resides on such servers.
And that is precisely why governments and central bankers are so unhappy: they have been entirely usurped. Hence China even banned bitcoin exchanges on 30 September. Malaysia is considering doing the same. South Korea has banned all new cryptocurrency sales. And in the US regulators are preparing to control the market.
Do cryptocurrencies really have value?
Two years ago you could have bought a bitcoin for $300. Yesterday, that bitcoin was worth over $7,500. Its price doubled between late September and early October. It seems that the supply of new bitcoin is restricted while demand is booming. This has attracted attention from mainstream money managers who wonder if there is not some kind of market mania afoot – akin to the tulip bulb mania which raged in the Dutch Republic in the 1630s.
If bitcoin is money – a currency – it should pass two tests. It should be a medium of exchange (you can buy and sell goods and services with it) and it should remain a store of value. It surely passes the first test; but I think it fails the second – especially as most purchases of bitcoin are not to facilitate transactions but seem to be entirely speculative in nature.
Unlike the pound coin in my wallet, bitcoin is not backed up by the state through the medium of a central bank. A currency that is not backed up by a central bank is not a currency: it has the same relationship to money as the points you accumulate on your Nectar Card when you shop at Sainsbury’s. (Or, for the over-50s, it is no more a “currency” than were Green Shield Stamps in the 1970s.)
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Nor can bitcoin be compared to a physical commodity such as gold. Gold is effectively useless unless you want to make jewellery or fillings or religious icons. It has limited industrial applications. And yet, it still exerts a psychological lure over the human psyche – something that the intelligent robots of tomorrow will find very strange. Even tulip bulbs have an intrinsic value given that you can plant them and grow flowers that will give you pleasure. Bitcoin has absolutely no intrinsic value whatsoever.
Devotees will argue that conventional currency has no intrinsic value either. On the UK ten pound note there is an inscription as follows: I promise to pay the bearer on demand the sum of Ten Pounds – signed by the Chief Cashier of the Bank of England. So, in theory, I can rock up at the Old Lady of Threadneedle Street, hand over my ten pound note and demand…ten pounds. At which point they will give me an identical ten pound note and some very funny looks.
But the point is that I am absolutely certain that my ten pound note will be accepted down the pub this weekend; whereas if I offered to buy a pint with bitcoin – well, I would also get some funny looks.
I think I’ll give the bitcoin bonanza a miss after all.
The big banks back blockchain
Jamie Dimon, CEO of JP Morgan recently trashed bitcoin as “a fraud that will soon blow up”. BlackRock Inc. (NYSE:BLK) CEO Laurence Fink said something similar. On 16 November, Morgan Stanley CEO James Gorman said that bitcoin was “by definition speculative”. Yet the banks are still enamoured of the amazing technology that underpins bitcoin and other virtual currencies – blockchain.
I reported from the United States recently that JP Morgan Chase (NYSE:JPM) is rolling out its own blockchain programme to secure cross-border payments with Royal Bank of Canada (TSE:RY) and Australia and New Zealand Banking Group (ASX:ANZPB). This trio is provisionally calling the blockchain payments system the Interbank Information Network. According to the Wall Street Journal, JP Morgan wants to increase the network from three to 24 banks over the next 12 months.
Proponents of blockchain argue that it will save billions of dollars of costs caused by payment delays within the financial system. Attacks on banks using existing payments infrastructure such as SWIFT (which is itself exploring blockchain) have highlighted security flaws. Sceptics of blockchain say the technology does not fundamentally improve existing settlement systems. Some also say that the technology’s promise cannot be fulfilled until a government-backed currency is issued on the ledger.
In the June edition of the MI Magazine where I focused on cyber-security, I identified a London-based unicorn which has developed tools to unpick and trace transactions across the blockchain. Elliptic is a company that tracks illegal activity involving bitcoin. It can uncover complex relationships between multiple entities making obscure transactions transparent.
Elliptic’s proprietary database delivers auditable proof of identity for millions of bitcoin addresses across thousands of real world entities. This enables law enforcement agencies and financial institutions to investigate and evaluate suspicious activity on the bitcoin blockchain.
If JP Morgan succeeds in replacing SWIFT with a blockchain-powered international payments system then Elliptic will be well placed to profit – even if the bitcoin bubble bursts. There will surely be other unicorns providing backup services and cyber-security safeguards to future blockchain-based payments systems.
Cryptocurrencies as a source of start-up finance
In August Dublin-based internet start-up Cloudwith.me raised supposedly $10 million without any regulatory procedures via a so-called Initial Coin Offering (ICO). Such ICOs involve the start-up issuing “tokens” to putative investors who pay for them in bitcoin. The Financial Conduct Authority (FCA) has described ICOs as “very high risk, speculative investments”.
Needless to say, China has banned ICOs outright. I sympathise with the Chinese on this one.
The dark secrets of the central bankers
I revealed in these pages last February that in June 2016 experts in blockchain technology met with Chair of the Federal Reserve, Janet Yellen, during an event in Washington DC to discuss ways in which the technology could improve the financial system and strengthen cybersecurity. Central banks from over 90 countries participated at the event entitled Finance in Flux: The Technological Transformation of the Financial Sector.
According to the speculator and guru, Doug Casey, the real purpose of this meeting was to discuss how state monopoly digital currencies could revolutionise the global monetary system. Doug Casey thinks that the Fed is already planning to respond to the de-dollarization of world trade by creating a parallel dollar in the form of a digital currency in the mould of bitcoin. Casey has christened this proto-currency Fedcoin.
This digital currency will have no paper form but will be accessible via laptops and smartphones. The Fed will operate an electronic ledger that is continuously updated and verified in “blocks” of records. It will be shared on computer servers between various parties and protected cryptographically to prevent it from being modified.
The Chinese are busy…
In November last year rumours surfaced that the People’s Bank of China (PBOC) was researching its own sovereign digital currency. China’s central bank banned bitcoin in 2013, saying that bitcoin was not a real currency and could not become legal tender. But Zhou Xiaochuan, the Governor of the PBOC since December 2002, has expressed interest in the idea of a sovereign digital currency entirely controlled by the Chinese authorities.
In June this year it was reported by CryptoCoins News that the PBOC is already testing its own digital currency[ii]. China’s plan, according to this source, is to integrate the digital currency into the existing banking system by allowing banks to operate digital wallets on behalf of the central bank.
For single-party state, authoritarian China, the idea of a monopoly digital currency running on blockchain must be a dream come true. Once they abolish cash, all transactions of all kinds will be monitored by the state.
The next steps…
As I shall explain in next month’s MI Magazine, John Maynard Keynes, the great economist who represented Britain at the Bretton Woods Conference (named after the town in New Hampshire where it took place), arrived at the conference with an audacious solution. Keynes proposed to establish a new international currency which would replace the gold standard. All countries would have an overdraft with the World Bank-IMF denominated in a synthetic reserve currency called Bancor. This uber-currency would be valued in terms of gold but would not be convertible into gold.
In the event, the Americans rejected Keynes’s “funny-money” solution and imposed the dollar peg. All currencies were to be valued in terms of the US dollar; but the dollar itself would be linked to gold. The price of gold was set in stone at $35 an ounce. This system endured until the Nixon Shock of 1971 when President Richard Nixon and his Treasury Secretary, John Connally, uncoupled the dollar from the price of gold. As a result, all currencies were left “to float” in the foreign exchange market.
But the idea of a synthetic international reserve currency has never gone away. And there are reasons why a digital currency would do the job extremely effectively. In 1971 Secretary Connally told the world: “The dollar is our currency – but your problem”. That is precisely why the Chinese cannot wait to overturn the existing global monetary order: and they are already working on the digital alternative.