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Bitcoin: An introduction to Cryptocurrencies and Blockchain

| December 27, 2017
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Disclaimer: The following materials are meant solely for educational purposes and are not to be construed as investment advice. This primer is not meant to be used as a specific buy or sell recommendation. Due to the volatile nature of this new asset, and the lack of contemporary valuation metrics, Tompkins Financial Advisors does not invest in crypto-currencies directly or indirectly. Investors should fully educate themselves on the risks of this new and volatile asset class before considering any type of investment.


Introduction

Can you name an asset that has grown over 1,600% since the beginning of this year? As of the writing of this paper, that same asset stands at over $280 billion in value. If you want a point of reference, that’s more than the current market capitalization of Intel Corp, Coca-Cola, Well Fargo & Co. or Wal-mart. Not to mention that this asset is only eight years old and has no revenue or discernible value as determined by traditional valuation methods. If you’re still scratching your head in wonderment, you’re not alone. We are of course talking about Bitcoin.

One would be hard-pressed to tune into financial media outlets without hearing about Bitcoin. 2017 may well be known as the year that Bitcoin and other cyptoassets gained mainstream acceptance. Before the end of the year, two of the world's biggest exchanges (CBOE and CME) will begin trading Bitcoin futures, pushing it further into the mainstream and perceived as a dose of legitimacy. Moreover, a Bitcoin ETF is likely to be a reality by summer of 2018. Several firms have already filed for an ETF license this year, with most applicants withdrawn for now. Amplify Blockchain Leaders ETF, which plans to use Blockchain Equity Securities and Funds, is currently in the registration process, as shown in the chart below.

Firms that filed for a Bitcoin ETF in 2017

ETF Name

Filing Date

Replication Strategy

Status

Winklevoss Bitcoin Trust

07/01/2013

Will store Bitcoin

Denied, but Appealing

Bitcoin Investment Trust

03/12/2016

Will store Bitcoin

Withdrawn for now

SolidX Bitcoin Trust

07/12/2016

Will store Bitcoin

Denied, Out of Race

EtherIndex Ether Trust

07/26/2016

Will store Ether

Withdrawn for now

VanEck Vector Bitcoin Strategy ETF

08/11/2017

Will use Bitcoin Funds/Futures

Withdrawn for now

Rex Bitcoin Strategy ETF

08/23/2017

Will use Bitcoin futures

Withdrawn for now

Rex Short Bitcoin Strategy ETF

08/23/2017

Will use Bitcoin futures

Withdrawn for now

ProShares Bitcoin ETF

09/28/2017

Will use Bitcoin futures

Withdrawn for now

ProsShares Short Bitcoin ETF

09/28/2017

Will use Bitcoin futures

Withdrawn for now

Amplify Blockchain Leaders ETF

11/01/2017

Will use Blockchain Equity Securities and Funds

In Registration

So what is it about Bitcoin and the underlying technology known as Blockchain that people worldwide find so intriguing? What is Blockchain’s theoretical and actual utility? The recent surge in price is interpreted by some market participants as a bubble. However; others view this exacerbated price appreciation as a belated recognition by the financial community that cryptocurrencies, or digital forms of currency, do in fact provide some form of value. The purpose of this paper is to provide a very basic understanding of Bitcoin and Blockchain technology.

Figure 1: USD per Bitcoin growth chart Jan. 01, 2016 - Dec. 08, 2017. Source: Bloomberg

History of Bitcoin and the Bitcoin Blockchain

The idea for “chained blocks” first was coined by an author(s) in 2008 under the pseudonym Satoshi Nakamoto in the seminal paper “Bitcoin: A Peer-to-Peer Electronic Cash System”1. The Bitcoin Blockchain seeks to provide secure ownership of digital assets by eliminating the ability to spend the same asset twice. The other problem solved is the need for a trusted third party or centralized authority. Trust is the operative word here and Blockchain networks seek to provide trust between individuals through the use of cryptography. Put differently, they wish to eliminate the NEED for trust.

In 2009, the bitcoin network came into existence with the release of the first open source bitcoin client and the release of the first bitcoins. Satoshi Nakamoto mined the first block, known as the “genesis” block, which had a reward of 50 bitcoins. Since this humble beginning the technology has seen growth in fits and starts, crashes and booms, and the bankruptcy of ancillary businesses designed to facilitate its use (MT. GOX). It’s undeniable how incredible the growth has been especially within 2017. Investors who are new to the space should take caution and understand that the price has dropped over 50% numerous times in its eight years of existence.


What is Bitcoin?

Bitcoin is a digital currency for a database where transactions can be verified cryptographically without the need for a central issuing authority. However; focusing on what Bitcoin is not may offer more insight. Bitcoin is not a common form of tangible currency you can hold in your hand. It can’t readily be used to purchase goods or services from traditional brick and mortar companies, i.e. the grocery store. It is not backed by a centralized authority or national government. On a fundamental level, bitcoin and its imitators are a set of software protocols used to generate scarce digital tokens (known as a cryptocurrency). These cryptocurrencies are then used to track online transactions in a way that prevents the creation of counterfeit tokens, and disallows the use of the same token twice.

So, think of it this way. What happens when you make an online purchase through your bank? The bank will first verify you have the funds available. It will then subtract the purchase price from your account, which is really a single data point within a giant database the bank maintains of accounts and balances, and then credits it in another. You can check your account balance online, and also monitor the cash movement, but the transaction is completely under the bank’s control. You are simply relying on the bank to remove the right amount of money from your account and make sure you can’t spend that money again. The premise behind Bitcoin is that it can be used instead of traditional currencies, acting as a digital currency used to transact online. But who then monitors the millions of online transactions? The Blockchain is a database that performs all those tracking functions without the use of banks or any other central authority.


What is Blockchain?

The key behind Bitcoin is the concept of Blockchain, which is a publically visible, largely anonymous online ledger that records every single Bitcoin transaction. Although commonly associated with Bitcoin, Blockchain technology has many other applications that go way beyond facilitating transactions including natural resource, file storage and computing power allocation using markets that previously did not exist. In fact, Bitcoin is only one of several hundred applications that use Blockchain technology today. Every time a Bitcoin transaction occurs online, that transaction is registered and recorded on every computer within the global network. The verification of that transaction is accomplished through a process known as mining. New transactions are grouped together into a batch, encrypted using a cryptographic function and then broadcast to the network once verified2. Who does all the work while making sure that online transactions are recorded accurately? In other words, who performs the function that would otherwise be handled by traditional financial institutions? That is accomplished by Bitcoin miners.


Who are These Bitcoin Miners?

Anyone can be a Bitcoin miner, as long as you have the dedicated resources. Bitcoin miners rely on incredibly fast super-computers and vast amount of electricity. In the previous section, we mentioned that transaction data in each batch is encrypted by a formula. This formula can only be unlocked through trial and error guessing which is done on a massive scale. Bitcoin miners put large-scale computing power to work as they compete with other miners to be the first to decipher the formula. If a miner’s “answer” is verified by others, the new data is added to a linked chain of blocks of data (the “Blockchain”) and the transaction is complete. So, how are the miners rewarded for all of their efforts and enormous use of resources? Simple, they are rewarded with a newly issued Bitcoin. The pace of creation is limited and, more importantly, no more than 21 million Bitcoins will ever be issued.


What is so Appealing About Blockchain?

Advocates of Bitcoin and Blockchain technology view it as a new way of conducting all sorts of business online. The use of Blockchain could potentially create new efficiencies, cutting down the costs associated with a centralized middleman keeping track of every transaction and charging customers for its services3. Financial institutions such as banks and stock exchanges have started to invest in Blockchain technology. Even retailers like Wal-Mart are experimenting with Blockchain for ensuring food safety. Central banks are beginning to speculate about the issuance of block-chain based official currencies. In one way or another, Blockchain has the potential to change the way business is conducted across the world.


Risks

Despite its decentralized nature and theoretical protection from the failure of a centralized authority, buying and selling bitcoin is not without risks. Among those risks are issues related to price volatility, cybersecurity, storage and a lack of reliable valuation methods. Investors need to be aware of these risks and perform rigorous due diligence before even considering investing in bitcoin or any other crypto-currency.

Bitcoin has become synonymous with price volatility in 2017 and has experienced significant price swings throughout its short existence. While bitcoin’s development was initially to facilitate exchange as an online currency, its price volatility has shifted its primary use instead to a store of value. People exchanging goods or services for bitcoin are less likely to if the price changes very rapidly. Ironically, people are more inclined to buy and hold when the price jumps by orders of magnitude rather than use it for medium of exchange. This issue is a motivating factor in the development of other crypto-currencies that attempt to address value stability.

Given Bitcoin's recent explosive rally, some investors may be looking to go short the cryptocurrency with exchange-traded products. However, unlike taking a long position where the most you can lose is 100% -- shorting has an unlimited downside, an especially important point in the case of bitcoin, which is up over 1,600% this year alone. Shares can be borrowed if investors have a prime broker. There is no data showing how many shares are shorted or what the borrowing cost is, but rumor is the borrowing cost for the Bitcoin Investment Trust (GBTC), an OTC-listed private trust is as much as 17%.

Cyber security and storage are real issues concerning bitcoin miners and exchanges that facilitate investment. Since digital wallets containing bitcoins are stored on networked computers they are at risk of theft by hackers. Mt. Gox, one of the first exchanges was subject to numerous hacks eventually resulting in their bankruptcy. The bitcoin mining company NiceHash recently experienced a theft of their wallet with the value exceeding $66 million at the time of the reporting. Methods of “cold storage” came about to back up the data and prevent theft. Such methods include storing bitcoin on USBs that can be stored in secure locations. Even paper records have been used to backup data. It’s doubtful that Satoshi Nakamoto could’ve foreseen people storing a digital currency on paper!

Bitcoin is difficult to value with traditional methods. As a result, you see very large difference in opinions about its future in the form of price volatility. An asset’s price when traded in a market usually contains two components. First, there is the valuation created by the asset’s discounted cash flows. Second, a speculative component is layered on top of that depending on the differing opinions of the participants in the market who wish to buy or sell the asset depending on what they perceive the future to bring. Bitcoin has no cash flows and because the Blockchain technology is so new and its ultimate use is not determined at this point, the speculative value attributed to its potential is seemingly quite high. Without a way to determine any sort of intrinsic value using traditional methods, a price or 1000 BTC/USD and 1,000,000 BTC/USD have equivalent justification. This is problematic if buyers and sellers can’t determine if it is overvalued or undervalued.

All of this is not to say that people aren’t working on this problem of valuation. The bitcoin network is designed to allow people to communicate value as opposed to the internet which allows people to communicate data. It remains to be seen what novel techniques will be devised to allow investors to make more informed decisions.


Conclusion

We’ve only skimmed the surface in explaining the profound changes this revolutionary technology has in store for us. Like previous methods of coordination, Blockchain may help humanity to fundamentally reshape the means by which we solve our problems. While the promise of Blockchain is great we must soberly assess where we are in terms of its evolution and application.

All new technologies are the vehicles by which utopians proselytize. Blockchain is certainly no different. Anybody willing to take on the risk necessary to navigate this space should do adequate due diligence. The available tools and metrics with which investors value current assets simply don’t apply here because the models themselves are so fundamentally different. Whatever fundamental value may exist is extremely difficult to define at the present moment and differs from network to network. Speculative fervor is driving crypto-currency prices sky-high while attracting entrepreneurs to the space. It remains to be seen what value they create and whether it can be understood using traditional methods of valuation.

Potential investors should also be aware of the space’s lack of consumer and investor protections. It is both a strength and a weakness that these decentralized networks lack the protections afforded by reliable and centralized institutions.

 

Bibliography

1. Nakamoto, Satoshi “Bitcoin: A Peer-to-Peer Electronic Cash System” https://bitcoin.org/bitcoin.pdf
2. https://en.wikipedia.org/wiki/Hash_function
3. https://www.coindesk.com/information/applications-use-cases-blockchains/

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