Employees of Fidelity can pay for their canteen lunch using bitcoin, after Abigail Johnson (CEO) showed her resolve to become a digital currency pioneer back in May 2017. Currently 1 Bitcoin could hypothetically buy you several  Amazon shares, quite a few ounces of gold or a decent vacation for two in a country like Italy.

There seems to be a growing consensus around cryptocurrencies. Exchanges are popping up. Becoming a bitcoin miner seems to be a new job. Many brokers are starting to offer Bitcoin. It’s time to understand what all this hype is about.

BitCoin and CryptoCurrencies

In 2Q17, the price of many virtual currencies surged to unprecedented levels. As with the “dot-com” bubble in the 1990s, the financial community remains skeptical of the concept behind these currencies. At the same time, retail participation continues to rise.

Retail traders and main street in general are not always wrong and are not always the last to get aboard a trend. However, very few do the necessary homework to understand what their dealing with. I believe that with all the banners popping up on the web, talking about massive possible gains in Bitcoin and other cryptocurrencies, traders really need to know what’s behind these vehicles.

So let’s build our understanding from the ground up. Bitcoin and other virtual currencies are:

  • electronic representations of value
  • issued by private entities and denominated in their own unit of account
  • not denominated in legal tender and are not issued by central banks (just like Airline miles)

Cryptocurrencies have several independent features that distinguish them from the broader concept of virtual currencies:

  • they do not rely on a central authority to function.
  • they are convertible into legal tender
  • they use technology from cryptography to solve several issues that arise in a decentralized virtual-currency system, such as the double-spending problem.

In the past eight years, Bitcoin has not only grown constantly in terms of market capitalization but is merely the father of the whole cryptocurrency family which now counts over 100 different coins based on various technology tweaks: Bitcoin, Ethereum, Ripple, Litecoin and Ethereum Classic are the five most important global cryptocurrencies.

Source: https://coinmarketcap.com/

Blockchain Technology Basics

Cryptocurrencies share a form of technology that was pioneered by Bitcoin: cryptographic blockchains and distributed ledger technology (DLT). One thing that many practitioners believe is that while Bitcoin is most likely not the future, the  blockchain technology could have implications far beyond the emergence of cryptocurrencies.

The Centre for Cryptocurrency Research and Engineering of Imperial College London has claimed that: “What is on offer is the ability to support a general notion of trustless, verifiable decentralized ownership and the ability to transfer and process information in a decentralized but programmable way. It is hard to begin to comprehend the significance of this development but suffice to say it has the potential to fundamentally change the way human society deals with contracts, identity, patents, copyright, votes, and more.”

In practice, ownership of a certain amount of bitcoins is linked to a pair of cryptographic keys:

  • a private key  which is the crucial piece of secret information that proves ownership of some address and its bitcoin balance. Only the knowledge of the private key allows one to initiate bitcoin payments to some other Bitcoin address. If the private key is lost or stolen, ownership of the related bitcoins is lost or stolen;
  • a public key which also serves as an account number and is referred to as the Bitcoin address.

Bitcoins are exchanged between Bitcoin addresses via internet with the global peer-to-peer Bitcoin network. There are two different types of Bitcoin software: full clients and lightweight clients. Full clients include a full copy of the Bitcoin ledger, the complete history of all bitcoin transactions since January 2009.

This ledger is a temporally ordered sequence of blocks (the blockchain), which contain bitcoin transaction data and additional information. The Bitcoin global public blockchain, which contains all payment transactions ever made since 2009, had grown to a size of 100 gigabytes by December 2016.

The Bitcoin novelty is the mecchanism that allows the network to achieve consensus on the next block that will be added to
the blockchain:

  • providing incentives: some network nodes, called miners, actively participate in the process to reach consensus on the new block.The lucky miner whose block is added to the blockchain receives the block reward, an amount of newly created bitcoins (currently 12.5 bitcoins) as well as any voluntary transaction fees.
  • using randomization: as several thousand or more miners might have assembled such a candidate for the next block – and these individual blocks will usually all be different – the Bitcoin network picks one of them more or less randomly.

However there seem to be capacity constraints for miners. A short calculation  verifies that the total number of bitcoins that can ever exist is 21 million so by 2040 this amount will have essentially been reached and the  economic incentive to maintain the Bitcoin network after that will then likely rely on transaction fees.

And this is the first sticking point: transaction fees are voluntary on the part of the person making the bitcoin transaction. And that’s the catch. You need a bitcoin miner to include your transaction into the blockchain if you want the transaction to be authorized. Without including a transaction fee, you will likely be excluded from the block. The transaction fee is therefore an incentive on the part of the bitcoin transactor to make sure that a particular transaction will get included into a block. And of course, transaction fees are calculated in Bitcoins so the actual value of transaction fees has been steadily rising alongside the value of BTC itself.

Source: https://bitinfocharts.com/comparison/bitcoin-transactionfees.html#1y

Real World Trading Risks

Now that we have a bit of a background in the academic side of blockchain technology and Bitcoin in particular, let’s explore the real-world trading risks of these cryptocurrencies. To understand trading risks, there’s no better place to go than the disclaimer section of a cryptocurrency exchange like QuadrigaCX.

Just by reading the information it becomes clear that:

  • purchasing Bitcoin (or any other digital currency) involves risk and the exchange will not be held accountable for any gains or losses that incur as a result of your trades;
  • cryptocurrencies are not “securities”;
  • any form of “market manipulation” that may occur, whether it be within the exchange, or in the cryptocurrency marketplace as a whole, is not imputable to the exchange;
  • cryptocurrency prices are often unpredictable and experience swings due to a variety of reasons, including government interference, market conditions and speculation;
  • cryptocurrency exchanges are not a banks, and therefore are not protected by the FDIC or CDIC or relevant body;
  • Fundings, whether they be in a national currency or digital cryptocurrency are not protected by any government insurance policy;
  • cryptocurrency exchanges are NOT a financial institution, bank, credit union, trust, or deposit business;
  • cryptocurrency exchanges aren’t required to have circuit breakers in place to halt trading during wild price swings;
  • cryptocurrency exchanges are frequently under assault by hackers, resulting in service interruptions.

Trading on cryptocurrency exchanges means exposing your capital to material risk. Still today, nearly 25,000 customers of Mt. Gox (once the world’s largest bitcoin exchange) are still waiting for compensation more than three years after its collapse into bankruptcy in Japan. The exchange said it lost about 650,000 bitcoins.

More recently, Bitfinex, one of the world’s largest cryptocurrency exchanges, was fined by a U.S. regulator, lost $72 million worth of bitcoins to hackers and was cut off by Wells Fargo, one of America’s biggest banks.

If that weren’t enough, spreads can and do widen to crazy extents.

Source: https://data.bitcoinity.org/markets/books/USD

What is Behind the BitCoin Trend

It’s hard enough to find reputable brokers that allow you to trade FX, CFDs, Commodities, Indices & the like. Trading on cryptoexchanges currently seems simply irresponsible. And yet volumes speak clearly: there has been an ever-increasing amount of interest in crypto-trading. What can justify this? Is it just pure madness and greed?

Unfortunately it might be pure ignorance: most people are willing to invest money in assets where they don’t fully understand the risks. What matters for cryptocurrency exchanges in particular is that they attract more new clients than they lose. There is no underlying for cryptocurrencies like bitcoin. There is no tangible asset. There is no fair value. It is as speculative as it gets from what I have been able to understand.

Finally, the maximum average number of Bitcoin transactions possible is only about seven per second. Therefore, it is not conceivable that Bitcoin will be adopted on Main Street.

A Question of Faith

Now that you are aware of the risks, you can decide for yourself whether to initiate your voyage into the crypto-world. Is it the right thing to do? Is there a future? It really comes down to a question of faith right now. Blockchain is a young technology that central banks are examinating – and receiving due consideration from top authorities is already a victory. I’m sure that when new products became tradable in the past (for example CFDs which are only about 25 years old), there was always an initial resistance and much doubt.

One thing is for certain: cryptocurrencies might have a future, but not in their current state. There are many weaknesses that are being exploited. There is no regulation. Governments and central banks will certainly not let their populations exploit a free lunch. Taxation and regulation will reach cryptocurrencies before they can become mainstream.

About the Author

Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.

Sources used in this article are:

  • Satoshi Nakamoto (2008), “Bitcoin: A Peer-to-Peer Electronic Cash System,” working paper, 31 October 2008.
  • Robleh Ali et al. (2014), “The Economics of Digital Currencies,” Bank of England Quarterly Bulletin, Vol. 54, No. 3,pp. 276–86.
  • Dong He et al. (2016), “Virtual Currencies and Beyond: Initial Considerations,” IMF Staff Discussion Notes No. 16/3.
  • Sarah Meiklejohn and George Danezis (2015), “Centrally Banked Cryptocurrencies,” (December 2015)
  • MIT Technology Review (2016), “A Bitcoin-Style Currency for Central Banks,” (10 March 2016)
  • Arvind Narayanan et al. (2016), “Bitcoin and Cryptocurrency Technologies,” Princeton University Press.
  • https://www.reuters.com/investigates/special-report/bitcoin-exchanges-risks/
  • https://en.bitcoin.it/wiki/Controlled_supply