Cryptocurrencies: The money of the future?

Published on 11th April, 2018 at 04:03 pm

Around dinner tables and water coolers, everybody’s talking about Bitcoin, blockchains, mining and more… Are cryptocurrencies changing the financial landscape? How do they work and are they here to stay? Worldwide, serious investors and ordinary consumers are increasingly dabbling in various cryptocurrencies, lured by the prospect of exceptional returns on their investments. Despite price swings and sentiments that the ‘crypto bubble’ may well be corrected, pundits believe that cryptocurrency is set to change the face and future of finance, challenging the normal banking model.

Growth and decline… where it all began

Since the introduction of Bitcoin (the world’s first cryptocurrency) in 2009 – created by the mysterious Satoshi Nakamoto – many other cryptocurrencies have come into being, fuelling the frenzy. As a result, on 31 December 2017, the number of cryptocurrencies available stood at 1 381, including currencies like Ripple and Ethereum and… uhm… BigBoobsCoin and CryptoKitties!

In January 2017, Bitcoin (which continues to lead the pack with a market capitalisation of more than $284-billion) started at $1 000 per unit, but by mid-December 2017 had shot up to close to $20 000. Barely a week into 2018, the total cryptocurrency market capitalisation achieved a new all-time high (on 4 January), briefly rising above $770-billion amid a widespread altcoin rally.

In line with international trends, demand in South Africa for Bitcoin has steadily increased. Phillip Strauss, a financial software manager who, together with a business colleague, has intensively studied cryptocurrencies and trends for the past few years, explains the growth: “In 2015, a mere 300 Bitcoins traded per day in South Africa, at around R3 000 per coin; last December (2017), up to 2 000 Bitcoins traded daily, at a price hovering around R200 000-R250 000 per coin.” However, by 6 February 2018, Bitcoin was trading as low as R76 500, further proving the volatility of cryptocurrency and the risks associated with it.

What is cryptocurrency?

Cryptocurrencies are essentially a digital medium of exchange, living in a land of numbers and addresses. Unlike our centralised banking system, cryptocurrencies are decentralised, transparent and allow users to exchange money without the need for a third party (for instance, a bank).

All Bitcoin transactions, for example, are logged and made available in a public ledger, helping to ensure their authenticity and preventing fraud. These digital tools of exchange use cryptography and blockchain technology to facilitate secure and anonymous transactions.

“In short, Bitcoin and other cryptocurrencies offer a value transfer that cannot be censored. The reason is due to its decentralised nature. It uses a consensus mechanism, known as the Nakamoto consensus, which establishes trust between untrusted parties. In layman’s terms, it’s a bearer asset which can be moved digitally between two consenting parties that have no reference of trust, without the ability for third-party censorship,” explains Strauss.

What is a blockchain?

Blockchain is the technology and protocols developed to store the information for cryptocurrencies. Blockchain is essentially a digitised, decentralised public ledger that works like a cash book with credits and debits, and allows people to make transactions and store information. “At its core, blockchain is simply a database of sequential transactions on top of which one can define rules,” Strauss explains.

Information about each transaction within the Bitcoin network, for example, can be found in the Bitcoin blockchain. What is a page in a cash book, is a block in the blockchain. If the block is “written”, a new block is attached to write in. It creates a chain of blocks, thus the blockchain. The blockchain is visible to everyone, so there is perfect transparency. Each block has a #tag, which is a type of code, and this links each block to one another.

“The blockchain is a distributed database. It’s not located on a central server that is accessed by all participants. Instead, every participant in the network has a copy of the blockchain on his own computer, which is constantly matched with the network, by downloading blocks from the transaction history,” explains Strauss. Blockchain technology is now being explored and used in many other spheres outside cryptocurrencies, for example insurance and banking.

What is mining?

To keep the blockchain up to date, updates of transactions must be distributed across the network and this is where so-called ‘mining’ comes into play. The Luno learning portal explains how this works with Bitcoin: “This process is not done by people or companies, but by thousands of computers all over the world that are all connected to the Internet. These computers are known as ‘miners’, but they should really simply be called ‘computers that process transactions’.”

Furthermore, it explains that “to do this processing in a very secure way, these computers need to perform very complicated calculations, basically cracking the code and generating a #tag, which take a lot of computing power and, in turn, require a lot of energy, as well as expensive and specialised processing equipment.

“Someone – the owner of the computers – needs to pay for all this equipment and electricity, so they must be compensated for all the money and effort they put in to make this network work. They earn this compensation through newly minted Bitcoin for creating a #tag. So, in short, all new Bitcoin acts as a reward and incentive mechanism for people to contribute their computers to the system to help process transactions.”

How to buy cryptocurrency?

A word of caution – cryptocurrencies are extremely volatile and you could lose a lot of money if you are not aware of the risks. However, should you decide to go ahead, the steps below detail the process. The first step to buying a cryptocurrency like Bitcoin in South Africa is registering on the website www.luno.com, currently the largest Bitcoin exchange operating in the country to facilitate Bitcoin-to-rand trades between registered users. (For other cryptocurrencies, you can also register on www.coindirect.com/za or www.altcointrader.co.za.)

Once you’ve registered, verified your identity and your account has been validated, you deposit rands via your bank into the Luno account and receive a reference number. You are now ready to buy a Bitcoin or part of a coin, via the Luno exchange.

You can either buy at the current price, at a lower price through a matching transaction (where a seller asks a slightly lower price than the going rate, which matches what the buyer is prepared to pay) or even just a small stake, say, R50 of a Bitcoin. Many of these platforms also charge a transaction fee.

Impact on the wider financial world

Although cryptocurrency is still in its infancy, its impact on the financial world is already widely felt, causing increasing interest and concern among traditional participants. Cryptocurrencies like Bitcoin, Litecoin, Ethereum and Ripple are starting to flex their muscle in the financial world insofar as they have become popular currency alternatives for online transactions in many different industries. By using cryptocurrencies for cross-border payments or money transfers, users also bypass costly foreign exchange services offered by banks and traditional payment processors. Moreover, the fact that, as an alternative financial system, cryptocurrencies remove the banks as middlemen and are transparent thanks to the public ledger, makes them particularly appealing to consumers. In South Africa, for example, a whole host of companies, including tourism, retail and IT, accept Bitcoin as payment (eg Bidorbuy, Takealot and WeFix).

Additionally, cryptocurrencies are also increasingly used as investment instruments, but there are fears that this might be a bubble. As Patrick Rassou, Head of Equities at Sanlam Investment Management, explains: “The current Bitcoin bubble is one of the most extreme examples witnessed in current time. Over the past few decades, we’ve seen a number of bubbles – the global property bubble in the mid ’90s, the dotcom bubble, the silver bubble of 2001 etc. While in nearly all these cases asset prices increased by 1 000% or more, the common trait was that the prices took at least a decade to inflate. In the case of Bitcoin, prices went up by over 1 000% within two years!”

The future

Like any other evolving (financial) product or service, cryptocurrency will have its fair share of challenges going forward, especially since it operates in an unregulated environment. Sorting out issues such as fraud, network congestion, high fee costs, processing times, the possibility of regulation and taxation by national governments, blockchain size, hyper-volatility, as well as maintaining high levels of safety and security, will certainly keep the crypto boffins very busy for a long time to come.

That said, judging by the interest in the concept (and potential) of cryptocurrency, the phenomenon looks set to have an impact on the financial landscape.

The views expressed in this article are not necessarily those of Sanlam Reality and Sanlam, and do not constitute advice.