Cryptocurrency Insights: Key Trends and Risks
The conference marked the inaugural event on the topic of cryptocurrencies held jointly by the Chartered Alternative Investment Analyst Association (CAIA) and the Sim Kee Boon Institute (SKBI) for Financial Economics. Ernie Teo, a research fellow at SKBI, kicked off proceedings by discussing how cryptocurrencies actually work.
He noted that there have been three eras of currency: commodity-based, politically-based and now maths-based. The first maths-based cryptocurrency was actually DigiCash, which was invented in the 1990s. The next was bitcoin, established in 2009 by an anonymous inventor subsequently identified as Satoshi Nakamoto who created the bitcoin protocol and reference software.
Bitcoins are created and held electronically, while encryption is used to create and verify the transactions. Bitcoin is based on a distributed network that uses blockchains. Data is stored by all individuals on the network and every node has a copy of the ledger of transactions, called the blockchain – a sequence of blocks, which holds the complete record of transactions like a public ledger and which is one of the most unique parts. Bitcoin is decentralised, with no central institution controlling it, and cryptography is used to secure transactions and control the creation of new units.
Bitcoins are not actually currency at this stage however, as a currency by definition needs to be a medium of exchange, a unit of account and a store of value. Bitcoin does not currently satisfy these three functions, although if becomes less volatile and greater stability leads to more merchants accepting it, Teo said, it could become money.
The key reasons for companies’ and individuals’ continuing interest in using Bitcoins, are that transaction costs are low, they are fast to use for a transfer for a payment and they can be used to hedge against hyper-inflation.
Regulators have noted the development of cryptocurrencies, Teo noted, and they are encouraging entrepreneurs to build more safeguards into the system. Bitcoin is not as anonymous as people might think, however, since almost 40% of bitcoin users’ identities could be recovered even if they were using the recommended privacy protections.
Looking ahead, Teo said that new bitcoins are created through mining, where a cryptographic puzzle is solved. The power of professional miners is growing as miners become more high tech and fewer people want to mine individually. He noted that if someone was to hold 51% of all bitcoins, they might be able to alter the protocol and destroy the cryptocurrency or use computational factors to gain advantages. Already there are already a number of competitors to bitcoin, including namecoin, litecoin, mastercoin, peercoin, darkcoin and ripple.
Financial Markets, Innovation and Analytics
In a panel discussion led by SKBI director David Lee, which focused on the practicalities of cryptocurrencies, Lafayette University professor Donald Chambers said that they are an alternative asset, most like venture capital, with returns not correlated with traditional stock and bond markets and with the potential to analyse investment opportunity or value.
“It won’t be a currency until people think in terms of bitcoins,” said Chambers, who added that he is not an optimist about cryptocurrencies succeeding, because regulation will “crush”people using block chains in a regulated nature. He does, however, envisage a future for alternative uses of blockchains, such as record keeping and for storage.
There are additional concerns about cryptocurrencies as well, noted Tim Swanson, head of business development at Melotic, a Hong Kong-based cryptocurrency exchange. Protocols such as “coin join” can make the heuristics invalid and there is also a high cost for the system. He estimated that it costs US$700m per year to maintain the bitcoin network.
Despite such concerns, Raymond Choo, senior researcher at the University of South Australia, said that Australia is moving forward and quietly taking the lead in cryptocurrency. That country’s tax and regulatory framework is relatively well structured compared to other countries – anyone who is going to accept cryptocurrency for payment needs to show the date of transactions, the amount in Australian dollars (AUD), how the amount is calculated, the nature of the transaction, and the identity of the owner. Since bitcoin is not a money or currency, according to the Australia Taxation Office, there is no goods and services tax (GST).
Electronic Payment Systems
Another panel discussion, moderated by Singapore Management University (SMU) professor Enoch Chng, focused on the technology behind cryptocurrency.
Another SMU professor, Robert Deng, said the key information systems risks in cryptocurrency include a loss of private keys or e-wallets due to a computer crash or attack, because the money cannot be recovered. There have also been an increasing number of phishing attacks from criminals looking for user credentials and also malware attacks. His team mounted a generic attack on the iOS application by sending 15 applications to Apple that looked like a game and had an attacking code underneath. All passed verification.
Even more alarming, Deng said, would be a 51% attack. If an attacker was to control more than half of the computational power, they could create significant problems. By the middle of 2013, just six central mining pools controlled 75% of the mining power. If some get hacked, the hacker could control a significant percentage. Moreover, once powerful quantum computers become available, they can break the systems.
Andrew Koh, former vice president at the Network for Electronic Transfers (NETS) in Singapore, said cryptocurrencies could become another revenue source for banks, but they will have to reconfigure payment gateways to accept them and improve security if they want to optimise the opportunity. Payment operators will similarly have to figure out how to reconfigure payment gateways, improve security and enhance risk management.
Offering one example from the corporate world, Gunther Sonnenfeld, acting chief information officer (CIO) of the research and discovery tool Faveeo, said that Amazon has already integrated blockchain protocol and added value-added services. Companies can get creative about giving the right information, pairing it with transactional behaviour and adding value.
Conclusion
While cryptocurrencies have moved forward quite significantly over the past five years, it became clear that there are still significant barriers to overcome before they enter the mainstream. That said, banks as well as corporates will need to monitor digital payments carefully and innovate with or around them so as not to become disintermediated.
Further reading: An investment guide to cryptocurrencies