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Cryptos: How promising are they?

Cryptocurrencies, like Bitcoin, are the talk of the town. Here's an assessment of their viability, usefulness and investment case.

Cryptos: How promising are they?

In the second week of August 2021, Forbes carried a report titled 'More Than $600 Million Stolen In Ethereum And Other Cryptocurrencies-Marking One Of Crypto's Biggest Hacks Ever' (https://bit.ly/2XksZWz).

Some of the other notable comments in the article are:

  • "Soon after the hack, Tether, the company behind the world's third-largest cryptocurrency by market capitalization, froze roughly $33 million in USDT tokens associated with the alleged hacker's wallet address..."
  • "Blockchain-based security firm SlowMist also issued a statement hours after the attack, saying it had identified the attacker's email, IP address and device fingerprints, and was working on tracking additional identity clues."

Subsequent updates on the event suggest that most of the money has come back barring what was blocked by Tether. This breach comes after hacks at Coincheck in 2018 ($550 million) and Mt. Gox in 2014 ($400 million).

The origin of cryptocurrencies
On November 1, 2008, a programmer using a pseudonym Satoshi Nakamoto sent out an email to a cryptography mailing list claiming that he had produced a "new electronic cash system that's fully peer-to-peer, with no trusted third party". This led to the formation of 'Bitcoin', which witnessed its first transaction a year later, in October 2009. Since, Bitcoin has grown to over $1 trillion in market capitalisation (before cooling off). It has also spawned many copycats - all of which claim to follow the same principles as Bitcoin.

Bitcoin works on a distributed ledger, where each transaction is stored across thousands of nodes. For adding every transaction, a 'miner' has to invest significant computational resources (doing what is known as 'proof-of-work') and once this is verified by others in the network, all separate copies get updated. This process eliminates the need of any single 'trusted party' and makes transactions immutable. No single entity can change the transaction. Satoshi's paper identified a potential security issue known as the '51% attack' - where, if a single malicious actor were to gain control over 51 per cent of the total computing power, it could alter Bitcoin blocks. By design, Bitcoins are limited and as more are mined, the cost of issuing becomes higher, i.e., the computational power needed increases. The network becomes safer as more coins are issued, and the possibility of a successful attack becomes more remote.

Satoshi disappeared after a few years of writing his paper without disclosing his identity. Bitcoin is ownerless and is independent of any individual miner or user operating on the network. This was the original promise of Bitcoins - they can be sent anywhere without asking for permission of anyone, without exposing the identity of the sender or receiver, and with perfect trackability.

One of the issues with using a distributed ledger is that the number of transactions possible during a day get limited. For Bitcoin, this may be limited to about 500,000 transactions a day (currently about half this rate). This limits the practicality of Bitcoin as a means of payment for regular transactions - paying for a coffee may take almost 10 minutes for the transaction to be committed - besides the not inconsiderable fee attached to each transaction, which has been reported at a median of $20 for the past 12 months. As a consequence, Bitcoin can serve as the 'reserve currency' but actual transactions will require intermediaries who issue tokens based on Bitcoins that are not transacted on-chain.

Other cryptocurrencies
This has led to the creation of many alternatives to Bitcoin, Ethereum being the biggest. Ethereum, while it has its own cryptocurrency Ether (ETH), also offers a platform where other application developers can develop solutions using the backbone that Ethereum has created. It is one such application that was hacked. The point to note is that (a) it was possible for the developer to lock up the hackers account, and largely reverse the transactions (b) for someone to figure out the identity of the hacker. This calls into question the core premise of the distributed ledger ecosystem - the lack of a single authority, immutability and anonymity. Other examples also exist where government agencies have managed to identify user accounts back to the real individual owner, and where blockchains have been modified to eliminate transactions that were approved but not to the liking of some groups of participants.

Except Bitcoin, most other cryptos are in the control of a third party and cannot be considered a true currency. Would you trust some software-company-created token as money when you don't trust what is created by the central bank? It's still the wild west out there.

The theoretical pushback
In June 2021, Nassim Taleb wrote up a paper available at this link (https://bit.ly/3sjwjN4) dissing Bitcoins. He concludes that Bitcoin is not "useful" and its value could be zero if technology trends were to change in the future. In his view, that would make the current value at zero as well. There are many who disagree with his view. This paper led to Taleb indulging in an unseemly Twitter name-calling with his earlier colleague Saifedean Ammous - author of a book called 'The Bitcoin Standard', for which Taleb had written the foreword where he claimed that "Bitcoin is an excellent idea". Ammous's book itself (a new updated edition is in the works) is well worth a read. It explains in terms a layperson can understand the issues related to Bitcoin and distributed ledgers. Even as Ammous is fascinated by the technology, he goes on to argue that "for any trusted third party carrying on payments, trading or recordkeeping, the blockchain is an extremely costly and inefficient technology to utilize". He goes on, "trustless digital cash has so far been the only successful implementation for blockchain technology... eliminating the need for trust in third parties is not an unquestionably good thing to do in all avenues of business and life".

Should it part of the portfolio?
Like most things new and shiny, it will take a while to figure out how time will treat cryptocurrencies. If Bitcoin becomes a currency that central banks begin to hold in their portfolio, the value will grow exponentially even from here. The likelihood that central banks will give up their ability to create their own currency and instead trade in Bitcoins seems far-fetched. The more likely scenario is a digital currency backed by the central bank - the e-yuan being an example. For non-Bitcoin cryptos that are managed by software developers, to become a global standard seems even more a stretch, notwithstanding the excitement around Ethereum and its user applications.

With over a decade of trading history, the volatility of Bitcoin or its knock-offs has not subsided. In a portfolio, a highly volatile asset can find a place only in small quantum. That effectively means that investors should tread lightly for now. Despite 100 million trader accounts, cryptos have still a way to go.