Brian Gaynor: The minefield of digital currencies

Are cryptocurrency values getting ahead of themselves? Photo / Bloomberg

The massive increase in cryptocurrency prices, particularly bitcoin, has been one of the biggest financial stories this year.

The cryptocurrency boom has been compared with Holland's Tulip mania in 1636-37, the South Sea Company bubble in 1720, the Florida real estate boom in the early 1920s and the Nasdaq dot-com bubble between 1997 and 2000.

Although speculators lost a fortune in these bubbles, the underlying assets remained in use, particularly Florida real estate and many Nasdaq technology companies.

Are cryptocurrency values just getting ahead of themselves, as they did in Florida in the early 1920s and on the Nasdaq in the late 1990s, or are we seeing one of the wildest and most irrational financial bubbles of all time?

A cryptocurrency is a digital or virtual currency that can be used as a medium of exchange or a store of value. One of the unique features of cryptocurrencies is that they are issued by private individuals or organisations; they are not issued by governments or central banks.

Cryptocurrencies appeal to individuals who don't trust politicians or central bankers.

These digital currencies are not subject to normal banking controls and regulations.

There are 1355 cryptocurrencies according to coinmarketcap.com, with the 10 largest by market value listed in the accompanying table.

Prices and market capitalisations fluctuate wildly, but at 7am yesterday, December 15, the total market capitalisation of all 1355 cryptocurrencies was US$515 billion ($737b).
Bitcoin, with a market capitalisation of US$278b, represented 54 per cent of the total value of all 1355 currencies.

Cryptocurrency prices have soared this year, as indicated by the following data:

• On January 1, 2017, there were 617 cryptocurrencies with a total market value of US$18b
• On April 2, there were 752 currencies valued at US$26b
• On July 2, there were 881 currencies with a total value of US$95b
• On October 2, there were 1091 currencies valued at US$147b
• On December 3, there were 1273 currencies with a market value of US$334b.

And by yesterday morning, there were 1355 currencies listed on coinmarketcap.com with a total market capitalisation of US$515b.

By comparison, there are 180 conventional global currencies.

The first point to note is the massive increase in cryptocurrency prices this year.

The NEW currency has surged 149.4 times, ripple has increased 124.5 times and ethereum 82.9 times.

Bitcoin has been a relative laggard, with its price rising just 17.3 times since the beginning of the year, from US$963.06 to US$16,621.50. Bitcoin's price was only 8USc in July 2010.

However, bitcoin's 17.3 times increase this year understates its performance. This is because bitcoin cash and bitcoin gold were established during the year, with all bitcoin holders receiving bitcoin cash and bitcoin gold in equal amounts to their bitcoin holding.

Thus, bitcoin's price multiple for the year increases to 19.5 times when the bitcoin cash and bitcoin gold distributions are included.

IOTA and cardano were also established this year and don't have a year-to-date price history.

The other point to note about cryptocurrencies is their massive trading volumes.

The top 10 currencies have had US$407.2b worth of trades over the past 30 days, with bitcoin topping the list at US$239.1b.

The highest trading volume to market capitalisation ratio during this 30-day period was litecoin, with trading volume of US$29.2b compared with a market capitalisation of US$15.2b.

This digital currency trading activity has been executed on 168 exchanges, according to coinmarketcap.com.

The cryptocurrency market has the ingredients of a roaring bull market with massive price increases, huge trading volumes, a proliferation of trading exchanges and the creation of several new currencies every day.

The 1980s NZX and 1990s Nasdaq booms were sedate by comparison.

Meanwhile, cryptocurrencies entered the mainstream this week when Cboe XBT bitcoin futures began trading and CME Group and Nasdaq expect to provide similar offerings in the next few weeks.

There are subtle differences between the individual cryptocurrencies, based mainly on security, privacy, transaction speed, transaction utility and mining algorithms.

Bitcoin has several potential problems, including slow transaction speed and a lack of scalability, but it has first mover advantage, the largest network and receives the most media attention.

By comparison, ripple seems to be putting more emphasis on transactional utility, rather than speculation, with media reports indicating it is developing close relationships with several banks.

Last month, it was announced that American Express had partnered with Spain's Banco Santander "to provide real-time payment processing, instantly connecting US customers to the UK, via the ripple network".

Cryptocurrencies have had security problems, as demonstrated by the collapse of the Tokyo-based Mt Gox bitcoin exchange in 2014. Mt Gox accounted for around 70 per cent of global bitcoin transactions at the time, and 850,000 bitcoins were stolen when the exchange filed for bankruptcy protection.

Based on media reports, little of this has been recovered and 24,000 Mt Gox customers are out of pocket to the tune of around US$14b based on the latest bitcoin price.

Mining, which is the creation of additional bitcoins and other cryptocurrencies, is a complex process similar to solving a difficult puzzle or mathematical problem by using a huge amount of computer processing power.

However, simply adding more computer power to try and solve these puzzles faster doesn't work, as the bitcoin network responds by increasing the difficulty of the problem to be solved.

Mining becomes more expensive as the mathematical problems become more complex.

These costs include energy, network connectivity, data storage and the cost of the computer processing units (CPU) required to mine bitcoin.

Total bitcoin supply is capped at 21 million units, which will be reached around the year 2140.

Cryptocurrency mining is rapidly expanding, in terms of both new currency and the theft of existing currencies. A Russian security agency believes there are around 1.65 million computers hacking into other people's computers in an attempt to steal cryptocurrencies.

Mining cryptocurrencies is legal, but hacking into computers to steal these currencies is illegal.

Cryptocurrencies create a huge problem for regulators, including New Zealand's Financial Markets AUthority (FMA). There is no defined legal classification of bitcoin in this country and it is unclear whether we should define it as a currency or an asset.

The FMA has published a note stating that if you are trading cryptocurrencies "you need to consider whether you are operating a financial products market" and if you provide services in relation to cryptocurrencies "you may have obligations as a broker under the Financial Advisers Act 2008".

The FMA concludes with the comment: "Given the bespoke nature of cryptocurrency-related financial services, we encourage you to approach us early about the services you plan to offer".

The problem with bitcoin, and other cryptocurrencies, is that they are new, hugely speculative, unregulated, susceptible to criminal activity and it is impossible to predict whether they have long-term viability.

On the face of it, the cryptocurrency market looks like a huge bubble that will collapse at some stage.

However, cryptocurrencies do have genuine potential and several of them could be successful in the longer term.

It is worth remembering that the best time to buy Florida land was after the bubble burst in 1925 and the best time to buy quality technology companies was after the 2000 Nasdaq crash.

For example, Apple's share price plunged 56 per cent between March 2000 and the end of the year but the company is now worth more than 300 times its December 2000 value.

There is a possibility that several of the existing 1355 cryptocurrencies have viable long-term prospects and may be attractive investment opportunities after a major market correction.

- Brian Gaynor is an executive director of Milford Asset Management.