by Martin de Bruyn, CFA, CFP®

Please note that anyone can invest in cryptocurrencies, but it is unregulated and as such nothing written here should be construed as advice. It is merely meant to enlighten the reader as to the opportunities and risks in this space. SARS, SARB and the FSCA is currently working on how best to regulate cryptoassets.

In this first part, I will introduce and explain how crypto works and why it matters.

Bitcoin, blockchain and cryptocurrencies burst onto the world stage in 2008, when the posting of an online pseudonymous white paper envisioned a new way to transfer value over the internet. During its first decade-plus, the cryptoasset market has gone through all the classic phases of a disruptive technology. As the cryptomarket enters its second decade, one thing is clear: Crypto and blockchains are not going away. Today, cryptoassets boast a combined market cap in excess of $1,5 trillion; major financial institutions, such as Fidelity Investments and CME Group, are heavily involved; large endowments, such as those of Harvard University, Yale University, and Stanford University, are investing, alongside such hedge fund legends as Paul Tudor Jones II; the crypto efforts of leading companies, such as Facebook, PayPal, Visa, and Square, are front-page news; and central banks, from the US Federal Reserve to the People’s Bank of China, are discussing how to develop blockchain-enabled digital currencies of their own.

Despite all the excitement, however, significant challenges remain for investors approaching the market. More fundamentally, few people even under­stand what crypto really is or why it might matter. Is it an alternative currency? A technol­ogy? A venture capital investment? A specious bubble?

The best place to start in understanding crypto and blockchain is with bitcoin. Bitcoin was the first cryptoasset and today is the largest, and the breakthroughs that allowed bitcoin to emerge underlie all other blockchain and crypto projects. As a result, understand­ing bitcoin—where it came from, how it works, and what new opportunities and challenges it creates—provides a firm foundation on which to consider the entire crypto and blockchain space.

Bitcoin was created by a pseudonymous com­puter programmer, working under the alias “Satoshi Nakamoto,” who published a white paper on 31 October 2008 titled “Bitcoin: A Peer-to-Peer Electronic Cash System” to a then-obscure mailing list of cryptographers. The author described a vision for how individu­als could hold, send, and receive items of value digitally, without any trusted intermediary (e.g., a bank or payment processor) in the middle. On 3 January 2009, shortly after the white paper was published, the software was released, the first bitcoin was minted, and the bitcoin net­work was launched.

As an initial reason why bitcoin (and the broader blockchain space) is important, consider this strange fact about modern life: Although much of our lives have migrated online, money remains stuck in an analogue age. We do not think about this reality much because we have slick fintech apps and online bank accounts, but the underlying plumbing of our “modern” financial system is archaic. You can feel this, for instance, in the facts that sending money abroad takes two to four days and paying bills using your online bank account requires an equal amount of time. Allowing money or items of value to move the way text messages do between any two people and without any central intermediary requires a different solution. Nakamoto’s solution to this problem (and the core idea behind all blockchain databases today) was to create a single distributed database that is accessible to everyone—where anyone in the world can view balances and submit transac­tions at any time—but where the ledger is not controlled by any single corporation, govern­ment, person, or entity. In other words, a “dis­tributed ledger” that is “permissionless” and is maintained on a “decentralized” basis.

The most impressive feature of bitcoin’s techni­cal architecture is that it works. Ten years after this novel system design was first outlined by its anonymous author, the bitcoin blockchain has shown a track record of running and hold­ing tens and even hundreds of billions of dol­lars of value securely and of processing only valid transactions, with nearly 100% uptime. The database has never been hacked and cur­rently settles roughly the same value of transac­tions each year as PayPal, all without a single employee or central organising figure. It is a true technical breakthrough—a significant advance in software and database design—and it is having a significant impact on the world.

What are these disruptive capabilities that are likely to have an impact on the world? There are mainly three: 1 – Rapid, Low-Cost 24/7 Settlement, 2 – The creation of scarcity and property rights in the digital world and 3 – digital contracts.

1 – Rapid, Low-Cost 24/7 Settlement

Consider this transaction: On 12 April 2020, someone transferred 161,500 bitcoin, worth more than $1.1 billion at the time, in a single transaction. The transaction settled in 10 min­utes, and the fee for processing the transaction was $0.68. Contrast that with an international money transfer, which can be sent only during banking hours, takes one to two days to settle, and has fees ranging from 1% to 8%.

The difference is startling.

2 – The creation of scarcity and property rights in the digital world

Because the underlying blockchain database is available to everyone without being controlled by anyone, cryptoassets can provide ownership guarantees that were previously nonexistent in the digital world. In fact, one could argue that the ownership assurances blockchains offer are stronger than most of the ones we have in the physical world. For instance, a key part of the software that cre­ated bitcoin guarantees that the total number of bitcoin will never be more than 21 million. Anyone can prove they own their bitcoin (or a fraction of a bitcoin) out of the eventual 21 mil­lion supply without any company or trusted intermediary having to say it is so. Also, the cryptography assures that no one can take that person’s bitcoin away without his or her authorization.

Many people talk about bitcoin as “digital gold” specifically because it introduced the idea of digital scarcity to the world.

Digital gold, however, is not the only potential application for digital scarcity. A bustling cor­ner of the crypto industry is what is known as nonfungible tokens (NFTs), which the gaming industry is exploring.

Imagine a video game that allows players to own an item, such as a special sword. What if you wanted to sell that sword to someone on eBay? How would they know you own it? How would you transfer it to them? The NFT vision is that players can prove they own a specific asset, can trade that asset with other players whenever they see fit, and might even do so outside the confines of the game.

Another example of experimentation with scar­city is the digital equivalent of traditional sports trading cards. One startup is working with the National Basketball Association (NBA) and the National Basketball Players Association to pro­duce digital playing cards. Oddly, in 2020, even though much of our lives takes place online, kids and collectors have not yet embraced digi­tal playing cards. But without a blockchain, the scarcity value of an online card disappears: You could just copy and paste the image of a card you wanted and say you had it. With a blockchain, ownership can easily be proven or disproven.

Anticipating what creative entrepreneurs will devise to leverage the technological break­through of digital scarcity and digital property rights is difficult. But this is a powerful concept that provides a way of doing things that was not possible before—and another place to watch for innovation.

3 – Digital Contracts (“Programmable Money”)

The final advance worth considering is that cryptoasset-powered blockchains allow users to effectively program money with certain rules and conditions, as you would program any soft­ware. These digital “smart contracts” can be created, reviewed, and enforced easily, instanta­neously, and with virtually no cost. With money programmable like software, you can create transactions with such conditions as the following:

Sannie transfers cryptoasset X to Koos, but only after Katlego agrees—which looks a lot like an escrow account.

Sannie transfers cryptoasset X to Koos, but only after a certain amount of time—which looks a lot like a trust.

Sannie sends cryptoasset X to Koos, but only if Katlego wins the race; if Katlego loses, Koos sends cryptoasset Y to Sannie—which looks a lot like a contract.

Blockchains allow these and many more-com­plex transactions to be executed without the need for trusted intermediaries. In so doing, smart contracts aim to replace or augment many of the core functions provided today by banks, lawyers, accountants, escrow agents, and notaries, albeit in a way that is cheaper, faster, more transparent, open to all participants, and available 24/7/365.

Like that of digital cash, this idea of smart contracts is not new. Smart contracts were introduced as a theoretical concept by crypto­currency pioneer Nick Szabo in 1997 but were made possible in practice only after the emer­gence of cryptoasset-powered blockchains.

The ability to program money with conditions and digital contracts is the third new capability we expect to lead to significant applications and economic impact.

In part two, we will discuss the crypto landscape for a better understanding. The following questions will be considered: why does more than one cryptoasset exist? Bitcoin vs. Ethereum, Bitcoin vs. XRP, Does the Existence of Thousands of Cryptoassets Damage the “Scarcity” of an Asset Such as Bitcoin?, Do You Need a Cryptoasset to Have a Blockchain?

If you would like to receive the source document that the above is based on or have any other crypto-related questions, please feel free to reach out to us.

Sources:

1. Cryptoassets: The guide to bitcoin, blockchain and cryptocurrency for professionals. CFA Institute Research Foundation.