Advertorial: Will you be giving your kids cryptocurrencies for pocket money?

First introduced in 2009, bitcoin has had a turbulent history that shows little sign of settling down. In spite of the drama that surrounds it, the cryptocurrency remains a topic for serious discussion. Graham Hawkins, XL Catlin’s head of fine art and specie, describes the unique characteristics of this “borderless currency”, and considers its viability for mainstream use.

Aristotle was the first to elaborate on the concept of money as a medium of exchange and an instrument for storing value. He also noted that whatever form it takes, money is most useful when it is:

  • Durable; it doesn’t fade, corrode or change over time
  • Portable; it carries a high amount of value relative to its size and weight
  • Divisible; it can be separated or combined without changing its fundamental characteristics
  • Intrinsically valuable; its value is independent of other objects and contained in the money

Gold has historically been a preferred choice as it comes close to meeting all of these criteria; its one shortcoming is its portability. Today’s fiat currencies can also possess these characteristics, although their intrinsic value depends on the credibility and strength of the issuing authority.

A new currency emerges

Bitcoin and other cryptocurrencies also have the potential to satisfy Aristotle’s conditions. As a digital currency, bitcoin is not susceptible to physical damage; it can be moved or transferred easily and securely; each coin can be readily divided into sub-units; and the characteristics of its digital architecture make it intrinsically valuable.

Bitcoin emerged in 2009. Its origins were mysterious and its purpose was not readily apparent. Eight years later, however, cryptocurrencies including bitcoin are worth almost $16bn. Bitcoin still dominates, with about 85% of the value of the entire cryptocurrency market.

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Bitcoins are based on “blocks” that have to be “mined” using extremely time-consuming computational processes. A miner who succeeds in finding a new block is issued newly created bitcoins and transaction fees.

The protocol also specifies that the degree of difficulty in finding new blocks is automatically adjusted to reflect the total amount of mining power in the network. That means uncovering a new block becomes progressively more difficult as the network grows.

At the same time, the bitcoin rewards from new blocks is being halved every 210,000 blocks mined. The value of new blocks will eventually reach close to zero, and no new bitcoins will be created. The protocol sets the ultimate theoretical maximum at just under 21 million bitcoins; that limit should be achieved around 2140.

These features – increasing difficulty, decreasing value, fixed upper limit – in effect represent a monetary policy based on artificial scarcity. That scarcity serves as the source for bitcoin’s value, even though they don’t exist in physical form. (Click here to read more about how ‘cold’ and ‘hot’ wallets are used to store bitcoins, plus how both can be vulnerable to theft.)

Money: it’s a hit

In addition to its murky origins, bitcoin’s short history has been turbulent. Its value has fluctuated wildly, and it has also attracted interest from criminal and terrorist organisations, both as an underground medium of exchange and as the target for several massive thefts.

Bitcoin can be transferred securely and anonymously. So drug dealers, for example, have used it to sell drugs on the dark web, and victims of ransomware attacks often have to pay in bitcoin for their data to be unencrypted. ISIS also reportedly relies on bitcoin to receive funds from anonymous donors. (Click here to read about how bitcoin has helped propel a worldwide surge in ransomware attacks.)

Compared to established currencies and other commodities, bitcoin’s value has been volatile. After declining precipitously in 2015, its value more than doubled in 2016. In fact, bitcoin was the worst-performing currency in 2015 and the best performer in 2016.

Also, large quantities of bitcoin have gone missing from some of the exchanges that have sprung up. Most notably, $460m-worth of bitcoin vanished in 2014 from the world’s then largest bitcoin exchange, preceding the collapse of the organisation. Mismanagement has been another challenge for new bitcoin exchanges, as cryptocurrency enthusiasts and programming experts are suddenly thrust into the role of managing large, complex financial organisations.

Definitely maybe

These controversies and setbacks notwithstanding, the infrastructures needed to establish and sustain digital currencies, including bitcoin, are slowly being built. Moreover, they are starting to establish footholds in diverse corners of the global economy.

Although few brick-and-mortar establishments currently take bitcoin for retail transactions, there is greater acceptance from online merchants. However, bitcoin could become more widespread in the consumer world as mobile payment platforms become more prevalent and widely used.

What seems more likely is that bitcoin could become a preferred medium of exchange in international commerce. As a “currency without borders” that relies on strong encryption algorithms and a distributed ledger – the blockchain – bitcoin is potentially appealing to companies dealing with customers, suppliers or business partners in multiple countries.

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Since intermediaries are not needed to process or verify an exchange, transactions using bitcoin can be conducted securely, efficiently and anonymously. Moreover, the blockchain architecture creates the possibility for smart contracts that execute automatically once certain conditions are met. And, so far anyway, blockchains have not been breached. (Click here to read more about blockchain and how it could upend business processes in many industries.)

A few barriers will have to be overcome, however, before bitcoin is used extensively in international commerce. Perhaps most importantly, its volatility will have to lessen considerably; few CFOs or treasurers will want to carry an asset on their balance sheets that fluctuates as wildly as bitcoin has recently. Also, companies will need to develop or buy new IT capabilities to incorporate blockchains into their business processes.

Investors seem to believe that the barriers will be overcome and that bitcoin – or perhaps another cryptocurrency – will become more commonplace in coming years; estimates vary, however, about the speed this will occur.

In the meantime, venture capital investments in cryptocurrency and blockchain startups continue to grow. Numerous exchanges have been created for storing and trading bitcoins and other cryptocurrencies. Coinbase, for example, has more than five million users who have traded more than $5bn in digital currencies. itBit is another; it is a regulated financial services company based in New York “built for financial institutions and active traders”.

Slushie fund

Experts are divided about bitcoin’s viability for mainstream use. For most, ‘who knows?’ is the most common view currently. Yet despite the many obstacles that fuel this uncertainty, bitcoin keeps springing back to life. In fact, it has been declared dead so many times now that some observers liken bitcoin to a zombie – both for its ability to endure and also because it continues to proliferate.

Interest has grown to the point where cryptocurrencies are undergoing increased scrutiny from regulatory agencies and some of the world’s biggest financial organisations. The New York State Department of Financial Services, for example, introduced ‘BitLicense’ in 2015 – essentially a framework within which cryptocurrency users should be operating. A former head of the US Federal Deposit Insurance Corporation, Sheila Bair, along with former senator Bill Bradley, are both board members of the aforementioned itBit exchange, and companies like JP Morgan have adopted bitcoin-style payment systems into their operational practises.

Considering what bitcoin has endured already, it seems a question of how, not if, it will be adopted into the financial mainstream in the future. Whether as a vehicle for investment, commercial exchange or even as a weekly candy fund for your kids, cryptocurrency in some shape or form is likely here to stay.

By Graham Hawkins, global chief underwriting officer – fine art and specie, XL Catlin