The cryptocurrency phenomenon shows few signs of slowing down, though the dominance of Bitcoin seems to be waning somewhat. With a market share as high as 50%2 as recently as November 2017, Bitcoin remains the largest of the cryptocurrencies, but price changes and new entrants have reduced Bitcoin’s share to only about 43%2 in just the past few months.
As activity spreads and other similar cryptocurrencies garner attention, the currency-specific risks and the systemic risks seem to be growing. In this article, we’ll dive a little deeper into this evolving craze and highlight some of the risks (for a more basic understanding of Bitcoin and other cryptocurrencies, please read How Bitcoin: Does It Have a Place in Your Portfolio?).
A brief history of cryptocurrency
A cryptocurrency is a digital form of an alternative currency originally intended to make it easier for people to transact business online, without the need for a third-party intermediary like a bank.
While cryptocurrencies are a fairly new development, digital currencies have actually been around for many years. Loyalty programs, such as airline frequent-flyer miles, hotel points and credit card points are all forms of digital currency. Holdings in these programs are not in dollars, but rather in the specific company’s self-created currency. Most of these programs allow the “points” to be redeemed for value, such as flights, nights in a hotel and even jewelry, electronics, luggage and other products. These digital currencies have no physical form and are not backed by a central bank, government, gold or cash—only the company that issues them.
Alternative currencies in general are not a new idea; they actually go back way before the computer age. Even trading stamps such as Top Value and S&H Green Stamps, dating all the way back in the 1890s, are types of alternative currencies. Like today’s modern loyalty programs, individual stamps had very little value, but large numbers of them could be used to purchase merchandise directly from the issuer. Digital currencies differ in that they can be used by any business willing to accept them, not just the issuer. The list of companies willing to accept digital currencies is still very small, but growing.
Bitcoin, the first digital currency, launched at a price of less than $0.01 back in 2010, but it has since risen to a peak of just under $20,000 in mid-December 2017. At the time of this writing (mid-April 2018) the price of Bitcoin had fallen from its peak to about $6,900. Bitcoins are divisible to eight decimals (.00000001), as opposed to the U.S. dollar, which is only divisible to two decimal places (.01). As a result, the high price doesn’t necessarily inhibit its use as a currency, as it can be bought and sold in small fractions. Its volatility, however, does inhibit its use by many merchants.
Is Bitcoin really a currency?
Currencies in most stable, developed nations are backed by a government-controlled central bank or group of governments (such as the European Union), thus the valuations tend to vary only by a small fraction of a percent each day. Therefore, exchange rate risk for short-term transactions is inconsequential. Relative to the U.S. dollar, however, Bitcoin price fluctuations (volatility) have been averaging about 5% per day3 over the past few months, meaning if you bought a product using Bitcoin as your currency, the very next day you might find that you paid 5% more than you had to, or that you got a 5% discount. Volatility is a measure of movement, not direction, so you never know which way it might go.
This vast difference might lead you to wonder if Bitcoin is really a currency. The answer to this question is a matter of opinion. For a currency to be viable, it usually requires three specific characteristics:
- it can be used as a medium of exchange;
- it can be a unit of account;
- it can be a store of value.
As long as Bitcoin is subject to such high volatility, it will likely continue to have only limited use as an actual medium of exchange, a unit of account or a store of value, and that could also prevent broader public acceptance as a true currency.
Why is Bitcoin so volatile?
The original Bitcoin code was written so that only 21 million coins can ever be produced. Some people believe Bitcoin is the future of currency, so they have created high demand; others have described it as a scam, a fraud or a Ponzi scheme, and that has caused nervousness among holders. Large demand and anxiety combined with a relatively small supply is typically a recipe for high volatility. Additionally, the market is very fragmented, and since Bitcoin cannot be sold short1 like equities or a true currency such as the U.S. dollar, British pound or the euro, true price discovery is more difficult. Since Bitcoin’s price rose by more than 1,300% in 2017 (but has fallen by roughly 49% so far in 2018), speculation has also driven volatility.
Unlike traditional fiat currencies, Bitcoin is not backed by any central bank or government. Bitcoin is protected, promoted, and its network and technology overseen by a consortium of enthusiasts and early adopters that are members of the Bitcoin Foundation. This form of oversight is what excites some people about cryptocurrencies but concerns others, because no one really knows who’s in charge and whether they can be trusted. That is a valid concern, but a basic understanding of the computer code that makes Bitcoin work, may help alleviate at least some of this concern.
How do cryptocurrencies work?
Blockchain technology is the computer algorithm on which cryptocurrencies such as Bitcoin run. Bitcoin and blockchain were created in open-source C++ programming code in early 2009 by the programmer or group of programmers known as Satoshi Nakamoto, though the true identity of this person or group remains a mystery. Blockchain is an open-source distributed transaction database that operates on a decentralized computer network—in other words, comparable to the Internet. Anyone can access the ledger and view the transactions because they are verified and replicated in multiple locations. Blockchain provides accountability but the records are immutable, meaning they cannot be altered. This unalterable characteristic is quite revolutionary, and it is the key feature that makes blockchain potentially applicable to many different types of businesses. Cryptocurrencies like Bitcoin are not the only use, just the first use of blockchain technology. Marketing organizations, financial companies, securities exchanges, clearing organizations, software companies, shipping companies and retailers are all researching, using or exploring potential uses of blockchain technology.
By April 11, 2018, there were over 1,500 digital currencies in the marketplace, of which over 760 had a market capitalization exceeding $1 million. The 10 largest were: Bitcoin, Ethereum, Ripple, Bitcoin Cash, Cardano, Litecoin, NEM, Stellar, EOS and NEO, which all had total outstanding values exceeding $3 billion2. Many of the other cryptocurrencies have specific attributes or were designed for a specific purpose not offered through the use of Bitcoin. For example, Ethereum’s platform allows users to generate programmable “smart contracts” which execute only after certain conditions are met between two or more parties. The biggest difference between these and Bitcoin is that Bitcoin was the first cryptocurrency, the best known, the most widely held—and with about 43% of the total cryptocurrency market capitalization, it is currently by far considered the most valuable.
How are cryptocurrencies created?
One way to create a cryptocurrency is known as an initial coin offering (ICO). An ICO is similar to an initial public offering (IPO) of a corporation. With an IPO, a company can obtain working capital by offering its private shares for sale to the public on a stock exchange. IPO investors get shares of the company, but with an ICO the offering company sells non-equity interest called digital tokens, or “coins,” created through blockchain technology. Tokens are often paid for with some other existing cryptocurrency, and while tokens do not represent ownership in the company (as do shares of stock in an IPO), tokens can potentially be exchanged for the new cryptocurrency at a later date, and if its price has increased, a profit can be made.
ICOs are currently considered extremely risky because they are largely unregulated and there is very little protection from fraud, scams or theft. In December 2017, The Wall Street Journal reported that the Securities and Exchange Commission (SEC) had taken an enforcement action against a Canadian company, PlexCorps, for violating U.S. securities laws. The SEC said PlexCorps’ $15 million ICO was a scam. Obviously the risks of cryptocurrencies abound, which leads us to the next topic.
What are the main risks of cryptocurrencies?
While cryptocurrencies are designed to be theft-proof, fraud and cyber-crime have occurred. Because user credentials to access them are stored with the exchange that provides the online “wallet,” a user must trust that the wallet provider is safe. A corrupt provider or one without adequate cyber security could be vulnerable to cyber-theft. Here are several examples of recent thefts, all of which resulted in price drops in these and other cryptocurrencies:
- In June 2011, Japan-based Mt. Gox, then the largest Bitcoin exchange, was the subject of a security breach in which 850,000 Bitcoins worth approximately $450 million were stolen.
- In November 2017, a cryptocurrency called Tether reported a $31 million theft.
- In December 2017, the Slovenian cryptocurrency exchange NiceHash was hacked for a loss of $64 million.
- In December 2017, after its second hack in less than a year, South Korean Bitcoin exchange Youbit filed for bankruptcy after announcing that it had lost more than 17% of its cryptocurrency assets.
There are also systemic risks related to government intervention. In September 2017, the Chinese government shut down some cryptocurrency exchanges, and in January 2018 it was also threatening to halt some Bitcoin mining operations—a significant concern given that China is the largest Bitcoin miner in the world. In February 2018 India’s finance minister said he would ban Bitcoin use altogether.
In late 2017, the South Korean government banned all ICOs. In January 2018, the South Korean government said it was preparing a bill to ban the trading of cryptocurrencies on exchanges, stepping up its efforts to curb speculation. The remarks came just days after the country’s financial regulator started inspecting some of South Korea’s largest financial institutions that trade digital currencies. Bitcoin prices tumbled more than 13% and Ethereum prices dropped 15% that day, before recovering part of those losses later in the day.
European Union regulators announced that they have already begun to restrict some cryptocurrency activity in an effort to fight terrorist financing. While Japan, with 50%4 of the cryptocurrency trading volume, is the most active global market for Bitcoin trading, as much as 20%4 of all cryptocurrency trading is done in South Korea, so these types of government actions could present a global systemic risk to all cryptocurrencies.
The SEC published an opinion in July 2017 saying they believe ICOs “might” be securities issuances. This opinion would not affect existing currencies, nor does it suggest that all ICOs are illegal or that all virtual currencies should be regulated as securities. The SEC said it would continue to assess the “facts and circumstances” of future ICOs. Future ICOs could come under scrutiny by the Financial Crimes Enforcement Network (FinCEN), which brought an enforcement action against Ripple Labs in 2015 for noncompliance with the Bank Secrecy Act and anti-money laundering requirements. Then in March 2018, the SEC said that online platforms trading cryptocurrencies must be registered with the agency, and a federal judge ruled that virtual currencies are commodities and should be regulated by the CFTC.
There are many other risks. Login IDs and passwords required to access cryptocurrency exchanges could be forgotten, lost or stolen. Bitcoin exchanges and even the Internet could be subject to computer outages caused by excessive demand. Bitcoins can be stored on computer hard drives and in physical paper wallets, but that creates many of the same risks as with all cash currencies: they could be lost, stolen or destroyed. Bitcoin has been associated with the black market, the dark web, money laundering, and it has been used for illicit and illegal activity.
Given all the risks associated with cryptocurrencies, you might think some sort of exchange-traded product could be launched with SEC oversight, but as of April 2018, the SEC has rejected dozens of Bitcoin ETF filings and cryptocurrency mutual funds. The SEC has repeatedly voiced concerns about the safety of trading ETFs that are linked to potentially illiquid assets such as cryptocurrencies, and whether these funds could even be priced accurately given the level of market fragmentation.
Futures markets are regulated by the Commodity Futures Trading Commission (CFTC) rather than the SEC. While both the Chicago Mercantile Exchange (CME) and the Cboe Futures Exchange (CFE) began to list futures contracts on Bitcoin in December 2017, trading volumes have been relatively light. All of this might lead you to wonder why anyone would be interested in buying cryptocurrencies.
What are some of the benefits of cryptocurrencies?
In calendar year 2017, Bitcoin’s price rose more than 1,200%, Ethereum’s price rose more than 8,900%, Litecoin’s price rose more than 5,500% and Ripple’s price rose more than 36,000%. While not all cryptocurrencies rose in 2017, and many could easily drop to a price of zero, speculators are often drawn to the prospect of easy money, even when the risk is excessive.
Many supporters of cryptocurrencies believe they could eventually decouple currencies and monetary value from governmental control, though others may also view this as a disadvantage. A single global currency could make global travel and commerce simpler, because if a single cryptocurrency were adopted by multiple countries, there would be no need for currency exchange, thus eliminating the risks of exchange rate fluctuations. Some cryptocurrency backers believe a single currency could also reduce or eliminate the risk of extreme currency inflation or deflation caused by corrupt governments, war, fraudulent banks or economic depression within a single country. However, for this to happen at least one country would likely need to give up control and lead the way by adopting a cryptocurrency as its primary currency, and then others would have to follow suit, a rather far-fetched idea at this juncture.
You can obtain real-time Bitcoin futures quotes from the CFE and the CME on Schwab trading platforms.
For CFE quotes: XBT+Expiration Month+Year
XBTG18 = CFE Bitcoin Futures contract that expires in February 2018
- For CME quotes: BTC+Expiration Month+Year
BTCH18 = CME Bitcoin Futures contract that expires in March 2018
Futures expiration month codes:
You can also get a quote on Bitcoin itself under the ticker symbol $GXBT (the reference price used for CFE futures contracts).
Beginning Friday April 6, 2018, clients with a Charles Schwab Futures account will be able to trade the CBOE Bitcoin Futures product (XBT) on StreetSmart Central or StreetSmart Mobile. Schwab does not currently offer trading on CME Bitcoin futures product (BTC), but may choose to offer it at a future date.
1Selling short is the sale of a borrowed security, based on a belief that the security's price will decline and can be re-purchased at a lower price, at a later time, to generate a profit.
2 Source: Coinmarketcap.com
3 Calculated using daily price data from Coindesk.com for the period of 11/1/17 through 1/18/18.
4 Source: FT.com