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The rise of bitcoin

Bitcoin has been making waves in the world of alternative finance, and its underlying blockchain technology could have uses across financial services and beyond
June 23, 2017

One bitcoin is now worth more than twice as much as an ounce of gold. At $2,981.51 (£2,351.82), the digital currency has far outstripped the current $1,271.19 asking price for an ounce of the precious metal. While gold may be one of the most familiar alternative assets to an everyday investor, bitcoin is likely to be new territory. But those who purchase gold as a way to store value outside of a mainstream bank could also find bitcoin of interest.

The emergence of bitcoin has given rise to a number of other online coins, commonly referred to as 'cryptocurrencies', where encryption is used to regulate the number of units of the currency that can be created and to verify transactions. The underlying technology supporting bitcoin, the blockchain, is also being made use of in a number of industries, from asset management to property registration.

The idea for bitcoin was first aired around 2009 in a white paper detailing the proof of concept written under the pseudonym Satoshi Nakamoto, whose real identity or identities have never been revealed. This anonymity of the founder may seem like a red flag for would-be investors, but the protocol and software underlying bitcoin are published openly, allowing any developer to review the code. Just as no one owns the technology behind email, the bitcoin network has no owner or overall controller.

Since launch in 2009 the price of a bitcoin has varied dramatically. It hit a peak of around $1,120 in 2013, before fluctuating between $230 and $500 until 2016. But the cryptocurrency has been on a tear over the past year, reaching an all-time high of $3,018.55 earlier this month. Some may worry that this bears the warning signs of a bubble, but so long as users continue to demand bitcoins and a growing number of vendors accept them as payment, then the value found in bitcoin could be here to stay.

 

What is bitcoin?

In the white paper bitcoin is first described as "a purely peer-to-peer version of electronic cash" that would "allow online payments to be sent directly from one party to another without going through a financial institution". This description underscores one of the key ideas behind the digital currency - that it bypasses traditional banking systems. Financial institutions such as banks traditionally act to prevent the double spending of currency, but bitcoin's founder accused this trust-based model of being an inherent weakness in the system as completely non-reversible transactions are not really possible. Having a middle man also increases the costs involved, making smaller transactions less practical. The ability to reverse transactions made through traditional banking facilities further increases the need for a third-party to oversee the system. Financial institutions also tend to demand more information from their customers in the trust-based model to verify identities. Since bitcoin was launched in the wake of the financial crisis, it also capitalised on the widespread distrust of banks.

Unlike traditional finance, bitcoin has no central monetary authority. Instead, it replaces banks with a peer-to-peer network made up of users' computers, which timestamps transactions by hashing them into an ongoing chain of work. This forms a chain of transaction history of every bitcoin that cannot be altered without re-doing the network, called the blockchain. The electronic payment system is based on cryptographic proof rather than trust, and allows two parties to send bitcoins directly between each other without the need for a third-party to intervene.

From the perspective of users of the cryptocurrency, it functions similarly to an app on a smartphone. An individual has a bitcoin wallet that contains a unique code rather than a username or personal information, allowing them to send and receive bitcoins to and from other users. The cryptocurrency can be purchased on a bitcoin exchange online or can be created by a network of computers with advanced hashing power that 'mine' the coins by solving increasingly difficult equations. Every time users buy or sell bitcoins or when coins are created through the mining process, a record of that transaction is made and added to the ongoing record of previous transactions. This ongoing chronological record forms the blockchain and is broadcast across the entire bitcoin network, preventing someone from spending the same bitcoin twice. This public ledger can be viewed by all bitcoin users, although individual users cannot be identified easily as it is the account number that appears, not the user's name. Bitcoin itself is not a physical object, and so owning one is to have claim to a piece of information listed on the blockchain distributed ledger.

For those who think that nearly $3,000 for a digital currency looks expensive, it is also possible to buy portions of bitcoin. These smaller units are dubbed 'satoshis', named after bitcoin's illusive founder, and are to a bitcoin what pence is to the pound sterling. Users can trade satoshis down to the one hundred millionth of a bitcoin.

 

 

Why buy bitcoin?

Bitcoin has positioned itself as a currency without fuss. No banks or fees are involved and users can reside anywhere in the world. Just like any other currency or commodity, the price of bitcoin is led by supply and demand. But unlike government-backed fiat currencies such as the dollar or sterling, there is a limit to how many bitcoins can exist. No more than 21m coins can ever be created, but the market is not likely to hit this limit for many years to come. Just over 16m have been mined so far, but those worrying that this looks close to the cap should remember that mining becomes progressively more difficult over time. There will never be an option to have the cryptocurrency version of quantitative easing and simply create more bitcoins, but since they can be broken down to the one hundred millionth through satoshis, it is unlikely that they should become untradeable at any point.

The clear market cap adds value to the coins. When the number of coins nears the 21m cap the price per bitcoin could see another spike. Bitcoin also shares common characteristics with money, including scarcity and divisibility. But rather than having a physical aspect such as gold and silver or trust in a central authority as traditional fiat currencies do, bitcoin is backed by the mathematics that must be solved in order to create a coin. Since there is a limited number of bitcoins in circulation and new coins are created at a fairly predictable rate, demand must follow this level of inflation in order to keep the price of bitcoin steady. But bitcoin remains a relatively small market for the time being, and so it does not take much to swing the price quite drastically in either direction, making it still very volatile. The value should stabilise in time with scale as more individuals use the cryptocurrency and more businesses accept it as payment. The more people who adopt bitcoin and the more vendors who choose to accept it as payment, the more value will be added over time.

Acceptance is already well under way. A number of online retailers have picked up on the potential for bitcoin as a currency. For example, Microsoft allows games and movies to be purchased on Xbox and Windows with bitcoin. Those looking to share their thoughts with the world can set up a blog on WordPress.com. Bargain hunters can purchase their finds at online retailer Overstock.com. Not only can you discuss bitcoin on Reddit, but you can also use the cryptocurrency to buy premium features on the website. The Pizza for Coins website takes payment in bitcoin and then orders are funnelled through to well-known names including Domino's, Papa John's and Pizza Hut. Those looking for love can set up an account with dating website OkCupid. US bitcoin holders can head to MovieTickets.com to buy tickets for a film. And those in a generous mood can make donations to Save the Children or Wikipedia's parent company Wikimedia.

In order to accept bitcoin, online retailers need to join forces with a payment processor that has the means to complete the transaction. Travel website Expedia partnered with Coinbase in 2014 to allow bitcoin as a payment method. Customers wishing to use the cryptocurrency are re-directed to the Coinbase website where the total cost of the holiday will appear in bitcoin based on the exchange rate set by Coinbase. In order to address the volatility of the price of bitcoin, users will have 10 minutes to complete the booking, after which time the price will be updated again. In order to claim a refund the customer's bitcoin wallet must be held with Coinbase, rather than other competitor websites. Returned bitcoins will be based on the exchange rate at the time of the refund.

Bitcoin payments are not confined only to purchases made online. Each bitcoin wallet will generate a unique QP code that can be scanned for in-person payments or transfers. According to Coinmap, around 9,213 venues worldwide now accept bitcoin as payment. Users can also head to one of the more than 1,200 bitcoin ATMs, which exchange bitcoins for cash or vice versa, scattered across 55 countries, most of which are in Europe or North America.

It is also possible to trade bitcoin on some well-established platforms. Earlier this month, IG Group reported that it had noticed a significant increase in the popularity of trading bitcoin on its platform, making it one of the most popular markets on the system. Through IG, traders can take out long or short positions on bitcoin through a range of currencies without actually having to own the cryptocurrency, which reduces concerns about the coin's security. Hargreaves Lansdown, Britain's largest online trading platform, allows users to invest in bitcoin through a fund offered by Swedish company XBT Provider structured as an exchange-traded note that tracks the price of the digital currency.

 

Risky business

The sudden increase in price has many rightly wondering whether bitcoin has become a bubble that could be ready to burst. Rapid rises, like the one seen earlier this month, tend not to be sustainable over the long term, leading investors to wonder if bitcoin is purely speculation, as the rising price encourages more buyers to pile in. But bitcoin can be used to buy goods and services, and proponents of the coin would like to see it one day pose as a serious rival to traditional currencies.

Some bitcoin exchanges have encountered technical errors, making users nervous that it could be difficult to get their money out should problems arise. Earlier this year, Bitfinex, ambition exchange, had problems exchanging bitcoin for traditional currencies, forcing users to buy bitcoin and exchange them elsewhere in order to retrieve their tied-up funds. The exchange was again hit this month by cyber attacks that denied service to its users, as was smaller platform BTC-e. Others have had trouble keeping up with the recent surge in investor demand, leading some to question the scalability of the currency.

The anonymity of bitcoin has also raised questions about whether it could be a tool for criminal activity. Bitcoin was a currency of choice on the now shut down Silk Road, a website notorious for selling illegal goods. But unlike cash, bitcoin transactions can never be truly invisible because all trades are broadcast on the blockchain, although the identities of those involved are not known. Counter-intuitively, in some cases bitcoin could actually help to deter crime. Developers claim that it is impossible to counterfeit, and that users are in complete control of their payments and cannot receive unapproved charges.

 

What about other cryptocurrencies?

Once investors start to take bitcoin seriously, they may start to look at what other coins are available. With a current market cap of $42.5bn, bitcoin is by far the largest cryptocurrency on the market, but not the only one. After bitcoin launched eight years ago a number of others sprang up to compete. Website Coin Market Cap shows that there are 877 coins in existence with a total market cap of close to $110bn. By market cap, bitcoin's two largest competitors are Ethereum and Ripple.

With a market cap of nearly $30bn, Ether is bitcoin's closest rival. It's targeted at those using Ethereum, a platform on which developers can build tailor-made blockchains. Ether is meant to act as an incentive for developers to write quality applications and maintain the network, as sloppy work tends to be an expensive waste of time. It also acts as a means for users to interact with the smart contracts that have been developed on the Ethereum blockchain.

Unlike other cryptocurrencies that work to eliminate the need for a bank, Ripple is working with banks to create an easier and more efficient was to send money around the world, allowing real-time payments across networks. Banks can save back-office costs by using Ripple to process and settle international payments. Although its nearly $10bn market cap trails that of bitcoin and Ether, it has already partnered with 15 banks across nine countries, including Standard Chartered, UniCredit and ATB Financial.

 

 

Behind the scenes: The blockchain

Below the surface of the bitcoin technology lies the blockchain. Bitcoin is just one function of what the blockchain is capable of doing, and while bitcoin may be its most well-known application so far, the blockchain has the potential to be used for so much more. As the name would suggest, each entry into the system forms a block that contains a record of the action or transaction. Each new entry then becomes part of an ongoing, chronologically ordered and continuously updated digital chain that can show what happened and when, without exposing confidential details about those involved.

This distributed ledger allows people who may not know each other to create a record of who owns what, or for businesses to easily keep track of clients and policies without the need for a middleman or third-party. Under the bitcoin protocol, all members can see every bitcoin transaction on the blockchain, and so depending on the nature of the transaction some permissions may be introduced by the company that looks after the blockchain to maintain security.

 

Blockchain in action

According to a report from consultancy PwC, over $1bn has been invested in blockchain companies since the technology's creation in 2009, with a 59 per cent increase last year. Job adverts on LinkedIn related to blockchain have trebled to more than 1,000 positions over the past year as companies look to hire employees well versed in the cryptography. According to the professional social media network, nearly 10,000 users list blockchain as a skill. Around half of those who count blockchain as a skill work in technology and are mainly in the US, while around a quarter are in the financial services industry.

Blockchain has started to make headway in finance as a way to cut costs and reduce transaction times. It could also help to ease the burden of regulatory requirements by allowing the regulator to have access to the blockchain to see all transactions in real time, thereby eliminating the need for traditional regulatory reporting. In its 2016-17 business plan, the Financial Conduct Authority (FCA) acknowledged the potential uses of blockchain in financial services, calling it an "alternative approach to safe storage of information", such as custody, execution, and clearing and settlement, that can provide secure, transparent and immediate confirmation of information and can be distributed without the need for a central record-keeping authority. While the regulator did note that this alternative approach could have its upsides, it added that challenges related to data privacy, defect corrections and trust could arise.

The Bank of England reported last month that it was testing an artificial intelligence system with Canadian start-up MindBridge AI in an effort to spot abnormalities in transactions and keep track of data input. It is also working with Ripple to trial cross-border payments made on blockchain to improve settlement risk and improve the efficiency of international payments.

Last year Santander became the first UK bank to start using the blockchain for recording international payments and may soon start rolling out the service to customers. Dutch bank ABN Amro stated that it has started reassessing all parts of its business, from mortgages to cross-border payments, and investigating how these can be improved through the use of blockchain. It asserts that the impact of blockchain could be as great as that brought by the internet.

Banks have started to test ways of using blockchain to make trading more efficient. Cliff Evans, head of digital banking at Capgemini, said that trade finance is an ideal candidate for blockchain because it is highly distributed, so use of the technology would give better visibility of what's going on between participants. While it is a highly networked model it is not often high in transaction processes, and so it could be an area where the scalability may not be an issue for blockchain.

Earlier this year, French bank BNP Paribas joined forces with fund house Axa Investment Managers on a blockchain project that would simplify fund distribution through the use of smart technology, where computers would control the transfer of assets. In the US, Northern Trust has developed a blockchain to improve record keeping for private equity funds, which is currently being used by Swiss asset manager Unigestion.

Technology company Calstone announced earlier this month that it has successfully completed phase one of testing blockchain as a way to buy and sell mutual funds, making it the largest-scale test of blockchain in the fund management industry to date. The company stated that the blockchain had been able to process a day's worth of transactions and trades from across its client base, which includes 12,000 trading links with more than 1,200 fund distribution and management clients over 34 countries. Phase two of Calstone's blockchain testing is already under way, which will include a range of clients across the distribution chain, such as banks and administrators, in order to work out what challenges might arise and come up with solutions. The activity aims to cut the costs of fund ownership for the end investor, as well as reduce the chance of errors by making the market infrastructure more resilient, making the blockchain a one-stop shop for trading and settling investment funds.

French fund house Natixis Asset Management has also been trialling the technology for fund distribution in conjunction with KPMG Luxembourg. Testing is due to finish later this month and the asset manager hopes to have its blockchain up and running by the end of the second quarter next year. A developer on the project suggested that by cutting costs it could offer cheaper products to clients, and perhaps enable a direct to consumer distribution option.

US stock market data has also made its way onto blockchain. Nasdaq has started to use blockchain to conduct share trades, claiming it reduces the risk of fraud. Last year blockchain-based data manager Factom partnered with Intrinio, a provider of financial data and apps, to publish pricing information for more than 3,000 US-listed stocks onto its blockchain. The aim is to allow the data streams to be used by developers to enable smart contracts and audits, which it claims could allow a whole new generation of financial technology applications to be developed.

Beyond acting as a means for executing transactions, blockchain can also act to verify truth. Some proponents have speculated that blockchain could act as a property register or a method of voting. Capgemini's Mr Evans said that some companies have started to explore blockchain for identity checks, such as completing KYC customer checks at banks, or for loyalty programmes between merchants and consumers.

 

Road blocks

Critics of blockchain argue that it could be difficult to bring the technology to a sufficient scale to be usable for a wider audience. While blockchain has proved itself for bitcoin, it's still in the relatively early stages for most other anticipated applications. Those companies currently testing applications will have to demonstrate to their peers that blockchain is a workable and worthwhile solution before there is industry-wide adoption.

Olivia Vinden, principal at Alpha FMC consultancy, said that widespread adoption could be one of the biggest challenges facing industry-wide acceptance. One of the benefits of blockchain is that it is distributed, so the more members you have the more secure it becomes. This makes it difficult for individual companies to be trailblazers in the technology, and so adoption is likely to be gradual as more and more companies sign up. Mr Evans also pointed to this challenge, as in this system you have to get a group of banks and suppliers to agree to operate on a common model.

But if done properly, blockchain has the potential to speed up transactions, allow for international transfers, cut costs, ease regulatory burdens, mediate disputes and improve transparency across a number of industries.