Are cryptocurrencies the future of international financial transactions? Can they be traded? Will the supermarket shopper use a digital currency to buy their groceries any time soon?
To answer those questions, it’s necessary to look at exactly what a cryptocurrency is.
Everyone is familiar with the concept of hard currency such as the dollar or the pound, which is issued by a central government. A digital currency such as bitcoin – the first, biggest and best known example – is ‘run’ by an opensource, peer-to-peer network.
All cryptocurrencies make use of what is called distributed ledge technology, or ‘blockchain’ – a database in the cloud that is continuously updated and certified. Each new transaction creates a new block of data that is permanently locked and cannot be tampered with.
The word ‘cryptocurrency’ is derived from the complex cryptographic algorithms used to make transactions secure and completely anonymous. Unfortunately, that anonymity also makes it an ideal target for crime syndicates looking to launder their ill-gotten gains – one of its major detractions.
With bitcoin, the currency is generated by ‘miners’ using special software, who compete with each other to solve complex mathematical problems, for which they are paid with new bitcoins.
Anyone can set themselves up as a miner, from an individual using spare capacity on their home PC to companies with banks of servers doing nothing but mining.
Mining new bitcoins
Mining is the only way of generating new bitcoins, and is also designed to verify all bitcoin transactions. The work and reward involved give the currency an intrinsic financial value, while at the same time keeping the process secure and transparent.
The system is not without its flaws, however – not least that the huge amount of processing power required by miners consumes a huge amount of electricity to power and cool the specialised computers used by the big mining pools.
One alternative put forward by Elaine Shi, co-director of the Initiative for Cryptocurrency and Contracts (IC3), is that rather than generating a random number, the computing power is used to do something socially useful, such as gene sequencing.
Bitcoin has increased dramatically in value. One Norwegian man bought 5,000 bitcoins in 2009 for just 150 kroner (£14) while writing a thesis on encryption. He then forgot about them until 2013, when having checked his bitcoin wallet, he discovered they were worth £468,000.
Bitcoin reached a peak value that year of $266. They then crashed to a low of $50 after the FBI seized 26,000 bitcoins held by a drug-dealer who was operating an eBay-style drug delivery service, taking advantage of bitcoin’s anonymity.
Bitcoin more than doubled in value over the 12 months from April 2016, rising from $417 to $1,026 in April 2017.
Cryptocurrencies are particularly suitable for international financial transactions that would normally be carried out using hard currencies such as the dollar. Already merchant banks such as JP Morgan Chase are rumoured to be investigating their use.
There are currently more than 700 different cryptocurrencies in existence, though only a handful had a market capitalisation in excess of $10m as of early 2017. The league table of market capitalisation looks like this:
- Bitcoin ($17bn)
- Ethereum ($4.6bn)
- Ripple ($663m)
- Dash $550m)
- Litecoin ($326m)
In terms of size, Ethereum is the main contender to bitcoin, which has some technical question marks over its ability to cope with an increasing number of transactions.
Ripple is ‘pre-mined’, meaning it doesn’t have to be earned, and is positioning itself an alternative payment system for financial transactions, rather than a currency.
Litecoin, launched by Charles Lee, director of digital asset exchange Coinbase, is a proven, maths-based cryptocurrency seen by some as a dark horse to take the overspill if bitcoin gets to a technically unmanageable size.
Cryptocurrencies such as bitcoin and Ethereum are also being traded on the financial markets.
Attempts are being made to launch the world’s first Bitcoin exchange-traded fund (ETF). This will be a holding where you can buy and sell shares in a fund that owns a type of investment (such as property), without having to buy the underlying investment itself.
The bitcoin ETF is being proposed by the Winklevoss twins, who famously took out a law suit against Mark Zuckerberg, claiming they had originated the Facebook concept.
The ETF would hold bitcoins as a long-term investment, and investors would benefit from any increase in value. However, US regulator the Securities and Exchange Commission (SEC) turned down the initial application to launch the ETF in March 2017.
Bitcoin is also starting to be used for everyday transactions, rather than just cash transfers. Already major US retailers such as Amazon, eBay, PayPal, Apple, Dell, Kmart and Home Depot are accepting transactions in bitcoins.
However, many retailers are immediately converting bitcoins into dollars using a middleman to avoid some of the currency’s historically wild fluctuations.
One thing is for sure – in a digital age and an increasingly cashless society, cryptocurrencies look set to have a growing influence on every aspect of our lives.