Friday, December 8

Understanding Cryptocurrencies and Block Chain technology.

Jamie Diamond caused a stir in September when he claimed bitcoin as a fraud although he did commend the block chain technology which facilitates not only the use of Cryptocurrencies such as Bitcoin, but has many other applications. 

Block chain is regarded by many as a brilliant technology which will revolutionise the way business is conducted.

Someone asked me yesterday at a luncheon celebrated with former workmates how to explain it and although I am no expert here is how I would attempt a simple explanation.
Maybe the first thing you need to understand is how the age old universally accepted Double Entry Accounting concepts work. In a nutshell the principle of double entry recognises the reality there is always two sides to every transaction, so there is always a seller and a buyer, a receipt to add to one account and a corresponding reduction in another’s indebtedness and so on. 
Now replace that double entry principle with double entry block chain accounting.  That’s because block chain accounting at the outset facilitates transactions between two pairs, a buyer and a seller or a receipt and payment or one virtual wallet increasing whilst another deceases. It happens virtually instantaneously because those in the encrypted chain using cryptocurrencies to record the transactional effects at the same time. Think of it as giant ledger in cyber space where all the debits equal to the credits of the linked parties from the aggregate of parties’ transactions at any given time in the block chain.
The final seal of approval has led some to try and distinguish the process from double entry accounting by call this the third entry. 
Parties hold the Cryptocurrencies in so called wallets and the largest of these is Bitcoin.
Hence, there is no need for 3rd party clearing houses or back office staff to facilitate large numbers of bundled same type transactions for subsequent settlements which mostly occurs to day.  

What is mining Bitcoin ? Mining can be carried out by anyone who has invested in a very powerful fast computer, has the capacity to pay for the large energy bills and has a penchant or talent to solve puzzles. The system was predicated on the basis of each batch of transactional  data is encrypted by a formula that can only be unlocked after a  massive scale of trial and error guesses. As the first miners solve the puzzle, the answer is verified by others, so that the data is added to an existing linked chain of blocks of data. The miner in return  receives newly issued Bitcoin. One of the criticisms of the system is it uses up a lot of electricity.    

I think financial institutions will eventually begin to use more of the Block chain technology which will mean the adoption of either a digital cryptocurrency or a similar substituted means to do that. After all cryptocurrencies are no more than bits of code. But eventually such facilities will have to have some form of regulation for what it is as an alternative more efficient system of settling business transactions. But even given eventual regulation not everyone is going to be happy trusting in the integrity of a new technology and we all will have to have a new breed of technologically savvy auditors to check the integrity of the Block chain providers. 
In relation to Bitcoin there are currently several Hedge Funds which have bought large holdings which of course have gone up exponentially due to the rapid rise in this Cryptocurrency. Such rises are underpinned by pure speculation as no one can put a value on this Cryptocurrency which is responding to a rapid demand when there is currently only a limited supply.

But Cryptocurrencies are no different to traditional currencies which appreciate or depreciate according to supply and demand.   But the important distinction of course is currently they are unregulated by any central banks and have attracted criminal activity as it is much harder to ascertain transactional records.

The question of trading in Bit Coin is facilitated by on line platforms such as Coinbase which provides a market. The facility allows for buying, selling or transfer of digital currency between online wallets involving merchants or individuals. Currently the facility is free of charges and such facilitators claim they provide both security and backups.
Nevertheless there has already been some bogus websites where the holdings of digital currencies have vaporised without trace.  Since the arrival of Cryptocurrencies more than one billion has been stolen from wallets. 

On the question of Bitcoin being a bubble set to burst that in turn depends more on whether or not merchants will continue to accept them. Microsoft and Pay Pal already accept Bitcoin under their platforms.

The total size of the traditional market dwarfs that of the Cryptocurrencies suggesting it may well have further to run. But when it finally crashes don’t rule out another version rising from the ashes.  


Rachael Byrnes said...

That's interesting about the double entry accounting in relation to block chain. The creator of bitcoin was certainly a genius engineer in many ways. Whether or not he/she's intentions were for good is hard to say. There are different theories about why it was created and why people believe in it as an unregulated system. Doesn't mean they're right.. but there are different ideas. It will be interesting to see how it all unfolds from here. The banking system will replicate aspects of the technology to enhance their own operations. Cryptos might keep evolving, bit coin might fade with an alternative that uses less computer energy/ power supply and a different code base perhaps.

Lindsay Byrnes said...

Hi Rachael
You might be interested to know in the US there are currently only 4 manufacturers of cars (apart from just a few specialising in electric cars or modifications) whereas the fledgling auto industry initially grew from its invention to generate 1500 manufacturers.
All of those either went broke or were unable to compete so we have only 4 left to day.
The first inventions in this new technology will similarly result in a number of players and a lot of them will fall away over time. But the invention is here to stay.
Best wishes

susan said...

Sorry not to have responded to this post earlier, Lindsay, but no matter how much I've read about bitcoins and the other blockchain currencies I simply can't get past the fact that they possess no intrinsic value. I do understand the value of blockchain computing for ledger keeping purposes, but unlike hard commodities - copper, say, or even gold - bitcoins have no utility value. And unlike securities such as bonds or stocks, bitcoins do not carry the promise of a future cash flow that allows investors to put a hard figure on their value today. I see them more as play money or tulips than legal tender. When huge virtual fortunes can be lost with the destruction (or loss) of a hard drive or the death of the wallet holder I personally can't see the value in holding them - unless, of course, I had a few of the early ones tucked away which I would have sold last week. :)
All the best

Lindsay Byrnes said...

Hi Susan,
Thanks for your interest and certainly I agree with you I would not compare Bitcoin to other securities where you can easily ascertain a value based on future returns. And if we had a few tucked away when they were only a few dollars what a bonanza. !

On the question of commodities however it’s complicated and hard to fathom the “Bitcoin Miners”, who use very powerful computer networks and algorithms to establish the difficult newly created Block chains necessary to provide the newly established links in the chain. In return they receive bit coins. The original inventors were no doubt very smart people and the technology is going to change the way business is conducted in the future. Rabobank for instance is currently investing in the block chain technology.

Although its virtually impossible to determine intrinsic value for Bitcoin bear in mind neither can you determine the underlying future values of commodities like gold. AS you can appreciate Gold has virtually no commercial application that adds value, but instead only has decorative appeal and at times of extreme crisis speculators will temporarily bid up its price.

But you may be interested to know the long term inflation adjusted returns of gold over any period is simply abysmal. It is only at a tiny fraction of what it was once worth in real terms. So one would never hold gold for any length of time on the pretense it is a long term store of value. Gold merchants will try to tell lone it is unique store of value but that's not true.

Best wishes