SHALL WE INVEST IN CRYPTOCURRENCIES

I raised this question after watching the videos in response to "Kraken Investment Case Competition 2016".

Challenge Summary

Bitcoin vs Ethereum: You have $1M to invest across these two blockchain technologies by buying bitcoins and ethers – the digital assets or “cryptocurrencies” that power these decentralized computer networks. You cannot touch your investment for the next 5 years. How much of that $1M do you invest in each? Why?

Competition challenge video

Competition video from the team of Ivy Business School, one of participating teams

What would I do

I would vote for the Ivy team. With the current state of cryptocurrencies, I would not recommend to invest unless you are an extreme gambler.

Cryptocurrency for dummies

The idea of digital currency is rather old. Any online service providers can issue their own digital currencies that are acceptable within their platform. For example, many online gaming companies issue their game currencies in different terms - points, coins, golds, weapons, etc. - for players to buy using real money in order to gain access to features and competitive advantages. Some gaming platforms allow players to collect game currencies as rewards and transfer to other players - mostly to exchange with real money.

The contemporary cryptocurrencies are different from the traditional digital currency for two major characteristics:

• They are strongly encrypted and cannot be broken - the same way we trust digital signatures. Of course, you will have to keep your private key safe. If you lose it, nobody can help you.
• They are decentralized running on top of Blockchain based platforms. By the way, it has to be public Blockchain and I would not accept any digital currency that runs in a private Blockchain as Cryptocurrency.

Bitcoin, the first Cryptocurrency was invented in 2009 by Satoshi Nakamoto, who still remains anonymous. The technology is open-sourced meaning anyone can create a new Cryptocurrency that works in a similar way. The second most influenctial Cryptocurrency is Ether, which runs on Ethereum public Blockchain. Ethereum was invented in 2013 by Vitalik Buterin, a Canadian programmer, and went live in 2015. From a technology perspective, Ethereum is more valuable in that the idea of Smart Contract is a revolutionary of Blockchain technology.In my opinion, it is as important as the idea of World Wide Web. Both Cryptocurrencies require some form of mining for the distribution of the currencies. The total number of Bitcoin is 21 million including those have not been mined. Satoshi Nakamoto keeps 7.5% (21,000,000 X 0.075 = 1,575,000 Bitcoins) of the Bitcoins for himself/herself/themselves. Bitcoin is highly divisible - the smallest unit is called Satoshi representing 0.00000001 Bitcoin. The main cost of the mining activity is electricity - which can be surprisingly huge. Satoshi Nakamoto has designed that the mining process would get harder and harder as more Bitcoins have been discovered. This creates incentives for miners to start mining earlier. It also implies that the value of Bitcoin will get higher and higher - no miner would be interested in mining the new ones if the mining cost surpasses the value of the new Bitcoins.

The Ideal World

The history of human civilization is essentially a history of efficiency creation. The trend of moving from inefficiency towards efficiency is unstoppable although it could possibly be slowed down by particular individuals and groups from time to time. If you agree with this, like myself, then you would agree that Cryptocurrency will be FUTURE reality - I don't think it is NOW, simply because none of the major retailers (e.g. Amazon, Alibaba, eBay, etc.) has started accepting it. P2P money transfer is apparently faster and cheaper than relying on a third party like a bank as the trusted authority, left aside the privacy issues. In an ideal world, one unique cryptocurrency is accepted by all human beings and the amount of the cryptocurrency each individual owns fairly represents his or her wealth. We live in a global economy and the future of the world will be a global village (nationalists might disagree.). If one currency works, why would we need two? You might be confused and wondered whether this contradicts to the ideology of democratization. Think again.

Then which one will be the ultimate winner?

Bitcoin and Ethers are the two main players currently. There are others and there will be more to come. Even the same Cryptocurrency can be forked to another copy resulted in two very similar Cryptocurrencies - this happened to Ethereum in 2016. Simply put, the creation of a new Cryptocurrency is almost instant and with no cost. Bitcoin somehow managed to convince the community to use it as the backup currency for all other Cryptocurrencies - you can only use Bitcoin or real money to buy other Cryptocurrencies. This move essentially makes Bitcoin the "Reserved Currency" of Cryptocurrencies - very much like using Gold and USD as the reserved currency for other currencies. However, Bitcoin Blockchain has encountered underline design problems - new transactions take too long to be verified by the chain. Who will be the ultimate winner? I don't know.

The Volatility

Institutional investors can profit from volatility by using a variety of hedging techniques. I imagine this would be applicable to Cryptocurrency exchange centers as well. However, for normal investors, volatility is bad. All currencies fluctuate in their values, but in completely different ways from how Cryptocurrencies do. Real currencies fluctuate in value based on the market risk dynamics and do not dramatically deviate from the underline value - the buying power. The price of Cryptocurrencies fluctuates based on nothing because nobody knows how to value it. One policy change from one authority could wipe off 50% of its value in one day. Until most people in the world start accepting cryptocurrencies and measure their values with real goods and services, their values are completely subjective to speculations. If Bitcoin would replace all currencies in the world, one Bitcoin would worth about one million USD. If Bitcoin loses, then it would worth zero, in theory. Cryptocurrency exchanges don't care as long as they can charge fees, in real dollars. The vast majority of bitcoin transactions happen in exchange centres not retailers. Speculators don't care as long as the Cryptocurrencies don't stuck in their hands.

What if Bitcoin wins

Then the initial distribution of the Bitcoins becomes questionable. And as an example, Satoshi Nakamoto would have the power to control the world economy. Would all countries allow this to happen? In theory, you can run a private organization that has Bitcoin mining factories all over the planet, in an attempt to control vast majority of the wealth in the world. Currently people spend too much efforts on mining and speculative trading. What we should really do is to promote Cryptocurrency adoption through the collaborations of all nations in the world. Yes, it is hard - easier said than done.

Conclusion

Though Cryptocurrency will be an important part of human civilization, the ultimate future unique or dominant Crypotocurrency remains uncertain. Currently their values are purely driven by speculations. Therefore, I would not consider them as investible assets for serious investors.