Drivers and Risks of the Cryptocurrency Boom

Friday, December 15, 2017 /10:55AM / FDC

The rapid price swings of crypto currencies are prompting volatility-starved investors to examine ways to join the biggest speculative boom since the dotcom fever. 

The best known, bitcoin, has in the space of 24 hours this week rallied to an all-time high of $11,434 before sinking as much as 21% to $9,009, having only touched $2,000 for the first time earlier in the year. 

What is a crypto currency?

Sometimes known as coins, crypto currencies are a 21stcentury creation — a mixture of digital assets, huge amounts of computing power and a network of servers on which to store shared data. 

Unlike everyday money, they are decentralized — meaning they are not issued or guaranteed by central banks and therefore fall outside the purview of regulators. The currencies are secured against hacking by cryptography and can be converted into real-world money anonymously. This has attracted some criminal elements, a point emphasized by regulators and critics. 

Apart from bitcoin, other crypto currencies have risen dramatically this year, including Ethereum, Ripple, Litecoin and Dash. They have different characteristics, which allow users to treat them very differently. That, in turn, partly underpins their appeal and valuations. Bitcoin sees itself as an alternative to central bank currency, while Ethereum is “cryptofuel” that is not to be used as a currency. Ripple, meanwhile, is a software aimed at financial markets, such as foreign exchange.  



Why have prices rallied so dramatically?
A mixture of scarcity, enthusiasm and — a big driver of such investor manias — the fear of missing out. Many investors come from China, using Japanese exchanges. 

For example, only a finite number of bitcoin — 21m — can be created. There are 16.7m in circulation, according to data from Canalysis, bringing bitcoin’s market capitalization to about $167bn. Of those in circulation, about 37% have been spent or traded in the past year, while about 22% are being held by “strategic investors”, and most of the rest have been lost. 

At the same time, enthusiasts, semi institutional names and even some hedge funds have sought to invest in crypto currency projects. Many have embraced so called initial coin offerings, a fundraising mechanism. “We think a large part of the potential value of Ethereum is its role as the money supply for ICO,” said Bank of America Merrill Lynch in a research note this month. 

The surge in bitcoin’s price has prompted some of the world’s biggest market infrastructure providers to explore ways for customers to trade the market using more traditional investment instruments, such as futures or contracts for difference. 

Chicago based exchanges CME Group and CBOE Global Markets are looking to list bitcoin futures, a prospect that has helped lend legitimacy to bitcoin and fuel recent price gains. 

With some marketing fanfare, spread betting and other online platforms have begun offering crypto derivatives to allow punters to buy and sell the market. 

What are the risks associated with bitcoin?
As comparisons abound with the Dutch tulip bubble of the 1600s, national regulators have warned investors of the dangers surrounding a market that, to date, has been unregulated, illiquid and prone to big swings in price that severely limit its use as a currency for transactions. 

“Bitcoins are concentrated in very few hands, who owns a bitcoin is not clearly defined, market manipulation is rife, and whether a transaction settles or not is probabilistic, rather than legally certain and final,” said Preston Byrne, a structured finance solicitor and founder of Monax, a blockchain software company. 

Higher prices mean that holders of the currency — whether exchanges, trading platforms or retail punters — are a more lucrative target for hackers. IG Group, the world’s largest online trading platform, suspended trading of some of its bitcoin derivatives on Monday, citing the growing security risk associated with offering the products. 

Like all asset classes, exiting the market is a crucial factor. Some platforms and exchanges take the risk of a trade on to their books and pay out customers from their own funds, until they can sell the currency on the market. If a fraction of customers sold, that could put a stress on the market intermediaries, which do not have access to credit at banks. 

And there are significant real world problems. For example, the mining of bitcoins this year has consumed more energy than the average electricity consumed annually by 159 nations, according to Digiconomist.  

Can crypto currencies enter the mainstream of finance?
Bulls argue that once price stability has been achieved, bitcoin could feasibly be used as a currency to denominate a transaction, rather than just for speculative gains. 

“The infrastructure is coming in to deal with [this shift],” said Gavin Brown, senior lecturer in financial economics at Manchester Metropolitan University and director of crypto currency hedge fund Block chain Capital. The process could take between 10 and 15 years, he said, adding that a “regulatory light touch approval” would be a necessary part of this development. 

But critics warn bitcoin cannot be used as a medium of exchange or store of value in the manner of central bank backed money. 

Tara Waters, a Fintech lawyer at Ashurst, said: “Central banks may decide to adopt such technologies themselves, although it is likely they would adapt the technology to better fit existing systems and norms.” 

Others fear the bubble could burst, causing upheaval to those involved in the market. 

“I don’t think bitcoin has any business in the mainstream financial system,” said Mr. Byrne. “I am hearing anecdotal stories of people maxing out credit cards and remortgaging their homes to buy bitcoin. Banks looking at it now should mainly be focused on limiting their exposure.” 

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