Beyond the Hype

Axel Wieandt - April 1, 2021

Tips for practitioners

Bitcoin is a cryptocurrency, a new form of digital asset based on a decentralized database or ledger that is distributed across a large network of computers. The Bitcoin network is public and permissionless, and can exist outside the control of central intermediaries and governments. There are no physical bitcoins but only database entries transparently kept on a public ledger which is accessible to everyone. The data entries are recorded in “blocks” that are added to an immutable “chain” of blocks, the “blockchain”. Bitcoin transactions either happen with no fees or very low fees and everyone with internet access and a so-called electronic wallet (e-wallet) can “pay” anyone in the world any amount of bitcoin by simply transferring ownership of a slot in the ledger.

Bitcoin´s recent volatile surge

Many observers prematurely predicted the demise of Bitcoin after the price of a bitcoin peaked at USD 20,089 in December 2017 and then tumbled to USD 3,300 in December 2018. However, since the global economy shut down due to the COVIDpandemic a year ago, Bitcoin and cryptocurrencies are back on a roll. In November 2020, amid concerns of accelerating inflation and US government collapse, Bitcoin surpassed its previous price peak and continued to set new records in January of this year. By mid-February, the price of a bitcoin rose above 55,000 USD, surpassing the USD 1 trillion market capitalizationmark. By the end of February, in highly volatile trading, the price had slipped below USD 50,000.

The recent cryptocurrency boom of 2021 is driven by increasing retail and institutional demand, with payment companies such as PayPal, Square and Mastercard jumping on the bandwagon, and companies such as Tesla announcing significant corporate treasury purchases and acceptance of Bitcoin for vehicle purchases. Even traditional banks such as BNY Mellon, which had hoped to be able to avoid offering crypto-currency investment services to their clients, are now openly considering Bitcoin trading and custody services. Investment vehicles such as the US Grayscale Bitcoin Trust and the recently launched Canadian Purpose Investments Bitcoin ETF are experiencing record flows. The increasing demand meets a limited supply as more and more people hold on to their bitcoins speculating on further price appreciations.

Is the Bitcoin boom the result of strong narratives?

Robert J. Shiller, a Nobel Prize-winning economist, suggests that one way to understand the rise of Bitcoin is to look at it through the lens of narrative economics, “the study of the viral spread of the Bitcoin boom through popular narratives that affect economic behavior” and the interwoven narratives driving the Bitcoin boom. In this regard, Schiller notes five self-reinforcing narratives:

1. Bitcoin as an instrument for peaceful anarchy

Cryptocurrencies and blockchains built on the distributed database system appeal to people who see Bitcoin as “the catalyst for peaceful anarchy in freedom." In fact, the explicit reference to the 2007-08 global financial crisis and UK bank bailouts in Bitcoin’s genesis block suggests that it launched in part in reaction to corrupt governments and financial institutions.

2. Bitcoin nourishes human curiosity

Even today, the identity of Bitcoin’s creator, Satoshi Nakamoto, is veiled in mystery. According to Bitcoin.org, “Satoshi left the project in late 2010 without revealing much about himself”. Such riddles shroud the concept of Bitcoin in mystery and encourage human curiosity.  

3. Bitcoin encourages equality and  individual empowerment

Schiller’s third narrative deals with heightened independence. Since cryptocurrency coin owners are anonymous and beyond the reach of government, many are attracted to Bitcoin’s ability to dispel the fear of inequality and the fear that computers will replace human workers and further increase social and financial inequality in society.

4. Bitcoin is new and exciting

The fourth narrative is tied to a vision for the future. Here, Bitcoin liberates owners and allows them to be part of something new and exciting.

5. Bitcoin enables entrance into the world economic community

The fifth narrative stems from the desire to be a global citizen. Many view Bitcoin tokens as signs of membership in the world economy. As Shiller states, “people are interested in Bitcoin precisely because many other people are interested in it”.

Let’s go beyond the narratives fueling the hype and get into the nuts and bolts. How does Bitcoin work? Is it a currency? Or a new type of asset class? And what kind of new risks does it introduce to retail and institutional investment portfolios?

The technical details: What constitutes a Bitcoin?

Satoshi Nakamoto initially conceived Bitcoin as “a peer-to-peer electronic payment system”. A basic blockchain is essentially a decentralized system to store data or log transactions that is replicated across a distributed network, which ensures real-time consensus and creates an irrevocable and auditable trail. It uses the consensus mechanism “proof-of-work” employing the “secure hash algorithm 256” (SHA-256). This hash algorithm translates any data set into a 64-digit hexa-decimal (0-9, a-f) code. As each of these digits has 4 bits the code has 64 x 4 = 256 bits and the number of different combinations is 2²⁵⁶, the hash algorithm is very secure. It is very simple to translate any piece of data into a SHA 256 hash value but nearly impossible to convert the hash value back into the original data set. A supercomputer performing 10⁹ calculations per second would need 3.7 * 10⁶⁰ years to work through all possible combinations.

Bitcoin Core is an open-source project which maintains and releases the Bitcoin client software descending from the original Bitcoin software client released by Satoshi Nakamoto in 2009. It consists of “full-node” software for validating blockchain as well as a Bitcoin e-wallet. All transfers of Bitcoins from one encrypted e-wallet to another are distributed to all “nodes”. Each node collects new transactions in a new block and tries to solve the mathematical problem for this block, which entails finding a hash value for the transaction data recorded in the block that starts with a minimum number of zeros. The higher the required minimum number of zeros, the more difficult the problem is. Specifically, the hash value for the combination of (i) the hash value of the previous block, (ii) the root of the so-called Merkle tree of hash values of all transaction data in the block, and (iii) a timestamp must be calculated. Then the random number (nonce) comes into play, which is modified until a hash value is found for the block that has the required minimum number of zeros. So the chaining of the blocks happens by calculating hash values, which in turn were calculated from other hash values, etc. Every manipulation in the transaction data of the previous blocks would be immediately noticeable in this chaining, which makes a blockchain (relative to the complexity of the hash algorithm) tamper-proof.

The first node to solve this mathematical problem is rewarded with bitcoins, currently 6.25 units per block. The other nodes accept the block only if all transactions in the block are valid and not already issued. They ultimately show their acceptance by starting to work on the new block, using the hash value of the new block in the field of the hash value of the previous block. To solve the mathematical problem by running many hash algorithms, the nodes employ dedicated “mining” machines which consume electricity.

Since the difficulty of the mathematical problem increases with the computing power in the open network, the Bitcoin blockchain is calibrated so that a new block is found or “mined” approximately every 10 minutes. As the mining reward is set to decrease with every 210,000 blocks mined, i.e. approximately every 4 years, it is expected that mining fees paid by bitcoin senders will ultimately replace bitcoin rewards as mining incentives. So far over 18 million blocks have been mined. The overall number of bitcoins is limited to 21 million. These will be mined by 2140. The overall number of available bitcoins, however, is lower as it is estimated that 3 to 4 million Bitcoin are sitting in e-wallets that can no longer be accessed due to the loss of private keys.

Bitcoin as an emerging asset class

Bitcoin is not a currency, nor a new form of money. This is because in order for something to qualify as a currency or a form of money, it needs to function as a medium of exchange, a unit of account and a store of value. Bitcoin fails to fulfill these functions. The number of companies that accept bitcoins as a means of payment remains comparatively low. More importantly, Bitcoin does not have legal tender status. Bitcoin’s high price volatility make it ill-suited as a unit of account, as does the high value of a single Bitcoin at which prices would need to be quoted in Satoshi as 1/100,000,000 of a bitcoin in order to avoid numbers with up to eight decimal places.

However, Bitcoin is increasingly used to store value because, as with precious metals such as gold or silver, its supply is limited, uniform, durable, portable and fungible, as the e-wallet and the Bitcoin blockchain can be accessed from any internet connection. Some observers view Bitcoin and other cryptocurrencies as a potential new type of asset class because they have a different risk-reward structure than other asset classes and correlate poorly with traditional asset classes such as real estate, bonds, stocks and precious metals such as gold.

Bitcoin introduces its own new, idiosyncratic risks into investors´ portfolios

Retail and institutional investors as well as corporate treasurers should be aware of the significant and new risks that Bitcoin poses for their holdings:

• The Bitcoin network is vulnerable to a “51 percent attack”, which would occur if rogue actors controlled the majority of node computing power and rewrote the transaction history. So far there has been no such attempt.
• There is a risk of hidden centrality. What if 95% of Bitcoin developers colluded with the majority of mining nodes to change the protocol and lift the 21 million cap? In this context it also important to know that most application-specific integrated circuit (ASIC) machines used to “mine” bitcoins are manufactured by Bitmain, a Chinese chip design company that also owns large mining pools. This creates an obvious conflict of interest in terms of releasing new, higher performing ASIC machines and exercising undue influence on the development of the Bitcoin open-source protocol itself. There is a high concentration of mining capacity in countries with low electricity prices and weak rule of law such as the People´s Republic (PRC) of China or Ukraine.
• There exists significant risk that influential institutions such as the US Treasury, the U.S. Department of Justice or the European Central Bank could impose more stringent regulations on cryptocurrencies such as Bitcoin. China banned Bitcoin trading in 2017, also to prevent the circumvention of capital controls. And the PRC has even considered a ban on crypto-mining.
• Bitcoin ownership is highly concentrated among so called “whales” which, in the absence of bitcoin market supervision, could engage in “pump-and-dump” schemes.
• Critics have also questioned the role of Tether, the USD stablecoin often used as a so called on- and off-ramp by bitcoin investors, as a hidden source of leverage.
• The technological risks are evident by recent serious hacks of investors’ Bitcoin wallets and crypto-exchanges.
• Breakthroughs in quantum computing could render SHA-256 encryption useless.
• Even though the nature of public blockchain allows law enforcement to trace bitcoin transfers “on chain” from e-wallet to e-wallet, Bitcoin has frequently been used for money laundering and to finance illicit activities, which creates reputational risk.
• The Bitcoin network consumes about as much electricity as Chile and has a carbon footprint the size of New Zealand, which is not compatible with sustainable investing, even though almost 40% of the electricity consumed for “hashing” already comes from renewable sources.
• Last but not least is the risk that Bitcoin could be replaced by another cryptocurrency. There are over 8,700 other cryptocurrencies out there, in many cases with higher scalability and lower energy consumption.

Since a bitcoin is only worth as much as another counterparty is willing to pay for it, if such risks materialize and the narrative is undermined, the demand for Bitcoins and their value could collapse.

Bitcoin is the largest and most popular cryptocurrency, an emerging asset class that is too different and too large to ignore. The underlying blockchain-technology represents an important innovation that will reduce transaction costs and redefine the boundaries between markets and organizations, thereby paving the way towards a more efficient and inclusive financial system.

Literature references

• Shiller, R. (2019): Narrative Economics, How Stories go Viral and Drive Major Economic Events, Princeton University Press, 2019, chapter 1, p 3–11, “The Bitcoin Narratives”.
• Lujan, S. (2016): „Bitcoin Was Built to Incite Peaceful Anarchy”, January 9, 2016, found at: https://news.bitcoin.com/bitcoin-built-incite-peaceful-anarchy/.
• Nakamoto, S. (2008): Bitcoin: A Peer-to-Peer Electronic Cash System, found at: https://bitcoin.org/bitcoin.pdf.
• Mankiw, G. (2009): Macroeconomics, 7^th edition, New York, Worth Publishers Inc., U.S, p 80.
• Burniske, C./White, A. (2017): Bitcoin: Ringing the bell for a new asset class, available through: research.ark-invest.com/bitcoin-asset-class , and Ankenbrand, Thomas, Biere, Dennis (2018): Assessment of cryptocurrencies as an asset class by their characteristics, in: Investment Mangement & Financial Innovation, 15(3), p 169-181.
• Cambridge Centre for Alternative Assets (2020): 3^rd Global Crypto Asset Benchmarking Study, University of Cambridge Judge Business School, September 2020, p 26.