An Objective Analysis of Crypto: An Open Letter by IB Insider
The popularity of cryptocurrencies is a growing phenomenon. Today, not only have members of the public globally become aware of and invested in cryptocurrencies, but professional and institutional investors have also taken increasing interest in it too. Cryptocurrencies present opportunities and significant risks both to investors and to the status quo of how capital flows are managed by governments internationally.
IB Insider seeks to provide objective analysis to better inform cryptocurrency stakeholders.
We here set out our thoughts on the factors that should determine the value of cryptocurrencies and how investors should go about objectively assessing these currencies.
We invite interested and intellectually curious stakeholders to put forward their own opinions and analysis on any section discussed below. IB Insider’s editorial board will publish responses, in part or whole, based on the soundness and the credibility of analysis put forward.
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An Introduction to Cryptocurrencies: How Cryptocurrencies Began.
In 2009, Bitcoin, the first cryptocurrency, was set out to serve as an alternative cash system that allowed people to make transactions without relying on established third-parties. These third parties have historically been through banks and governments which are part of the traditional financial system. However, the failure of banks and regulators to mitigate and avert the Global Financial Crisis, damaged the public’s trust in financial institutions. This inspired the development and the creation of an alternative financial system.
Bitcoin claims to offer trust in a decentralised system in which a network of independent individuals validate transactions. The Bitcoin ledger is a publicly available record of transactions which keeps the identities of transacting parties unidentifiable. This differs from the status quo, in which transactions are facilitated by the traditional banks and transacting parties are identifiable by the banks, regulators and governments.
Cryptocurrencies are today challenging, and creating a divergence from, the security and control of the regulated intergovernmental banking systems. Cryptocurrencies have both positive and negative effects. On one hand, cryptocurrencies provide greater freedom and less regulation for money to flow across borders without the interference of government controls. On the other hand, stakeholders who use and rely on cryptocurrencies are exposed to greater risk and volatility as cryptocurrencies are unregulated.
What Purpose Do Cryptocurrencies Serve?
All cryptocurrencies serve the same purpose: to provide an alternative payment system that decentralises money. This enables cryptocurrency users to make payments cross-border without restrictions or the interference of governments and regulators. However, ultimately, all cryptocurrencies are currently denominated back into local currencies, which is the form of money that, traditionally, people and businesses use to pay for goods and services.
Cryptocurrencies also have other applications besides being payment systems. For example, some cryptocurrencies, such as Ethereum, have implemented smart contracts, which perform a predetermined action when a member of that blockchain meets a set of criteria. Other uses for cryptocurrencies are buying and selling NFTs, a piece of code that certifies the legitimacy of a digital asset.
Furthermore, some cryptocurrencies have the ability for members to program decentralised applications known as dApps. These applications can take any form, such as messaging services, gaming platforms or even financial service applications. Thus, blockchains and cryptocurrencies have multiple uses.
Who are the stakeholders of the cryptocurrency ecosystem?
The introduction of cryptocurrencies has disrupted a range of industries worldwide and has presented opportunities for a transition towards decentralised and digital systems. As a result, this has attracted various stakeholders to interact with cryptocurrencies in both its economic and regulatory landscapes. We recognise that it is important to understand who these stakeholders are in order to evaluate how different parties are affected by the increased adoption of cryptocurrencies.
The cryptocurrency ecosystem includes different stakeholders, some of whom can be categorised as follows:
- Technical developers of cryptocurrencies and blockchain technology
- Cryptocurrency miners or validators (which includes individuals or organised pools)
- Retail and institutional investors /speculators/traders in cryptocurrency
- Individuals or organisations operating on a cryptocurrency network
- Governments and central banks
- Firms, organisations, and regulators in sectors including banking, online payments, cybersecurity, and computing hardware
- Cryptocurrency-based firms or start-ups
- Individuals or organisations with an influence on public sentiment
How can we measure the monetary value of a cryptocurrency?
Objectively determining the monetary value of a cryptocurrency is challenging. Our objective opinion is that the starting point for valuing a cryptocurrency can be determined by taking into consideration the following factors:
- The purpose and relevance of the cryptocurrency
- The technology that supports the cryptocurrency to keep it functional
- The trustworthiness of the cryptocurrency regarding its technology, purpose, and its adoption by users and investors.
- The scalability of the cryptocurrency
- The availability, supply and demand of the cryptocurrency
- The environmental impact of the cryptocurrency’s widespread adoption
- The regulatory controls over the use of and trading of cryptocurrencies
- The performance of the cryptocurrency in comparison to other commodities or tradable assets
- Public sentiment towards cryptocurrencies
- Actions that regulatory authorities may take in restricting the use of cryptocurrencies.
While one may seek to explain what the value of a cryptocurrency is, based on the objective factors that can be evaluated and calculated, the monetary value that a cryptocurrency may have at any time will also be determined by public sentiment towards the cryptocurrency, its liquidity, and how widely it is adopted in the market.
Competition idea: how can we measure the value of a crypto/which is the most important factor outlined above/what is another factor that we have not discussed above
What are the Technologies Behind Different Cryptocurrencies?
All cryptocurrencies are peer-to-peer networks that are open and accessible to anyone. They achieve decentralisation through a technology called blockchain, which is the database of all transactions that is maintained publicly.
Since there are many thousands of cryptocurrencies on the market, it is important to understand the differences between them. Cryptocurrencies mainly differ in the architecture of their blockchains and the nature of their supply. We here introduce some of the most-commonly traded cryptocurrencies.
The cryptocurrency’s blockchain self-monitors the influx of new tokens. The number of new tokens introduced by mining is coded into the blockchain and cannot be changed for a public blockchain. Therefore, the influx will vary for each unique cryptocurrency.
No one owns the Bitcoin network; all Bitcoin users around the world control Bitcoin. So, while developers are improving the software, they can’t force a change in the Bitcoin protocol because they can choose what software and version they use.
Bitcoin is a virtual currency. It is an entirely virtual monetary system, so Bitcoin is used to buy products and services like a fiat currency, such as the pound and dollar. Bitcoin uses the SHA256 hash function to validate transactions.
There are smaller transaction fees for international payments. Users can control how they spend their money without an intermediary/third-party authority like a bank or government. Bitcoin purchases are discreet and are not associated with someone’s identity. Therefore, they cannot easily be traced back to individuals. The Bitcoin payment system is purely peer-to-peer, meaning that users can send and receive payments to or from anyone on the network worldwide without requiring approval from any external intermediary authority. Bitcoin is not subject to the traditional banking charges.
1 Bitcoin transaction consumes about 178.4 MWh. The primary energy consumption from Bitcoin comes from mining. It consumes around 121 terawatt-hours (TWh) a year and accounts for 0.53% of the total world’s electricity consumption, with 65% of this consumption originating in China as of 2021. Cambridge Bitcoin Electricity Consumption Index suggests that 39% of any energy consumed by mining comes from renewable sources.
The Bitcoin community has seen numerous developments on the Bitcoin network, which are introduced in the form of hard or soft forks. There are plans to make Bitcoin a more scalable cryptocurrency through the introduction of the Bitcoin Lightning Network, a solution which provides faster transactions due to delayed settlement.
Bitcoin’s supply is limited to 21 million Bitcoins by design, which has led some to characterise it as digital gold. According to CoinMarketCap, there are currently over 18.7 million Bitcoins in circulation.
Proof-of-work (currently), Ethereum developers expect to replace the blockchain’s proof-of-work with a new mechanism known as proof-of-stake by the end of 2021.
Thousands of individuals around the globe maintain the Ethereum network as. These are known as nodes. The founders of ethereum, Vitalik Buterin, Mihai Alisie, Amir Chetrit and Charles Hoskinson, are the most influential.
Ethereum is an open-source blockchain-based platform used to create and share business, financial services, and entertainment applications. It enables developers to build and publish smart contracts and distributed applications (dApps). Ethereum uses Keccak-256 in a consensus engine called Ethash to validate transactions.
Unlike Bitcoin, Ethereum can run smart contracts that can represent financial agreements such as escrow. Ethereum’s code can also build and create businesses, financial services, and entertainment applications.
Ethereum consumes 44 terawatt-hour (TWh) per year, and only 39 per cent of that electricity comes from renewable sources (Visual Capitalist 2021)
Ethereum developers expect to replace the blockchain’s proof-of-work with a new mechanism known as proof-of-stake with effect from the beginning of 2022 (Fortune, 2021).
Unlike Bitcoin, Ethereum does not have a fixed supply cap, however, there is an annual supply cap of 18 million coins (Investopedia)
Proof-of-stake (Ouroboros, which is a peer-reviewed blockchain protocol)
Cardano is not owned by any organisation. However, several independent entities oversee its development and maintenance. These include The Cardano Foundation, IOHK and Emurgo, as well as the Cardano community. Cardano uses Ouroboros to validate transactions. Ouroboros is a peer-reviewed, verifiably secure blockchain protocol.
Cardano is a blockchain platform built for dApp development. Its cryptocurrency, Ada, facilitates transactions on the Cardano blockchain.
Cardano claims to restore trust in global systems by providing a foundation for individuals and organisations to exchange value in a more trustworthy and transparent way. Cardano differs from other blockchains because it was founded by academics through peer-reviewed research and evidence-based methods.
Cardano claims to be 1.6 million times more energy efficient than Bitcoin (Source: Hoskinson, Cardano). This is due to its more sustainable proof-of-stake consensus mechanism. Cardano’s energy consumption per transaction is of 0.5479 KWh.
Cardano is constantly updated to add new features and improve functionality. A roadmap of the 5 major stages of development is set out on the Cardano website. Cardano updates sometimes lead to price movements in ADA.
The supply of ADA is capped at 45 billion tokens.
The Ripple Protocol consensus algorithm (RPCA) – Transactions rely on a consensus protocol to validate account balances and transactions on the system
Ripple labs Inc.
Ripple aims to provide an efficient system for the direct transfer of money in real-time while being less expensive, more secure, and transparent than other systems employed by conventional financial institutions. Ripple uses SHA512 to validate transactions.
Ripple is a payment settling, currency exchange and remittance system designed for banks and payment networks. It provides a system for the direct transfer of assets. Traditional currencies act as an exchange mechanism for goods and services, and the entire population uses them. In their jurisdiction, they universally get accepted by any shop for any transaction.
The average number of transactions per day is 766, which leads to a total yearly number of transactions of 279590. Ripple consumes only 0.0079 KWh per transaction; therefore, the total energy usage for ripple is 2207.8 KWh per year.
As of this time, Ripple labs have not reported any updates to the Ripple blockchain in any form. Nevertheless, the privately-owned company advertise the benefit of using their payment method, although there are no submitted plans to improve Ripple.
XRP currently has 45.404 billion tokens in circulation, while its total supply is 100 billion XRP tokens. Ripple Labs own these tokens and distributes them with a maximum of 1 billion coins each month.
Billy Markus and Jackson Palmer
Dogecoin was created as a joke, making fun of the speculation on cryptocurrencies such as Bitcoin, which attracted significant popularity. Similarly to other cryptocurrencies it can be used to buy and sell goods and services by validating transactions. Dogecoin uses the Scrypt algorithm to validate transactions.
Dogecoin enables peer-to-peer transactions across a decentralised network similar to other cryptocurrencies mentioned earlier.
Dogecoin uses 0.12 kWh of energy per transaction. It currently has an estimated 1825000 transactions per year, leading to an estimated total annual energy consumption of 2190 MWh per year.
Dogecoin is getting two significant updates (Currently there is no confirmed release date for the updates): Firstly, the integration of Segregated Witness (SegWit) and CheckSequenceVerify (CSV). SegWit lowers the threat of transaction malleability and slightly increases transaction speed, and CheckSequenceVerify will allow Dogecoin to create second-layer payment channels similar to the Lightning Network on Bitcoin.
10,000 new tokens are rewarded to miners per block mined with no cap on supply. Due to this policy, there can never be a scarcity and supply is controlled by the miners.
What are the Environmental Challenges Facing Cryptocurrencies?
Not all cryptocurrencies require energy-intensive activities that make them a threat to environmental goals. However, some cryptocurrency activities such as proof-of-work mining use powerful computers that require significant volumes of electricity and consume energy in large quantities. As a result, as the cryptocurrency industry continues to grow, there are concerns about its the environmental impact. Traditional currencies are not without environmental damage – given that trees and metals must be extracted from the earth and transported to location to location in order to produce notes and coins. Moreover, as a result of the greater demand for high-spec computer systems, the demand for raw materials that go into the building of the systems has risen for limited natural resources. Therefore, a more detailed analysis is required to determine comparatively how detrimental cryptocurrencies are in comparison to traditional currencies. For further analysis please visit our articles on cryptocurrencies.
On the analysis of Cambridge Bitcoin Electricity Consumption Index, Bitcoin accounts for 0.53% of total world electricity consumption, with 65% of this consumption originating in China. It is also suggested that the proportion of energy consumed by mining that comes from renewable sources ranges from 39% to 73%, according to different organisations. Given that Bitcoin is only one currency amongst many others, it can be assessed based on this data, that Bitcoin is not the most environmentally friendly cryptocurrency.
What are the regulatory challenges facing cryptocurrencies?
Cryptocurrencies have emerged as a new type of monetary system. As the number of people using cryptocurrency continues to increase, regulators have become increasingly aware of the attraction of cryptocurrencies as a form of investment. Due to the volatility, lack of transparency, and accountability of issuers of currency, regulators have increasingly become concerned that the public need to be better protected. For example, some cryptocurrencies have no commercial use or genuine monetary value whatsoever. An unsophisticated investor may buy worthless cryptocurrencies in anticipation they will increase in value. Whereas other cryptocurrencies will have genuine use cases and fluctuate based on the value that the cryptocurrency provides and public market sentiment towards investing into a specific cryptocurrency.
Legal frameworks and policies in different countries
The UK does not as of Q4 2021 have any policies on of cryptocurrencies would seek to stifle money laundering, as well as increase market efficiency and ensure the safety of its financial system.
The EU has developed a legal and regulatory framework for blockchain-based applications that seeks to achieve both consumer and investor protection. It has taken an open approach to allow pilot regulations and exemptions to determine the best route that will ensure both safety and innovation. As a result of the EU’s proactive regulatory action, more institutional investors and resources will enter the cryptocurrency market.
Currently, cryptocurrencies must be traded on qualified exchanges, so they are subject to regulatory oversight by the Securities and Exchange Commission (SEC). Cryptocurrencies in the US are also be subject to state laws which may impact how cryptocurrecies are permitted to be used and taxed.
Since 2013, China has banned financial institutions from transacting in or holding bitcoin and other cryptocurrencies. Further crackdowns on financial and exchange services such as insurance, savings and trading have been imposed since 2017. China sees cryptocurrencies as a threat to its fiat currency, the yuan, and to the safety of retail investors.
The price of individual cryptocurrencies will be more likely to represent their true value since their utility will be the only factor determining price. This reversion will occur because there are many cryptocurrencies currently available for consumers to invest in, so if governmental regulations tighten, only the most functional cryptocurrencies will be of use to consumers.
How are cryptocurrencies likely to continue to scale?
For a cryptocurrency to be scalable, it must be able to process a large number of transactions simultaneously. Scalability is determined by the architecture of the cryptocurrency’s blockchain. The following are often proposed as solutions to increasing the scalability of a cryptocurrency:
- Larger block sizes – this increases the number of transactions stored in each block so that, when blocks are mined, more transactions are verified at a time. Bitcoin Cash is a updated and alternative currency to Bitcoin but allows for larger block sizes in its blockchain. This means more Bitcoin Cash transactions can be verified per second compared to Bitcoin transactions.
- “Layer 2” – an additional layer built on top of the foundation blockchain. Individuals move funds into this layer where transactions are settled without mining and without altering the underlying blockchain ledger. After all transactions are settled, the net result is sent to the foundation blockchain where they are verified and added to the ledger in the normal way.
The commercial scalability of cryptocurrencies will be dependent on:
- The regulatory environments
- The ability for cryptocurrencies to be traded freely cross border
- The commercial use case that the crypto provides through its blockchain
- Public sentiment towards cryptocurrencies and specific currencies.
What are the most common risks of investing in cryptocurrencies?
We recognise that the regulatory environment varies from a country-by-country basis. Some countries have banned cryptocurrencies while some have limited or no regulation. For example, as at (Q4 2021), at least 25 governments around the world have already outlawed cryptocurrencies. We here set out some of the risks of which investors should be aware before making a capital commitment into a cryptocurrency.
- High volatility – cryptocurrencies such as Bitcoin and Ethereum experience significant fluctuations in price over time. In fact, in recent times cryptocurrencies have been far more volatile than major global stock market indexes. As the popularity of cryptocurrencies has increased, some people have made, and others have lost a significant amount of their investment. Due to the lack of regulation of cryptocurrencies, influencers such as Elon Musk have been able to directly impact the price of cryptocurrencies based on their comments on social media. The environmental impact of energy consumption of cryptocurrencies may build momentum and be a basis for governments to argue and crackdown on cryptocurrencies. Some cryptocurrencies have no limit on the number of coins that can be issued. There are many issues that can impact the fluctuation of cryptocurrencies, that are not easily identifiable or measurable in the same way as making investments in more traditional fields such as buying property or stocks in different companies.
- There are thousands of cryptocurrencies in existence. So selecting which cryptocurrency to invest into must be done with prudence. Investors should not overly allocate a high proportion of their portfolio into these hopes of investments due to the uncertainty in their performance. However, we can say with some certainty that cryptocurrencies are here to stay and will continue to grow for the foreseeable future. The acquiring of cryptocurrencies should be done with caution and by understanding what value the cryptocurrencies blockchain actually provides to the people using the software. Who the originators of the blockchain are, what their motivation for issuing the currency is, and if they are a trustworthy source, are all factors to consider before investing in said cryptocurrency.
How are cryptocurrencies different from digital currencies?
Digital currencies are the electronic forms of national currency coins, notes and bills, that can be stored in a digital wallet. Unlike cryptocurrencies and NFT’s, governments will seek that the public progressively recognise digital currencies as equivalent to traditional money in the sense they can buy goods and services. Digital currencies are backed by central banks.
Whereas cryptocurrencies are decentralised, meaning that the currencies are not under the control of a government or central bank. This means that cryptocurrencies can be traded without any regulatory checks with regards to what is being transferred by whom and to whom anywhere in the world. The growth of cryptocurrencies can pose a material risk to tax-raising powers. A government can only control what has been traded once the cryptocurrency has been converted back into a national currency. All trades outside of the national currency are undetectable.
Cryptocurrencies are mined by individuals who make their computers available to validate transactions. For each transaction that is successfully validated, the miners and the cryptocurrencies their computers are supporting
Moreover, digital currencies are not transparent like cryptocurrencies. Whereas cryptocurrency blockchains are validated by nodes, and they become publicly available, digital currencies transactions are not publicly available, and can be detected and traced by governmental regulatory authorities.