Should Digital Currencies Be In Your Wallet?

Cryptocurrencies may be the money of the future.

They may be a fraud. Carey business school faculty members are among the experts trying to answer the question: should digital currencies be in your wallet?

Bitcoin. Ether. Litecoin. Whatever name you choose, the phenomenon of cryptocurrencies is among the hottest business topics of the past year.

But the questions about these new digital currencies are manifold. How do they work? What risks are attached to obtaining or investing in them? Can they actually become a new currency? And what are the regulatory and tax implications?

Such questions have created not only confusion in markets but also a sharp divide in expert opinion.

Founders and early adopters see cryptocurrencies as a way to bypass centralized financial institutions and middlemen and create a more direct, more secure system of monetary transactions. They are also designed in a way that creates wealth for those building the new currencies.

In late 2017, the financial media trumpeted the fact that the number of accounts holding cryptocurrencies at digital currency exchange Coinbase (13 million) had exceeded the number of accounts at brokerage firm Charles Schwab (almost 11 million). Investors are flocking to speculate in these new currencies on futures exchanges or in so-called ICOs (initial coin offerings), a cryptocurrency-based challenge to the traditional IPO (initial public offering).

Yet the rush to embrace cryptocurrencies has many vocal (and prominent) naysayers. Some economists see the entire concept as worthless. Others point to precipitous plummets in valuation. On the last day of trading in March, Ether was trading at under $400 after having lost 47 percent of its value since the start of 2018.

Berkshire Hathaway Chairman Warren Buffett told CNBC in January: “I can say almost with certainty that cryptocurrencies will come to a bad end.”

There is a growing consensus that the foundational structure of cryptocurrency – known as the “blockchain” – will have far-reaching impacts on how people make legal contracts or purchase health care. But the prospects for the emerging cryptocurrencies themselves remain mercurial, even to those who are in the thick of the fight.

Matt Green, an assistant professor of computer science at the Johns Hopkins Whiting School of Engineering, helped create the protocol that fuels a cryptocurrency called Zcash. He observes, “There is a lot of sketchy stuff going on. So it’s valid to ask if deploying all these new currencies makes any sense.”

Cryptocurrency has also occasioned a lively debate among Carey Business School economists.

Jim Kyung-Soo Liew, an assistant professor in finance and real estate at Carey, is bullish. He co-authored a recent paper recommending that investors place a sliver of their portfolios in cryptocurrencies to get ahead of the curve, despite the murky landscape.

“We looked at it purely from an empirical exercise and determined that 1.3 percent of a traditional institutional investor’s portfolio should have exposure,” says Liew. “Sure, there’s lots of fly-by-night stuff out there at the moment, but the underlying blockchain technology is legitimate and has the potential of creating tremendous efficiency gains across many industries.”

Nicola Fusari, an assistant professor of finance at Carey, is more skeptical about the immediate prospects. “The volatility of cryptocurrencies,” he observes, “is way too wild to do anything reliable with them.”

An asset revolution

Even the initial creation of cryptocurrencies is shrouded in mystery. Satoshi Nakamoto (or a team under that pseudonymous name) produced the original cryptocurrency, Bitcoin, in January 2009. Nakamoto shepherded it for more than a year, then handed over the controls to others and vanished.

Carey’s Alessandro Rebucci, an associate professor of finance and real estate, likens Nakamoto’s innovation to a “white paper” on the technology.

So what did Nakamoto create – and how does it work?

Cryptocurrencies such as Bitcoin are built on the “blockchain” – a cryptographically secured and widely distributed digital ledger for transactions. These currencies exist in digital space and take no physical form, but the blockchain is where entries to the digital ledger are secured and maintained.

Users access the blockchain via electronic “wallets.” These devices hold the two cryptographic keys – a private key known only to the owner and a public key established on the blockchain – that are required to store, send, and receive cryptocurrency funds.

Open your Bitcoin wallet to buy, say, a milkshake, and a number of things happen.

First, your request to spend on the milkshake is broadcast to an entire network of computers (or “nodes”) that run the cryptocurrency’s software. That network (a) authenticates the request via algorithms and (b) keeps a permanent and time-stamped record of it.

Your approved purchase of that milkshake with your Bitcoin funds is then welded together with other approved transactions into a “block” added to a pre-existing “chain” of Bitcoin blocks that began with Nakamoto’s very first block.

This process is how the “blockchain” gets its name – and its growing record of collectively authenticated transactions (cemented with cryptography and time stamps) is extraordinarily difficult to alter without the consent of the entire network that created it.

What, then, is the incentive for members of this network to authenticate Bitcoin transactions? This is the “mining” – or creation of blocks – that is an essential part of building cryptocurrencies.

Creating blocks is not an easy process. It requires that a “miner” solve a complex computational problem (also known as “proof of work”). But successful completion of the process allows a miner to claim newly minted cryptocurrency offered as a reward for creating a block.

Other cryptocurrencies have followed in Bitcoin’s wake. Green says establishing them is a leap into a different economic future. “If you make these kinds of assets,” he observes, “that are open and widely accessible, and trustworthy in the sense that people believe that they won’t go to zero just because the technology breaks down, then they will be worth money. And once you have them even if the prices are volatile and terrible and they can be traded electronically and efficiently, then you can build applications to do things that you could not do before.”

The lure of this promise of efficiency is precisely what has Liew bullish about cryptocurrencies and the potential they hold to forge innovative ways to raise capital and bring services to customers. “Blockchain technology can disrupt almost any industry that has a middleman,” he says.

One part of the blockchain’s underlying strength, says Liew, is the way it distributes benefits widely through the network that creates and maintains cryptocurrencies. “The economics are very important,” says Liew. “The blockchain incentivizes the nodes correctly. If Satoshi had gotten the formula wrong, it wouldn’t have taken off.”

Liew says initial coin offerings hold the promise of even greater transformation. An ICO offers investors tokens – which they purchase with popular cryptocurrencies or fiat money (physical currency declared legal tender by a government) – to raise capital for a project in development. Closer in spirit to crowdsourcing than the ownership stake offered in an IPO, most ICOs offer no ownership with the purchase of a token. Purchasers may see a sharp rise in token value if the project succeeds, and the use of cryptocurrency pulls in a different investor class with an already existing stake in digital currency networks.

“It’s realigning where the benefits go,” argues Liew. “Benefit usually accrues to the shareholders of the company. With an ICO, value can accrue to the network. That is really exciting. It’s shifting how people think about raising capital and who benefits. Who are the real stakeholders? Is it just the equity shareholders, or is it the network?”

Seeking equilibrium

A challenge to business, as usual, is embedded into the sinews of cryptocurrency. It intentionally stands apart from traditional currency. Its structure aims to reward the work of creating and securing value in the system. And in a financial industry riddled with hacks and identity theft from centralized databases, the distributed network of the blockchain is extraordinarily difficult to hack in any meaningful way.

Carey economists Nicola Fusari and Alessandro Rebucci agree on the technology’s future potential. But they have questions about its current viability and functionality.

“The whole technology and system are in its infancy,” says Fusari. “We’re trying to think about what the equilibrium will be down the road. Is it sustainable?”

The questions burrow down to the very foundations of blockchain technology. “Bitcoin and any other cryptocurrency is a set of rules that somebody created – and someone can change the rules,” says Fusari. “With my skeptical eye, I also wonder, because this is the first time they wrote rules for it, what are the chances that these are the optimal rules? Maybe some of these rules are too binding. Maybe we need to relax them.”

Rebucci says that efficiency, as well as innovation, will govern the adoption of this new technology to replace existing models. “The blockchain was a great way to illustrate the potential that we have to replace government with something administered by the community,” he observes. “But, economically, the blockchain is not necessarily the most efficient solution.”

Efficiency can be measured in something as simple as buying a cup of coffee. A growing number of businesses do accept digital currencies, but they lack the simplicity and speed of paper currency or a debit card.

And precisely how many Bitcoins does it take to buy that coffee? The extraordinary volatility of cryptocurrencies also has caught the eye of both economists.

“The Bitcoin bubble is like nothing since the 14th or 15th century,” says Rebucci. “It is the largest in history ever.”

Fusari says that individual digital currencies also are not differentiating themselves from competitors in a meaningful way. “You believe you are buying many different kinds of cryptocurrency,” he says. “But the correlation of these currencies is almost one to one. You have the appearance of diversifying investment, but you are just buying the same thing.”

Cryptocurrency also lacks some of the safety nets – typically provided by government regulations and protections – that would guard against a systemic failure such as the bursting of the cryptocurrency valuation bubble.

Additionally, ICOs have offered investors none of the protections found in IPOs, and it is an environment in which scams are rife. In December, a newly-formed “Cyber Unit” in the U.S. Securities and Exchange Commission took what it described as “emergency action” to halt an ICO called PlexCoin, which used fake experts and claims of a rate of return of more than 1,330 percent to take in $15 million from consumers.

“Economists know that there are market failures and government failures,” observes Rebucci. “As economists, we want the best of both worlds in dealing with them – market solutions and government solutions. It’s difficult to see how to strike that balance when it comes to blockchain technology.”

Exposing cryptocurrencies to wider market forces is becoming key to testing their worth and stabilizing them. The Chicago Board Options Exchange opened a futures exchange for Bitcoin in December 2017, and there is a significant consensus that this is an important step in the evolution of cryptocurrencies.

“Investors can take a contrarian view that it’s a bubble and try to take it down,” says Rebucci of the exchange. “This is a stabilizing force.”

Fusari adds that the futures exchange is also a bridge for investors. “When you buy a Bitcoin future, there’s no exchange of Bitcoin,” he observes. “Investors are saying, ‘I don’t want the complication of Bitcoin; I just want to buy the value of Bitcoin.’”

Rebottling the genie

Cryptocurrencies and the blockchain are moving into markets and other areas of business and finance at a dizzying speed.

Green wrote his first paper laying out the structure of Zcash in 2014. “By 2016,” he says, “it was a real currency, and it launched. That’s the neat thing about this. You can come up with an idea and crank away at it and have it up and running with real people. Very few actual advanced research projects ever do that in the rest of the world.”

Liew is teaching a blockchain course at Carey this fall. “Advances in blockchain technology are rapid,” he observes. “MBAs may have to come back and get retooled for the new economy. There are skills I’m teaching now that I didn’t teach even two or three years ago.”

The speed of innovation also may accelerate solutions to some vexing problems posed by cryptocurrencies and the blockchain. “The sky’s the limit on the innovation side,” says Liew.

For instance, the race to solve complex mathematical problems, which undergirds the “proof of work” model, requires an intensive use of energy and computing resources to be profitable. Proposals to adopt a “proof of stake” model – which prioritizes holders of significant amounts of a cryptocurrency as creators of new blocks for the block chain – holds the promise of drastically reducing wasteful consumption.

One feature of Nakamoto’s design for Bitcoin was its utter transparency. Everyone with access to the blockchain knows the details of every transaction, which doesn’t square with most consumers’ expectations of being able to control knowledge of their finances.

Green’s work on Zcash aims to improve on that aspect of the technology. “You don’t want the rest of the world to know how much money you have,” he says, “or who you’re spending it with, or what you’re spending it on.”

Green sees his work on building more capacity for privacy in cryptocurrency as part of a larger debate: “If you start with the most privacy as a technology, it’s easy to relax that if you want to. But you can’t go the other way very easily. Then there’s no privacy, and you are at risk.”

Some inherent tensions in the burgeoning cryptocurrency movement – especially its relationship with government – cannot be solved by technology and innovation, and digital currencies are drawing increased scrutiny from regulators. Some governments, such as China’s, have made tentative moves to regulate cryptocurrency. In March, the Trump administration announced a ban on Venezuelan cryptocurrencies.

But aside from emergency actions for fraud, most watchdogs are taking a wait-and-see approach. “Regulators are not leading the process,” says Rebucci. “They are just trying not to make mistakes.”

In part, observes Fusari, that’s because the cryptocurrency movement is not yet a big enough headache: “Right now, people don’t look at it, because the ecosystem is too small. But as it gets bigger, they will look at it.”

Fusari adds that the still undefined “legal risk” in holding cryptocurrency is perhaps the largest unsolved element. “From a taxation perspective,” says Fusari, “it’s not 100 percent clear how you declare, or what you declare. Is it a currency for those purposes?”

Liew says governments that overregulate may lose the chance to shape the new landscape. “If regulators clamp down in their home markets,” he observes, “all this stuff is just going to move to other countries.”

Despite the divide over how cryptocurrencies are functioning in today’s markets, there is broad agreement that they will eventually take their place in the future of the global economy.

“I don’t think we can put the genie back in the bottle,” says Liew. “You have to learn about it, embrace it, and integrate it into your business or organizational processes. If you don’t do it, but your competitor does, you will subsequently fall by the wayside.”

Green thinks keeping an eye on the big picture is key. “What does matter is that this tech has applications,” he says. “We don’t know what they are yet. But we have to pay attention.”

As with any emerging force in finance, observes Rebucci, “you need to let the process play out. There will be winners and losers. There will be casualties. There are already casualties. But a new business model has come about, and it’s important. It’s making the world a more exciting, and better, and more competitive place.”--Richard Byrne

This story originally appeared in the spring 2018 issue of Carey Business.