Out of the ashes of the financial recession rose the decentralized digital age; cryptocurrencies are just one of the applications of this decentralization. In 2009, the first cryptocurrency, bitcoin, of the Bitcoin protocol was created by the enigmatic Satoshi Nakamoto. Bitcoin uses Blockchain technology to securely verify transactions without having to rely on a trusted central authority. This cryptocurrency now holds a value of about $15,000 per coin, as of 8AM EST on 12/7/17, and is the topic du jour at every happy hour. By association, other lesser known cryptocurrencies, particularly Ethereum (ETH), Litecoin (LTC), and Ripple (XRP) are also gaining traction. There is much skepticism around this subset of digital assets; however their adoption will ultimately prove or disprove their legitimacy.
In our initial analysis, we put cryptocurrencies (coins) into two groups: i) store of value, ii) token of utility. To be a store of value, the cryptocurrency must be able to retain purchasing power and be seen as a unit of currency that can be used to verify the transfer of funds. To be a token of utility, the coin is more so a unit of service used as a means of facilitation on a certain platform. Some coins exhibit both properties, but are primarily intended to be one or the other. Bitcoin is a store of value; however its popularity amongst online merchants has also made it the coin with the highest real world utility. On the other hand, Ethereum is a token of utility, and arguably has the highest utility potential of all cryptocurrencies. There are a plethora of teams developing Ethereum based platforms to create new disruptive technologies.
We should note that much of the price action in this space has been highly speculative; however we identify some parameters to consider when analyzing cryptocurrencies:
With that in mind, we have identified five coins that have our attention: Bitcoin, Ethereum, Bitcoin Cash, Ripple, and Litecoin. These five coins make up around 84% of the cryptocurrency market.
Bitcoin (BTC) and Bitcoin Cash (BCH)
There are currently around 17 million bitcoins in circulation right now and there is a fixed cap of 21 million coins that will ever be in existence (in the current system). Bitcoin’s network is powered by miners, which are groups of individuals and companies that use computing power to process transactions in exchange for compensation in bitcoin (both from newly minted coins and from transaction fees). Transactions are recorded on a global database called the blockchain. Miners compete against each other to verify blocks of transactions by attempting to calculate a hash function output that is smaller than a target value by altering a parameter called the nonce.
Let’s consider how bitcoin actually works as a means of exchange for goods. Most people pay for their coffee using cash, credit card, or prepaid card and the sale transaction process takes only a few seconds. Paying for coffee with bitcoin is fundamentally different from those methods because there is no immediate mechanism to guarantee that there are enough funds in the purchaser’s account until the balance is actually deducted. Due to the lack of a trusted central authority, a bitcoin purchase is most similar to writing a check and waiting for it to clear before completing the transaction. The wait time to confirm a bitcoin transaction will vary but it generally takes around 10 minutes, which probably feels twice as long if waiting for your morning cup of coffee. In addition, bitcoin miners do not process transactions for free and so, a “small” incentive is needed: 150 satoshi per byte, with a typical transaction size being 200 bytes. This is equal to 0.0003 bitcoins (100,000,000 satoshi equals 1 bitcoin) or approximately $4.50 USD at current bitcoin valuations. It is very unlikely anyone would be willing to spend an extra $4.50 to buy cup of coffee. As such, we expect to see bitcoin’s prevalence in large transactions as opposed to day-to-day payments. Bitcoin’s rapid appreciation has actually impaired its usefulness as a means of exchange for many things.
In August 2017, Bitcoin underwent what could loosely be described as a dividend payment. As Bitcoin was gaining in popularity, the volume of transactions was increasing but the actual processing speeds were getting slower and slower. Disagreements between members of the Bitcoin community resulted in a “hard fork” and the creation of Bitcoin Cash, which prioritizes its usage as a transactional currency (lower transactional costs) versus as a digital store of value. Holders of bitcoin were given Bitcoin Cash tokens equal to the number of bitcoin tokens they owned. Given the philosophical divide which prompted its creation, Bitcoin Cash is relatively closer to a token of utility although issues remain with high transaction costs and processing time.
Outlined in 2013 and launched in 2015 by Vitalik Buterin, Ethereum is a platform that enables smart contracts which replace legal contracts with code and also provides compensation to developers for creating and running decentralized applications. Ether is the cryptocurrency that drives the Ethereum platform. There is no set limit on the supply of ether and so it is inherently inflationary, and aims to be a token of utility rather than a store of value. Whereas Bitcoin is fully decentralized in the way of leadership (its founder remains anonymous), the Ethereum community generally follows Buterin and this allows the platform to implement systematic changes faster. The miners who support a more decentralized system approach have switched to another cryptocurrency called Ethereum Classic. Due to its focus on ease of use in applications, Ethereum has become the platform of choice for initial coin offerings and for many corporate blockchain initiatives.
Ripple is a foreign exchange platform created for instantaneous settlement between banks. This venture was launched in 2012 by former Bitcoin developers in an effort to improve and possibly disrupt the global remittance industry. Ripple is a network which makes use of the ripple token (XRP) to facilitate transactions. As such, we view XRP as a utility token, whose value will be dependent on its adoption and acceptance. Ripple, in effect, is very different from Bitcoin, Ethereum or Litecoin, and is solving for a totally different problem. XRP is not mined and the venture has set the maximum number of XRP in circulation to 100 billion coins. The Ripple network has already been adopted by a number of large banks, as they test its value proposition. Critics point to the Ripple networks independence, and its ability to function without XRP as a drawback. However the use of XRP is extremely advantageous in facilitating transactions amongst currencies that suffer from poor liquidity. Ripple hopes to complement other coins by bringing the space into “the mainstream world of finance” – Stephen Thoman, Senior Developer, Ripple Protocol.
Litecoin is popularly called digital silver, where bitcoin is digital gold. This cryptocurrency was launched in 2011 by a former Google employee and was intended to be a cheaper, faster and more practical substitute to bitcoin. Its fast processing time makes it the practical solution for everyday transactional use. For instance, in the cup of coffee example earlier, the preferred method of payment would be via litecoin, as the transaction is validated within a minute or two, as opposed to upwards of 10 minutes with bitcoin. Also, it has much lower fees than Bitcoin, at about $0.30 per transaction vs Bitcoin’s $4.50.The Litecoin’s protocol lends itself to daily transactional use, thus most likely to be adopted if cryptocurrencies one day become a day-to-day medium of payment. Because litecoin is very similar to bitcoin, it has a higher correlation to bitcoin relative to other coins.
In our previous post Digital assets and the tokenization of commodities, we mentioned that the monthly return correlations of bitcoin over the past five year period against other traditional asset classes showed a weak relationship. Surprisingly, the correlation between bitcoin and gold was also slightly negative despite the fact that many consider gold to have similar store of value qualities. Bitcoin does correlate fairly highly with a few other coins, most notably litecoin, however it doesn’t show much correlation with ether and reduced correlation with ripple. It is important to note that the relationship between inter-cryptocurrency monthly returns in the future can change quickly especially given their short histories.
Bitcoin is currently all the rage, and although its actual utility as a means of purchasing goods has been impaired, its appreciation has certainly boosted its standing as a traded asset. By the same token, other coins have shown some great potential to disrupt the status quo. As there are well over 1,000 different cryptocurrencies in existence currently, we expect that when the space matures, only a handful of cryptocurrencies will capture the bulk of the cryptocurrency market cap. Look out for these alternative coins to start making bigger headlines… so at your next happy hour, you too can add to the conversation by bringing another coin into the mix.