According to bitcoin lore, the world’s first cryptocurrency transaction was made on May 22, 2010, when 10,000 BTC were exchanged for two pizzas. Bitcoin has been relatively well known in techie circles ever since. But Joe and Jane Average pretty much remained clueless about digital alternatives to fiat money until last year.
When did bitcoin officially go public with a bang? The exact date is debatable, but late last November is a good guess. After all, that’s when it had a starring role on the television sitcom The Big Bang Theory.
In an episode entitled “The Bitcoin Entanglement,” TV’s favourite science nerds recalled collectively mining bitcoin back when it was virtually unknown to the public, not to mention worthless. They didn’t digitally dig for the stuff hoping to get rich. They did it for the fun of exploring new technology, and once done feeding their curiosity, they forgot all about the coins that they earned using the processing capacity of a personal computer to solve complex math problems. Years later, after market demand for bitcoin started soaring, the Big Bang gang suddenly realized that the fruit of their algorithmic labour had become worth a small fortune, so they frantically started hunting for the now misplaced computer holding their digital treasure.
When the Big Bang script in question was finalized, the missing cryptocurrency was given a value of US$5,000 per token. But there is always a lag period between when a taped TV show is written and televised. And by the time this episode aired, the market value of bitcoin had doubled. In the weeks that followed, it soared above US$19,000, then crashed back under US$10,000. This volatility, of course, should not have caught anybody by surprise, not even on Main Street. After all, the possibility that bitcoin demand is based upon unrealistic expectations also went mainstream in late 2017—when more than a few Twitter votes for best Halloween costume of the year went to a guy sporting a bitcoin bubble suit.
Bitcoin is not easy to understand, not even for a rocket scientist. The concept was first described in a research paper published online during the global financial crisis. Posted under the pseudonym Satoshi Nakamoto, it covered a variety of topics, ranging from transaction costs, trusted third-parties, and the money supply to distributed decision making, data routing, cyberattacks, and cryptography.
The Nakamoto paper abstract states:
A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution. Digital signatures provide part of the solution, but the main benefits are lost if a trusted third party is still required to prevent double-spending. We propose a solution to the double-spending problem using a peer-to-peer network. The network timestamps transactions by hashing them into an ongoing chain of hash-based proof-of-work, forming a record that cannot be changed without redoing the proof-of-work. The longest chain not only serves as proof of the sequence of events witnessed, but proof that it came from the largest pool of CPU power. As long as a majority of CPU power is controlled by nodes that are not cooperating to attack the network, they’ll generate the longest chain and outpace attackers. The network itself requires minimal structure. Messages are broadcast on a best effort basis, and nodes can leave and rejoin the network at will, accepting the longest proof-of-work chain as proof of what happened while they were gone.
Get it? Me neither. Anyway, shortly after introducing the idea, bitcoin’s unknown creator(s) published enough code to create the world’s first decentralized cryptocurrency, which now exists in a software ecosystem comprised of pseudonymous users and miners who are rewarded for maintaining the so-called block-chain of transactions. With its roots in the anti-establishment cypherpunk movement, which advocates the use of cryptography to protect individual privacy and liberty, the bitcoin revolution has true believers who see the world’s original cryptocurrency as an ideal replacement for fiat currencies, or government-backed money, which is controlled by corporate middlemen and always at risk of being inflated or deflated by fiscal or monetary mismanagement. According to promotors in this camp, bitcoin is destined to be worth much more than its recent peak, which is why many retail investors are now spending real money to get in on the action. Market bears, on the other hand, insist the bitcoin revolution is nothing more than a libertarian fantasy based upon already dated technology.
The simple truth is that bitcoin will always be worth exactly what buyers are willing to pay for it. And as former U.S. Federal Reserve Chairman Alan Greenspan noted a few years before the dot-bomb market crash, buyer demand isn’t always rational. In a speech entitled “The Challenge of Central Banking in a Democratic Society,” Greenspan famously noted that central banking is tough because nobody really knows exactly when “irrational exuberance has unduly escalated asset values.” He also noted that central bankers “need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability.” As things stand, bitcoin doesn’t pose a major threat to the global economy, so central bankers are not losing sleep over the enthusiasm for it. But investors should be very concerned with the impact of irrational exuberance on bitcoin demand, since it has a nasty habit of evaporating.
Last October, as the value of outstanding bitcoin approached US$100 billion, CNBC reported on a Dutch family that had sold everything they own—from house to shoes—to buy as much bitcoin as possible. As pointed out in Bitcoin, Gold & Money, a market commentary by influential U.S. money manager David Kotok, this extreme consumer enthusiasm for betting on bitcoin screams out for comparison to tulip fever. During the Dutch Golden Age of history, a market love affair with imported tulips—seen as a status symbol—led to the first financial bubble on record. Soaring demand spawned an early futures exchange dominated by speculative trading. At the peak of the mania, some tulip bulbs were reportedly sold for more than ten times a local craftsman’s annual income, leading more than a few individuals to sell all their belongings to invest in the market. The bubble “popped” when demand for tulips virtually evaporated in the winter of 1636–37. As Charles Mackay reported in Extraordinary Popular Delusions and the Madness of Crowds: “The rage among the Dutch to possess them was so great that the ordinary industry of the country was neglected, and the population, even to its lowest dregs, embarked in the tulip trade.”
Mackay’s account has been questioned by fact-checkers who see a bit of a story bubble. According to Anne Goldgar’s book Tulipmania, Holland in the 1630s did indeed see a speculative rise in tulip prices, but she says its height and bursting have been exaggerated. Either way, die-hard cryptocurrency investors should see Dutch history as a cautionary tale. But many of bitcoin’s true believers remain blinded by crypto fever. One of the faithful, for example, posted a YouTube commentary that concluded bitcoin investors would be “set for life” if history repeats itself because the lesson he draws from the tulip bubble is that bitcoin must eventually be worth many times a decent modern annual salary.
“Every time a new-and-improved cryptocurrency is announced, bitcoin as an investment starts to look more and more like a digital Beanie Baby.”
The neat thing about market bets is that they don’t have to make sense to win or lose. Logic simply mitigates risk. The Dutch family that sold everything to bet on bitcoin in October could have doubled its net worth if it had sold its holdings in December. But investors who made the same bet at the price peak are currently sitting on a significant loss. Clearly, you don’t have to be a student of asset bubbles to question going all in on bitcoin (or any asset class). According to Didi Taihuttu, the father of the Dutch clan betting all its marbles on bitcoin, risking everything seems like a good idea because the world economy is “going through a revolution that’s changing the monetary system.” But if that’s true, the revolt remains bloodless, meaning government-backed money isn’t even close to being displaced, which is why central bankers are not overly concerned with the possibility of a bitcoin value collapse.
The Wall Street Journal nicely summed up what many optimistic investors apparently fail to see with the following one headline: “Bitcoin Is the World’s Hottest Currency, but No One’s Using It.” As things stand, using bitcoin might make sense for making dodgy transactions, but it is an expensive pain in the butt for most buying and selling that drives mainstream economics. As Globe and Mail finance writer Ian McGugan pointed out earlier this year, there are at least four glaring obstacles in bitcoin’s path to glory. The most obvious is cost.
“A few days before Christmas,” McGugan writes, “I watched as a friend tried to purchase a greeting card at a trendy Toronto boutique using her newly acquired bitcoin wallet. Yes, the helpful woman behind the register told us, we could certainly pay using bitcoin if we insisted on doing so. But we probably shouldn’t, she told us, because there would be at least a $30 transaction fee on top of the $3 price of the card. So we walked away. Multiply that experience a few million times and you have some idea of the challenges lying ahead for the world’s most famous pseudo-cash.”
It is important to note that the fees reported by McGugan were much higher than the historic norm and have since plunged to about US$2 (at least at press time for this story). But it is also important to note that they fluctuate with transaction volume.
Why does it cost money to use bitcoin?
Despite common belief, while the system is indeed peer-to-peer, every transaction still needs to be verified by third-parties. Every transaction is broadcast across the entire network, where miners compete to solve complex math problems, hoping to win the right to update the block-chain ledger in return for transaction fees, which rise and fall with system activity. Mining operations, which reportedly already burn as much energy as the Irish economy, are also rewarded with newly minted bitcoins until the total number of tokens generated reaches 21 million.
Bitcoin miners are not like the institutional middlemen who currently control most monetary transactions since they don’t have access to any information on the nature of transactions or the parties involved. Furthermore, every bitcoin user can serve as a miner at virtually no extra cost (since computing capacity is required just to own bitcoin).
Nevertheless, the system needs to reward miners to ensure it is constantly maintained. And nobody knows what will happen to transaction fees when there are no more bitcoins available to offer as an incentive. Fees could simply skyrocket. But a majority cartel of miners could also conspire to increase the supposedly limited supply of bitcoins to keep profiting off maintaining the system. Any disagreement on altering the bitcoin ecosystem, of course, can lead a minority group to “hard fork” the block-chain and move forward as a separate cryptocurrency, impacting demand for bitcoin while creating complexity issues for users. This is how bitcoin cash was born, which you could argue was a bit like printing money (although media reports that the bitcoin cash fork instantly generated billions of dollars in new wealth out of the air fail to account for the rising demand that cryptocurrencies in general were experiencing at the time).
Whatever happens down the road, confidently conducting bitcoin transactions is also currently tedious because it takes significant time for new blocks of data to be verified and added to the master block-chain ledger. Meanwhile, as McGugan points out, the private nature of bitcoin transactions pretty much guarantees that the cryptocurrency will never be used for making loans, which are relatively important to global economic activity.
In the academic paper From Bretton Woods to the Euro: How Policy-maker Overreach Fosters Economic Crises, Wilfrid Laurier macroeconomics professor Pierre Silos notes policy makers behind the post-war Bretton Woods system of pegged exchange rates, which was supposed to include a form of peer review of member economic policies, promised too much in terms of “stability and durability.” In particular, Silos notes the developers of Bretton Woods failed to give sufficient thought to how the system would function long-term without installing the logic of collective action. The same can be said about the people who designed the bitcoin revolution.
True believers can talk all they want about displacing fiat money with bitcoin, but it will take more than a first-mover advantage and market hype to make it happen. In addition to consumer acceptance, the bitcoin dream requires government and banking-sector support for replacing entrenched monetary systems with a flawed cryptocurrency. As McGugan notes, none of this necessarily spells doom for the cryptocurrency revolution. But although bitcoin has already made history by introducing the possibility of scarcity in the digital world, nothing guarantees that it can maintain its position as revolt leader, which is constantly being threatened by more innovative revolutionaries. Every time a new-and-improved cryptocurrency is announced, bitcoin as an investment starts to look more and more like a digital Beanie Baby (look it up, kids).
“Bitcoin is dead,” concludes Jean-Philippe Vergne, founding coordinator of Ivey Business School’s Crypto Capitalism Center (which offers a free online crash course on the origins of cryptocurrency technology and its applications beyond payment systems). In Disrupting the IPO, an IBJ Insight that examines the potential of so-called initial coin offerings to add value to the capital-raising process, Vergne notes that bitcoin’s legacy is secure, since it opened the door for cryptocurrencies to be taken seriously and sparked the emerging world of cryptoeconomics, which the Ivey professor says is about using a combination of cryptography, economics, and game theory to design mechanisms and incentives to obtain desired properties in a decentralized network wherein digital or digitized goods are produced, distributed, and consumed. But when the crypto chapter in history is finalized, bitcoin probably isn’t going to go down as the slayer of establishment money.
So, what is to become of the world’s original cryptocurrency?
“The bitcoin project has shifted from being electronic cash to a digital store of value,” says Vergne, who also serves as co-director of Ivey’s Scotiabank Digital Banking Lab, noting pretty much everyone he knows in the bitcoin community recognizes the goal is no longer “to facilitate payments for buying a cup of joe at Tim Hortons.”
In other words, the future of bitcoin, if it has one, probably lies in giving gold a run for its money as a hedge against the stability of fiat money. Gold itself, of course, hasn’t had an official place in monetary affairs since the breakdown of Bretton Woods, which is why Gordon Brown, Britain’s former chancellor of the exchequer, was comfortable unloading about 400 tonnes of the U.K.’s gold reserves for less than US$300 an ounce in 1999.
As John Kenneth Galbraith told me shortly before his death in 2006, logic dictates dismissing gold enthusiasts as simple metal collectors. “No one should take gold as seriously as it was once taken,” he said, arguing that investing in the yellow metal was not much different than betting on whisky or tobacco. However, as the legendary Canadian economist also noted, “There is a presumption that with money and the control of monetary institutions goes an inborn intelligence. But all you really need is to know that community to find out how unreliable that presumption may be.”
There is no question that the investment case for gold was strengthened by the massive money-printing programs initiated by central bankers to prop up the global economy following the financial crisis, which led John Mauldin, a Texas-based adviser to the rich, to introduce his popular newsletter on economic affairs by quoting R.E.M.’s “It’s the End of the World As We Know It (And I Feel Fine).” At the time, Mauldin didn’t expect the global monetary system to collapse. But he still bought gold. “My fondest dream,” he explained, “is that I will give my gold coins to my great-great-grandkids some 70–80 years from now, and they will be rather embarrassed that their Papa John bought all that much of that barbarous yellow metal instead of more biotech stocks. But as I live in the real world, I buy gold, even though I am optimistic we’ll get through this rough patch; because I simply don’t trust the bas*%*ds who are driving this ship with 100% of my money in dollars, or any fiat currency, for that matter.”
Following the global economic meltdown, national foreign reserve managers showed how little they trusted each other by moving from being net sellers of gold to net buyers, which helped push the price of bullion above US$1,900 an ounce in 2011. This renewed interest in alternatives to fiat money was shared by the public. As Greg Newman, director of wealth management at ScotiaMcLeod’s Newman Group, pointed out in my Financial Post Magazine column a few years ago, the Great Recession took the case for owning gold mainstream, but “many investors are now watching their gold assets sputter while other assets appreciate and produce generous cash flow. Convictions are now being tested.”
Today, with governments once again spending like drunken sailors, there is good reason to worry about inflation. But just as many former gold bugs regret buying bullion at the market peak, confidence in bitcoin is being tested. What happens to the value of the cryptocurrency in the short term is anybody’s guess. The multibillion-dollar question is whether demand will increase or decrease as investors realize that bitcoin’s long-term potential is probably greater as an unofficial digital store of wealth than as an unofficial means of exchange—with no intrinsic value or any barrier to competition—embraced by the so-called dumb money that often gets trampled when an investment herd turns and runs for the exit.
Ironically, bitcoin’s potential to become the new gold is considered weak by critics who note that cryptocurrencies all have something troublesome in common with fiat money. “They may not be legal tender yet,” points out a commentary by Riskhedge partner Olivier Garret, “but they’re also not backed by any sort of physical commodity. And while total supply is artificially constrained, that constraint is just… well, artificial.”
New gold or not, the hype around bitcoin is invaluable as an awareness generator for the real revolution going on in cryptoeconomics and the greater fintech space. And this is particularly true in Canada.
Nobody knows exactly how big an impact the digital revolution will have on the financial sector. “You never know, the cool new thing amongst the kids in 20 years might just be carrying around paper-based bank books,” Jesse McWaters, the World Economic Forum’s financial innovation lead, noted at a fintech conference sponsored by the SWIFT Institute and Ivey’s digital banking lab in 2016. But you can probably soon forget about regular branch visits or banking at an ATM. In fact, you can probably even forget about using banking apps.
As I noted in FinTech: The Disruptive Enabler, the digital world will eventually allow you to bank anywhere at any time without access to a computer or smartphone. Think about all the wasted time you currently spend in traffic. That won’t be an issue in the not-too-distant future, when you will probably travel around with a personalized AI assistant (think Siri or Alexa on steroids) embedded in special glasses or your head. After hailing an automated transport pod to take you to work or out for dinner, your robo life manager will be there to offer advice on investing matters, help you find the best deals on consumer goods, or do other productive things like arrange a crowd-sourced mortgage or peer-to-peer loan. As you travel from A to B, you might just earn enough reward credits making transactions to pay for your trip.
Simply put, the banking customer experience will eventually be nothing like it is today. In 20 years, McWaters figures financial institutions might even exist below the surface of consumer perception, providing a secure platform for an ecosystem of products and services, including plenty of third-party offerings. Visible or not, banks will not just be in the business of providing financial services and offering market advice. Using a combination of behavioural science, biometrics, transaction data, and customer tracking data, financial service firms will exist to offer advice throughout your day. For example, your bank will coach you to be a better spender. “I think that’s a fundamental shift in the way we perceive the role of financial institutions that really could be coming over the next 10 to 15 years.” Meanwhile, behind the scenes, block-chain technology will enable distributed ledger systems and digital currency options that will vastly improve payment and settlement systems, reducing industry costs along with consumer frustrations.
Many market-watchers still expect the Canadian financial sector to face off against fintech firms in a battle for market dominance. After all, large financial institutions have proven relatively slow to innovate in the past thanks to their size, heavy procurement processes, and legacy systems. However, when previously challenged, the heavily regulated sector has shown significant resilience partly due to consumer inertia, which is being eroded by demographics. Thanks to the so-called uberization of market expectations, banking customers want better service. As former Apple CEO John Sculley noted in an IBJ Q&A on the soaring opportunities for disrupting market incumbents (see Shooting for the Moon), when rising consumer expectations are combined with new low-cost and reliable new technologies, established players across all industries are at risk. Bankers know this, which is why they are moving to disrupt themselves. But an all-or-nothing war for market share doesn’t appear to be in the cards, at least not between incumbents and fintech ventures.
As SWIFT Institute Director Peter Ware pointed out in 2016, since banks and fintech firms exist at “opposite ends of the spectrum,” they are almost a “perfect match” for strategic partnerships, especially when you consider the possibly larger threat posed by social media companies, cable and telephone providers, and foreign banks looking to move into Canada’s lucrative market. “Rather than being a disruptor,” Ware said, “I believe fintech represents an opportunity and an enabler for the financial industry.” But it will take more than a willingness to partner for Canadian banks and fintech firms to successfully navigate the coming waves of disruption because a lot depends on consumer adoption rates and government support. And unfortunately, Canada is weak on both fronts.
According to an EY global survey of digitally active consumers conducted last year, fintech adoption in Canada sits below the global 33 per cent average, seriously lagging leading nations such as China (69 per cent), India (52 per cent), the United Kingdom (42 per cent), Brazil (40 per cent), and Australia (37 per cent). The state of local government support is equally depressing. Indeed, while politicians in other countries champion fintech innovation with national strategies and open banking initiatives (the United Kingdom and European Union have moved to give third-party developers access to bank data), the Canadian fintech community is still waiting for someone in government to mount a horse.
As noted in Preparing Canada for the Fintech Tsunami, a call to action by Ivey Professor Michael King, who also serves as co-director of the business school’s digital banking lab, our nation should be well-positioned to benefit from the fintech revolution, but it is lagging other nations thanks to “a lack of a national strategy and the absence of a fintech champion to provide leadership in this vital sector.”
Bitcoin is now a decade old, which in tech time is near death. But the hype around it obviously still has legs. In late February, Trademark Renovations, a general contractor based in Calgary, announced that it would now accept bitcoin to support a more level payment playing field. The press release insisted: “Once cryptocurrencies are adopted by the mainstream, the pricing for building materials and logistics will not be subject to the current fluctuations of fiat currency exchange as they are with USD to CAD.” Try telling that to the sad sack who spent 10,000 bitcoins on two cheese wheels back in 2010.
For the record, on the day of this fake news announcement, the Canadian loonie was worth around US$0.79, down less than 5 per cent from its 52-week high and less than 5 per cent up on a year-over-year basis. Bitcoin, on the other hand, was trading at US$9,688, up about 750 per cent year-over-year and 50 per cent off its December peak—when 10,000 bitcoins were worth close to US$200 million
Before this story is finalized, the value of bitcoin could reach a new record. But sooner or later, its true believers will likely pay for underestimating its offspring, meaning newer disruptive technologies. In the meantime, let’s hope Canadian politicians are watching the pace of change in the crypto space and soon realize that now is not the time to wait and see how fintech strategies work out for other nations. If not, anyone in the future who claims Canada is an innovation leader might just end up looking as silly as that guy sporting a bitcoin bubble suit.