The Treasurer’s Guide to Digitisation 2015

Cryptocurrencies: investing in the future of finance

Published: Sep 2015

Much has been written about cryptocurrencies in recent years. For some, they are a dangerous and volatile commodity. For others, they are powerful tools that have the potential to reinvent the global financial infrastructure. Either way, ever since bitcoin – the world’s foremost cryptocurrency – began to gain in popularity, people have debated its potential and asked whether it, or any other cryptocurrency, has what it takes to establish itself as a major digital payment method.

In 2009, bitcoin became the first decentralised cryptocurrency to enter circulation. At the time of its creation, the value of one bitcoin was practically zero because it had few users – mainly cryptography fans ‘playing’ with the new currency. Fast-forward to early 2011, and bitcoin reached parity with the US dollar before experiencing the first of a number of bubbles that year, rising to $31 per bitcoin. Since then, bitcoin has experienced dramatic peaks and troughs, famously reaching over $1,250 in November 2013. The value has since fallen quite dramatically and, at the time of writing, sits at around $200/300 per coin.

How do cryptocurrencies work?

Despite growing mainstream coverage, to many casual observers the conversations around cryptocurrencies remain full of jargon and complex concepts – and above all, for many corporates, they seem irrelevant. But before we begin to examine the arguments for and against bitcoin, let’s take a look under the hood of the cryptocurrency.

According to the Oxford English Dictionary, a cryptocurrency is “a digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank.” Unlike traditional fiat currencies that are printed by a central bank, cryptocurrencies are ‘mined’ by individuals and now, more commonly, by specialised mining groups. To mine a cryptocurrency, specialist software and hardware are needed in order to solve complex mathematical algorithms that become increasingly difficult the more coins that are mined. The process is often compared to the mining of commodities, such as gold, that are finite and become increasingly problematic and costly to attain.

The computer power that is used to mine a cryptocurrency is what maintains and keeps the network alive, and at the heart of this network sits a decentralised public ledger (more on this later) that records every transaction made using the currency in real-time. All users are given their own unique bitcoin address and the cryptography built into the chain maintains its integrity and chronological order. As such, it is easy to see how much value belongs to a certain address at any point in time. It also makes adjusting the chain very difficult, so it is nearly impossible for a bitcoin user to spend more than they have.

Once mined, bitcoins can be held as an investment, converted into fiat currency or used to purchase goods and/or services. Statistics released by bitcoin payment processor BitPay show that the majority of merchants currently using the cryptocurrency choose to convert their bitcoins into fiat currencies.

A game changer?

One of the most commonly mentioned benefits of a cryptocurrency is its decentralised nature. Cryptocurrencies, such as bitcoin, are built on a decentralised ledger that is built and maintained by its users. Transactions take place on the network peer-to-peer or through an exchange and are automatically recorded on the ledger. Essentially there is no need for any of the traditional financial infrastructure to exist – and the costs associated with it – for cryptocurrencies to be used. For corporates, who in recent years have been tasked with doing more with less and have been focusing closely on transaction banking costs and looking to reduce fees where possible, this may sound appealing.

As all treasurers know however, there is no free lunch and transacting in cryptocurrencies doesn’t change this. There is a transaction fee that is applied when using the various exchanges. This currently sits around the 1% mark, however when compared with the 4% fees charged by card providers such as Visa, MasterCard and American Express, the attraction is clear.

In addition to being independent from the traditional financial system, cryptocurrencies also transcend nations, their borders and governments. There is no jurisdiction or economic underpinning to cryptocurrencies and this may have a benefit to corporates operating across borders. For example, cryptocurrencies are not subject to the rules and protocols that dictate the movement of fiat currencies across borders (although they are subject to some regulation in certain countries – more on that later). In theory, this means that a cryptocurrency could be used as a vehicle to move cash out of those countries where it has often been trapped.

A third characteristic that could make cryptocurrencies an attractive proposition for some corporates is that payment is entirely irrevocable. Traditional clearing and settlement systems involve – to a greater or lesser extent – the issue of revocation of payment instructions, particularly in the international system. Because of this, corporates are often faced with the risk of the payment being recalled. Products exist that look to mitigate this risk, letters of credit for example, but there is a cost involved in using these.

Those analysts in favour of cryptocurrencies also believe that they offer a new way for corporates to look after their customers – and protect their data. Consumers who use them will not need to provide any personal payment information. Comparisons here can be drawn to PayPal. However, cryptocurrency advocates suggest that it is more secure than PayPal because they have no database of information that can be leaked if an account is hacked. And while individual crypto-wallets have been subject to such attacks, new security developments, such as multi-sig technology are making this more of a challenge for cyber thieves.

As such, accepting cryptocurrencies may prove an innovative way to attract business from security-conscious consumers. Indeed, computer giant Dell, a company who began piloting the acceptance of bitcoin in the US in July 2014 and have since expanded this to the UK and Canada, is seeing positive feedback from its customers. Paul Walsh, Chief Information Officer at Dell Commerce Services told Treasury Today in 2014: “We’re pleased by the initial response to our current bitcoin pilot on for consumer and small business shoppers in the US and purchases have exceeded our expectations.”

Some big barriers

According to bitcoin payments processer BitPay, in February 2015, 100,000 merchants worldwide accepted bitcoin as a means of payment. As we have seen, Dell is one of these companies but others include Amazon, Microsoft and Subway. While this is a fairly large number it is by no means widespread. It is also worth noting that for many of these large companies ‘accepting’ bitcoin, that they themselves are not accepting it and have partnered with various bitcoin partners who accept the coins, convert them into USD and then pass these onto the company.

This rather slow rate of adoption comes as little surprise when you consider the deluge of negative press that surrounds the cryptocurrency. In late 2014, Bloomberg classified bitcoin as the world’s worst currency that year. And given that the value of bitcoin dropped 56% against the USD during 2014, it’s easy to understand why.

The cryptocurrency’s volatility is a huge barrier to adoption, not least in the corporate sphere. In 2013, bitcoin was on average ten times more volatile than the S&P 500 and 15 times more volatile than the EUR:USD currency pair. Against this backdrop, can treasurers really afford to embrace bitcoin?

The argument against bitcoin is made even stronger when we consider the high-profile controversies that it has encountered during its short life span. Most notably the collapse of Mt. Gox, the Japanese-based exchange that in 2013 handled 70% of all bitcoin transactions, which ‘lost’ 850,000 bitcoins valued at more than $450m at the time. Although 200,000 coins have since been recovered the reason for the disappearance of the coins remains unsolved and many are concerned that something similar could happen again.

Compounding matters, cryptocurrencies cannot be held in a bank account, with the long established security protocols that support this. Traditionally, the currency is instead held in a bitcoin wallet. The digital wallet can come in multiple guises including in the cloud, on a hard drive, or even on a device locked away in a safe. All current methods have their own issues, firstly the security of the cloud solution needs to be optimal, as security around bitcoin has been under the spotlight with a number of high profile breaches and ‘heists’. So-called ‘cold storage’ (storing the bitcoin on a device that is not connected to the internet, be it a hard drive or physical coin) on the other hand, may be a safer option as the wallet is disconnected from the internet and therefore away from hackers. That said, it poses its own challenges because it is not easy to access the wallet quickly or conveniently to make and accept payments.

The Mt. Gox affair also highlights a separate issue: namely, the anonymity that cryptocurrencies offer. Although any transaction that occurs will appear in the blockchain (the decentralised public general ledger) for that day, the lack of identifying information available and the lack of forensic tools to analyse the blockchain can make following transactions extremely difficult, if not impossible. Hence why cryptocurrencies are often associated with ‘dark net’ trades. So while anonymity is a selling point to some, it is more a barrier for corporates.

Case study

Air Lituanica joins the bitcoin revolution

In August 2014, Air Lituanica announced that passengers could now purchase their plane tickets using bitcoins. Speaking at the time of the announcement, Simonas Bartkus, Director of Commerce at the company said: “Bitcoin payments are highly beneficial for the aviation market – this currency helps to attract more buyers from abroad as bitcoins can be used anywhere in the world. The money transfer is fast and there are no added taxes otherwise deducted by banks and agents.”

Since then, Sandra Meškauskait -e, the company’s Communication Manager, has spoken with Treasury Today and explained a little more about the company’s decision to accept the cryptocurrency. “Bitcoin is the most universal and reliable currency in the world. We installed it on our flight tickets booking engine and this has been a very popular decision – it is used by international customers all over the world.”

One of the drivers behind the decision was to give customers more real-world payment choices. What’s more, it’s simple to use. “When customers choose to pay by bitcoin, they are redirected to our payment service provider’s webpage (MisterTango) where they can find a QR code or bitcoin address which they can use to send the currency to. Once the payment is processed, we receive confirmation from our payment service provider and we then sell the ticket to the customer.”

In terms of security and risk management, Air Lituanica does not store payments in bitcoin. “MisterTango sells the bitcoins on the exchange and we receive euro in return. That is why we do not have a lot of risk associated with bitcoin and we treat it like a faster, more convenient payment method for our customers.”

While the company is only using bitcoins for simple transactions at present, Sandra Meškauskait -e believes that it has far wider applications and that customers will become increasingly interested in using bitcoin. “It is an extremely useful innovation and in the future it may eliminate current online payment methods,” she notes.

Regulating the unknown

In an age when the traditional financial system is coming under increasingly stringent regulatory pressure, it is perhaps no surprise that cryptocurrencies have also fallen under the gaze of the regulators. The challenge, however, is how can a national regulatory body regulate a decentralised system that transcends borders?

The answer is complex and a number of different countries have taken alternative views. For example, in early 2014, US Federal Reserve Chairperson Janet Yellen announced that: “It’s important to understand that this (bitcoin) is a payment innovation that’s happening outside the banking industry. The Federal Reserve simply does not have the authority to regulate bitcoin in any way.” With this statement many in the industry breathed a huge sigh of relief as it meant they no longer had to worry about the Fed cracking down on the currency. However, bitcoin has gained the attention of other global regulators both at state and local level.

At the other end of the spectrum, in China, a country that bitcoin was once very popular in, the regulators have come down hard and restricted its use. The use of cryptocurrencies in Iceland has also been prohibited falling under the capital controls put in place in 2008 – how they will be impacted now that Iceland has lifted these controls remains to be seen.

How cryptocurrencies are classified is another interesting area and the lack of agreement from regulators seems to suggest it is a question to which they do not know the answer. In the UK, it is classed as private money and in Iceland is it a currency. But in Australia it is seen as property. Inconsistencies such as this place a huge burden on companies accepting bitcoin and other cryptocurrencies when it comes to reporting, auditing and tax.

The importance of regulation cannot be underestimated and according to Nathalie Reinelt, analyst with US Boston based research firm Aite Group: “it will make or break bitcoin.” And while many experts who commentate on the currency also share this view, it remains a bone of contention in the cryptocurrency community. Cryptocurrencies, by their very nature, are decentralised and not tied to governments, yet as they become more popular, and are used more by consumers, there will need to be regulation. “It is a catch-22,” says Reinelt.

Ultimately, these issues need to be resolved – otherwise cryptocurrency use cannot be standardised and there will not be mainstream consumer or business adoption. The ambiguity of cryptocurrency regulation is mainly caused by the fact that the cryptocurrencies fall under the watch of a wide range of regulators at both national and local level and there are few steps being taken to create a global regulatory framework that could standardise their use. And for Reinelt this may never happen: “I don’t think it will be possible to get that many regulators to agree,” she says. “I think the best outcome will be if countries watch what the big nations do; the US, UK and China, for example, and then augment those regulatory concepts to meet their own needs.”

Building blocks

While cryptocurrencies often grab the headlines, it may actually be the technology behind them that provides the real potential. As explained earlier, the blockchain is a distributed public ledger that is backed and secured by mathematical algorithms. It works by blocks being added to the chain in a linear fashion once any change has occurred – thus providing a full digital history of every transaction in the chain. Although the primary use of the blockchain is currently to enable cryptocurrency transactions, the blockchain can actually facilitate the transfer of value of anything which is digital, be it cash, an invoice or even a contact and this should always be 100% irrefutable, irrevocable and fully visible.

In the digital age, the transformational power of the technology is, in theory, limitless. For example, it could be used to facilitate free and fair elections, carry public records such as passports, and even store more frivolous items such as coupons and movie tickets. But it is in the financial services industry where the majority of innovation is currently happening and we have already seen some banks beginning to experiment with it. For instance, Australia’s biggest bank, the Commonwealth Bank of Australia has announced that it has begun experimenting with Ripple – a payments platform that is inspired by blockchain technology – to transact between its subsidiaries. While in Singapore, DBS has hosted events which encouraged people to develop ideas and concepts around how the technology can improve banking in emerging markets.

In the world of corporate treasury, blockchain’s potential is also great as a glue that binds all these new innovations together. Take the trade space for example, which is slowly moving towards electronic documentation. Once all documents involved in the trade transaction are made electronic, then these can all be transacted on the blockchain providing a fully secure and visible digital record of the transaction. These documents could also be turned into smart contracts which are automatically traded once certain conditions are met allowing the entire transaction to be made fully automated and visible end-to-end.

And there is another step that can potentially add further benefits. As Gautam Jain, Managing Director and Global Head of Client Access and Product Development at Standard Chartered explains: “If a corporate already has smart electronic documentation being traded on the blockchain that is a great start, but there remain some issues.” He explains that during a trade transaction there are instances when a corporate is in the dark regarding the location of their goods – while in transit from a port to a depot for example. It is here that technology can again provide a solution. “The corporate is exposed to risk during this period, but this can disappear if a chip is placed into the container which transmits its location,” says Jain. “This can then be logged on the blockchain automatically so all involved in the transaction can see there is no issue.”

In this example, electronic documentation, the internet of things (the tracking chip) and the traditional trade transaction have all been married together by the blockchain, giving the corporate an automated and fully visible transaction end-to-end. “This gives corporates not only certainty, control and visibility,” adds Jain, “but also can allow corporates to revisit trade financing and shift towards more event-based financing options, whilst reducing the cost because the risk is gone.”

Beyond theory

While currently many developments around blockchain are conceptual, there are some platforms which provide a working example of how blockchain can be used. One such company is Ripple, which is advertised to be “the first open-standard, Internet Protocol (IP)-based technology for banks to clear and settle transactions in real-time via a distributed network.” This allows banks to make faster payments in more currencies and into more markets, with lower cost and risk than is possible today.

Ripple claims that it can do this because, unlike the traditional financial infrastructure, the platform is not tied to governments or third-party intermediaries such as clearinghouses. Instead, Ripple has adopted a similar model to the blockchain (a distributed public ledger that is backed and secured by mathematical algorithms) but with a key difference. Unlike, the bitcoin blockchain which relies on mining to create value (a bitcoin), the Ripple network is powered by participating users agreeing on changes to its ledger every few seconds. As such, banks are able to clear transactions on its network 24/7 and 365 days a year in real-time and (by avoiding third parties) without the same level of cost.

Currency conversion, of any currency can also take place on the network and again for little cost. This is because of the platform’s ability to allow market-makers to sit in the middle of transactions. For example, banks can ask the network for a quote on converting $100 dollars into euro. Market-makers (other banks, corporates or just individual users) are then able to bid for this by offering a conversion rate. An algorithm will in seconds analyse these and accept the cheapest quote, convert the money and then send this to the recipient bank in Germany, for example, in a matter of seconds. “This makes the market highly liquid and allows for FX deals to be executed at the best rate,” says Dilip Rao, Managing Director Asia Pacific at Ripple.

Although only a few banks have currently gone public regarding their interest in Ripple, Rao claims that: “banks of all shapes and sizes are interested in the platform.” He believes that for the big banks the main attraction, aside from the lower cost, is their ability to act as market makers. While for smaller banks the attraction comes from them being able to expand and offer cross-border services without the need to invest as much capital.

While investigations into the full potential of blockchain technology are in their infancy, it is certainly an interesting space – and one that may eventually eclipse the debate on cryptocurrencies altogether.

Meet the coins

According to the cryptocurrency market tracker, as of May 2015 there are 555 cryptocurrencies in circulation. The top ten based on market cap are:

  1. Bitcoin – $3,395,897,331
  2. Ripple – $235,489,897
  3. Litecoin – $55,872,371
  4. Dash – $14,287,791
  5. Stellar – $13,669,284
  6. Dogecoin – $8,902,662
  7. BitShares – $8,715,288
  8. Nxt – $8,151,106
  9. BanxShares – $7,507,594
  10. Peercoin – $5,006,785

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