Fintech | 22 November, 2017

Cryptocurrencies: benefits and risks of virtual currencies

Albert Estruch Gestor de Mercados

2017 has been the year of cryptocurrencies: More than 300 new virtual currencies have been created.

Bringing their total to over 900. In other words, the number of virtual currencies in the world more than triples the number of conventional, state-issued currencies, which according to the UN currently stand at 180.

As investors and potential holders, we should firstly describe the main features of these virtual currencies, to then analyse their possible benefits, risks and valuations.

Main features:

A virtual currency is a currency that serves as a means of payment and is, in turn, decentralised, i.e., it is not issued by a central bank or a state.

On the contrary, they are a community of technology developers who, at the time it is created, reach an agreement on the following criteria about:

  • How much, at what speed and until when the new currency is going to be issued over time, because money supply tends to be finite.
  • How transactions in the same are going to be verified, because each transaction (called a “block”) only exists if it has been verified by another user and is published in a single “ledger” (the so called Blockchain is a public list where each block is a verified transaction).
  • What commission fees are going to be charged in virtual currency for verifying said transactions; in the majority of currencies this is how new currency is generated, through the verification of transactions between third parties (computers with very high powers of calculation are needed to decipher the code encryption).
  • And many other questions of an economic and technological nature as well as protocols for taking decentralised decisions.

The market is currently dominated by Bitcoin. It was the first such currency to be widely accepted in 2009; it capitalises some $138,000 million and has appreciated by around 773% in 2017. As we can observe at below graph, the current price amounts more than 8.000 dolars per bitcoin.

BBVA - SWISS PRIVATE BANKING

The other dominant virtual currency is Ethereum, the main differentiating factor of which is that it offers “Smart contracts” as a means of payment; these contracts are autonomously activated by a computer programme in a predefined way and they imply different obligations stipulated beforehand between two or more parties.

Analysis:

Benefits: They allow almost instantaneous money transfers with very low commission fees, without verification by a financial entity. Furthermore, they offer anonymity because each transaction is encrypted. On an investor level, they are totally uncorrelated with any other asset.

Risks: Cryptocurrency valuations are extremely volatile, whereby it is very difficult to predict their future value. They are subject to theft (hacking) either at the exchange entities where they are bought and sold or in each end-user’s online wallet.

State regulation may be contrary for them or prohibit their usage, such as recently occurred in China. Many of them will fall into disuse and lose their value or they will be split into other currencies as has happened to Bitcoin three times already.

Conclusions:

  • Traditional currencies are assessed by the interest rate, in absolute terms and relative to other currencies, established as a benchmark by the issuing country’s central bank and the expected inflation in the country’s money supply.
  • Virtual currencies have no benchmark interest rate and are deflationist because their money supply is limited, hence it is extremely complicated to reach a valuation for them.
  • Their intrinsic value is the use their users make of them, the supply and demand produced for each currency due to their value as a means of payment (based on the agility of transactions in the same and the commission fees charged).
  • Their efficiency when it comes to executing and assuring compliance of the “Smart contracts” (software that assures and enables agreements between two or more parties): many virtual currencies are beginning to offer them, although their use is limited, concentrated largely in the start-ups sector.