Cryptocurrencies: Deconstructing blockchain for would-be investors

Fibo Quantum

Investors should not treat non-asset-backed cryptocurrencies like stocks or bonds. They should dive deeper into what a cryptocurrency is and what value the blockchain technology underpinning it could provide businesses and society, says EquitiesTracker Holdings Bhd chief future officer Andrew Vong.

“In the strictest definition, cryptocurrencies such as bitcoin and ether are not securities. They do not provide investors with capital appreciation or dividends,” he adds.

Some may say holding cryptocurrencies is like holding gold, the market price of which depends on the supply and demand. But this is not completely correct as digital currencies merely consist of lines of code and are deemed virtual assets while gold is a physical asset, says Vong.

He points out that the infrastructure for cryptocurrencies is built around a particular blockchain using a mining machine. These machines consume a huge amount of electricity on a constant basis to ensure a steady generation of cryptocurrencies from time to time. However, a person does not own the infrastructure by holding cryptocurrencies, says Vong.

“A cryptocurrency is not a currency as most people do not exchange it for products and services. Instead, they view it more as an alternative asset that could provide holders with potentially high returns if they cash out at the right time,” he adds.

So, what is a cryptocurrency and how do investors decide whether or not to invest in it?

Vong, who is the instructor for EquitiesTracker’s cryptocurrency masterclass, says they should think of it as participating in the growth of a relatively new technology that is essentially built on top of the internet protocol TCP/IP. This is a suite of communications protocols used to interconnect network devices on the internet and can also be used as a communications protocol in a private network.

 

Participating in the growth of an internet protocol

Vong says a blockchain is a relatively new type of protocol built on top of internet protocols that allow users to perform various activities online. These are similar to the protocols developed in the early days of the internet such as Hypertext Transfer Protocol (HTTP), Secure File Transfer Protocol (SFTP) and User Datagram Protocol (UDP).

To put it simply, HTTP is the underlying protocol of the World Wide Web, which allows people to interact online and is one of the most well-known protocols to internet users. FTP enables people to transfer files via the internet while UDP allows people to transfer short messages known as datagrams. These networks were developed in the 1980s and 1990s and continue to be utilised by internet users today.

Similarly, a blockchain is a protocol that allows people to perform various tasks over the internet, says Vong. Among others, the bitcoin blockchain enables people to transfer value through a decentralised system while the Ethereum blockchain lets users execute various contracts automatically without any intermediaries. The latter is also known as smart contracts.

“The old and new protocols are similar in the sense that they are open-source and everybody can see the codes and use them,” says Vong.

The main difference is that the protocols developed three decades ago did not have the cryptocurrency component that would allow them to be monetised quickly and efficiently. The developers of these protocols could not raise funds from the public by issuing cryptocurrencies while investors were not able to trade them.

“Even if the idea of blockchain and cryptocurrencies had existed back then, the internet speed at the time was too slow for them to be implemented,” says Vong.

It is different today. A blockchain developer can raise funds by issuing a cryptocurrency while investors can hold on to the cryptocurrency if they like a particular blockchain. Both parties will be able to earn a profit if the price of the cryptocurrency increases on the back of a high adoption rate and strong market demand.

“For instance, the demand for bitcoin increases when more people purchase it and use it for transactions through the bitcoin blockchain. In other words, the price of bitcoin increases when more people adopt it,” says Vong.

Following this line of argument, a cryptocurrency holder is actually participating in the growth of a particular blockchain, which is essentially an internet protocol, he adds. “You are owning a piece of the [blockchain] network by holding the cryptocurrency. It is like owning a small plot of land in Kuala Lumpur in the early days. Thirty years later, the price of your land has risen and you can sell it to make a profit.”

That is why a person who buys a cryptocurrency should understand the function of its underlying blockchain and how it adds value to businesses and society. They should also know the people behind the project and have a view on whether more people will adopt this protocol in the future, says Vong.

“People need to understand the technology and that is why cryptocurrency is not an easy topic to approach. You need to have some knowledge of computer science, economics, finance and cryptography to understand the basics. A lot of education is needed in this area,” he adds.

 

Widely adopted protocols

Vong says bitcoin, litecoin and ether are currently the most established cryptocurrencies and the most widely adopted blockchain globally. “Bitcoin and its blockchain, as many already know, only has one function — for people to transfer value. It is the first blockchain. So, it has the longest history and is the safest one. While various security breaches have happened at cryptocurrency exchanges in the past, the bitcoin blockchain has never been hacked.”

Meanwhile, litecoin was developed by Charlie Lee, a Google employee and former engineering director at US-based cryptocurrency exchange Coinbase. The cryptocurrency is widely used by many bitcoin users as an alternative to transfer value.

Vong says the main advantage of litecoin is that it has a faster transaction speed than bitcoin. In 2011, Lee realised that while the bitcoin blockchain was secure enough to store and transfer value, it required too much time and computing power to perform transactions. So, he designed litecoin, which consumes less computing power and enables faster transactions.

When there are too many transactions on the bitcoin blockchain, people tend to transfer value through litecoin and the litecoin blockchain, says Vong. “People like to compare bitcoin and litecoin to gold and silver. Historically, when bitcoin prices go up, litecoin tends to follow.”

While there are many cryptocurrencies and blockchains out there for people to transfer value, these may not be as safe as litecoin, he says. “Litecoin is usually the second option after bitcoin.”

Ether, which is underpinned by the Ethereum blockchain, is another popular cryptocurrency. “While bitcoin and litecoin are for people to transfer value, ether allows users to access much wider solutions such as smart contracts, which allow users to come up with and execute a contract using lines of computer code and without the need for an intermediary,” says Vong.

An oft-mentioned example is the purchase of a property using a smart contract. Assuming that all the necessary information — such as that of the buyer, seller and yet-to-be-purchased property — is stored on a decentralised blockchain network, a person could buy a house efficiently without having to go through all the paperwork. All the necessary details are verified via the decentralised network by the relevant parties and once the requirements have been met, the property is sold automatically.

“Another use case is to create tokenised assets or securities where the token holder can be paid ‘dividends’ [in the form of digital tokens] via the enforcement of a smart contract,” says Vong.

 

Emerging trends

Vong believes that blockchain technology will continue to mature. He says the technology continues to develop quickly and software developers have been coming up with various solutions to fix the weaknesses of a particular blockchain. More start-ups have emerged to provide cryptocurrency holders with a host of new services.

For instance, there is the introduction of the lightning network, a new payment protocol that operates on top of a blockchain-based cryptocurrency that will increase a blockchain’s transaction speed and lower the transaction fee. The lightning network protocol has already been adopted by the bitcoin and litecoin blockchains, says Vong.

Then, there is the trend of decentralised finance (also known as DeFi), which is expected to gain traction globally. “It is not in the mainstream yet, but a lot of people are already talking about it,” he says.

To put it simply, DeFi is a decentralised financial system that allows people to take loans by pledging cryptocurrencies as collateral. “The traditional financial industry is highly centralised and only accepts traditional assets as collateral. Most only accept properties and nothing else,” says Vong.

“But what if you are holding a lot of bitcoin and you want some money for, say, house renovation? At the same time, you do not want to sell those bitcoins as you believe they will appreciate in value.

“You can pledge your bitcoins to a DeFi company. It may give you, say, 40% of the value of your bitcoins as it is a volatile asset class. It may give you some stable coins (cryptocurrencies whose prices are pegged to a specific fiat currency) such as Tether (USDT) and charge you interest. Then, you can sell these stable coins on an exchange or over-the-counter to get the cash you need.

“At the same time, when bitcoin prices fall below a certain level, you will be required to top up your collateral or the DeFi company will force-sell your pledged cryptocurrencies. All these processes can be automated using smart contracts.”

A DeFi company runs pretty much like a regular financial institution, except that it is not subject to the rules and regulations of a particular country. Some examples of DeFi companies are US-based SALT Lending Holdings Inc, which is already up and running, and Singapore-based REN, which is still developing its solutions. The latter is looking to provide financial institution-like services in a decentralised format to cryptocurrency holders, says Vong.

The issuance of digital currencies by companies could be the next trend in this sector, as demonstrated by the upcoming launch of Facebook Inc’s Libra in 2020. If the project takes off, the cryptocurrency can be acquired by Facebook and WhatsApp users to pay for various products and services. The value of Libra is expected to be pegged against a basket of fiat currencies and, theoretically, should be more stable than that of bitcoin. Also, its transaction speed is expected to be faster.

While Vong is unable to predict the impact of such digital currencies, he says this is not new. “You can see examples of currencies issued by private companies decades ago if you visit the Bank Negara Malaysia Museum and Art Gallery. The trend is coming back because the internet and blockchain enable it to happen more easily.”

However, such a trend would need clearance from regulators in the US and around the world for people to use Libra to purchase goods and services. “I think Facebook will continue to engage the regulators and the process will take quite some time. However, it is great publicity for cryptocurrencies in general,” says Vong.

 

Upside potential

Given the increased adoption of cryptocurrencies globally and ongoing developments in the industry, cryptocurrencies merit a space as an alternative asset class in one’s investment portfolio, says Vong.

He points out that cryptocurrencies have no correlation with traditional asset classes such as stocks and bonds and can help investors diversify their portfolios. Although their prices are currently volatile, their upside potential is much greater than that of traditional assets.

“There are seven billion people on earth, of which 4.2 billion have access to the internet. Based on a rough estimate, only a fraction of that — about 6.4 million — have cryptocurrency wallets and hold digital currencies,” says Vong.

He adds that the market capitalisation of cryptocurrencies stood at US$265 billion as at Sept 17. “By comparison, the total market capitalisation of gold was about US$8 trillion globally while those of the stock and property markets were even bigger. If a percentage of investor funds flow from these markets into cryptocurrency, the upside will be quite huge.”