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The Future Of Cryptocurrency

September 10 2013| Filed Under Currency,Market MechanismAcryptocurrencyis a digital currency that is created and managed through the use of

advanced encryption techniques known as cryptography. Cryptocurrency made the leap frombeing an academic concept to (virtual) reality with the creation ofBitcoinin 2009. WhileBitcoin attracted a growing following in subsequent years, it captured significant investor andmedia attention in April 2013 when it peaked at a record $266 per bitcoin after surging 10-fold in the preceding two months. Bitcoin sported a market value of over $2 billion at its peak,

but a 50% plunge shortly thereafter sparked a raging debate about the future ofcryptocurrencies in general and Bitcoin in particular. So, will these alternative currencieseventually supplant conventional currencies and become as ubiquitous as dollars and eurossomeday? Or are cryptocurrencies a passing fad that will flame out before long? The answerlies with Bitcoin.

Bitcoin

the Current Standard

Bitcoin is a decentralized currencythat uses peer-to-peer technology, which enables allfunctions such as currency issuance, transaction processing and verification to be carried outcollectively by the network. While this decentralization renders Bitcoin free from governmentmanipulation or interference, the flipside is that there is no central authority to ensure thatthings run smoothly or to back the value of a Bitcoin. Bitcoins are created digitally through amining process that requires powerful computers to solve complex algorithms and crunch

numbers. They are currently created at the rate of 25 Bitcoins every 10 minutes and will becapped at 21 million, a level that is expected to be reached in 2140.

These characteristics make Bitcoin fundamentally different from afiat currency, which isbacked by the full faith and credit of its government. Fiat currency issuance is a highlycentralized activity supervised by a nations central bank. While the bank regulates the

amount of currency issued in accordance with its monetary policy objectives, there istheoretically no upper limit to the amount of such currency issuance. In addition, localcurrency deposits are generally insured against bank failures by a government body. Bitcoin,on the other hand, has no such support mechanisms. The value of a Bitcoin is whollydependent on what investors are willing to pay for it at a point in time. As well, if a Bitcoinexchange folds up, clients with Bitcoin balances have no recourse to get them back.

Increasing Scrutiny

Bitcoins main benefits of decentralization and transaction anonymity have also made it afavored currency for a host ofillegal activities including money laundering, drug peddling,smuggling and weapons procurement. This has attracted the attention of powerful regulatoryand other government agencies such as the Financial Crimes Enforcement Network(FinCEN), theSEC, and even the FBI and Department of Homeland Security (DHS). InMarch 2013, FinCEN issued rules that defined virtual currency exchanges and administratorsas money service businesses, bringing them within the ambit of government regulation. InMay that year, the DHS froze an account of Mt. Gox the largest Bitcoin exchangethat washeld at Wells Fargo, alleging that it broke anti-money laundering laws. And in August, New

Yorks Department of Financial Services issued subpoenas to 22 emerging paymentcompanies, many of which handled Bitcoin, asking about their measures to prevent money

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laundering and ensure consumer protection.

Alternatives to Bitcoin

Despite its recent issues, Bitcoins success and growing visibility since its launch has res ulted

in a number of companies unveiling alternative cryptocurrencies, such as:

LitecoinLitecoin is regarded as Bitcoin's leading rival at present, and it is designedfor processing smaller transactions faster. It was founded in October 2011 as "a cointhat is silver to Bitcoins gold, according to founder Charles Lee. Unlike the heavy

computer horsepower required for Bitcoin mining, Litecoins can be mined by a normaldesktop computer. Litecoins maximum limit is 84 millionfour times Bitcoins 21-million limitand it has a transaction processing time of about 2.5 minutes, aboutone-fourth that of Bitcoin.

RippleRipple was launched by OpenCoin, a company founded by technologyentrepreneur Chris Larsen in 2012. Like Bitcoin, Ripple is both a currency and a

payment system. The currency component is XRP, which has a mathematicalfoundation like Bitcoin. The payment mechanism enables the transfer of funds in anycurrency to another user on the Ripple network within seconds, in contrast to Bitcointransactions, which can take as long as 10 minutes to confirm.

MintChipUnlike most cryptocurrencies, MintChip is actually the creation of agovernment institution, specifically the Royal Canadian Mint. MintChip is a smartcardthat holds electronic value and can transfer it securely from one chip to another. LikeBitcoin, MintChip does not need personal identification; unlike Bitcoin, it is backed

by a physical currency, the Canadian dollar.

The Future

Some of the limitations that cryptocurrencies presently facesuch as the fact that onesdigital fortune can be erased by a computer crash, or that a virtual vault may be ransacked bya hackermay be overcome in time through technological advances. What will be harder tosurmount is the basic paradox that bedevils cryptocurrenciesthe more popular they become,the more regulation and government scrutiny they are likely to attract, which erodes thefundamental premise for their existence.

While the number of merchants who accept cryptocurrencies has steadily increased, they arestill very much in the minority. For cryptocurrencies to become more widely used, they haveto first gain widespread acceptance among consumers. However, their relative complexitycompared to conventional currencies will likely deter most people, except for thetechnologically adept.

A cryptocurrency that aspires to become part of the mainstream financial system may have tosatisfy widely divergent criteria. It would need to be mathematically complex (to avoid fraudand hacker attacks) but easy for consumers to understand; decentralized but with adequateconsumer safeguards and protection; and preserve user anonymity without beinga conduit fortax evasion, money laundering and other nefarious activities. Since these are formidable

criteria to satisfy, is it possible that the most popular cryptocurrency in a few years timecould have attributes that fall in between heavily-regulated fiat currencies and todays

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cryptocurrencies? While that possibility looks remote, there is little doubt that as the leadingcryptocurrency at present, Bitcoins success (or lackthereof) in dealing with the challenges itfaces may determine the fortunes of other cryptocurrencies in the years ahead.

Should You Invest in Cryptocurrencies?

If you are considering investing in cryptocurrencies, it may be best to treat your investment

in the same way you would treat any other highly speculative venture. In other words,recognize that you run the risk of losing most of your investment, if not all of it. As statedearlier, a cryptocurrency has nointrinsic valueapart from what a buyer is willing to pay for itat a point in time. This makes it very susceptible to huge price swings, which in turn increasesthe risk of loss for an investor. Bitcoin, for example, plunged from $260 to about $130 withina six-hour period on April 11, 2013. If you cannot stomachthat kind of volatility, lookelsewhere for investments that are better suited to you. While opinion continues to be deeplydivided about the merits of Bitcoin as an investmentsupporters point to its limited supplyand growing usage as value drivers, while detractors see it as just another speculative bubble

this is one debate that a conservative investor would do well to avoid.

Conclusion

The emergence of Bitcoin has sparked a debate about its future and that of othercryptocurrencies. Despite Bitcoins recent issues, its success since its 2009 launch has

inspired the creation of alternative cryptocurrencies such as Litecoin, Ripple and MintChip. Acryptocurrency that aspires to become part of the mainstream financial system would have tosatisfy very divergent criteria. While that possibility looks remote, there is little doubt thatBitcoins success or failure in dealing with the challenges it faces may determine the fortunes

of other cryptocurrencies in the years ahead.

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