Bitcoin and Altcoins: The Age of Cryptocurrency

In the recession of 2008, technological advances and alleged illegitimate banking practices created a need for a new way of thinking about currency.

The famous white paper written by an author under the alias of Satoshi Nakamoto in 2008 laid out the foundation for the first digital currency named Bitcoin. In this system, transfers of currency across vast distances would be enabled with no interference by governments or banks- with only a need for Internet access.

Although the groundbreaking Bitcoin was created in 2009, according to Coin Market Cap, the total market capitalization as of December 2017 was about $370 billion for all cryptocurrencies available in the market.

Robert Murphy, one of the authors of “Understanding Bitcoin” and assistant professor at the Free Market Institute at Texas Tech, said digital currency came out of a mistrust of banks by some and a need for unregulated, cheap currency transfers by others, as Nakamoto illustrated in his white paper.

“It’s a digital currency and a payment system all wrapped into one- that’s what makes it different from things like PayPal,” Murphy said. “I think the thing that makes Bitcoin special is that it’s called peer-to-peer, so it’s decentralized and there is no one in charge of the Bitcoin network.”

Robert Murphy via Texas Tech

The process of individual Bitcoin creation is described in Murphy’s book, in which users known as ‘miners’ create new coins. These miners use the computer’s processing power to solve mathematical equations needed to create a new block of data in which transaction information is stored. This combination of blocks of data is known as the blockchain and works as a public ledger of all transactions.

“Obviously they were using an analogy with gold- to mine and bring new currency into circulation,” Murphy said. “So that was part of the trick. Why would it be in anybody’s interest to have a whole blockchain on their computer stored and to do all that? The main mechanism originally was that they would be rewarded new Bitcoins for every time they add a new block to the chain.”

According to Murphy’s book, cryptography is used so that each person who purchases a cryptocurrency is shown on the public ledger but his or her hidden keys are secured through a mathematical equation that only it can solve. The other computers in the system only have the ability to check to make sure it is correct once the key is used to make a transaction.

Once new Bitcoin has been mined, users can purchase the cryptocurrency by connecting directly to the blockchain and keeping coins in a wallet. Users can also go through one of the many exchanges available, such as Coinbase.

Exchanges are different than having your own cryptocurrency wallet, Murphy said. Exchanges hold the keys and are responsible for completing the transactions. Because of this, they work similar to a bank in that they owe an investor the money they claim to contain once it is time to withdraw or exchange funds.

After the success of Bitcoin, alternative coins or ‘altcoins’ using blockchain technology such as Ethereum and Litecoin entered the growing digital currency market along with more exchange services. These new coins claimed to address problems that had arisen in Bitcoin.

“We are seeing this now with a sort of civil war inside the Bitcoin community. Right now, you can only add one megabyte for each new block,” Murphy said. “So if you run the numbers that implies a theoretical cap of about seven transactions a second. To give a frame of reference Visa and MasterCard do thousands.”

While Bitcoin has problems, security concerns for all cryptocurrency have grown due to hacks of exchanges and fraudulent activity.

A hack of the altcoin Ethereum led to a loss of $64 million in 2016 and many exchanges have been hacked since the advent of digital currency, according to CBC.

Robert Long, a partner at Bell Nunnally and Martin law firm in Dallas, specializes in cryptocurrency and Bitcoin law. He said hacking and security issues are a significant risk to any rising market.

“I presume the domestic exchanges are being vigilant and trying to prevent any kind of cyber security issue, but you always have people out there that are on the other side trying to hack those systems and crack those codes so hacking is a risk in this space,” Long said.

About 17 percent of exchanges’ budgets are spent on security, and about 52 percent of small exchanges hold a formal government license along with 35 percent of large exchanges, according to the Global Crypto Benchmark study of 2017.

In addition to security issues within the community, companies are running into scandals regarding possible dishonest business practices due to a lack of regulations.

In January, the crypto-to-crypto exchange service Tether was subpoenaed as investors suspected the company of not containing the direct dollar backing it claimed to hold, according to Bloomberg.

“With any hot emerging area there is always the risk of fraud and this one is no different,” Long said. “If you look back when the Internet was emerging, the SEC established an internet enforcement group to go after Internet-based securities law violations. Well, fast forward and now the SEC has a cyber unit that’s investigating, among other things, cryptocurrency and blockchain technology related issues.”

Bitcoin alone grew from $400 per-coin in 2011 to over $17,000 in 2017, according to Coin Market Cap. Following this, most cryptocurrency saw a subsequent rise and fall within months.

Associate Professor Xiaohan Ma in the Texas Tech Economics department, said that cryptocurrency such as Bitcoin is more difficult to use than traditional currency at the moment. This leads to it functioning less as a method of exchange and more as a store of value for investors.

“If you think of this as hot money, they just go to wherever there is a higher return,” Ma said. “If they think this digital money is a relatively good investment compared to those other assets, then this money may affect the demand of Bitcoin which will affect its price.”

Xiaohan Ma via Texas Tech

With no backing behind this digital currency, as well as a cap of 21 million coins and barriers to spending in Bitcoin, volatility would remain an issue, said Ma. However, this currency is still attractive if investors are willing to overlook the volatility because return can be very high. In addition to returns, some users see cryptocurrency as a safer choice if they have significant mistrust of their government.

“For some countries that are less stable and have a government that is not very trustworthy, digital money might be a good alternative to hold,” Ma said. “This is compared to their own currency because the residents in the country may know that the government itself is not able to affect the value of this Bitcoin or the value of this money, but rather it is affected by the global market.”

Although the cryptocurrency market fell in January, many investors still see the chance of high returns as a reason to engage in short-term investments.

Daniel Beard, a music producer out of Alabama, invested in cryptocurrencies once he noticed the success of early investors.

“So, I bought $75 worth of Ethereum and $25 worth of Bitcoin,” Beard said. “The Bitcoin was a waste of money because with the transaction fee for it I ended up with about seven dollars by the time they took out all the processing fees and stuff.”

Beard said his experience with Ethereum was better, highlighting the problems with Bitcoin’s difficult transactions. He said the processing was much quicker and fees were lower, making small investments worthwhile.

Like many others, volatility led Beard to invest just enough so that if he loses it, it won’t hurt him financially, but he could get decent returns if the market rises quickly again.

Cryptocurrency is a chance to end the need for trust when it comes to the movement and holding of currency, according to Nakamoto’s white paper. As the cryptocurrency market grows quickly and catches more attention for volatility, trust is something many investors still seem to be looking for.

“The way I try to summarize it is the original white paper showed the vision of Bitcoin having both elements,” Murphy said. “That this is going to be this ledger that is decentralized and there’s thousands of copies around the world so it’s public and nobody can mess with it without the community knowing; and there is going to be low hurdles to usage so that everybody around the world- even unbanked people- can use it as a payment system. Right now, you can’t have both so the community is divided on which way to go.”

About Anna Holland