The biggest buzzwords in the financial media toward the latter part of 2017 were certainly Bitcoin, cryptocurrencies and blockchain technology. As the Bitcoin frenzy picked up, the AOG wealth Management team received multiple inquiries from clients to ask about the implementation possibilities of such “investments” into their portfolios.

The start of 2018, however, saw a noticeable drop in the excitement for these new financial inventions as significant sell-offs ensued, leaving many investors with questions about the uses of digital currencies. As with all new financial products, the key is to fully comprehend the fundamentals and underlying economics before considering any kind of capital investment. In this article we’ll break down the basics of cryptocurrencies, how its created, and the future challenges facing this new industry.

As an upfront disclaimer to this article, it should be noted that AOG Wealth Management’s investment committee has not approved of the purchase of cryptocurrencies in client’s portfolios.  Additionally, AOG Wealth Management through its broker-dealer, Kalos Capital, is not permitted to provide a recommendation to buy/sell/use bitcoins or other cryptocurrencies. The intent of the article is therefore to merely highlight some of the characteristics of these newer financial inventions from an educational standpoint.

Throughout the centuries, people have come up with innovative ways of transferring value between one another. Be it a barter system, exchanging of gold or other precious metals, using currencies backed by gold reserves or merely exchanging free-floating currencies based on the credit worthiness of the issuing government, humans have always found a way to transact. Today’s digital era and the globalization of markets creates a need for the free flow of goods, services and money at a much faster rate than ever before. It is this very notion that forms the backbone of how the digital currency age came about. Not only was there a need for a method of exchange that could transcend national borders, but the desire to have such a unit of accounting that was entirely decentralized and free from regulatory interference truly appealed to the early creators. In the absence of any central governing body, users of the digital currency are left only to supply and demand to influence the value. Along with a lack in oversight, a level of anonymity could also be established with a digital currency – allowing for the true unhindered flow of funds across the globe.

Aside from the ideological case for digital currencies, the underlying technology used to create them is rather impressive and has already paved the way for further application in other industries.  To understand Bitcoin (and most other digital currencies), an explanation of blockchain and the “mining” process used to create Bitcoins is required. The most basic way to think about blockchain is to imagine an ever-growing ledger that contains the list of all transactions ever conducted using Bitcoin. When the latest transactions (grouped into blocks) are added to the list (or chain), the updated list must be verified and circulated globally for all other participants to see. Digital currencies are different from physical currencies in the way that a digital currency has the risk of duplicate transactions when a digital coin (or fraction thereof) might be fraudulently used in more than one transaction. The bitcoin “miners” therefore fulfill a vital role (think of an auditor of sort) to continuously verify that all bitcoin transactions on the blockchain are correctly accounted for to reflect the movement of bitcoins from one party to another. They verify the latest transaction in batches called blocks, where each block represents about 1MB of data. That 1MB might contain as little as one up to several thousand transactions. Interestingly, it’s also this block size and the differing opinions amongst miners about what the size ought to be that created many of the spin-off cryptocurrencies found in the market today.

Verifying the latest transactions made using Bitcoin is however just one half of the mining process. The second part is where the real technicalities begin. In addition to verifying all the transaction in the latest block on the blockchain, miners are only rewarded for the work done once they correctly identify a “Hash” number. What this number represents is a 64-digit hexadecimal number assigned to each block. To comprehend the number of possibilities that such a number can have is to think of a 64-digit number where each digit has 16 (hex; 6 %20 deca; 10) possible outcomes. For the math brains reading this, that means 16^ ⁶⁴ possible combinations that could represent the target hash number. Miners face the task of reaching this number first (before all other miners working on the same block) to be awarded a few bitcoins as a reward for the work done. Getting to this number basically involves millions of random guesses – something for which an incredible amount of computer power is required. A quick internet search for videos on this topic is sure to show rooms full of computer processors humming away as they verify transactions and seek to guess the target hash number. Running that many computers at such a fast rate requires great amounts of power. Crypto miners must optimize the cost of equipment, efficiency of processing (hashing rates) as well as energy cost and consumption to make a profit in this industry. A very interesting website that shows the calculations behind the mining process can be found at CryptoCompare.com.

Mining for Bitcoins will ultimately become more specialized as time goes by. The whole process is in some way modelled on real world commodities which are finite in nature. As such, the number of Bitcoins to be circulated will be capped at 21 million coins. Miners are currently rewarded 12.5 BTC for each block, but as the maximum number approaches, those rewards will be halved approximately every four years. Bitcoinclock.com provides a handy visual of when and how each new reduction will take place. The Bitcoin scarcity feature in part helped influence the recent extreme valuations.

Given this overview of the underlying workings of cryptocurrencies, one last piece to consider is where they eventually fit into everyday use. Many analysts have come up with advanced models to try and predict the value of these new inventions, but what it ultimately comes down to is how widely these currencies are accepted as a means of transaction. Blockchain.com provides a great amount of detail about the blockchain, one being the number of transactions made with Bitcoin each day. A fascinating observation from this data is that the number of transactions have dropped significantly as the sell-off started mid-Dec ’17. An established payment system is not expected to be this sensitive to changes in price. You don’t use your Visa card or cash significantly less when the Dollar weakens relative to other currencies. Current daily activity stands at ~180K transactions per day, a far cry from the vast number of transactions conducted using Dollars or other global currencies each day. This is yet another sign of the infancy of this new payment system and the long way it will have to go to gain widespread acceptance. In order for digital currencies to maintain their current valuations, the commercial uses will have to increase in line with the recent hype of trading such instruments. One of the most recent blows to Cryptocurrencies and its hope to gain wider commercial application came in the form of a rejection by major US banks and credit card issuers stating that they would not support crypto purchases. Subsequently, as less support is given to these cryptocurrencies, its price continues to fluctuate widely on a daily basis, making the stability required from a viable payment system even less likely.

Looking at the future of this industry, one word basically captures the potential upcoming success of cryptocurrencies: Regulation. Although the creation, issuance and valuation surrounding these currencies are completely independent of any government entity, national regulators still have multiple ways through which they can restrict the uses of such instruments. The ability of governments to prohibit the acceptance of cryptocurrencies as legal tenders have been one of the major reasons for the recent sharp sell-offs. India, South Korea, China and France are a few examples of countries where much stricter measures have been put in place regarding the trading and use of cryptocurrencies. In addition to restricting its use, many governments are still trying to establish how to tax these new inventions. As a “currency” Bitcoin and other cryptos largely escape taxation, but governments are contemplating reclassifying these new inventions to allow it to be taxed.

In the US, other forms of regulation have also been instrumental, particularly those laws governing how participants in the crypto markets are allowed to structure the exchanges where such instruments trade. The SEC has restricted multiple applications for Bitcoin ETFs over concerns of the speculative risks to which they might expose retail investors. The anonymous characteristic of the payment method has also been criticized for its role in facilitating transactions in illegal products and money laundering. Law enforcement therefore has been sharpened to a large extent to try and detect transactions on the blockchain that might be used for illegal activities. As time progresses, we are sure to see even more regulation surrounding these inventions appear globally.

All in all, many kinks of this new technology will still need to be ironed out before it can truly stand side by side with more traditional payment systems. We trust that this overview of Bitcoin, the underlying technology, and challenges facing the industry helps to highlight why so much uncertainty and risk is still contained within them. AOG’s investment committee is continuing to monitor and track the newest developments within the cryptocurrency world.  Until such time that a clearer picture emerges about the true value and application of these new financial inventions, AOG will not be recommending or advising on any purchase, sale, or use of cryptocurrencies.

Kalos Capital, Inc. nor Kalos Management, Inc. nor any of its independent registered representatives does not support nor endorse the sale and/or solicitation of bitcoin. The article and opinions in this publication are for general information only and are not intended to provide specific advice or recommendations for any individual. We suggest that your consult your accountant, tax or legal advisor with regard to your individual situation. The opinions in the preceding commentary are as of the date of publication and are subject to change. Information has been obtained from a third party sources we consider reliable, but we do not guarantee the facts cited are accurate or complete. This material is not intended to be relied upon as a forecast or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. We may execute transactions in securities that may not be consistent with the report’s conclusions. Investors should consult their financial advisor on the strategy best for them. Past performance is no guarantee of future results. This material is educational in nature and should not be deemed as a solicitation of any specific product or service. All investments involve risk and a potential loss of principal. Kalos Capital nor Kalos Management offer tax and legal advice. Please consult with a tax advisor or attorney for advice regarding the impact on your portfolio.