If the challenge were to imagine what would result from combining the business model of a company like Uber, the popular video game *Mario Bros.*, and a dystopian future, the answer might well be Bitcoin—the digital currency that everyone from small amateur investors to the world’s largest banks is talking about.
And this is also happening in Uruguay, where, just as in other countries, there are people willing to pay real dollars for an imaginary, invisible currency that still has very limited purchasing power.
Some view this as an investment, while others see it as a risky bet on a speculative bubble that could burst at any moment. In between lie the events of this year: although it was created in 2009, in 2017 its price rose from $1,000 in January to $20,000 in December (by the end of the month, it had fallen to about $17,000).
This means that anyone who invested $1,000 at the beginning of the year saw a return of nearly 2,000% in less than twelve months—well over the 2% annual return currently offered by local banks.
Of course, with the benefit of hindsight, everyone is a winner, and the truth is that we still don’t know what will happen to the popular—yet paradoxically little-known—bitcoin.
Meanwhile, some view this cryptocurrency—as digital currencies are called—as an anarchist manifesto created in the wake of the 2008 economic crisis by someone who goes by the name Satoshi Nakamoto, though his true identity remains unknown. It was that year when the financial giant Lehman Brothers announced its bankruptcy, sent the markets into a tailspin, and left thousands bankrupt. The ground was fertile for a currency like Bitcoin, which operates without owners or regulatory authorities—entities that were reeling from the scandal at the time.
But then there are those who look beyond the world of finance and point out that what lies beneath is a true technological revolution in which Bitcoin is merely a footnote. For them, Nakamoto’s real breakthrough is the so-called blockchain, the system on which Bitcoin is based. Let’s agree that while this currency is still relatively unknown, blockchain is a whole new world.
To learn more about this cryptocurrency and this disruptive technology, accountant Rodrigo Ribeiro—a partner at the consulting firm KPMG Montevideo—and economists Julio De Brun —an independent advisor and former president of the Central Bank— and Gustavo Michelin —a consultant and former vice president of Banco República—, professors and faculty members at the Faculty of Administration and Social Sciences (FACS) at Universidad ORT Uruguay, answered some questions that help shed light on the rise of Bitcoin and its potential future:
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What is Bitcoin, and how did it come about?
It all began in 2008 with an article authored by Nakamoto and posted on aninternet forum. The text proposed a new global payment system based on a digital currency that eliminated the need for intermediaries—banks and other institutions—and enabled direct transactions between users. The article explained that these transactions would be anonymous, would not be recorded in a single location, and would be encrypted—that is, hidden by mathematical keys.
This is how the system came about; it is supported by numerous data centers located around the world and operates using open-source software shared by all those computers, which records Bitcoin transactions.
Unlike traditional banks—or even PayPal—which rely on a central server to collect information, in the proposed new system, the data is distributed across a network.
All of the above gives the system three main characteristics: anonymity (accounts have an identification code but are not linked to a name), security (derived from cryptography), and data decentralization (which makes it virtually impervious to hackers).
This system is known as a blockchain, and it gets its name from the fact that transactions are linked together like a chain of blocks, so that as new blocks resulting from new transactions are added, the system’s security increases.
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How does blockchain work?
Here's how blockchain works, the experts explained: when someone buys bitcoins, the transaction is sent to every computer in the network—known as nodes—and the system proposes an algorithm that the network participants must solve.
The first one to do so shares the solution with the rest of the nodes, thereby confirming the transaction. This process is known by the curious name of “bitcoin mining” and is essentially how transactions are validated.
But it is also the way new bitcoins are generated. However, from the outset, the system was designed to issue only 21 million coins, which are gradually added as transactions are processed. Currently, there are about 16.7 billion bitcoins in circulation, and each year a new amount is generated, which is also determined by the software. To maintain the system’s logic, the number of bitcoins added annually decreases as more of these coins enter circulation, and the algorithm to be solved becomes increasingly difficult and requires more computational power. In this way, the value of the generated bitcoins is maintained.
Just like in a video game where you have to earn coins to build wealth, when a node solves the algorithm, the system awards it a certain amount of bitcoins as a reward; this, combined with a transaction fee, constitutes the income for those who perform this task.
From that revenue, one must subtract the cost of that work, which includes the time spent solving the mathematical puzzle and, above all, the cost of the equipment and the enormous amount of electricity required to generate the computing power.
That is why mining nodes are currently located in countries where electricity is cheap, such as China, Russia, and Venezuela, and many people are investing money to ensure they have enough computing power to solve the puzzle and earn these virtual currencies.
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Given the explosive rise in the value of bitcoin this year, is it a speculative bubble or a financial revolution?
The volatility Bitcoin experienced this year led, as expected, to the emergence of two major schools of thought: those who believe that the overvalued Bitcoin is a financial bubble—much like the dot-com bubble or the subprime mortgage crisis, more recently—and those who think it is the currency of the future.
They claim that this is a disruptive system that will be used more and more for commercial transactions, thanks to its open and decentralized nature.
On the other hand, those who believe that bitcoin will soon be worthless argue that cryptocurrencies lack any backing. "Bitcoin really only exists within a system," said Ribeiro, an associate professor of corporate finance at FACS. “If this has a market value, it’s because someone was once willing to exchange dollars for bitcoins. That’s how exchanges—places where bitcoins are traded for dollars—and the exchange rate came about, and today there are people paying $16,000 to own this digital currency,” he added.
Furthermore, critics of Bitcoin point out that the anonymity of transactions enabled by this currency facilitates its use in illegal activities—such as the sale of weapons or drugs, or the payment of ransoms—and that this will, in their view, lead to it being banned or restricted by governments.
"Naturally, banks and financial intermediaries that see their role threatened by Bitcoin oppose this currency, but the irony is that some banks trade in cryptocurrencies, and many of their customers are inquiring about Bitcoin because of its rapid rise," said Ribeiro.
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Why did the value of Bitcoin surge so dramatically in 2017?
"There was no single event" that explains the rise, Michelin noted. "As demand increases, and since supply is limited, the price goes up. Only about 400,000 bitcoins are generated each year, and the 21-million-bitcoin cap is getting closer," explained Michelin, a professor of Economics of Uncertainty at FACS.
"In addition, many people are entering the Bitcoin market because of what’s known as FOBO—‘Fear of Missing Out’—which is the fear of missing out on something that could generate profits," Ribeiro added. "We’re seeing two types of behavior: those who give it a try and those who don’t even bother, because they believe it’s going to crash at any moment," he emphasized.
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What stance should we take regarding these two trends?
The three experts agreed that the best advice is to exercise caution, because the bitcoin market is still highly risky and volatile.
"You can take a middle-of-the-road approach. If you do invest, make it a small portion of your capital—that way, you won't regret it if you lose it, but if you make a profit, it could be a nice return," explained Ribeiro.
"In a way, and setting aside the disruptive aspects of the underlying technology, it's a bit of a gamble, because there's no clear basis for the current valuations," he said.
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But beyond opinions, what concrete indicators help us understand the Bitcoin phenomenon?
"Those who believe it is the currency of the future think that more and more transactions will be made using bitcoins," says De Brun, a professor of Uruguayan economics at FACS. "But the reality is that over the past year, transaction volume grew by 40% while the value of bitcoin rose by 1,600%. "In a way, to justify these valuation levels, one would expect transaction volume to grow significantly in the coming years," he added.
However, on the other hand, there are also some signs that point to a bright future for the Bitcoin market.
The key development took place on December 11, when the Chicago Board Options Exchange (CBOE) launched a futures market for bitcoin prices. "Futures" are contracts that allow investors to buy or sell an asset today at a set price but for a specific date in the future.
In addition, a week later, on December 18, CME—the leading U.S. futures exchange, also based in Chicago—joined the CBOE and launched another futures market for bitcoin prices. It is expected that the Nasdaq futures market will do the same in 2018.
According to experts, the decision by these major global platforms is a crucial step toward Bitcoin’s recognition in financial markets, and it also allows financial firms that deal in this cryptocurrency to protect themselves from sudden fluctuations in its price.
At the national level, meanwhile, in Argentina, President Mauricio Macri’s administration included a provision in the recent tax reform bill that imposes a 15% tax on the net profit in dollars from digital currencies—that is, the difference between their purchase and sale prices. In a way, this also acknowledges that there is a promising market.
China, for its part, has outright banned bitcoin exchanges that deal in local currency, although transactions and the operation of nodes are still permitted in the country.
In the private sector, bitcoin transactions have also begun to emerge: there are already some examples in the U.S. real estate market, and in Japan, it can be used as legal tender to pay off debts or purchase electronics, for example.
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Is Bitcoin the only cryptocurrency?
Bitcoin is the king of cryptocurrencies, but it is far from being the only one. In fact, it is estimated that there are about 1,400 such digital currencies, although only about 20 are following in Bitcoin’s successful footsteps.
Far behind Bitcoin in second place are Ethereum and then Ripple, while other growing cryptocurrencies include Litecoin, Iota, Dash, and many others.
Michelin explained that Ethereum is a platform that stands out for its unique applications, particularly in the creationof smart contracts, and has risen to second place in terms of market capitalization. It is followed by Ripple, which is used for international money transfers; and Iota, which focuses on services related to the Internet of Things; as well as various startups seeking to develop platforms that add value to financial transactions and eliminate intermediaries.
What this cryptocurrency boom actually highlights is a technological shift of great significance.
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Why is blockchain technology revolutionary?
In addition to improving data security, "the great revolution of blockchain is the replacement of a central intermediary—which could be a bank account or a public registry—with a decentralized system. "At its core, what is being questioned is the role of the state, which in today’s society is the major intermediary. To the extent that people can conduct peer-to-peer transactions under a decentralized control system, many of the functions currently in the hands of the state will be called into question," said De Brun.
In fact, many argue that “Nakamoto’s greatest achievement is this technology, since the same logic applied to bitcoin transactions can also be used to register or trade property titles for a car or a house, for example. Or it could even be used to cast a vote,” added De Brun.
This technological shift is very significant, but first it will have to solve a problem that, in addition to its economic importance, has environmental implications: the energy required to run the algorithms, Michelin noted. However, this problem is similar to the one faced during the First Industrial Revolution, when the steam engine sparked an industrial revolution. That first machine seemed unviable: it moved very slowly, made a lot of noise, and polluted, but it nonetheless sparked a revolution once it became more efficient and changed the concept of its use. Blockchain also faces these challenges, but it will surely overcome them,” he concluded.