Understanding the architecture supporting digital currencies like Bitcoin is increasingly important 

Key points

• The evolution of the digital currency sector suggests the long-term value of crypto assets may reside in the underlying blockchain technology
• Both established investment managers and newcomers offer pathways for institutional investors to allocate capital to cyrptocurrencies
• It is essential that investors understand the algorithms and code that create cryptocurrencies and control their supply

When more than 8,500 blockchain entrepreneurs and digital currency market participants converged on New York City in May for The Consensus Conference, bitcoin bulls predicted the collective enthusiasm for digital currencies would spark big rallies in the value of crypto coins.

That price surge failed to materialise, but the dramatic increase in attendance at The Consensus Conference, up from the 2,700 who attended in 2017, demonstrated that interest in the blockchain technology that generates digital coins is surging – and the technology is what may turn out to be a long-term investment opportunity whether or not digital coins prove to have any lasting value.

Consensus is organised by CoinDesk, one of the main cryptocurrency exchanges through which investors can use funds denominated in sovereign currencies – or ‘fiat currencies’– to buy Bitcoin and Ether, the two leading digital coins that can be traded into the growing universe of cryptocurrencies. 

Consensus anchored Blockchain Week NYC, an event staged in partnership with the New York Economic Development Corporation.  

The week included a cameo by Twitter and Square founder and CEO, Jack Dorsey, who says crypto coins are the currency of the future. There was also a post-conference performance in the West Village for crypto start-up Ripple, where the rapper Snoop Dogg crooned for recently-arrived digital tenants of a district that was last a cultural destination when Bob Dylan played area coffeehouses in his early acoustic period.

The attraction – a digital method of transferring money that proponents claim, with apostolic earnestness, promises to reduce the cost of global payments and replace inflation-prone fiat currencies issued by central banks with a decentralised form of money created by a global network of computer nodes beyond the corrupting influence of regulators and politicians.

Cryptocurrencies have attracted interest and participation from investment industry newcomers and stalwarts alike. But a key question remains: what exactly do digital currencies like Bitcoin, the most successful version so far, offer to investors? While a definitive answer may take years to emerge, the evolution of the digital currency sector is starting to indicate that the value may reside in the underlying technology, an electronic record-keeping method based on the cryptographic maths behind online passwords, which gives out crypto coins as a reward to those who help maintain the digital ledger in good order.

Tech enthusiasts have been working since at least the 1990s to replace cash and financial intermediaries with a low-cost digital payment tool using the internet to enable peer to peer transfers beyond the reach of the banking and payment system. But as it turns out, the current system works pretty well, and the cost of cryptocurrencies is rising owing to the massive computer power required to ‘mine’ digital coins. 

The underlying blockchain technology, however, is proving to be useful as a compliance or logistics tool for tracking inventory, contract administration, and performing other functions that require a secure record that’s hard to alter. From that perspective, the value of a digital coin is related to the commercial potential of the software project. Entrepreneurs are issuing digital coins in large amounts to raise capital for their software projects, instead of issuing coins piecemeal as transactions are booked on the blockchain – and it is this practice that is drawing both regulatory scrutiny and investor interest in what could be the next big thing in the digital disruption of the economy.

Both established investment managers and newcomers offer pathways for institutional investors that might want to allocate capital to cyrptocurrencies.

christopher keshian

According to recent news reports, Goldman Sachs is starting a unit that will utilise firm capital to trade with clients in a variety of contracts valued in relation to the price of Bitcoin. Goldman is reportedly looking into getting regulatory approval to buy and sell actual Bitcoin, but will not be doing so until it determines how to manage the risks entailed by holding actual cryptocurrency units. Through a representative, Goldman Sachs declined IPE’s request for an interview.

News reports indicate that Goldman Sachs has concluded that Bitcoin is not a currency, but the unit’s price movements are similar to emerging market currencies, so its initial Bitcoin operation will be co-located with the firm’s currency operation. Requests for Goldman to provide Bitcoin management services, reports said, came from hedge funds and from endowments and foundations that had received cryptocurrencies as donations from newly-wealthy cryptocurrency entrepreneurs. 

The initial approach also reflects interest in trading Bitcoin like gold and other commodities owing to the limited supply of coins that is created by the software code underlying each digital currency.

Goldman’s involvement would mark a significant step towards overcoming the unsavory reputation that digital currencies have acquired as a result of being widely used as a tool for financing drug dealing and other criminal activity on the Internet. 

There are other signs that cryptocurrency technology is gaining commercial acceptance. Square has begun offering Bitcoin services to its customers in the payments sector, and Chicago’s commodity exchanges launched Bitcoin futures contracts last December, providing a hedging and price-discovery venue that could help mitigate the notorious volatility of digital coin prices. 

The CEO of Nasdaq recently said the exchange is optimistic that blockchain technology will play a key role in the economy, and pointed to a deal with Gemini Trust, a cryptocurrency exchange founded by early Facebook investors Cameron and Tyler Winkelvoss, to use Nasdaq’s technology to ensure trading activity on Gemini is conducted in compliance with regulations.

Institutional approaches

An emerging generation of digital entrepreneurs is bringing an institutional-style approach to the management of crypto-assets. The asset class includes cryptocurrencies created to be means of monetary exchange, as well as tokens issued by blockchain projects, says Christopher Keshian, managing partner at the blockchain asset hedge fund Neural Capital. “Blockchain allows any distributed computing system to create and issue its own native digital asset,” says Keshian. “There are innumerable use cases for blockchain, and they’re not exclusive to currency,” he adds. 

The proliferation of digital coins illustrates that “often it makes sense for a blockchain project to integrate a token, which would be a representation of value in that certain blockchain ecosystem”, Keshian explains. The technology project will “then use that [token] as a means of raising capital, and effectively, you can almost think of it as being like a publicly traded stock”, he says. “It’s almost an indicator of the health or efficacy of the company that collateralises those assets.”

The coins or tokens issued by blockchain projects are an “indirect representation” of the value of the issuing company, Keshian says, reflecting factors such as how the issuer releases tokens, the number of token holders, how much of the supply of tokens is held by the core team, and the relative scarcity of any given token. “All these components weigh into it, which makes a token’s value less of a one-to-one indication of the health of a given crypto asset,” he says.

alex de vries

Ultimately, Keshian says, the key question is whether a particular blockchain project is “providing some sort of solution to a need, and whether that need is something that will have a network that will continue to grow,” he says. An example is Golem, a company that provides the infrastructure to let people rent out unused computing power, a sort of Airbnb for digital devices, end-running the cloud networks that run on large centralised server farms. Renters pay in something called Golem Network Token, and if that asset is scarce and more people want to use the Golem network, the value of the token would increase.

An investment fund accesses the asset class through an exchange. Typically, says Keshian, investors need to buy Bitcoin or Ether, the other substantial cryptocurrency, directly through an exchange site such as Coinbase. “This is really easy for anyone to use,” Keshian says. “You can connect your bank account or your debit card to it, and then you buy Bitcoin or Ether, and you trade that for one of the more esoteric assets like Golem,” he explains. “There are some layers to it, but anybody can touch it.”

Neural Capital is a long/short fund, a distinctive approach in a field where most funds are long-only. Keshian also manages the Apex Token fund, the world’s first crypto-focused, tokenised fund-of-funds. Apex gives investors access to a diversified portfolio of 10 crypto hedge fund strategies. The investment process includes technical analysis of cryptocoin price movements, but also a hefty dose of fundamental analysis of the source code of each blockchain project, which is conducted by an engineering team based in the San Francisco area. 

The goal of the code analysis is to ensure that the issuance of a digital currency will occur according to the disclosed rules. “All of these are open source,” Keshian says, “so you can actually comb through the source code and see if it’s written in a way that it’s going to execute in the way that the group says it will.”

How code is utilised

Confirming how code will be executed is critical. In general, cryptocurrencies are created by mathematical formulae. Cryptographers write functions that scramble an input message of random length, like the account password you type on your keyboard, into a string of numbers and letters of fixed length called a hash. A hash looks like a random series. But it is not random; the scrambling takes place according to a set of rules – an algorithm – and hackers work hard to figure out those rules or ways around them so they can get into bank accounts, steal credit card numbers and generally wreak havoc.

The source code for Bitcoin is “surprisingly simple,” according to Michael Taylor, professor of computer science and engineering at the University of California at San Diego and director of the UCSD Center for Dark Silicon. The code is based on one of the most widely used and strongest cryptographic functions, a “secure hash algorithm,” SHA-256. Secure hash algorithms are one family of computer security standards published by the US National Institute of Standards and Technology (NIST) a division of the Department of Commerce based in Gaithersburg, Maryland. The code for the SHA-2 series was originally written by the National Security Agency. The SHA-2 standard was adopted in 2005, after researchers who had figured out how to break the previous SHA-1 code revealed the formula.

A Bitcoin account consists of a public name that allows a user to send funds to another user or a merchant, and a private name that allows the user to move the funds from the public name into a personal account. Both are identified by unique strings of letters and numbers; the public string is your Bitcoin identity that others interact with; the private string is your personal identity, which is not recorded in the Bitcoin system.

Each Bitcoin transaction is grouped into a block that is posted to a blockchain, a digital public ledger that records every Bitcoin transaction as it moves between parties. Each block is identified by a specific name, a hash. Bitcoin miners compete to figure out that hash. Those that succeed win the fixed number of Bitcoins awarded to transaction verifiers. Cryptographers call that unknown name the ‘nonce’, a word taken from the Middle English of Chaucer’s Canterbury Tales that means ‘for a unique purpose’. To figure out the nonce, miners must guess the value that will make the algorithm produce the hash string that is the block’s name. In essence, the miners are solving an equation, such as 6x=12, looking for ‘x’.

crypotcurrency mining rig

Crypotcurrency mining rig: the specialised semiconductor chips that perform cryptocurrency maths requires an enormous amount of electricity

To keep the supply of Bitcoin in check, Bitcoin’s code varies the difficulty of solving the algorithm. That adjusts the number of guesses required to find the answer – called the hash rate – which is the key measure of the computing power of the Bitcoin network. When a lot of miners are active, it is more difficult to find the answer and the hash rate rises. The goal is to have miners figure out the name of a block and post it to the chain about every 10 minutes. That boundary works in conjunction with a halving of the number of Bitcoin awarded for confirming each block, which happens every 210,000 blocks; together, that limits the number of Bitcoins created to about 1,800 per day.

Guessing the nonce requires an enormous amount of electricity to power the specialised semiconductor chips that perform cryptocurrency maths. According to a recent study in the energy-science research journal Joule, the Bitcoin network consumes about 2.55 gigawatts of electricity today and could reach to 7.67 gigawatts by the end of 2018 – comparable to the energy consumed by countries such as Ireland, at 3.1 gigawatts, and Austria, at 8.2 gigawatts. 

Bitcoin is “extremely energy-hungry by design, as the currency requires a huge amount of hash calculations for its ultimate goal of processing financial transactions without intermediaries”, according to study author Alex de Vries, a data consultant and blockchain specialist at PwC in the Netherlands. As of mid-March 2018, de Vries notes, the Bitcoin network performs 26 quintillion hashing calculations – guesses at the nonce – every second to confirm two to three transactions per second. That may not be sustainable. “Bitcoin has a big problem, and it is growing fast,” de Vies writes.

Whether the economics of the blockchain prove to be profitable in the long run remains an open question. What is certain at this point is that entrepreneurs, investors, and investment managers are feeling their way into the digital future offered by distributed computing.

The US Securities & Exchange Commission appears to be seeking to develop a regulatory approach that would protect investors from risks posed by initial coin offerings that constitute securities offerings, without impeding entrepreneurial efforts to create new products and services based on blockchain technology. According to a recent analysis by Dechert partner Timothy Spaengler, recent cautious testimony by the chairman of the Securities and Exchange Commission (SEC), taken together with comments by another commissioner that were encouraging of blockchain innovation, “suggest the possibility of an SEC approach to cryptocurrency that would seek to better understand the underlying technology and its potential, and to identify the proper regulatory approach in light of that significant potential.”