Is crypto your kryptonite?

An introduction to cryptocurrency and blockchain technology

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A couple of decades ago, finance was conducted on paper ledgers with all transactions written by hand. We developed as we moved into the digital-age banks. Central banks and other financial institutions started using digital ledgers, but those ledgers are still centralised. Blockchain, which is a method of sharing and verifying information, allows us to decentralise digital ledgers. Because a blockchain network is freely accessible to anyone with an Internet connection, the lines become blurred between what a user can and is allowed to do and what the regulator does. In a blockchain, these two roles are the same.

Any node (user) can join a blockchain network and essentially programme their computer to run a specific protocol (set of rules) that regulates the network. The node participates on the network as a user, and at the same time, watches and verifies every other transaction that goes through the network. This gives rise to a certain set of characteristics on a blockchain network. Foremost is decentralised governance – there is no longer one single entity that dictates to the network what the rules should be regarding the monetary supply of that network. Unless every single user or node on that network agrees to a rule change, those rules will stay fixed rendering blockchains as very robust. Terms such as censorship resistance, immutable, anti-fragile are used because it is practically impossible for anyone to change a rule once a network is established.

With good comes bad; the risks associated with open networks need to be understood.

In a blockchain network, once a transaction has been verified and committed to the ledger (or confirmed in a block, as the jargon goes) it, again, is impossible to reverse or change that transaction. This is different from what we are used to in a traditional centralised banking service, where we can contact the bank and reverse transactions. This is a very specific difference when transacting on a blockchain versus in the traditional banking sector.

Each user on a network speaks to the other, and all of them verify every single transaction that goes through that network. In the 10 years or so that we have seen the emergence of blockchains, these networks have typically grown to hundreds of thousands if not millions of geographically separated nodes.

If an individual, corporation or government wanted to try to shut down these networks, it would be impossible to do so because they would need to go to every single one of those nodes and destroy the copies that they maintain of these ledgers. As the blockchain grows and more nodes join the network, it becomes anti-fragile, more robust and users can trust in the network progressively as it grows.

This contrasts to what we are used to in the traditional system, which is generally a producer-user interaction. Using our banking system as an example, we have a centralised system where the South African Reserve Bank (SARB) takes monetary policy and interest rates to the entire market. They decree the policy to commercial banks who then offer services to retail and corporate clients. We do not have a say in what that policy should be or how the rates should change. We are dictated to as users of the system. The benefits of this system are that there is insurance in cases of fraud, you can reverse transactions and you can speak to someone at the bank, if necessary.

There are also pitfalls to this type of system. As an example, in the great financial crisis of 2008 there was a lot of leverage built into the banking system and investment banks took a lot of risks. As users, we had no power to mitigate ourselves from those risks and as the markets collapsed, ultimately the users and depositors suffered because of the banks’ recklessness. We rely on the regulations that these institutions instil so that the economy runs well. But in history, we have seen that there are times when the system becomes stressed, and the protocols don’t work. Another major difference is that central banks are inflationary with monetary policy. If you, as a holder of the rand or foreign currency, save in that currency, central banks can arbitrarily dilute the value of your savings by inflating the supply of that currency. Blockchains offer an alternative to the centralised system, in that the monetary policy is regulated by the network. If I save in Bitcoin as opposed to the US dollar, I know that the monetary policy in Bitcoin is not going to change, and my savings cannot be diluted although I am still exposed to market fluctuations in the Bitcoin price.

A blockchain simply verifies and records transactions that flow within a network. There are thousands of different cryptocurrencies on the market, so it is useful to have a framework to evaluate each of them and determine their value. Since the advent of Bitcoin, and over the last decade or so, we have seen the emergence of three main categories of cryptocurrency. The three main services/types of crypto (tokens) being built off the backbone of blockchain technology are money, gas and utility. Because these networks follow their own protocol, which is determined by the nodes, the token in these blockchains becomes valuable and carries a monetary premium. Money tokens are private or non-sovereign money and monetary networks compete directly with national currencies. The best example is Bitcoin, the oldest, largest and the most established network.

Secondly, we have gas tokens or infrastructure blockchains. Ethereum, one of the most well-known blockchains, is home to digital money, payments and applications. This blockchain sends and receives value internationally using its native cryptocurrency, Ether (second only to Bitcoin in market capitalisation). The platform emerged because developers were frustrated with the ability to code or to create complex transactions (referred to as smart contracts) on top of the Bitcoin blockchain. Ethereum and a range of other blockchains that allow for this capability were developed. They allow for a richer development environment where smart contracts are created and developers build apps on top of blockchains. There is currently a lot of innovation in this space. A native token is required to transact on this blockchain to create contracts and applications – and this native token is referred to as gas.

The last type is a utility token, or a layer-two token (they do not have their own blockchain). Utility tokens offer a more specialised service. An example is Arvie, which has no protocol for its own blockchain and exists on top of layer-one blockchains. Arvie specifically is a type of lending contract where a lender and borrower reach an agreement. The unit of account for this contract is essentially the Arvie token and because it runs on top of a layer one, it requires the layer-one token as gas to execute the contract.

The cryptography in blockchains is initially complex and difficult to grasp.

RESULTING RISKS

With good comes bad; the risks associated with open networks need to be understood. The cryptography in blockchains is initially complex and difficult to grasp; transacting for the first time is difficult to do, knowing how to store these tokens securely, how to pass them on, etc.

Handling risk. If you enter an incorrect digit or send a Bitcoin over the wrong network, that value will be lost forever. There are many examples of users making simple mistakes, losing a lot of value and not being able to recover that value.

Counter-party risk. With crypto being an early market, people have sought intermediaries to assist them with investments. Due to the unregulated market, there is a gap for fraudsters and scamsters; exchanges have collapsed, and brokers have run away with millions in investors’ money. Unless investors interact with these networks themselves and understand how to use them, they must accept that they are taking on counter-party risk.

Market risk. Market risk is inherent in any investment, but that risk is further heightened with cryptocurrencies because there is a large amount of volatility in this market.

TRACKING TRENDS

The overarching trend is digitisation. We have been through the computer age, the Internet age, in the late 20th century many services became digitised and now most of the valuable companies worldwide are digital (Google, Amazon and social networks, for instance). More and more of our time is spent online and on digital platforms. Cryptocurrency is the final piece of the puzzle.

Positive regulatory acceptance. The attitude has shifted towards acceptance and the treatment thereof varies in different parts of the world. Certain nations legalise cryptocurrency and, in some cases, Bitcoin is legal tender. In other cases, regulators treat crypto as assets, sometimes as capital assets or foreign currencies.

Adoption. Demand from consumers drives the price and the valuation of the crypto. The trend is towards increasing demand because crypto is becoming easier to use. Decentralised networks are gaining popularity as demonstrated by increased demand and usage metrics, whether it be to store value for the long term, for payments and micro-payments or for more complicated smart contracts.

Andoni Nicolau, Head of Digital Asset Operations, Jaltech Digital Investments

REGULATION AND TAX

Although cryptocurrency is not defined under South African law, it does not mean it is unregulated. This is a misconception. In 2014, SARB provided guidance stating that cryptocurrencies are not legal tender and as this status is reserved for the rand, any further regulation falls outside of SARB’s mandate. We are unlikely to see any more explicit direction from SARB about how investments in cryptocurrency should be treated but they were clear in that blockchain networks cannot be used to circumvent exchange controls. In 2018, SARS said that cryptocurrencies should be regarded as assets of intangible nature and as such normal tax rules apply. So, it depends on the usage of the assets and on the type of investments. For example, if you are a trader using cryptocurrency to day-trade on a regular basis and extract gains from that trading, then your returns will be seen as part of your income account and taxed. If these assets are used for long-term investment, they will be treated as capital assets and taxed as capital gains.

The Inter-Governmental Fintech Working Group (IFWG) is a policy think-tank on how fintech should be regulated and cryptocurrencies falls under its mandate. As the market develops, we should expect to see more guidance from the IFWG that will eventually be written into law and regulate cryptocurrency as an independent asset class with its own licensing category. Once that happens it will fall under the purview of the FSCA and will become a fully regulated asset class.

THE IDEAL INVESTOR

The archetype blockchain investor has risk appetite, can handle volatility and doesn’t get skittish at the first sign of weakness. A time horizon of a minimum of three years is recommended for two reasons: historically any investment held for a period of three years will realise a gain. Within those three years, there will be volatility and large drawdowns. The second reason is from a tax perspective; any gain realised from an investment held for three years or longer falls into the category of capital gains. A tax benefit is realised with this time horizon as well.

And then, lastly, one underappreciated reason for investors to allocate to this asset class is to diversify away.


*Taken from FPI’s CPD accredited webinar entitled An Introduction to Cryptocurrency in partnership with JalTech Digital Investments.