By: Dr. Sidika Gulfem Bayram, Associate Professor of Finance
Cameron School of Business, University of St. Thomas
As a child, I was fascinated with science fiction movies that utilized utopian technologies that were farfetched compared to the realities of our day-to-day lives and limitations. I vividly remember the TV show that used what we now call artificial intelligence (AI), “Knight Rider”, and how the car in the series, Kitt, was equipped with unimaginable capabilities at that time. I was utterly speechless after each episode. I dreamt that maybe one day I would have a car like that! It turns out that the day is already here as self-driving AI-powered vehicles are all around us with some accidents and collisions here and there, of course!
How about self-functioning artificially intelligent financial markets? Are they on the horizon as well? The rapid acceleration in new technological developments has changed our lives in many ways. In my lifetime so far, three things have changed our routines forever: computers, cell phones, and the Internet. So, how have new technologies impacted the financial markets and products?
Finance has always been at the forefront of adopting new technologies and innovating products and services through them. I would like to share my perspective on one of such recent technologies and its use in finance: blockchains.
Even as a Ph.D. student in 2009, the idea of a digital currency developed based on a vaguely known blockchain technology was hard to grasp. I have started reading on the subject and listened to the experts from both the technology and finance fields, to better understand how it works. Yaga et al. (2018) describe blockchain technology as:
“Blockchains are tamper-evident and tamper-resistant digital ledgers implemented in a distributed fashion (i.e., without a central repository) and usually without a central authority (i.e., a bank, company, or government). At their basic level, they enable a community of users to record transactions in a shared ledger within that community, such that under normal operation of the blockchain network no transaction can be changed once published.”
I believe that this description reveals several unique characteristics about blockchains that empower them to provide trusted environments without the existence of a trusted third party or intermediary:
1) usage of an append-only ledger to provide entire transactional history,
2) cryptographically secure data environment,
3) shared ledger amongst multiple participants to accomplish transparency,
4) distribution of the blockchain to enhance its security through an increased number of nodes.
Blockchain networks can be permissionless or permissioned. Anyone can read and write to the blockchain without authorization in a permissionless blockchain network. On the other hand, permissioned blockchains require approval to read and write in the network. Knowing the difference between these two types of blockchains enables us to evaluate the suitability of this technology to different problems and settings. One of the most widely known applications of permissionless blockchain technology is the creation of cryptocurrencies.
We all heard about cryptocurrencies and their significant rise and popularity. Although recently known to the majority, cryptocurrencies have been around since 2009. Bitcoin, the first cryptocurrency that utilized blockchain technology, was created by a presumably pseudonymous developer, Satoshi Nakamoto. Nakamoto issued the original Bitcoin white paper in 2008 to explain technical specifications and details about this peer-to-peer electronic cash system and the motivations behind it. The cryptocurrency market has grown exponentially since the introduction of Bitcoin, the majority of the growth taking place in the past five years. It is hard to believe that there are now over ten thousand different cryptocurrencies around the World as of the end of February 2022, totaling a global market capitalization of $1.7 trillion (this is equivalent to the GDP of Canada). The largest three cryptocurrencies by market capitalization are Bitcoin, Ethereum, and Tether, with Bitcoin still dominating the market with almost 42% of the global market share. The significant difference between Bitcoin and Ethereum is that the latter blockchain network allows for writing smart contracts (self-executes when predefined conditions are met) on top of the traditional peer-to-peer electronic cash system Bitcoin offers. Ethereum also has a sustainability advantage over bitcoin. Both its transactions and mining process uses less electricity than bitcoin. Tether is the first stablecoin, which means the circulating volume is backed by the value of a specific asset, in tether’s case, the U.S. dollar. Tether acts as a medium when investors move from one cryptocurrency to another and appeals to investors who wish to stay away from the extreme volatility of the crypto world.
Some of my students asked me whether cryptocurrencies were here for good or just another market hype on a newly applied technology in finance. I have always assured them that cryptocurrencies or similar applications of blockchain technologies are here to stay. As a matter of fact, they are just opening their act in the financial marketplace. They appeal to individuals, businesses, and entrepreneurs by offering decentralized, fast, transparent, secure, and reliable transactions. Even governments are now exploring their technological options and creating digital currencies as the future of all financial transactions are headed towards this path. However, these digital assets are not bulletproof. Although it is hard to hack a blockchain network, it is not impossible (Yaga et al. (2018)). There are also a wide array of ethical, moral, and environmental issues with blockchain technologies producing crypto assets. Many critiques of cryptocurrencies focus on the fact that cryptocurrencies can be used for illegal and dangerous activities for society by money launderers, criminals, terrorist organizations, corrupt politicians/bureaucrats, and hackers. An excellent example of this misuse was the cyberattack orchestrated by DarkSide, a cybercriminal group believed to operate, at least in part, out of Russia on Colonial Pipeline, a Houston-based energy company. The company CEO admitted ransom payment of 75 bitcoins, roughly $5M at the time of payment, of which the FBI recovered $2.3M back. The almost two trillion dollars virtual assets market remains largely unregulated in many countries, although the European Union and other developed countries are now venturing their options on how they can regulate the market. As I am writing this blog, China and eight other countries banned all cryptocurrencies and made their usage and mining illegal, with prison time for violators. Their justification for the ban was the risk that cryptocurrencies, the mining process included, imposed on destabilizing their economies. However, if you look at the common characteristic of these countries, you will see that these governments would not risk anything to lose control of their money and authority. In addition, we must never forget that even the current traditional financial system and its institutions have loopholes, shortcomings, and bad actors. Therefore, the arguments of the cryptocurrency skeptics are not isolated issues to the crypto-assets markets. Nevertheless, they sure need to be evaluated holistically with data-driven evidence.
The economics and finance literature identifies three attributes for an ideal currency: exchange rate stability, full financial integration, and monetary independence. If we evaluate the cryptocurrencies from this traditional framework of an ideal currency, cryptocurrencies currently fall short of fulfilling any of these attributes. Therefore, in my opinion, it is still too early to call them currencies. Instead, they are widely utilized as investment assets included in the portfolios of other risky financial assets to achieve better performance in risk management. Turning new technologies into innovations is a process, and I believe that applying blockchain technology into the currency framework has great potential but requires more time and experience. Only time will show us which cryptocurrency blockchains will withstand the test of time and what specific features of these technologies will fulfill the needs of the future global financial system.
Yaga, D., Mell, P., Roby, N., & Scarfone, K. (2019). Blockchain technology overview. arXiv preprint arXiv:1906.11078.
Market Data source: www.coinmarketcap.com