Monday, January 1, 2018

Unfit For Purpose: A Tale of Two Currencies

I initially wrote off cryptocurrencies because of deep Bitcoin skepticism that largely remains with me to this day. I was also turned off by the fact that some of the most enthusiastic early Bitcoin enthusiasts were criminals (because of a healthy aversion to prison) and people who had a political axe to grind particularly when it came to central banking.  Throw in Mt Gox and endless stories of how the underground economy was leading the way on Bitcoin usage and it was easy enough to just write it off.  In my defense, I was working on an MBA so I wasn’t paying close attention to much of anything in this space.  It was probably best that I wasn’t doing much blogging then or I would have beclowned myself early and often on this topic.

I eventually came to a conclusion that while Bitcoin was stupid, blockchain was not. I’ve since decided even that was the wrong approach to take as I’ve come to view Bitcoin as the Wright Flyer of blockchain technology.  It shows everyone what is possible and kicks off a revolution in technology that has immense potential even if the original technology starts to look very old, very quickly.

Bitcoin’s problems are legion with one of the biggest being that it’s simply a wretched currency in its present state.  It’s a horrible store of value given how volatile it is. The fact that it’s rocketed up in value over the past year is an illustration of how unreliable it is as a store of value rather than an argument for it.  As I write this, it’s gone up 1,413% since last year, anything that can go up that fast can go down just as fast and we’ve seen price drops of 15% on some days.

A currency that instable isn’t fit for purpose particularly when it comes to being something you can trust to store your money.   If that’s not enough for you, it’s bat poop crazy to use it for contracts that are defined in Bitcoin.  For example, what possible sense would there be to enter a contract to purchase real estate in Bitcoin? What buyer in their right mind would enter into a contract to purchase a house for 10 Bitcoins worth $145,000 at the time of the contract when in thirty days at the time of close those bitcoins are now worth $207,350 because the price went up 43.55% between contract and close?

Throw in the high transactions fees and the slow settlement time and it’s gotten to the point where even the underground economy is starting to use alternatives such as Litecoin. Anyone who has done research on Bitcoin by doing transactions knows how expensive it gets. It’s certainly some of the most expensive research I’ve ever done.

I also have concerns about “decentralized” cryptocurrencies that relentlessly devour so much energy that the infrastructure is concentrated in a handful of nation-states that can offer up cheap energy to feed the beast.

You can Google to your heart’s content on what makes for a good currency, but at a minimum a good currency will act as a stable store of value that doesn’t go wildly up or down. You have to know that if you put money into that currency that it will remain largely the same value weeks or years down the road.   It also has to be easily transferable (so you can engage in transactions reasonably quickly and easily) and acceptable (people will actually recognize it as a valid currency and will transact with you using it) or it’s just not a viable currency in any meaningful sense.

Ultimately, currency is deeply psychological because it’s about trust.  Once upon a time, currency was all about obtaining precious metals like silver and gold and then turning those commodities into actual coined money.  Eventually, we ended up with paper money that was backed by commodities which is how we ended up with the gold standard.  The gold standard was awesome until it wasn’t. We are now in the fiat-currency era where supply and demand is the primary determiner of value rather than what the currency issuer has stored in its vaults somewhere.  The trust that the market has in the issuer of the currency has a large impact in the value of the currency.

I had a whole section written up for this post that went into more detail on the history of the commodity-backed currencies and fiat-currencies, but even my eyes glazed over when I was trying to edit it for publication so I deleted it.  Suffice it to say that both commodity-backed currencies and fiat-currencies have had successes and failures.  The Great Depression was the beginning of the end of the gold standard because every major currency at the time left the gold standard during that time.

Just as the gold standard showed its limitations at various times in the past century, we’ve seen some spectacular fiat-currency disasters that have helped fuel interested in cryptocurrencies.  The most recent example is the Venezuelan bolívar and the immense amount of human misery that the mismanagement of that currency has created.  I started following the bolívar’s plight even before I started an executive MBA program at the University of Florida, but I really started to understand what I was seeing better after getting a great education in emerging market finance and macroeconomics.  The executive summary is falling oil prices coupled with gross mismanagement of the country resulted in the bolívar essentially being destroyed over just a few years of time.  Like everyone else who is interested in this topic, I’ve followed the story through the dolartoday website.  We’re at the point where the only question I have about the bolívar is whether it ends up like the Zimbabwe dollar simply goes away or whether it remains as a testament to what can happen when a government destroys its currency and economy. 

Even the Venezuelan government knows the gig is up with the bolívar. Their response? Wait for it….wait for it….they’re launching a cryptocurrency called the petro which will be backed with their oil reserves. This will obviously be a wildly successful cryptocurrency and a terrific store of value given how competent the Venezuelan government has been at managing their economy and their previous currency. Wait. I hear it now.

The bolívar is an excellent use case for a stable cryptocurrency that can’t be mucked with by a nation-state.  Many people saw their life savings destroyed by the destruction of the bolívar just as many other people have seen their money disappear in previous fiat-currency disasters.  Even with well managed currencies like the United States dollar and the European Union euro, we’ve seen periods of high inflation and trouble such as the Greek currency controls and Cyprus bank account levies.  

Nation-state economic and monetary mismanagement provides a great use case for well-crafted cryptocurrencies that are truly decentralized and are stable stores of value.  We don’t even need a cryptocurrency that can be used at the grocery store for this to be a successful currency. Something that is a stable store of value and can move money from demand deposit account to demand deposit account relatively quickly and inexpensively can provide an excellent global hedge against nation-state related currency disasters.

So why are you reading this on a cyber crime and digital forensics blog? Because it’s going to be part of your investigative life whether you like it or not.  Being ignorant of blockchain isn’t an option if you intend to be an effective cyber crime investigator or digital forensics examiner.  Anyone who is working on cyber crime cases will have to deal with bad guys moving money around through blockchains. Anyone doing digital forensics exams will be asked by the people doing the cyber crime investigations to provide them evidence that the devices were used to move money via blockchains and to help them determine the classic investigation questions of who, what, why, where, and when.