Is Bitcoin a replacement for money?

“If it was created out of thin air and it vanishes, there is nowhere to get it back from”

Bitcoin is just the latest in a series of attempts to create a digital currency which is a medium of exchange, a unit of account and a store of value. The early micropayment systems such as egold and GoldMoney used precious metals to perform the “store of value” function.

In 1996 egold, a micropayments system backed by bullion was launched and by 2008 it had more than $US2bn in transactions.  Unfortunately the anonymity it provided account holders facilitated criminal activity and the business was found to be money laundering.

GoldMoney enabled precious metals to form the basis for instantaneous transactions in an on-line patented currency. It had extensive money laundering and customer identification security. By 2011 it had over $2bn of customer assets in the form of stored precious metals all fully insured and independently audited, but in early 2012 it decided that it’s future was as a savings process and turned off the payment process citing poor demand and the high costs of regulatory compliance.

Bitcoin which was devised in 2009 was a cryptocurrency which means that it used cryptography  to create and transfer money.

Bitcoin created a network of its users’ computers, and used an algorithm to release new bitcoins into the network, beginning with 50 every 10 minutes and halving the pace of issue in increments until 2140 when the limit of 21 million bitcoins was reached.

The protection against fraud was the maintenance of a public ledger of every transaction. If a user was able to crack one of a number of cryptographic puzzles and was the first to do so there was a “prize” of 50 new bitcoins. The public ledger was secured using public-key encryption which generates a private key  retained by an individual and used to approve any transfers to another’s account; and a public key used to encode payments. This was not a fool-proof system but it was enhanced by the use of the cryptographic techniques of hashing and forced work. A hashing algorithm converts a message into a number described as a hash value or a digest. If the number is large enough it provides a unique representation of the original and could not be reconstructed.

All transactions were analysed in portions referred to as “blocks”. For the latest block to be valid, there is a forced work task of using the valid blocks and the new transactions to generate a digest comprising 256 bits, and the task is complete when the system’s algorithm provides a hash value below a preset target. Bitcoin’s view was that it would be necessary for an intending fraudster to control over half the network’s capacity in  order to have a fictitious block created and validated. The system has been “hacked” successfully so this has not offered sufficient security.

Does this make Bitcoin a substitute for money? It was accepted as a medium of exchange by some but it only had a limited issue and it could function as a unit of account, but it failed as a store of value as its only value was what someone else would pay for it, and  the value was highly (and unpredictably) volatile .

Bitcoin could not survive in the US unless it was issued by, cleared by or settled through a supervised bank which means it would have to incur regulatory costs. Remember that GoldMoney found the regulatory costs too high.   JPMorgan Chase now has  a patented method of making anonymous payments, through a Payment Portal Processor (PPP)  an enhanced electronic wallet with automatic credit and form-filling features, that provides the user with a secure and guaranteed form of virtual cash . What distinguishes it from Bitcoin is that payments will still be processed using existing Electronic Fund Transfer (EFT) networks and the e-wallets will be stored on a host web server controlled by a bank.

What have we learned?

1. Never boast that your internet system is “totally secure” it just attracts hackers who successfully hacked Bitcoin
2. Do not avoid the regulatory authorities because they will not allow unidentifiable participants as part of your business
3. There is a role for a cheaper way to transfer funds internationally, but Bitcoin is not it.

By Rae Wilson Dragon Wild Blue Pty Ltd 

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Golden investment: is gold really gold?

The term “paper gold” used to refer to claims for the present or future delivery of some form of physical gold.

The reason for that “attachment” to the physical asset reflected the idea that “real” or “hard” assets were quite distinct from financial claims. With the advent of gold ETNs and EFTs it is very important to examine each product offered and to identify whether it is a genuine claim on gold, would it enable an investor to take delivery of gold or is it just another financial instrument which has “gold” in its title.

For example Exchange Traded Notes (ETNs) are senior unsecured, unsubordinated debt securities that are intended to allow investors to access the returns of market benchmarks. For gold ETNs the benchmarks include the price of gold bullion, Deutsche Bank Liquid Commodity Index-Optimum Yield Gold and the S&P GSCI Gold Index. These ETNs are neither equities nor index funds. The guarantee, if one is provided, is by the note issuer, usually financial institutions.

The term “access to returns of market benchmarks “ also does not necessarily mean the close tracking of an index. For example, the Royal Bank of Scotland has issued the RBS Gold Trendpilot TM ETN (NYSE Arca: TBAR) which replicates the price of gold bullion when gold is trending upwards and trades above its 200 day moving average for 5 days, and when the price is below that average, provides exposure to the yield on a hypothetical notional 3 month US Treasury Bill. Clearly an investor here does not have any claim on physical gold.

Some Gold Exchange Traded Funds (ETFs)  do hold gold, e.g. the value of SPDR Gold Trust shares relates directly to the value of gold held by the Trust less its expenses. SPDR note that the shares do not generate any income and as it sells gold over time to pay for its on-going expenses, the amount of gold represented by each share will decline over time.

This means that the investment is in unallocated gold, that is, an investor is an owner in common with other shareholders of an undivided interest in the Trust’s pool of gold bullion, maintained in unsegregated storage on a fungible basis, without specific identification by investor.

A contrast to this is EFT Physical Gold’s reference to all of its exchange traded gold securities as “backed by allocated gold held in a vault on behalf of investors ”.

There is an interesting comparison here with the Perth Mint’s offerings of investment in gold bars. The Perth Mint is government guaranteed. If an investor buys specific bullion coins or gold bars from the Mint, these are removed from the Mint’s inventory and placed in its Depository Vault, under the investor’s account number, in a custody arrangement. On purchase the investor pays for the precious metal in the coin or bar, fabrication and a year’s storage fees. These are described as allocated or investor-specific gold coins or bars.

As an alternative the Mint offers unallocated storage where investors have purchased an interest in a pool of precious metals held by the Mint. For every unallocated ounce of gold the Mint sells to investors, it purchases an ounce from the spot market, providing 100% backing. The Mint records the purchase on its balance sheet as an asset and the unallocated amounts sold to investors as a liability. The investor only pays for the precious metal on purchase and will only have to pay fabrication charges or storage fees on electing to sell. Because the Mint is a manufacturer of gold it offers fee-free storage for the unallocated gold. There is an agreement between the Mint and the investor which allows the Mint to use the investor’s unallocated metal but this does not affect an investor’s right to sell or to request delivery in the form of bullion coins or bars.

The Mint itself has noted that investors often take a three stage approach, of which the first stage is holding unallocated gold when the external environment is stable; the second stage is a conversion to allocated gold if the external environment becomes uncertain; and the third stage of taking delivery of the physical gold occurs when investors feel the world is in a crisis.

It is worth reflecting on what an investor’s strategy could be for the “paper gold” investments described above .  Contact www.dragonwildblue.com.

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