Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.

Executive summary: Digital currencies have the potential to do for finance what the Internet has done for commerce and communications. They also represent part of the broader disruption that is occurring within the banking sector, where conventional services are being unbundled and replaced by alternatives. Many problems still need to be overcome, but acceptance levels are growing. Almost 8m people already have digital wallets and greater than 80,000 merchants accept currencies such as Bitcoin. These figures have grown by over 200% in the last year and should expand further in 2015. Venture capital and private equity have begun to grasp the opportunity. Over time, payment processors and other traditional financial intermediaries may be at threat.

Bitcoin, the world’s largest and best-known digital (or crypto-) currency celebrated its sixth birthday last month. During its still-short life, it has experienced huge price volatility and substantial amounts of negative publicity, primarily relating to the bankruptcy of a major Bitcoin trading exchange and the FBI-enforced closure of a website where Bitcoins could be exchanged for illicit drugs and arms (Mt. Gox and Silk Road respectively). However, as easy as it may be to focus on these negatives and dismiss the case for digital currencies in general, the reality is that most investors and consumers do not appreciate fully the revolutionary potential offered by such cash alternatives. As 2015 develops, expect to hear a lot more about Bitcoin and its peers.

Finance has, in many ways, been digital for years. In the roles Heptagon Capital performs for its clients, all its transactions are electronic. Nonetheless, there is still a high requirement placed on third parties – banks, payment processors and the like – to record and vouch for transactions. Digital currencies dispense with all this. Buyers and sellers interact directly on a peer-to-peer basis in the digital world. Furthermore, in a fully digital world, not only are there no notes and coins, but also no banks. The system exists in the cloud and is maintained by a network of computers that anyone can join. Central Banks also, theoretically become redundant, at least in their role as arbiters of the amount of money in circulation.

A digital currency can be defined as a form of currency or medium of exchange that is electronically created and stored. Both virtual currencies and crypto-currencies are types of digital currencies, in the sense that they exist electronically. However, while virtual currencies are not intended for use in the real world (and are typically the preserve of computer games or online gambling salons), crypto-currencies are different. These have the characteristics of money (durability, portability, scarcity, divisibility and recognisability) based on the principles of mathematics rather than relying on physical properties (as would gold and silver) or trust in central authorities (like fiat currencies). Crypto-currencies use cryptography to secure transactions and control the creation of new currency units.

Crypto-currencies have three main important characteristics: they are decentralised, transparent and anonymous. The pace at which any such currency is created is pre-determined. An algorithm defines the creation and the distribution of the currency and a market (governed by the conventional laws of supply and demand) determines the value of the currency. In other words, the currency trades on a public exchange and can be instantly transferred between two people anywhere in the world with the speed of an email. The system works because all the participants involved in the process rely on a common technological process or protocol to confirm and validate every transaction made. Whenever two people conduct a transaction, it is broadcast throughout the whole network, visible to every participant. Every transaction that has ever happened in the network is stored in this electronic ledger. While substantial amounts of computing power are required to verify, confirm and record every transaction, the system is essentially self-funded, creating a virtuous circle.

There are many reasons why individuals and businesses would want to use a crypto-currency. First, there is the speed of transaction. There is no clearing or verification process of customer identities; it is possible to send and receive any amount of money instantly anywhere in the world at any time; there are no bank holidays, borders or imposed limits. Users are in full control of their money. It is also cheap for all parties since transactions do not incur merchant or fulfilment fees. Transactions are secure. While they are visible for all participants in the network to see on a public ledger, each individual transaction is made using a personal, private formula, which is unique and irreplaceable. Despite the ledger, no-one else knows who holds which account, with all transactions effectively anonymised.

The concept of such a compelling alternative to cash was first discussed in academic papers as early as 1998, but only rose to prominence at the peak of the recent financial crisis when Bitcoin was launched in January 2009. Since then, more than 500 other competing crypto-currencies have also come into existence including rivals such as Ripple, Litecoin, Peercoin, Dogecoin and Namecoin. Nonetheless, based on the number of virtual currency units in current circulation multiplied by the spot price, only around 10 of these have effective market capitalisations of more than $10m, while Bitcoin is more than 7 times the size of its closet peer, currently capitalised over $3.3bn.

Many markets already exist for buying and selling Bitcoins, a number of businesses have begun to accept Bitcoins, and, as a result, a whole other range of Bitcoin-related service providers have begun to emerge. There are currently 7.9m holders of virtual Bitcoin wallets, they conduct around 80,000 transactions daily and 82,000 merchants now accept Bitcoins (as of 31 December 2014, according to bitcoinpulse, an online information aggregator). There are even 340 ATM machines, where users can convert their Dollars, Euros or Pounds into a Bitcoin-equivalent. The extent of Bitcoin’s growing entrenchment can be seen by the growing number of retailers that have now begun to accept this cash-alternative. Household names such as Microsoft, Dell, Expedia and DISH as well as Monoprix, the French supermarket retailer, all allow consumers the option of transacting in Bitcoins. PayPal and Square have also both recently announced that they have begun to work on integrating Bitcoin payment and integration into their systems. Furthermore, the Caribbean island of Dominica (with 70,000 inhabitants) has said that it intends to adopt Bitcoin as its national currency later this year.

While Bitcoin’s progress is evident (the number of virtual wallets and participating merchants have both risen more than twofold over 2014), it is still far from mainstream, with other competing crypto-alternatives even further behind. Theoretically Bitcoin is an elegant and efficient way to streamline global payments. However, in practice, the web of businesses and support structures around the Bitcoin protocol must pass a wide variety of tests, from storage security and compliance to the creation of tradable derivatives and merchant adoption before its presence becomes meaningfully established. As with the chicken and the egg, for a large-scale Bitcoin economy to develop, its users will seek price stability; and, for its price to stabilise, a larger network of consumers and businesses need to start using Bitcoin. For context, Bitcoin has traded in a range of over ~$500-equivalent ($183-672) during the past year.

Other issues also need to be considered. For any currency to function effectively, its reputation has to precede it and be based on trust. The avoidance to-date of Bitcoin by almost all established financial institutions (which may be explained by vested interests) has compounded the slow adoption rate by consumers and merchants. Meanwhile, regulators have tended to adopt an ambivalent attitude towards it and other crypto-currencies. Regulators have tended to tolerate such currencies rather than embrace them. The European Central Bank, for example, has made the valid observation that conventional financial sector regulation is not applicable since Bitcoin (and others) do not involve traditional financial actors. Some authorities have gone further, dismissing virtual currencies simply as forms of investment speculation.

The issue over the future status of crypto-currencies is further complicated by the fact that such currencies pose a potential challenge to the ability for Central Banks to influence the price of credit for the broader economy. Inevitably, should Bitcoin and its peers become more established, there may be an associated loss of confidence in fiat currencies. It may also become more difficult for statistical agencies to gather data on economic activity and hence pose challenges to Central Banks when considering the setting of monetary or exchange-rate policy.

Although crypto-currencies will likely take time to develop, with most users preferring the convenience afforded by conventional currencies over the speed and anonymity offered by alternatives, the opportunity and potential is significant. Over $15trillion of payments were transacted using credit and debit cards in 2013 (according to research from Citi). Such transactions are typically weighted with a 3-4% fee and remittances can run at up to 10%. Assuming the various noted objections could be overcome, the cost advantages offered by Bitcoin and the like over conventional payments would reduce the need for payment-processor intermediation. Moreover, if fraud and charge-backs can be reduced or eliminated by digital currencies, payment firm margins could be further eroded. In addition, the cost of retail transactions/ money transfers across borders could fall substantially. Visa and MasterCard dominate the payment processing market with a market share of more than 80% and have a combined market capitalisation of over $250bn. Also potentially at risk over the longer-term could be money transfer businesses such as Western Union, banking software companies such as Fiserv and payment hardware operators such as NCR, Ingenico and Wincor Nixdorf.

From an alternative perspective, the primary ways currently to get exposure to the crypto-currency opportunity is via venture capital and private equity vehicles. A plethora of start-up businesses have begun to emerge involved in all aspects of the value chain. Cumulative venture capital investment in crypto-currency related businesses had topped $430m at the end of 2014 and rose more than four-fold during the year (according to CoinDesk, a leading online provider of digital currency information and news). Bitcoin and its peers are currently perhaps at the stage where the Internet stood in 1995. At this time, just $250m had been cumulatively invested by VC firms into online start-ups. And we all know what happened over the following 20 years…

Alexander Gunz, Fund Manager, Heptagon Capital


The document is provided for information purposes only and does not constitute investment advice or any recommendation to buy, or sell or otherwise transact in any investments. The document is not intended to be construed as investment research. The contents of this document are based upon sources of information which Heptagon Capital LLP believes to be reliable. However, except to the extent required by applicable law or regulations, no guarantee, warranty or representation (express or implied) is given as to the accuracy or completeness of this document or its contents and, Heptagon Capital LLP, its affiliate companies and its members, officers, employees, agents and advisors do not accept any liability or responsibility in respect of the information or any views expressed herein. Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation. Where this document provides forward-looking statements which are based on relevant reports, current opinions, expectations and projections, actual results could differ materially from those anticipated in such statements. All opinions and estimates included in the document are subject to change without notice and Heptagon Capital LLP is under no obligation to update or revise information contained in the document. Furthermore, Heptagon Capital LLP disclaims any liability for any loss, damage, costs or expenses (including direct, indirect, special and consequential) howsoever arising which any person may suffer or incur as a result of viewing or utilising any information included in this document. 

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