Taking the cryptic out of cryptocurrency

Welcome to From Florida, a podcast where you’ll learn how minds are connecting, great ideas are colliding and groundbreaking innovations become a reality because of the University of Florida. 

Cryptocurrency is a mystery to many of us. In this episode of From Florida, Mark Jamison provides a straightforward explanation of cryptocurrency’s origins, how it works, why it’s attractive to some investors, what regulators are looking at and implications of cryptocurrency for the average person. He also talks about the one big question no one has yet answered: Who is or was Satoshi Nakamoto? Jamison is the director and Gerald Gunter Professor of the Public Utility Research Center and director of the Digital Markets Initiative at the University of Florida's Warrington College of Business.

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Transcript:

Nicci Brown: Welcome to From Florida, where you'll learn how minds are connecting, great ideas are colliding and groundbreaking innovation is becoming a reality because of the University of Florida. I'm your host, Nicci Brown.

Cryptocurrency. I'm sure I'm not the only one who is trying to figure out what it is and what it means for most of us. However, it is the topic of conversation in the financial and political worlds, drawing both enthusiastic and cautious investors and the scrutiny of regulators.

Our guest today is Mark Jamison and he knows a thing or two about cryptocurrency. Mark is the director and Gerald Gunter Professor of the Public Utility Research Center and director of the Digital Markets Initiative at the University of Florida's Warrington College of Business.

Welcome, Mark!

Mark Jamison: Glad to be here. Thank you.

Nicci Brown: So, cryptocurrency has been around a lot longer than many people may realize. Can you give us a little history and a basic explanation of what it is?

Mark Jamison: Sure. Let me take you back to 2008. As you might recall, the country was going through a financial crisis and that attracted the attention of a group of people called Cypherpunks. Now they go clear back to 1992. It’s basically a group of people that met in somebody's basement in Oakland, California, and they had two basic worries. One is they worried about the government getting into their privacy, getting all their information about them. And then also about just how big and controlling the financial institutions were around the world. So the financial crisis played right into their suspicions. So they were very worried at this moment. And they had worked on cryptography — how do you hide your digital information so nobody can read it — and they had also tried to figure out a type of digital currency that would be something that could keep them independent from the banking system. But they'd never quite been able to solve one particular problem. And it's what's called the double-spend problem, which is, if I'm going to tell you that I have this digital money and I'm going to buy something from you, how do you know I really have it? I might be giving it to somebody else at the same time.

Well, on Halloween, October 31, 2008, on their listserv shows up an email that says basically this: I have been working on a new electronic cash system that is fully peer-to-peer with no trusted third party. And it's signed by Satoshi Nakamoto. Now the trusted third-party issue is important because when you and I engage in an electronic transaction there's a bank between us that verifies that, yep, Mark really does have that money. And yes, I am delivering it to you. So, this was no party in between. It's just the computers took care of it.

Now, there were a couple of curious things about this paper or about the person. One is that no one had ever heard of this person before. And so how did he actually get access to their listserv? And then so many people had worked on digital currency before the listserv pretty much just blew him off — except for one gentleman named Hal Finney. Hal said, you know, if you need some help, I'll help you. And so this Satoshi Nakamoto — who we still do not know who that is. It may be a guy, it may be a woman, it may be a group of people. We have no idea who it is. All we ever have are emails from this person or group of persons.

Nicci Brown: Do we even know where this person, these people, were?

Mark Jamison: No, we really don't know. We're guessing from the timestamps on the emails this person and or persons sent that they were probably either in Europe or the U.S. That's just the best speculation that we have, but we don't know, actually.

So Hal helped, via email, Satoshi work out some of the computer coding and in January 3 of 2009, Bitcoin launched. That's what emerged from that work.

And it's important in that Bitcoin gave us what we call a blockchain. And this idea of a blockchain is that you have a network of computers that are all peers. It means there's nobody in charge. They're all basically working off the same software. And the purpose in Bitcoin, of this network of computers, is they all act as what we call miners, which means that each of them has a complete record of every Bitcoin that's ever been created, who's it gone from, who's it gone to and you can download all of that anytime you want to and become a miner — I won’t go into the details of how that works — but their job is to keep that ledger all up-to-date. That worked. And it got so many people excited that now we have a lot of these types of what we call cryptocurrencies floating around.

Nicci Brown: Right. So Bitcoin, as you just said, is one example and the oldest one, but it seems that every day we are hearing about a new cryptocurrency. So how does one get launched and who sets the value?

Mark Jamison: Well, you're right that we have a lot of what we call cryptocurrencies around. There are over 10,000 the last time I looked. But there are basically three types and it's important to tease those apart in order to understand what's going on. There are some that are indeed pure cryptocurrencies, which is what Bitcoin is. It is simply a ledger that says I've transferred this from me to somebody else. And that's all it represents — a transfer.

Then you have some that are called utility tokens. A utility token is something where it's actually a close system that where you have all these entries of the currency, if you will, or the token, on the ledger, but it can only be used for particular purposes. So, the most famous of those is something that's called Ethereum. And I won't go into the details on it, but essentially Ethereum allows people to share a network of computers. And by owning the Ethereum token, you can use those computers. So it's a closed economy in some sense.

Then you also have what are called security tokens. Security tokens means that you actually have some property rights to something out in the tangible world, if you will. And so those have their own types of properties and own legal arrangements.

So the question about where do they come from and how do they get value? The creation of a cryptocurrency of any of those types always starts with what we call a white paper, where some person or group of people say I'm going to create this cryptocurrency and I'm doing it for these purposes. And here's how the computer code is going to work. Then they launch that particular business or enterprise or whatever it might be. If it is a pure cryptocurrency, like a Bitcoin, or if it is a utility token, like an Ethereum, they have what we call an initial coin offering. If it is a security, we call it a security token offering — just different names.

Now, how does the value get set? Well, there are two ways. One is that at the start, the person launching the coin or token might set the value and say it's worth this much, how many people want to buy it? And they may have a target number in mind or what have you, but that's essentially how it would work. Other people will say, yeah, I've got 2 million of these I want to sell and I'll just put them out in the market and see what you people want to buy them for. People just bid on these. So, it's in some sense an auction of some sort. And either of those ways works just fine. From that point forward, it is simply supply and demand that determines what the prices of these tokens or coins are.

Nicci Brown: So, is the proliferation of cryptocurrencies a problem then?

Mark Jamison: Well, no. The producers and the users of the cryptocurrencies determine whether or not it's going to be successful. If the producer has a good business plan or a good functional token that people can use or cryptocurrency that people can use for a lot of different things and the users agree, then that works. And it has value to all of them, that's why they engage in it. And actually in some sense, it has been helpful to a lot of small enterprises because there are some businesses that can't afford to go through some of the traditional means of raising capital. Trying to get money out of a venture capitalist is tough. You've got to be in the right network of people. You've got to meet certain demands of the venture capitalist. As long as you stay within the law, you can issue some sort of a security token and get the capital that you need. So it actually has helped in a lot of places for that. Also has helped a lot of people with transactions that for whatever reason don't have access to banks. But you can engage in transactions with these cryptocurrencies.

Nicci Brown: What about data mining? Can you tell us a little bit more about data mining?

Mark Jamison: Well, data mining is a very different kind of a thing. A data mining is where you're gathering massive amounts of data and you're using different mathematical statistical formulas to say, what does the data tell me? So, you don't go into it with a particular question in mind. I'm an economist. I always go in with a question in mind. I'm trying to figure out how something works or what explains something else. Data mining just says, I'm going to let the data speak and it may relate, it can relate, to cryptocurrencies but it doesn't have to, but it can relate to cryptocurrencies because this blockchain, this massive database on all these computers is a lot of very clean data that data miners love.

Nicci Brown: Got it. So we've heard in the news issues surrounding the environmental impact of cryptocurrency. Can you tell us a little bit more about that?

Mark Jamison: Sure. When Satoshi Nakamoto designed Bitcoin, he, she, they had to make it expensive for someone to cheat. That was the key to keep someone from getting it to that double-spend problem. They tried to make it really expensive to lie. And the way they did that was by developing a computer algorithm that took a lot of energy to solve, a guessing game is what it essentially turned out to be. Well, that's fine. But once you get several thousand computers around the world all playing the game, they start burning up a lot of electricity. So when you look for miners, you typically find them in places in the world where energy's very cheap. And so people worry about this.

Now that is called a proof of work concept. There are other ways of running blockchains. For example, Ethereum, one I mentioned earlier, which is a really popular utility token, is trying to implement what they call a ‘proof of stake,’ which says that you don't have to go through lots of expensive effort to be credible in our system if you just have a big stake in the system. That decreases your incentive to cheat. And so we'll take it that way and they may get it to be much less expensive. There are some other algorithms that people have worked on out there, hypergraphs and things, that might be a lot cheaper to run as well. So people are working on the problem, but there have been some concerns.

Nicci Brown: Interesting. Could you tell us a little bit more about some of the opportunities and I guess the dangers that investors might come across?

Mark Jamison: Sure. Now, first off, I don't give investment advice.

Nicci Brown: Okay.

Mark Jamison: I actually hire somebody to do that so no investment advice from me. But it helps to think through the three different types of cryptocurrencies, tokens, that we have because they have different kinds of financial properties. Let's start with just the pure cryptocurrency. If you think of yourself as investing in a pure cryptocurrency, I discourage people from using the term “invest” in that case because there's nothing tangible behind it. The currency is only good for transactions and its value is determined by two things. One is how useful is it for making transactions? If it's accepted by two or three people, that's it, it's probably not very valuable. If it's accepted by thousands or millions that makes it valuable to use. It also has value for speculation. These cryptocurrencies tend to be a bit volatile. And so a lot of people just love trying to own them in, buy low sell high with them because they move a lot. So that is the demand side.

The supply side is that they exist only in a fairly fixed amount. It's very predictable how many they're going to be out there. So, if you're thinking about, ‘I would like to speculate or own or whatever in a cryptocurrency’ think in those terms. You know, are you paying a price that reflects speculation or its actual functionality? And how's the supply going to change. Similar for utility tokens. There's a computer that says here's how many they're going to be in circulation. Demand is indeed still functionality. How big is this system? How valuable is this system that people can trade in? And then there's a lot of speculation as well.

Now the security one is different. Again, the number of security tokens is fixed in a computer algorithm, but there are underlying assets. You might be an owner in a business or a debt holder in a business. You've got some stake in the success of a particular business. And the value of that business helps determine the value and then there's speculation as well.

Probably one of the better pieces of advice I've seen on using these types of things for investments is they might be really useful for diversifying your portfolio. You know, a portfolio you manage risk by having different types of things you own, where one of them goes up and value to other going down in value so that the portfolio stays about the same value. It turns out these cryptocurrencies behave very differently from all of our other financial instruments. So it is a new way to diversify that portfolio.

Nicci Brown: Because it's so new is that part of the risk, though, as well and some of the danger?

Mark Jamison: Perhaps. You have to understand what the volatility is, how it relates. And that has been pretty well researched. Now, a lot of academicians jumped into that. There is one thing though, I need to point out as well. And that is while there's this idea that there's no trusted third party, that computers just do it and it all works great, you are trusting the computer programmers. Very few of us have the skills to go read the computer code and know that the algorithm is doing what it said it would do. In fact, there was a research study done at the University of Pennsylvania, which looked at — this is several years ago now — 50 of the top initial coin offerings that were done over the past year. And some computer scientists read the paper, looked the computer code and found out that many, many times the computer code did not do what the white paper said. So, you might want to find a trusted third party to check out that computer code for you.

Nicci Brown: So, speaking of third parties, I guess, Congress is looking at regulating cryptocurrency. And so it's interesting for me to understand what are lawmakers looking at and why?

Mark Jamison: Well, I think as far as I follow it, there are basically two efforts. One is actually by our Securities Exchange Commission. That's the one that regulates Wall Street, if you will. They are worried that some of these security tokens, primarily, but they reach pretty far, so some of the utility tokens as well. They say these look like securities to us and we regulate securities. So, you know, here's the 150 or 2,000 pages of paperwork that you've got to do to launch one of these things. And so they're after it and they're checking into it. They have now approved some of the different types of cryptocurrencies, but some people have gotten in trouble for not following the rules, even though they didn't know the rules were there and thought they didn't apply. It was kind of the wild, wild west there for a while.

So that is going on out there. Oh, I should mention as well, just to be complete. There's also anytime you have a technology change that really affects traditional business models, the incumbents fight back and some of that's going on as well because we have in our banking system a trusted third-party system that makes a lot of money being the trusted third party. And if that can be replaced by computer software, that's a little scary for those folks.

There's another effort, and this is actually showing up in some legislation in Congress, to force the entities that are involved in helping people trade these cryptocurrencies to requiring them to report everything that's happened. So if you and I, for example, well, let me change the example. Suppose that that you're a large business and you do work in the U.S. and Europe. There'll be times where you will want to convert dollars to euros and times you want to convert euros to dollars. Any time there's a change in value of those you have to report that to the IRS. It might be a loss. It might be a gain. The IRS wants to do that with cryptocurrencies as well. Right now, you are required if you're trading in cryptocurrencies to report that. Congress, the IRS, would love for the exchange entities to have to do the reporting just to make sure nobody's cheating.

Nicci Brown: Understood. So at least two countries, Afghanistan and El Salvador, have adopted cryptocurrency as their official national currency. Why did they make this move? And what are your thoughts about cryptocurrency as the basis of a country's monetary system?

Mark Jamison: Well, my understanding in the case in Afghanistan, Afghanistan and El Salvador as I understand them, are different in this regard. In Afghanistan, this is primarily a movement of the citizens and it's largely with the Taliban taking over. People were concerned about what if they come and take my money? You know, where can I, how do I manage the risk, what if the currency collapses, all of these things. So they just started using a lot of cryptocurrencies and they had limited access to banks. That was particularly true for women and girls — that generally in a lot of those countries, women and girls are not allowed to have bank accounts, but they can have Bitcoin. And so they start managing their own finances that way. That's how El Salvador started out as well. People who did not have bank access started using Bitcoin or perhaps some other cryptocurrency.

Eventually, my understanding of it is, that the president of El Salvador saw that, that's pretty cool. In fact, I would like to be a really cool president. So he said, let's have Bitcoin as one of our currencies. So now they have two currencies, Bitcoin and the U.S. dollar. Now that can be a problem. So there's no problem with having a cryptocurrency as your currency, per se, as long as it's designed for that purpose. So in the case of like an El Salvador or even an Afghanistan, if it became official and they had two currencies, just think of yourself as a person running a small shop or just sitting out in the street and selling goods, you have to accept either Bitcoin or dollars and their values change considerably relative to each other. So, you have to keep track of all of that. That's going to be difficult for a lot of people, it would be easier for them just to have one currency.

So that's a challenge for a poor country if it tries to do that. But what I also encourage countries to think about is that they've got a real supply problem when it comes to a cryptocurrency. The way that our currency, the U.S. dollar, the way its volume changes is if you want to create a business, you go to a bank and you borrow money to do that. And the bank doesn't really have that money that it loans to you. It has some percent of it. So, when you borrow that money from the bank that creates new money, but it's based upon you creating value in the economy.

So, there's a tracking of how much the economy is growing and how much the currency, the volume of currency, is growing. The only exception of that is things that we have going on right now where the Federal Reserve Bank tells the U.S. Treasury, “I'm giving you a billion dollars, just go spend it.” It comes from nowhere. They just make it up and send it. So that becomes an issue. But the supply can follow the demand for the U.S. dollar. That's not true with the cryptocurrency. The supply follows a formula in a computer, regardless of how many people want the cryptocurrency. That rate of growth is stuck by that program. And that's one of the reasons why the values are so volatile. And if you're a country thinking about this should be my currency, understand it's going to be very volatile.

Nicci Brown: Do you ever see a time where currency, as we know it, traditional currency, is going to be phased out?

Mark Jamison: You mean like the hard-copy currencies that some of us still see, but not everybody?

Nicci Brown: Yes.

Mark Jamison: I would be surprised, not for a very long time. One is that not everybody has a smartphone and certainly your smartphone doesn't work every place you go and you need something like that to engage with a cryptocurrency. So I don't think that'll happen anytime soon.

Nicci Brown: Moving on, how might investments in and use of cryptocurrency impact Wall Street and the financial markets?

Mark Jamison: So far, it's been additive. We've created new financial markets with these cryptocurrencies because they don't have a lot of the cost of the traditional system built into them. A lot of people who can't afford those costs, those transaction fees, are now part of a financial system. So there are people who might migrate from one country to another and want to send money back to their family, they can do it through Bitcoin or some other cryptocurrency at almost no cost. If they were to do it through the official banking system, they would lose 10, 20, whatever percent of that. And if they tried to do it through the informal system, it even gets more expensive. So we've added new financial markets.

We've also added new financial instruments that are showing up in the traditional markets. There's an effort to have futures of Bitcoin. I think that's about wrapped up. I didn't follow the latest news on it. It's been a multi-year effort, but it looks like there's the traditional Wall Street systems are now going to be participating in the cryptocurrency system.

Nicci Brown: So then for the average person, what's the bottom line as far as cryptocurrency goes? What does it mean for us now? And I guess in the future.

Mark Jamison: Well, you can just blow it all off and pay no attention to it whatsoever and it won't affect you a bit. You can decide that you want to diversify your portfolio, make sure you know what you're doing, because there's no one guaranteeing that this all continues to work, because we have had cryptocurrencies disappear. So you want to watch out for that. You could maybe help finance a new business with some of it as well. You could do that kind of a thing. But I just encourage people to think carefully, know what you are doing because a lot of this is still being discovered, still being developed, and we'll see how it all works out. It's going to play a role in our future economy. How big of a role and exactly what role is yet to be seen.

In fact, it's interesting to note that having founded Bitcoin and being the very first miner, Satoshi Nakamoto actually owns, I don't know how much millions of dollars in Bitcoin and has never touched it. There's some speculation that maybe he, she or they have passed away and just can't access it. And that is something to make sure you pay attention to with cryptocurrency. I think it's true for almost all of them — I may be wrong, but I think it is — that if you lose the code that gives you access to your cryptocurrency, you can't get it anymore. No one else has that code except you. There's no way to break into the system and pull it out. So we've had a lot of people that have gotten a lot of Bitcoin worth, a lot of money, lost their code and there it sits and it'll sit there forever.

Nicci Brown: Wow. That's a word of warning there.

Mark Jamison: Yes. 

Nicci Brown: Mark, thank you for sharing your insights with us today. It's been great having you with us.

Mark Jamison: It's my pleasure. Thank you for having me.

Nicci Brown: Listeners, thank you for joining us for an episode of From Florida, where we share the stories of faculty, researchers, students and administrators whose thought leadership is moving our state, our nation and our world forward. I'm your host, Nicci Brown. I hope you'll return for our next story of innovation From Florida.