Tuesday, July 27, 2021

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    Bitcoin and cryptocurrencies: the trilemma of the ‘blockchain’

    The world blockchain and that of cryptocurrencies have come a long way in more than 12 years since Satoshi Nakamoto first published the initial bitcoin white paper in 2008, in the midst of the Great Financial Crisis. In the same year of the collapse of the U.S. bank Lehman Brothers, that of the mortgage crisis and that of the sharp rises in the unemployment rate, the book was published that could render obsolete the entire existing financial system.

    Although much progress has been made since 2008, the biggest problem, the trilemma of the blockchain has not been resolved yet and continues to be a major brake on the development of the system today.

    For any system blockchain it really works as a useful decentralized database, it must have three essential characteristics: security, decentralization and scalability. However, the trilemma states that, most of the time the technologies blockchain will be forced to sacrifice one of these aspects for the sake of the other two.

    Price stability is one of the most important pillars of a currency and bitcoin has never achieved it

    The largest cryptocurrency, bitcoin, is secure and decentralized but, as far as scalability is concerned, it has enormous drawbacks. Depending on certain factors, bitcoin only achieves between five and 15 chain transactions per second, a result far removed from what is necessary for it to function as a useful global payment solution.

    Visa and Mastercard are already able to process tens of thousands of transactions per second. Although bitcoin meets two of the three necessary characteristics, not all cryptocurrencies based on the proof-of-work system (proof-of-work) they do. Feathercoin, vertcoin, bitcoin gold, verge, grin, firo and even ethereum classic have suffered 51% attacks in the past.

    Many of the small cryptocurrencies based on the proof-of-work system operate in an environment in which they are absolutely decentralized, but in which both their scalability and their security are not entirely guaranteed.

    This explains the investment slowdown technology-related blockchain, not only in a timely manner, but rather as a trend that will continue in the future.

    It’s been a wild year for bitcoin. First of all sold even more than equities during the sales period caused by the Covid crisis in March 2020.

    Once again it showed that it tends to behave more like a risky asset than a safe haven like the U.S. Treasuries or gold. From that point on, it began to rebound and reached new all-time highs, before falling back down quickly recently.

    Bitcoin tends to behave more like a risk asset than a safe haven

    While many people are aware of the big drop in the value of bitcoin and other cryptocurrencies during 2018, it is important to remember that this was not “the only detour” suffered by the crypto-asset in its approximately 12 years of history. On three occasions, or approximately every four years, the most prominent of the cryptocurrencies experiences a peak-to-valley retreat of 70% or more.

    Equities have only experienced such a decline in the entire last century, following the peak of 1929. Of course, stocks have also not shown bitcoin’s compound annual growth rate over the past 12 years, or in any time frame of 12 years during the last century.

    Although the recent decline is actually very striking in dollar terms, historically speaking, it’s not particularly significant in percentage terms. The key is that bitcoin has not only shown an extremely high profitability profile, but has done so with very high levels of risk and significant temporary falls.

    Bitcoin volatility is driven almost entirely by demand, and as cryptocurrency is not tied to any real-world value, the demand side coincides prácticamente with market sentiment. The same market sentiment, in turn, is the result of the story that market participants trust the most.

    Therefore, it is not surprising that statements from major regulators or even tweets from famous people, such as Elon Musk, can have important implications on the price of bitcoin and, therefore, making cryptocurrency extremely volatile. During 2017, the idea prevailed that “the blockchain could change every facet of how companies operate, we have to buy crypto right now.” As a result, bitcoin multiplied by 20.

    When the story changed to “where are all the promised revolutionary use casesMaybe blockchain it’s not the future,” the price fell from around $20,000 to about $3,500.

    Bitcoin volatility is driven almost entirely by demand

    If we move forward in time, the discourse became “central banks are deranged; they are printing money in a coronavirus relief effort; we need to use bitcoin to protect ourselves from inflation,” and the price again reached exorbitant levels. Recent concerns about the banning cryptocurrencies in China for the use of payments and issues of environmental impact have caused the general perception to be negative again.

    As a result, the price has oscillated sharply downwards. Although tomorrow’s sentiment is almost impossible to predict, bitcoin is likely to react strongly and therefore continue to show levels of volatility that will even achieve that emerging market equities be perceived as a stable asset compared to cryptocurrency.

    The enormous volatility experienced by bitcoin highlights its failure as a reserve currency of value. Few want to use a payment method for everyday transactions that presents such eye-catching value oscillations as bitcoin. Price stability is one of the most important pillars of a currency and bitcoin has never been able to achieve it in its more than 12 years of history.

    From our point of view, since the value of cryptocurrencies is fundamentally im powered by network effects, these remain primarily a speculative asset for risk-loving investors who are not afraid of extreme volatility, rather than a true safe haven.

    Alexander Ruchti is a Next Generation Research analyst at Julius Baer

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