PBS Economist Squad Bitcoin vs Ethereum: $1M to invest across these two blockchain technologies - The Economist
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PBS Economist Squad Bitcoin vs Ethereum: $1M to invest across these two blockchain technologies October 2016 Francisco Cudell Pedro Vilas-Boas Rui Rosas
Introduction We’re living in a world driven by technology. Existing business models keep challenging absolute truths we had for granted in the past, disrupting well established industries and monopolies thus our global economy. For the last decades, since the appearance of the internet in 80/90’s up to now, the rate of change driven by technology and innovation has forged a new type of economy, the digital economy. Advancements in computer processing power, data storage solutions and chip evolution in addition with network’s backbone infrastructure continuous development in parallel with cultural and operational shifts not only on companies modus operandi but in society in general, in a continuous virtuous cycle of innovation and raise of challenges, have unfolded numberless opportunities, both technologically and economically impossible in the past, that go beyond our imagination. More than 3.5 B1 people are currently connected to the internet at a distance of a click, which can be translated into a huge opportunity for entrepreneurs, newcomers and SMEs and a remarkable challenge for established companies in many different sectors. Business that fail to get digitally connected will become excluded from the global market as business are going digital. Figure 1 - Internet users in the world - June 2016 1 Source: Internet World Stats - www.internetworldstats.com/stats.htm 1
We’ve already experienced the disruption of well-established industries such as public transportation and hospitality business, just to name a few, and more will certainly follow them in the future. Shared economy platforms, automation and robotization in the industry, the so called industry 4.0, smart cities and smart grids, IoT and machine learning in addition with the amount of data generated by, and that can be accessed from, every single person/consumer (big data) unfolds huge challenges in terms of data mining, contract management, finances and cybersecurity within what can be considered a borderless digital world. This ever growing intersection between digital technology, financial and non-financial services fostered new ecosystems to flourish. The need to improve digital financial economy efficiency, either by reducing its costs and/or increasing its speed, while shoring up its security and at the same time increase its exposure by reaching people that were previously excluded from the formal financial service, led to the emergence of many FinTech applications and start-ups, as the VC funding of more than $21B in the past two years and up to $7.4B during the first two quarters of 2016 in FinTech start-ups is a clear sign of. Figure 2 - Annual global financing trend to VC-backed Fintech companies This digital need, associated to society’s rising lack of trust in fiat currencies, mainly due to recent past financial crisis and scandals, and denoted dependence on government 2
policies (exchange rate, treasury notes and measurement against foreign exchange reserves) created the perfect ecosystem for the growth and birth of cryptocurrencies. Mandatory to the rise of this trend is cybersecurity and this helps to explain why a number of FinTech subsectors like blockchains started gaining more traction. Some global banks and financial institutions increased their bet in blockchain technology, public ledger system, and during Q2’16 started focusing in proof-of-concept pilot tests while at the same time, several significant funding rounds concerned blockchain focused companies (3 in the top 15)2. The impact of blockchain technology within the bank sector could allow huge savings in its operations (ex: remittance, transactions, etc…). Santander Bank estimates that the adoption of blockchain technology could reduce its infrastructure cost by US$20B/year3. Figure 3 - 30 Largest VC FinTech deals of 2016 (YTD) 2 Source: The Pulse of Fintech Q2 2016, Global Analysis of Fintech Venture Funding, KPMG International and CB Insights, August 17th, 2016 3 Source: https://letstalkpayments.com/an-overview-of-blockchain-technology/ 3
In addition to the financial services applications, the non-financial use cases of blockchain has been a significant trend in the recent past, where a considerable number of Startups (50+) focused on asset servicing, IoT, identity and privacy management and documentary trade, have come into life with brand new blockchain technology supported business models. Hereafter, we’ll overlook the industry as a whole and both Bitcoin and Ethereum in detail to assess the changes, trends and developments ongoing in order to understand each cryptocurrency investment potential. POLITICAL The absence of external legislators in the cryptography industry is one of the several great advantages the industry has. Up to now, there was no interference from central governments in trying to legislate it. However, this industry is being followed by the official entities (as the European Union), as it can take away the power and data strength inherent of who manages currency and data. Central government pressure is expected to be raised, as soon as the lobbying against cryptocurrencies gets followers. ECONOMICAL Trading markets have seen their liquidity flowing away over the past years. Adding to this, the capital requirements and the multibillion dollar fines for market manipulation, has been forcing the banks to implement more automation. Over the past 3 years, trading in the spot market fall 19% to $1.7tn a day4. This gap has been taken by electronic markets, as use faster and better technology, namely the blockchain technology. The latter brought with it low frictional costs and is predicted to save around 4 Source: Financial Times, “Liquidity holes hold key to flash crash mystery”, 11th October 2016 4
Bitcoin emerged as the first main digital currency with global acceptance. Even if today has a market cap of $10 bn and a volatility standard deviation 30 days of 0.89% 5, already had its volatility turmoil times, having more than 15% in the volatility index, at the 30 days BTC/USD standard deviation. Figure 4 - Bitcoin volatility series Ethereum is a recent platform with 14 months of trading activity, has a market cap of $1 bn already and still has a high volatility. Ethereum developed the blockchain technology up to a point that can be considered the next big tech revolution after the internet 20 years ago or the cloud 10 years ago. Some say that it came to “redraw the internet as it should be”. The growth opportunities are uncountable, as it can be used in such vast areas as financial service for faster, secure and cheaper transactions; in the automotive industry, mainly in the autonomous cars; crowdfunding; voting; healthcare, where patients' health information can be encrypted and then shared; in the vast world of the IoT and so many other applications. A McKinsey study about the 12 disruptive technologies6 assesses the economic value of IoT, Cloud Technology, Automation of 5 Source: https://btcvol.info/ 6 Source: Disruptive technologies: Advances that will transform life, business, and the global economy. McKinsey Global Institute 5
Work and Mobile Internet up to +$73.4 trillion by 2025, and in all of these, the blockchain will be the key connection element. SOCIAL Global society has been divided about the blockchain technology adoption. While some are truly focused on its benefits, others are concerned with the underground side of it, mainly due to the usage of Bitcoin in “grey” transactions and also the fact that Bitcoin didn’t became a global currency. In fact, more than 500 Altcoins have been created up to date7. Another concern regards to cybersecurity, and Mt. Gox bankruptcy is a great example (850.000 bitcoins stolen, equivalent to $450 million)8. Ethereum came to solve this issue with the smart contracts development. Another important factor is that with the birth and expansion of this technology, the central governments are being stripped of the big data they possess due to the control over the currency and transactions. This loss of control will also possibly jeopardize the tax laws in all the governments worldwide, with several reactions that will possibly be felt, against the new and upcoming liberal and borderless currencies. TECHNOLOGICAL The world has seen the ground-breaking technology that has emerged with the birth of the blockchains, at the time, when bitcoin was created, we assisted to an important leap in terms of technology, which allowed for greater security and cheaper transactions. This breakthrough has however been updated with the birth of new platforms such as Ethereum, which corrected many of the Bitcoin issues. 7 Source: https://coinmarketcap.com/all/views/all/ 8 Source: www.thedailybeast.com/articles/2016/05/19/behind-the-biggest-bitcoin-heist-in-history- inside-the-implosion-of-mt-gox.html 6
Cybersecurity has to be considered as one of the most important aspects of the industry, being that it is vital to attract adopters and allow for safer transactions. Without cybersecurity, the whole industry would collapse due to the fear of the general populations. The fact that the world internet infrastructure has increased substantially the access to internet worldwide, also with larger bandwidth, has allowed for greater developments in terms of capacity. This new and improved infrastructure allows for high speed transactions and increased security in the industry. ENVIRONMENTAL In terms of environmental impact, a rising concern has been seen related to the energy consumption of transactions. Nowadays, the increasing size of blocks is demanding an equivalent to 3 Gj/s for computation, an equivalent to Ireland consumption today.9 In depth industry analysis Analysing the digital assets industry in some depth, several conclusions can be understood. Regarding new entrants in the industry, the disruptive nature of the crypto digitalization technology reduces the risk of new and strong cryptocurrencies being born during the next 5 years. The risk of increasing competition is high, with the foreseeing entrance of new players such as banks and financial institutions using blockchain technology to reduce frictional costs and increase the speed in operations, one must also note that new cryptocurrencies are bound to appear in the industry landscape, occupying different market niches, and therefore increasing the competition. 9 Source: Bitcoin Could Consume as Much Electricity as Denmark by 2020, http://motherboard.vice.com/read/bitcoin-could-consume-as-much-electricity-as-denmark-by-2020 7
Large corporations are viewing cryptocurrency as an important opportunity with key investments, as the digital assets management. The NASDAQ, Australian Securities Exchange, MIT, Microsoft, IBM, Blockstream, Euroclear and so many other are just a few examples of powerful corporations already investing and using this technology. And the value behind this disruptive technology can be seen by the quick adoption and ongoing developments from 42 major banks - Bank of America, Credit Suisse and HSBC are just a few examples10. Regarding substitutes, the fiat currencies must be taken into account. Although the fiduciary currencies are being outdated due to the inadequacy to the instant digital world’ requirements and its dependency on Central Governments, they still account for the large majority of transactions worldwide, and must still be considered as the currencies most use. For a detailed analysis regarding Bitcoin and Ethereum, please refer to the appendix. 10 Source: Deloitte - Blockchain applications in banking. 2016 8
PROJECTION (risk analysis) In order to further assess both considered digital assets and their possible projections, several calculations were performed, which led to a clearer analysis and decision making process. Bitcoin Projections The process started by analysing the historical values for Bitcoin from January 2012 until the 17/Oct/2016. In order to have a blunt projection of Bitcoin, a logarithmic regression was performed, with a projection for the following five years, using the logarithmic regression. This analysis shows the trendline for growth in value, until the year 2021. There is a clear growing trend line, which by 2021 should be approaching the $1.150/bitcoin as per projection. This is translated into an approximated growth of 81% ($635 in 17/Oct/2016 to $1.150 in 01/Jan/2021). Figure 5 - Bitcoin value projection In order to further assess the possibilities of Bitcoin, several Monte Carlo analysis were performed. In order to reduce the volatility and the speculative forces of the market, the starting date considered for the bitcoin analysis was the 01/Jan/2015. As can be seen in 9
the historical values, this is the period where the volatility of Bitcoin starts reducing, enabling for a better projection for the 5 year period. Also the fact that in 2015, several other competitors started to appear in the industry landscape leads to a better understanding of the possibilities of the Bitcoin as a currency. Average 381 Average return (%) 21% Std deviation return 47% Time to retire 5 Inicial investment $ 1,000,000 Year Return Ending value 1 45% $ 1,449,170 2 15% $ 1,670,208 3 10% $ 1,839,463 4 -17% $ 1,533,657 5 -30% $ 1,076,985 Mean $ 2,480,113 Median $ 1,854,970 Std. Dev. $ 2,366,392 Percentile 5% $ 144,105 25% $ 824,707 Figure 6 - Rate of Return BITCOIN 01/01/2015 Also, in order to evaluate a period where both Bitcoin and Ethereum were present in the market, another Monte Carlo analysis was performed for Bitcoin, starting in the period of 01/01/2016. 10
Average 517 Average return (%) 20% Std deviation return 25% Time to retire 5 Inicial investment $ 1,000,000 Year Return Ending value 1 29% $ 1,289,223 2 -24% $ 982,932 3 35% $ 1,322,994 4 6% $ 1,397,262 5 19% $ 1,665,800 Mean $ 2,478,533 Median $ 2,261,968 Std. Dev. $ 1,222,898 Percentile 5% $ 927,666 25% $ 1,611,279 Figure 7 - Rate of Return BITCOIN 01/01/2016 The results of these analysis show precisely what was previously discussed in the qualitative part of the report, where the reduction in the volatility in the Bitcoin has led to a slow but constant progression in terms of value, which makes Bitcoin a still valuable cryptocurrency for the next 5 years. 11
Ethereum Projections An analogous process was performed for Ethereum, also with a logarithmic regression that can be seen in the following graph. Figure 8 - Ethereum value projection The takeaways of the logarithmic regression can be seen as a fairly positive trendline that shows the capacity and the numerous possibilities that the Ethereum platform shows. By 2021, the value of Ethereum could be at $90/Ethe, showing a growth of 657% (from $11.89/Ethe in 17/10/2016 to $90/Ethe in 01/01/2021). As per the Bitcoin quantitative values, a Monte-Carlo analysis was performed using the values from the beginning of the year of 2016. The same mind-set regarding volatility of the beginning of the platform was considered, being that by blocking the time frame to the latest developments, the analysis gives less speculative values, while taking into account other competitors. Average 12 Average return (%) 931% Std deviation return 421% Time to retire 5 Inicial investment $ 1,000,000 12
Year Return Ending value 1 754% $ 8,537,672 2 483% $ 49,767,499 3 846% $ 470,924,704 4 1220% $ 6,218,498,711 5 482% $ 36,214,615,122 Mean $ 124,186,364,125 Median $ 80,916,646,765 Std. Dev. $ 137,894,882,427 Percentile 5% $ 3,595,975,276 25% $ 35,302,088,018 Figure 9 - Rate of return Ethereum 01/01/2016 These values portrayed in the previous tables show an impressive mean returns, but also an impressive standard deviation, proving what was considered in the qualitative analysis of the possible volatility and risk associated with a new digital asset such as the Ethereum, which should be expected to fluctuate considerably during the following years. But by combining both the qualitative and quantitative analysis, Ethereum is by far a valuable investment, which should be seriously considered in any portfolio. 13
Conclusion Considering the qualitative evaluation performed, we consider that both bitcoin and Ethereum are here to stay. Although they are currently facing difficult challenges and threats, which will be kept in the near future, namely in what concerns legislation, government and central bank pressures, society lack of trust and mediatic awareness, given the lack of efficiency, high costs involved in digital transactions and the new needs of today’s business models in particular and society in general, they have been able to find space to thrive. We consider that the decentralized platform model of Ethereum, based on blockchain technology, will be spread as the backbone infrastructure of future business models and its potential is still far from reaching its limits. As an open source platform, Ethereum allowed developers to program and build applications on it, which is supporting its growth strategy and rising adoption. Being able to call large tech and financials corporations’ attention and grant their support is a sign of Ethereum vitality and potential, and placed it in the pole position of the most potential cryptocurrencies in the market. Bitcoin reached the market in 2011 and six years later is still present. Although facing some up and downs during this period, it has had the ability not only to survive, which in the digital world is already a huge achievement, but more importantly maintain a positive trendline and continue to increase its value year on year. Based on the blockchain technology, Bitcoin can be considered the father of younger generations of cryptocurrencies and benefits from mediatic recognition granted by the 6 years of presence in the digital economy ecosystem. Contrary to Ethereum, Bitcoin is not a platform and thus its use is limited to transactions and deposits. Nevertheless due to its maturity, lower volatility, market 14
valuation and limited number of coins, we believe that Bitcoin can positioned itself as a digital commodity, the digital gold. As per our quantitative analysis, which goes in line with the qualitative one, both present themselves as good, yet high risk, investment options. According to our projections based on historical behaviour, which we recognise present some risks due to the volatility of digital environment, we’ve have reached to the following forecasts in a 5 year period: Ethereum US$11.9 @ 17/Oct/2016 US$90 @ Oct/2021 Growth in value of 657%. Bitcoin US$635 @ 17/Oct/2016 US$1150 @ Oct/2021 Growth in value of 81%. Given the inherent risk associated to projection making based on past behaviour with digital assets we’ve complement our investment analysis running a Monte-Carlo simulation using data from the 01/January/16 up till the 17/Oct/16 for a 5 year forecast considering US$1 million investment made today.. Ethereum US$1 million @ 17/Oct/2016 15
Average mean of return of US$119 million with a standard deviation of US$126 million. Bitcoin US$1 million @ 17/Oct/2016 Average mean of return of US$2 million with a standard deviation of US$1.1 million. Based on the previously seen analysis, and taking into account the spectacular possibilities of the Ethereum, one could even consider the investment solely in Ethereum. But the fact that Bitcoin shows less risk with a much smaller standard deviation, aligned with the possibility of becoming a commodity analogous to Gold must be considered. Therefore, with all the quantitative and qualitative analysis shown before, the investment should be divided in the percentage of 80% for Ethereum ($800.000) and 20% for Bitcoin ($200.000). This is without a doubt the division that most protects the investor and ensures the greater outcome for the investment, with less risk. 16
APPENDIX 1 – SWOT ANALYSIS BITCOIN ANALYSIS Bitcoin had the first mover advantage. Was able to develop and mature its structure by exponentially increase the hashrate, increasing a secure blockchain production. Currently, transactions are secured by 1.4 billion Gigahash/sec11. Figure 10 - Bitcoin hashrate TH/s A market capitalization of $10 billion and its maturity allowed the Bitcoin volatility index to present a downward trend that should inspire confidence in Bitcoin as a currency The bitcoin network already ranges 200,000 daily transactions for approximately 9 million wallets, and is expected to be in the excess of 10 million users very soon. Figure 11 - Blockchain wallet users However, there are obstacles in Bitcoin’s way threatening its pole position. 11 Source: www.blockchain.info 17
Was designed as a digital cash system. As such, has limitations that other altcoins identified as market opportunities, like media polarization, compliance concerns related to money laundering - traceability, reversibility and privacy. The Bitcoin network hardly scales. It can only handle seven to ten transactions per second, what is too low for a mainstream system requirement. As an example, Visa processes thousands of transactions per second12. As it became popular, Bitcoin block size became larger. The average block size is now around 700 kb, sometimes reaching 1Mb. As larger sizes delay the transactions, users are forced to pay higher fees to prioritize their transactions. This cost increase is chasing away users. Another concern, mainly for its stakeholders, is how Bitcoin model shall proceed for the future. This is now a conflict of interests for developers, miners, infrastructure providers and end users. The partnerships being done with commercial banks can be seen as traction indicator. Recently, Bitcoin signed one with Barclays Bank, after the UK’ FCA granted Barclays and e-money license, becoming the first tier 1 bank having accounts for a Bitcoin business. As any other blockchain technologies, Bitcoin as a world of possibilities for its usage. Nevertheless, due to its maturity for being the first cryptocurrency, fixed issuance, market acceptance and independency from governments, already serves as a store of value - digital gold - and has been used to secure investment when financial markets lack liquidity. However, there are new alternatives more flexible than Bitcoin. Companies are betting on the Bitcoin weaknesses and attempting to perform better. These companies are 12 Source: www.fortune.com 18
innovating on the smart contract platform, sidechain technology to improve scalability, clearing the risk associated and also in the interoperability of services. And what to say about the regulatory threats? As far as the cryptocurrencies growth, higher the government's concern will be. The later can see this technology as a revolutionary way to lose control of the markets, currency, data and lastly, the power. The European Commission already expressed the need to regulate the digital currency. Related to regulatory threats, comes the media coverage about whether the digital currencies are being used for. ETHEREUM ANALYSIS Ethereum came up to the market with a revolutionary solution of smart contracts, powered by flexibility, diversification and its inherent capabilities of blockchain technology development. Allied to it, are the tremendous drivers backing it up, as the partnership with Microsoft Azzure, which will provide access to the software to millions of basic users. Other drivers providing powerful traction are the partnership with IBM, MIT and the latest one with R3, resulting in blockchain developments for 42 main banks. The improvements made to the blocks technology, allied to a truly independent platform reduced the processing time from the needed 10 minutes at Bitcoin to an average of 17 seconds per transaction at Ethereum. Also as a decentralized cryptocurrency, was able to improve and solve several cybersecurity issues that were pending. Smart contracts are now in a great macroeconomic spot due to its potential capabilities, being applied to financial services, automation of the workforce or public records, for instance. The undoubtable future relation of smart contracts with IoT, AI and Industry 4.0 is one of the major factors for so many upcoming startups to have their Business Model 19
based on this technology. Knowing that the opportunities for this technology are beyond imagination, one that can’t be disregarded is the potential disruptive power to eliminate third parties - intermediaries or platforms, as AirB&B and UBER. Ethereum youth is followed by the typical high volatility and low maturity. And this volatility represents one of the most representative risks in any investment on the company. Being an independent platform, accountability and liability are important subjects that must be accounted for. Will the core developers be accountable for any issue? And if yes, who are they? If not, who will be accountable for any cyber breach? New entrants are always a threat. Knowing that there are high technological releases every six months, potential new entrants are expected in the near future, mainly due to the high number of start-ups developing this technology. In common with Bitcoin, Ethereum faces the fact that new regulatory principles need to be integrated in order to make blockchain technologies an integral part of the market infrastructure. Also, as an independent platform, Ethereum is a threat to central governments and banks, as an answer to these threats, Governments are developing their own blockchain platforms. Besides, the risk of more governments taxing Ethes or consider it as an asset, as Australia does it already, is high. Concerning cybersecurity, the operational risk needs to be minimized. This move will require a quick recovery of participants to revert to the traditional ecosystem as a fall back. 20
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