Editor’s Note: This is Part Two of a multi-part primer on Blockchain is brought to you courtesy Canaccord Genuity. It is authored by analysts Robert Young, Michael Graham and Scott Suh. For Part One and important disclaimers, click here.
We note that bitcoin-related investments have not been concentrated in any one financial sub-sector. This indicates to us that demand for bitcoin services may be arising from a multitude of use cases, which could be a long-term positive for demand.
Miners’ incentives While the nodes running bitcoin software are spread all over the world, the miners controlling that computing power are highly concentrated.
Bitcoin miners are incentivized to provide computing power that enables the transaction because they receive a payment of (currently 12.5 BTC per block processed) for doing so. The miners then own BTC which can be sold at some point in the future, and their revenue is consequently linked to the future value of bitcoin. The net compensation they receive adjusts for mining costs, which include fixed costs for hardware and variable electricity costs.
Economics for bitcoin miners have been changing due to the increasing complexity of computing problems that need to be solved (requiring more power) as well as due to “halving,” a rule programmed into the bitcoin protocol that will cap the bitcoin supply.
The current reward of 12.5 BTC is down from the 25 BTC reward received before bitcoin’s second halving, which took place on July 9, 2016. This reward will decline to 6.3 BTC programmatically with the next subsequent halving, which should happen in ~three years (by ~July 2020), which is the approximate time it will take for another 210,000 blocks to be processed.
The exact date will be determined by the pace of mining, which is partially “controlled” by the bitcoin protocol that gradually makes mining more difficult. This can create a mismatch between transaction volume (number of transactions that market participants would like to execute) and throughput or mining capacity (the number of transactions that the various network nodes can validate in a given period of time). This mismatch has already become more noticeable, with times to validate bitcoin transactions expanding and thereby creating throughput issues, and ultimately resulted in bitcoin being forked in August 2017 to bitcoin and Bitcoin Cash (more on this later), which possesses larger blocks allowing for shorter transaction verification times.
Miners’ geographic distribution Despite the recent headlines regarding China’s plans to ban ICOs and cease trading on cryptocurrency exchanges, miners continue to remain concentrated in China for the time being. The top six mining pools (many bitcoin miners share their hashing power and split the reward according to the amount contributed;) by hashrate (a measure of computing power) distribution, are all based in China and have a market share of ~65%. China is likely a popular venue for miners due to the low cost of energy. However, as China continues to clamp down on cryptocurrency activity within its borders, miners’ geographic distribution will likely be increasingly dispersed, with signs already pointing to increased mining activity in other Asian countries such as Japan and South Korea. Nonetheless, we think the trend toward consolidation will continue, as previously miners often have collaborated to help solve blockchain puzzles, as it increases the chances that they discover the solution and are rewarded with bitcoin. As the amount of BTC rewarded continues to decrease due to halving, it will become increasingly imperative for miners to achieve greater degrees of scale to stay in business. We note that this concentration, however, may contribute to illiquidity (if the miners “hoard” their newly mined BTC).
The main “competitors” currently are ethereum and other blockchain applications Ethereum: Developers have created new blockchains that seek to improve on the benefits of bitcoin while mitigating some of the issues associated with the bitcoin blockchain. One of the best known is ethereum, which has emerged as the clear #2 cryptocurrency by market cap. However, we note that a key difference is that there is currently no limit to how much ethereum may ultimately be circulated, whereas with bitcoin there is a verifiable limit to supply. This key difference may prove a source of valuation support for bitcoin over time.
Another key difference that may be a positive for ethereum is its more centralized governance structure, which was best observed through its decision to implement a hard fork after a hacking in June 2016. While this decision was controversial, according to a report published by CoinDesk, 37% of respondents thought ethereum had better governance than bitcoin as a result. Note that 34% of respondents thought both cryptocurrencies had governance issues. The study also revealed that initially, 45% agreed with the hard fork, 33% disagreed, and 23% were unsure. After the hard fork, 8% of respondents changed their view and of those who did, 88% viewed it favorably.
Other blockchain applications: Blockchain applications outside of bitcoin and ethereum can also be used to route payment. Many of these may be on permissioned blockchain networks. One example is the partnership between Visa and Chain forged in October 2016. Chain does not use a cryptocurrency, but leverages blockchain technology to process transactions. This partnership is one of the first commercial applications of blockchain – Visa has deployed a prototype that will connect with 30 banks in 10 countries and is slated for launch by the end of the year. We expect similar types of partnerships between blockchain-based startups and established companies to help accelerate blockchain adoption. At last year’s Money 20/20, panelists believed that additional proof of concepts would likely be viable by 2018 or so, though other commercial applications might take four to seven years to be commercialized at a larger scale. As these applications proliferate, their respective blockchains may “compete” for volume with the bitcoin blockchain.
That said, we note that in November 2016 PWC launched Vulcan Digital Asset Services, a joint platform with Bloq, Libra and Netki, and a solid endorsement for the future of bitcoin. The platform aims to unite the divided blockchain and digital currency ecosystems, suggesting that bitcoin and blockchain could complement one another in a further developed ecosystem.
BTC versus fiat currencies versus gold We consider BTC to be a form of money because it satisfies the three functions of money (as described by the St. Louis Fed). In short, BTC is:
1) A store of value (its value does not degrade over time);
2) A unit of account (it is used as a yardstick to measure the value of economic transactions); and
3) A medium of exchange (it is an accepted means of payment that has gained a large degree of traction).
Bitcoin 106 Transaction volume for BTC as a form of payment
Right now, there are approximately 16.6M bitcoins in circulation, which amounts to ~$69.4B based on the current BTC exchange rates. We observe that bitcoin prices have rallied extensively since the spring of 2015 (when a bitcoin would have only cost you just over $200) driven at least partially by increased transaction volumes as BTC’s usage increases. We note that, at least visually, the chart below shows that the rapid rise in BTC’s value was simply a matter of “catching up” to the transaction volume, and also note that the latest BTC correction correlates closely with a softening of transaction volume.
However, while bitcoin’s transaction volumes ($) are increasing, they still are significantly below established global payments standards. MasterCard processes ~202x more transaction volume than seen in bitcoins, with Visa processing ~172x, PayPal ~7x, and Western Union ~6x.
Stay tuned for Part Three.