I’ve historically been dismissive regarding cryptocurrencies, especially given the numerous signs of speculative mania and colorful personalities involved. But recently, I’ve been starting to develop conviction that there is more at play here than a simple ‘tulip mania’ type phenomenon. The problem for investors is sifting the signal from the noise. And there is a LOT of noise. Whether it’s Elon Musk’s tweets on the topic, stories of teenage crypto millionaires, the sometimes gut-wrenching volatility in the prices of the assets, or the pace of new technologies and applications coming to market (e.g. the recent NFT craze)- it’s hard to figure out what’s really going on. A lot of conservative investors have decided to dismiss the entire sector as some kind of fad or bubble due to the abundance of speculative activity. Others have decided it’s too much work to sift the signal from the noise and have put crypto in the ‘too hard pile’. This could be a mistake.
As of this writing, the total crypto market cap is ~$2.7tr. Bitcoin alone is a >$1tr asset with backing from numerous large institutions (BlackRock for e.g.) and is becoming increasingly accepted as a superior store of value relative to traditional alternatives such as precious metals. As much as the ‘crypto is a bubble’ crowd would hate to admit, it seems increasingly likely that Bitcoin is here to stay. And there is more to the story than just Bitcoin. Tokens like Ethereum are opening up the potential for a whole new way of organizing and structuring the internet, the economy and institutions in a way that could overcome many of the limitations and failures of our current world order.
Decentralization
The technology behind blockchain and how it works is beyond the scope of this blog post, and there are countless resources on the internet that help explain the fundamentals (this is a great resource to get started). For this piece I’m going to keep the discussion focused on the problems crypto is trying to solve, how it uniquely solves them and some key topics to research before getting involved in the space as an investor.
The way I think about blockchain and cryptocurrencies (including tokens and other crypto assets… the distinction is important but doesn’t matter for this discussion) is that they solve a fundamental problem with how we have structured modern society, the internet and the economy: the properties of trust and power have become concentrated in the hands of a few, preventing frictionless collaboration and creating increased fragility and opportunities for the abuse of power; this is also exacerbating wealth inequality as the members in various centralized ecosystems are not getting the fair share of the value they add to these ecosystems.
For example, the largest technology companies are starting to look like monopolistic toll roads for economic activity. Want to market your business and sell products online? You have to pay a toll to Facebook, Google, Amazon, Shopify etc. Want to develop an app and sell it to millions of users? You have to pay a toll to the Apple App Store. Want to collaborate in a work environment? You have to pay a toll to Microsoft Teams or Slack.
This isn’t a problem limited to technology. Other large institutions like banks, insurance companies etc. have been generating toll-like revenue from our economic activities for much longer than Big Tech. Government institutions also tax our day to day activities in exchange for the promise of public goods and services, but often fail to to address burning structural problems like inequality and climate change that require short-term pain (which often reduces the government’s chances of re-election) in exchange for long-term results.
At this point you’re probably thinking I’m going to paint some kind of utopian picture of a world built on the blockchain, but that’s not where I’m going with this. Blockchain technology has its limitations, and it certainly isn’t a solution to all the problems I just listed. But it does address the root of where these problems originate: it’s hard to establish trust in society in the absence of centralized power and institutions. In doing so it offers a new tool kit to problem solvers to work on addressing these issues in ways that weren’t possible before.
Why do we pay a toll to Facebook? Because Facebook ensures that we can trust people are actually who they say they are in their online profiles (well not always… but they try). Facebook manages a centralized database of user identities which allows us to socialize online. Why do we buy things on Amazon? Because buying them directly from someone online exposes us to the threat of counterparty credit risk and counterfeits as well as the issue of figuring out transportation logistics. Amazon allows us to trust online counterparties and offers a streamlined online shopping experience. Why do we pay a toll to banks, law firms and insurance companies for day-to-day transactions? Because these institutions have the infrastructure and checks and balances in place to ensure the identity of various counterparties in a transaction and the validity of economic transactions and contracts. Why do we elect politicians to make decisions for us? Because we can’t trust each other to collaborate and work in the absence of a centralized authority in a way that advances broader society’s well being rather than just looking out for ourselves.
Trust is essential for capitalism and democracy to work, and while institutions have become ever more efficient at providing it, they have become dangerously powerful and are extracting an ever greater cost from society in exchange for offering it.
Double Spending Problem
Let’s bring this down to earth. A simple example of the ‘trust’ problem is sending money to someone over the internet. Because software has zero marginal cost of distribution, if I send a piece of code to someone that represents $1, it’s effortless for me to copy and paste that code and send it to someone else as well. That way I’ve spent $1, twice – the classic double spending problem. To avoid this problem we use intermediaries like banks and payments software to transfer money online in exchange for a fee.
This problem exists because of the fundamental nature of how software and computers today are architected: computers are controlled by humans, and humans can often alter computer programs with minimal effort. This means its hard to establish trust in a piece of code.
Chris Dixon of Andreesen Horowitz does a great job of explaining succinctly how blockhains solve this problem:
“I like to say that blockchains are computers that can make commitments. Traditional computers are ultimately controlled by people, either directly in the case of personal computers or indirectly through organizations. Blockchains invert this power relationship, putting the code in charge. The programming logic behind it is more complicated than we need to get into, but the end result of it is that blockchains, once established, are resilient to human interventions
As a result, a properly designed blockchain provides strong guarantees that the code it runs will continue to operate as designed. For the first time, a computer system can be truly autonomous: self-governed, by its own code, instead of by people. Autonomous computers can be relied on and trusted in ways that human-governed computers can’t.“
In the case of the double spending problem, the blockchain solution is to create a commitment to scarcity. Every Bitcoin has a unique identifier, and each transaction on the Bitcoin blockchain is verified and recorded into a database that can never be altered by anyone. The responsibility for security and preservation of this architecture is distributed throughout the network as opposed to one central authority. Through this genius architecture, Satoshi Nakamoto created digital scarcity and trust without the need for a centralized institution.
Based on how the Bitcoin algorithms are written, only 21mm Bitcoins will ever exist. And no centralized authority has the power to alter that. This means that Bitcoin is an excellent store of value for someone looking to hedge against the risk of monetary debasement. This is similar to gold which has a finite supply and a very high and well-defined stock-to-flow ratio (the amount of gold mined every year is fairly stable and a very small percentage of the overall stock of gold). But in some ways Bitcoin is even better than gold: 1/ it’s annual supply is completely fixed and independent of the price of Bitcoin (gold supply can and often does fluctuate with gold price) 2/ since gold is a physical commodity it can easily be mixed with impurities and sold fraudulently to unsuspecting buyers, whereas Bitcoin and the underlying blockchain can never be altered (except with an impractical/unfeasible amount of computing power) as this is the fundamental principle behind their design.
Moving Beyond Store Of Value
In a way digital trust is even stronger than the types of trust we place in physical processes such as signing a document, or visually inspecting a piece of art. These physical processes often involve human intervention and judgement whereas the blockchain relies on a much stronger security protocol rooted in cryptography.
Let’s extend this concept of digital trust beyond monetary ‘store of value’. Imagine if you could trust someone’s identity online without a centralized database and use this as the foundation of different types of online interactions (social, ecommerce/payments, collaboration etc.). That would allow us to move beyond the limitations and value extraction of Big Tech to a completely new type of internet (commonly referred to as Web 3.0) which is far more open, collaborative and offers better incentives to developers and programmers to develop the best technologies.
Similarly imagine everyday economic transactions happening on the blockchain – let’s take the example of real estate where there are multiple layers of trust required all the way from proof of ownership to proof of funds and identity. A decentralized repository of identities, combined with decentralized finance (DeFi) and a blockchain to record real estate transactions would mean a lot less involvement by banks and real estate lawyers to securely close real estate transactions. The concept of title insurance would disappear.
Billions of dollars are spent every year on copyrights / licensing. But with blockchains, verifying authenticity of content can be made a lot simpler and cheaper. When you buy a painting you usually need some kind of physical inspection or appraisal to ensure what you’re buying is original. But even then there is room for error as no inspection is 100% fool proof which is why art fraud is still fairly common. With Non Fungible Tokens (NFTs), every piece of digital art is associated with a token on the blockchain which acts as a certificate of authenticity. When you buy this piece of digital art, what you’re actually buying is the underlying token (which cannot be replicated) and the transaction gets added on the blockchain. If someone now tries to sell a fake copy of this piece of art, the fraud will be easy to detect as this individual won’t be able to present the original token as proof of authenticity.
Finally, let’s think about collective action, government and institutions. Today, we depend on governments to provide us with public goods and services because we have few good ways to trust each other and collaborate on such projects. We also rely on corporations to accumulate capital, labor and formulate and enforce the rules that allow us to work together to achieve certain economic objectives. However these centralized forms of resource allocation leave us exposed to abuses of power. Governments promise one thing and often deliver another, companies often change their original agreements with workers for the benefit of shareholders.
Using blockchain technology, these activities can be organized under Decentralized Autonomous Organizations (DAOs). DAOs are represented by rules encoded as a transparent computer program on the blockchain. Since these rules are agreed upon by the members of the DAO and cannot be changed by any one individual, DAOs do not require traditional governance structures such as boards of directors and executive officers. This ensures that the organization operates on a truly neutral and democratic basis. Every member of the organization has a “voice” through community governance and can choose to exit if the organization no longer meets their goals and principles by either leaving the network or selling their coins / tokens to someone else. DAOs are already being used for various crowd-funding projects including charity / donations, buying NFTs and group investments.
Down The Rabbit Hole
The potential applications of the digital trust created by blockchain and crypto assets are almost endless. Through the examples above I’ve tried to offer a small glimpse of the kind of future that’s possible with their application. The fact that some of the smartest minds in Silicon Valley are working on this, as well as the fact that the asset class as a whole continues to grow despite the constant dire prognostications of naysayers, suggests to me that this is not a transitory speculative phenomenon and could very well represent the seeds for the next big technological revolution. That being said, like with any other emerging technology investment there are countless risks associated with investing in crypto. Below are three major topics I think investors should research in detail as a starting point before putting a dime into these assets:
1/ Not A Monolithic Asset Class
As I mentioned the blockchain has almost countless applications / use cases. As a result investors should ensure they understand the specific problem any given blockchain application, token or coin is trying to address before investing. Treating the sector like one big monolithic project is a mistake. For example Bitcoin was initially thought of as a future means of payments but is increasingly becoming a store-of-value play. This is because transactions on the Bitcoin blockchain remain incredibly slow, the value of Bitcoin remains highly volatile, and the Bitcoin community has pushed back against changes such as increasing the size of each Bitcoin block to allow more transactions to be processed per second. Given the lack of development and resistance to change, there is a consensus forming that Bitcoin is the equivalent of ‘digital gold’ or a way of protecting your wealth against bad central banking policy.
Compare this to the Etherium blockchain which wants to use the properties of digital trust to build a lot more than just a monetary database. The Etherium blockchain is being used to build decentralized applications for a number of the use cases I discussed earlier including a repository for identities, decentralized file storage, decentralized finance (DeFI), DAOs, NFTs among others. The Etherium blockchain currency ETH lets you pay a network of computers to run various applications that are built on top of it and in that sense is more of a ‘token’ rather than a ‘currency’ and referred to as such in the community. The fee paid in order to process transaction on the Etherium block chain is knows as a ‘gas fee’ and varies depending on how busy the network is at any given time. Recently these gas fees have become extremely expensive during times of peak usage as the amount of traffic on the Etherium network continues to grow fast.
In order for Etherium to achieve the stated objectives of its founders (i.e. build real-world tools and applications on the blockchain that can be widely used all over the world) it needs to constantly evolve. There are currently various updates under progress to help the Etherium blockchain process transactions faster and to improve scalability. Etherium therefore embodies the Silicon Valley ethos of ‘moving fast and breaking things’. But this also means that Etherium has more competition. While Bitcoin has nearly monopolized the ‘store of value’ application for blockchains, Etherium is facing competition from a slew of new entrants like Cardano and Solana that claim to have found better solutions to the problem of scalability. For example Solana uses the concept of Proof of History (PoH) as a technological improvement over Etherium to process a greater number of transactions per second (~700K transactions / sec which is ~30x the number of transactions Visa handles).
To conclude, successful investment in crypto requires an understanding of the different types of crypto assets and their respective use cases. Without this understanding you won’t know the risk / reward implications of what you are buying and are therefore likely be surprised by the ultimate outcome. Buying a meme coin like Dogecoin exposes you to very different set of risks vs. something like Etherium which has a significant ecosystem of developers working on solving real-world problems on the blockchain.
2/ Regulatory Overhang
It’s no surprise that the decentralized nature of crypto assets has attracted a lot of illicit activity. By circumventing the banking system, Bitcoin has allowed many types of criminals all over the world to transfer / launder money with ease. Just this summer Colonial Pipelines paid $5mm in cryptocurrency to a group of hackers from Russia who infiltrated the Company’s systems and caused a days-long shutdown of a major gas pipeline that led to a supply shortage on the U.S. East Coast. The FBI somehow managed to acquire the private key to the cyrpto wallet where the assets were held and retrieved $2.3mm (the price of Bitcoin had fallen), but the fact that the hackers asked for ransom in Bitcoin goes to show the increasing preference of nefarious actors to conduct their business in cryptocurrency.
While it’s estimated that only 1% of crypto transactions involve illegal activity, and the vast majority of money laundering continues to be in the form of fiat currency, the ability to own cryptocurrency without divulging your identity and the fact that regulators are behind the curve in terms of technology has alarmed policymakers all over the world:
“Cryptocurrencies have been used to launder the profits of online drug traffickers; they’ve been a tool to finance terrorism,” Treasury Secretary Janet Yellen.
“Very few people are using Bitcoin to pay their bills, but some people are using it to buy drugs [or] subvert elections,” New York Times columnist Paul Krugman.
“[Bitcoin is] a highly speculative asset which has conducted some funny business and some interesting and totally reprehensible money-laundering activity.” ECB President Christine Lagarde
Additionally, the whole crypto economy extending beyond Bitcoin, Etherium and including all other tokens and meme coins continues to be unregulated and has turned a bit into the Wild West of the technology and financial world. The whole space is moving so fast that regulators are having a hard time keeping up with rising and continuously evolving forms of speculative activity. The creation of stablecoins and DeFi has led to an orgy of leveraged speculation in crypto assets manifesting in increased volatility and boom / bust cycles for many of the most traded coins as well as increasing the fragility of the entire system. The following passage from Financial Times captures the potential systemic risks posed by the asset class:
With the stablecoin market now $100bn+, regulators are starting to take note. On Nov 9th, SEC Commissioner Caroline Crenshaw published a statement on DeFi which should have rung the alarm bells for anyone in the crypto space taking regulatory risks too lightly. The statement makes it clear that while DeFi is ‘decentralized’, it’s still a subset of ‘finance’ and involves activities which have traditionally fallen under the SEC’s jurisdiction. I found the following few passages to be particularly noteworthy:
“But these offerings are not just products, and their users are not merely consumers. DeFi, again, is fundamentally about investing. This investing includes speculative risks taken in pursuit of passive profits from hoped-for token price appreciation, or investments seeking a return in exchange for placing capital at risk or locking it up for another’s benefit.”
“For example, a variety of DeFi participants, activities, and assets fall within the SEC’s jurisdiction as they involve securities and securities-related conduct. But no DeFi participants within the SEC’s jurisdiction have registered with us, though we continue to encourage participants in DeFi to engage with the staff.”
“That being said, for non-compliant projects within our jurisdiction, we do have an effective enforcement mechanism. For example, the SEC recently settled an enforcement action with a purported DeFi platform and its individual promoters. The SEC alleged they failed to register their offering, which raised $30 million, and misled their investors while improperly spending investor money on themselves. To the extent other offerings, projects, or platforms are operating in violation of securities laws, I expect we will continue to bring enforcement actions.”
These statements suggest that regulatory crackdown on the whole space is only a matter of time. While the SEC has chosen to use an enforcement framework for now, I think a broader regulatory framework for crypto is probably on its way. While such a framework will add a lot more transparency and certainty, it will likely also lead to short term volatility, de-leveraging and potentially massive losses for some investors and speculators exposed to activities that will be made illegal, or severely constrained in scope going forward. It may also end up making DeFi a lot more like TradFi.
Perhaps the biggest reason to expect regulatory crackdown on the space is that governments will not tolerate a potential loss of confidence in fiat money and the banking system as a result of cryptocurrency adoption. Modern monetary policy relies critically on the central bank’s ability to increase money supply to encourage credit creation, and for all economic actors to continue treating this money as the primary means of economic exchange. If cryptocurrencies continue to rise in value, people could start to view this increase as a sign of uncontrolled inflation or the debasement of fiat currency. Such expectations can be self-fulfilling as people could start hoarding crypto assets and anchoring wage expectations to their price, starting a wage-price spiral. Additionally if people move from the current banking system to DeFi platforms, then the channels through which central banks exert their power (i.e. injecting liquidity / credit creation, regulatory frameworks etc.) will be neutered.
Based on all the above, it’s not surprising that China and India have effectively banned all cryptocurrency transactions, and leaders in the developed world continue to speak in a cautious and increasingly threatening tone about the whole space. More national bans and restrictions are almost a certainty in my opinion.
3/ Buying and Storing Crypto
Most crypto is bought and sold on major exchanges like Coinbase, Binance, Gemini etc. When choosing an exchange it’s important to consider security features, fees and capabilities. Some of the smaller exchanges may offer lower fees but they leave you exposed to security risks (hackers have broken into exchanges and stolen assets). In general it’s best to stick to the largest exchanges that have backing from big venture capital and other institutional investors. It also makes sense to transfer your assets to a private wallet off the exchange if you’re planning on buying and holding significant amounts of cryptocurrency for the long term.
While most big exchanges will store your assets in a secure wallet, security is not their primary business. Make sure to choose an exchange that will allow you to move assets off the exchange and into a private wallet. A ‘hot’ wallet runs on internet-connected devices like computers, phones, or tablets which makes it quite convenient to access your assets and transact. But because it’s connected to the internet, a hot wallet is also exposed to online security breaches and threats. The safest form of crypto storage is a ‘cold’ wallet or hardware wallet which is not connected to the internet. This could be in the form of a USB or hard drive, but requires more technical knowledge to set up. A good way to set up your wallets is to have an exchange account to buy and sell, a hot wallet to hold small to medium amounts of crypto you wish to trade or sell, and a cold / hardware wallet to store larger holdings for long-term durations.
Signing up for an exchange usually requires setting up an account and verifying your identity by submitting government issued documentation (though some exchanges allow anonymous accounts). However this doesn’t mean that your identity will be revealed on the blockchain. Blockchains record all the transactions you and everyone else is making and share it with everyone, but these transactions are linked to every user’s public key, not their personal information. This makes the transactions anonymous, but not confidential. A public address is where the funds and assets are deposited and received but only a private key allows you to retrieve those assets or make transactions with those assets. Think of a public address on the blockchain like a mailbox and the private key as the mailbox key. Anyone can put mail into the mailbox, but only you can access the contents of the mailbox with the private key. This is why keeping your private key somewhere safe is essential.
Conclusion
While there is a lot more to be said on the topic, I hope this post has been a good intro on the potential applications of crypto and some of the key research topics and risks associated with the space for investors to dig into further. I’m still early in the process of doing the same and hope to write more pieces that delve deeper into specific topics. For now I have decided to allocate a small % of my net worth (~1%) to a diverse basket of crypto assets to keep me motivated to learn more. It could be that I’m too early, or that the majority of the assets in the space eventually implode due to regulatory or other factors, but given the enormous potential and asymmetric upside I think it’s a worthwhile topic for all investors to keep an eye on.
The Pale Blue Dot 