Posted by in Cryptocurrencies.

A rational take on cryptocurrencies

What they are and what they’re not. Probably.

Here at Coin Sciences, we’re best known for MultiChain, a popular platform for creating and deploying permissioned blockchains. But we began life in March 2014 in the cryptocurrency space, with the goal of developing a “bitcoin 2.0″ protocol called CoinSpark. CoinSpark leverages transaction metadata to add external assets (now called tokens) and notarized messaging to bitcoin. Our underlying thinking was this: If a blockchain is a secure decentralized record, surely that record has applications beyond managing its native cryptocurrency.

After less than a year, we stopped developing CoinSpark, due to both a push and a pull. The push was the lack of demand for the protocol – conventional companies were (understandably) reluctant to entrust their core processes to a public blockchain. But there was also a pull, in terms of the developing interest we saw in closed or permissioned distributed ledgers. These can be defined as databases which are safely and directly shared by multiple known but non-trusting parties, and which no single party controls. So in December 2014 we started developing MultiChain to address this interest – a change in direction that Silicon Valley would call a “pivot”.

Two years since its first release, MultiChain has proven an unqualified success, and will remain our focus for the foreseeable future. But we still take an active interest in the cryptocurrency space and its rapid pace of development. We’ve studied Ethereum’s gas-limited virtual machine, confidential CryptoNote-based systems like Monero, Zcash with its (relatively) efficient zero knowledge proofs, and new entrants such as Tezos and Eos. We’ve also closely observed the crypto world’s endless dramas, such as bitcoin’s block size war of attrition, the failures of numerous exchanges, Ethereum’s DAO disaster and Tether’s temporary untethering. Crypto news is the gift that keeps on giving.

Crypto and the enterprise

Aside from sheer curiosity, there’s a good reason for us to watch so closely. We fully expect that many of the technologies developed for cryptocurrencies will eventually find their way into permissioned blockchains. And I should stress here the word eventually, because the crypto community has (to put it a mildly) a far higher risk appetite than enterprises exploring new techniques for integration.

It’s important to be clear about the similarities and differences between cryptocurrencies and enterprise blockchains, because so much anguish is caused by the use of the word “blockchain” to describe both. Despite the noisy objections of some, I believe this usage is reasonable, because both types of chain share the goal of achieving decentralized consensus between non-trusting entities over a record of events. As a result, they share many technical characteristics, such as digitally signed transactions, peer-to-peer networking, transaction constraints and a highly robust consensus algorithm that requires a chain of blocks.

Despite these similarities, the applications of open cryptocurrency blockchains and their permissioned enterprise counterparts appear to be utterly distinct. If you find this surprising or implausible, consider the following parallels: The TCP/IP networking protocol is used to connect my computer to my printer, but also powers the entire Internet. Graphics cards make 3D video games more realistic, but can also simulate neural networks for “deep learning”. Compression based on repeating sequences makes web sites faster, but also helps scientists store genetic data efficiently. In computing, multi-purpose technologies are the norm.

So here at Coin Sciences, we believe that blockchains will be used for both cryptocurrencies and enterprise integration over the long term. We don’t fall on either side of the traditional (almost tribal) divide between advocates of public and private chains. Perhaps this reflects an element of wishful thinking, because a thriving cryptocurrency ecosystem will develop more technologies (under liberal open source licenses) that we can use in MultiChain. But I don’t think that’s the only reason. I believe there is a compelling argument in favor of cryptocurrencies, which can stand on its own.

In favor of crypto

What is the point of cryptocurrencies like bitcoin? What do they bring to the world? I believe the answer is the same now as in 2008, when Satoshi Nakamoto published her famous white paper. They enable direct transfers of economic value over the Internet, without a trusted intermediary, and this is an incredibly valuable thing. But unlike Satoshi’s original vision, I do not see this as a better way to buy coffee in person or kettles online. Rather, cryptocurrencies are a new class of asset for people looking to diversify their financial holdings in terms of risk and control.

Let me explain. In general people can own two types of asset – physical and financial. For most of us physical assets are solid and practical items, like land, houses, cars, furniture, food and clothing, while a lucky few might own a boat or some art. By contrast, financial assets consist of a claim on the physical assets or government-issued money held by others. Unlike physical assets, financial assets are useless on their own, but can easily be exchanged for useful things. This liquidity and exchangeability makes them attractive despite their abstract form.

Depending on who you ask, the total value of the world’s financial assets is between $250 and $300 trillion, or an average of $35-40k per person alive. The majority of this sum is tied up in bonds – that is, money lent to individuals, companies and governments. Most of the rest consists of shares in public companies, spread across the stock exchanges of the world. Investors have plenty of choice.

Nonetheless, all financial assets have something in common – their value depends on the good behavior of specific third parties. Furthermore, with the exception of a few lingering bearer assets, they cannot be transferred or exchanged without a trusted intermediary. These characteristics create considerable unease for these assets’ owners, and that feeling gains credence during periods of financial instability. If a primary purpose of wealth is to make people feel safe in the face of political or personal storms, and the wealth itself is at risk from such a storm, then it’s failing to do its job.

So it’s natural for people to seek money-like assets which don’t depend on the good behavior of any specific third party. This drive underlies the amusingly-named phenomenon of gold bugs – people who hold a considerable portion of their assets in physical gold. Gold has been perceived as valuable by humans for thousands of years, so it’s reasonable to assume this will continue. The value of gold cannot be undermined by governments, who often succumb to the temptation to print too much of their own currency. And just as in medieval times, gold can be immediately used for payment without a third party’s assistance or approval.

Despite these qualities, gold is far from ideal. It’s expensive to store, heavy to transport, and can only be handed over through an in-person interaction. In the information age, surely we’d prefer an asset which is decentralized like gold but is stored digitally rather than physically, and can be sent across the world in seconds. This, in short, is the value proposition of cryptocurrencies – teleportable gold.

On intrinsic value

The most immediate and obvious objection to this thesis is that, well, it’s clearly ridiculous. You can’t just invent a new type of money, represented in bits and bytes, and call it Gold 2.0. Gold is a real thing – look it’s shiny! – and it has “intrinsic value” which is independent of its market price. Gold is a corrosion-resistant conductor of electricity and can be used for dental fillings. Unlike bitcoin, if nobody else in the world wanted my gold, I could still do something with it.

There’s some merit to this argument, but it’s weaker than it initially sounds. Yes, gold has some intrinsic value, but its market price is not derived from that value. In July 2001 an ounce of gold cost $275, ten years later it cost $1840, and today it’s back around the $1200 mark. Did the practical value of dental fillings and electrical wiring rise sevenfold in ten years and then plummet in the subsequent six?

Clearly not. The intrinsic value argument is about something more subtle – it places a lower bound on gold’s market price. If gold ever became cheaper than its functional substitutes, such as copper wiring or dental amalgam, electricians and dentists would snap it up. So if you buy some gold today, you can be confident that it will always be worth something, even if it’s (drastically) less than the price you paid.

Cryptocurrencies lack the same type of lower bound, derived from their practical utility (we’ll discuss a different form of price support later on). If everyone in the world lost interest in bitcoin, or it was permanently shut down by governments, or the bitcoin blockchain ceased to function, then any bitcoins you hold would indeed be worthless. These are certainly risks to be aware of, but their nature also points to the source of a cryptocurrency’s value – the network of people who have an interest in holding and transacting in it. For bitcoin and others, that network is large and continuing to grow.

Indeed, if we look around, we can find many types of asset which are highly valued but have negligible practical use. Examples include jewelry, old paintings, special car license plates, celebrity autographs, rare stamps and branded handbags. We might even say that, in terms of suitability for purpose, property in city centers is drastically overpriced compared to the suburbs. In these cases and more, it’s hard to truly justify why people find something valuable – the reason is buried deep in our individual and collective psyches. The only thing these assets have in common is their relative scarcity.

So I wouldn’t claim that bitcoin’s success was a necessary or predictable consequence of its invention, however brilliant that may have been. What happened was a complete surprise to most people, myself included, like the rise of texting, social media, sudoku and fidget spinners. There’s only one reason to believe that people will find cryptocurrencies valuable, and that is the fact that they appear to be doing so, in greater and greater numbers. Bitcoin and its cousins have struck a psychoeconomic nerve. People like the idea of owning digital money which is under their ultimate control.

Against crypto maximalism

At this point I should clarify that I am not a “cryptocurrency maximalist”. I do not believe that this new form of money will take over the world, replacing the existing financial landscape that we depend on. The reason for my skepticism is simple: Cryptocurrencies are a poor solution for the majority of financial transactions.

I’m not just talking about their sky-high fees and poor scalability, which can be technically resolved with time. The real problem with bitcoin is its core raison d’être – the removal of financial intermediaries. In reality, intermediaries play a crucial role in making our financial activity secure. Do consumers want online payments to be irreversible, if a merchant has ripped them off? Do companies want a data loss or breach to cause immediate bankruptcy? One of my favorite Twitter memes is this from Dave Birch (although note that bitcoin is not truly anonymous or untraceable):

While it’s wonderful to send value directly across the Internet, the price of this wizardry is a lack of recourse when something goes wrong. For the average Joe buying a book or a house, this trade-off is simply a bad deal. And the endless news stories about stolen cryptocurrency and hacked bitcoin exchanges aren’t going to change his mind. As a result, I believe cryptocurrencies will always be a niche asset, and nothing more. They will find their place inside or outside of the existing financial order, alongside small cap stocks and high yield bonds. Not enough people are thinking about the implications of this boring and intermediate outcome, which to me seems most likely of all.

A pointed historical analogy can be drawn with the rise of e-commerce. In the heady days of the dot com boom, pundits were predicting that online stores would supersede their physical predecessors. Others said that nobody would want to buy unseen goods from web-based upstarts. Twenty years later, Amazon, Ebay and Alibaba have indeed built their empires, but physical stores are still with us and attractive to buy. In practice, most of us purchase some things online, and other things offline, depending on the item in question. There are trade-offs between these two forms of commerce, just as there are between cryptocurrencies and other asset classes. He who diversifies wins.

Now about that price

If cryptocurrencies will be around in the long term, but won’t destroy the existing financial order, then the really interesting question is this: Exactly how big are they going to get? Fifty years from now, what will be the total market capitalization of all the cryptocurrency in the world?

In my view, the only honest answer can be: I’ve no idea. I can make a strong case for a long-term (inflation-adjusted) market cap of $15 billion, since that’s exactly where crypto was before this year’s (now deflating) explosion. And I can make an equally strong case for $15 trillion, since the total value of the world’s gold is currently $7 trillion, and cryptocurrencies are better in so many ways. I’d be surprised if the final answer went outside of this range, but a prediction this wide is as good as no prediction at all.

Most financial assets have some kind of metric which acts to anchor their price. Even in turbulent markets, they don’t stray more than 2-3x in either direction before rational investors bring them back into line. For example, the exchange rates between currencies gravitate towards purchasing power parity, defined as the rate at which a basket of common goods costs the same in every country. Bonds gravitate towards their redemption price, adjusted for interest, inflation and risk, which depends on the issuing party. Stocks gravitate towards a price/earnings ratio of 10 to 25, because of the alternatives available to income-seeking investors. (One exception appears to be high-growth technology stocks, but even these eventually come back down to earth. Yes, Amazon, your day will come.)

When it comes to the world of crypto, there is no such grounding. Cryptocurrencies aren’t used for pricing common goods, and they don’t pay dividends or have a deadline for redemption. They also lack the pedigree of gold or artwork, whose price has been discovered over hundreds of years. As a result, crypto prices are entirely at the mercy of Keynesian animal spirits, namely the irrational, impulsive and herd-like decisions that people make in the face of uncertainty. To paraphrase Benjamin Graham, who wrote the book on stock market investing, Mr Crypto Market is madder than a madman. The geeks among us might call it chaos theory in action, with thousands of speculators feeding off each other in an informational vacuum.

Of course, some patterns can be discerned in the noise. I don’t want to write (or be accused of writing) a guide to cryptocurrency investing, so I’ll mention them only in brief: reactions to political uncertainty and blockchain glitches, periods of media-driven speculation, profit-taking by crypto whales, 2 to 4 year cycles, deliberate pump-and-dump schemes, and the relentless downward pressure caused by proof-of-work mining. But if I could give one piece of advice, it would be this: Buy or sell to ensure you’ll be equally happy (and unhappy) whether crypto prices double or halve in the next week. Because either can happen, and you have no way of knowing which.

If the price of a cryptocurrency isn’t tied to anything and moves unpredictably, could it go down to zero? Barring a blockchain’s catastrophic technical failure, I think the answer is no. Consider those speculators who bought bitcoin in 2015 and sold out during the recent peak, making a 10x return. If the price of bitcoin goes back to its 2015 level, it would be a no-brainer for them to buy back in again. In the worst case, they’ll lose a small part of their overall gains. But if history repeats itself, they can double those gains. And maybe next time round, the price will go even higher.

This rational behavior of previous investors translates into a cryptocurrency’s price support, at between 10% and 25% (my estimate) of its historical peak. That’s exactly what happened during 2015 (see chart below) when bitcoin’s price stabilized in the $200-$250 range after dropping dramatically from over $1000 a year earlier. At the time there was no good reason to believe that it would ever rise again, but the cost of taking a punt became too low to resist.

bitcoin-chart

So I believe that cryptocurrencies will be with us for the long term. As long as bitcoin is worth some non-trivial amount, it can be used as a means of directly sending money online. And as long as it serves this purpose, it will be an attractive alternative investment for people seeking to diversify. The same goes for other cryptocurrencies that have reached a sufficient level of interest and support, such as Ethereum and Litecoin. In Ethereum’s case, this logic applies whether or not smart contracts ever find serious applications.

On that subject, I should probably (and reluctantly) mention the recent wave of token Initial Coin Offerings (ICOs) on Ethereum. For the most part, I don’t see these as attractive investments, because their offer price may well be a high point to which they never return. And the sums involved are often ridiculous – if $18 million was enough to fund the initial development of Ethereum, I don’t see why much simpler projects are raising ten times that amount. My best guess is that many ICO investors are looking for something to do with their newly-found Ether riches, which they prefer not to sell to drive down the price. Ironically, after being collected by these ICOs, much is being sold anyway.

Back to reality

There’s a certain symmetry between people’s reactions to cryptocurrencies and enterprise blockchains. In both cases, some shamelessly drive the hype, claiming that bitcoin will destroy the financial system, or that enterprise chains will replace relational databases. Others are utterly dismissive, seeing cryptocurrencies as elaborate Ponzi schemes and permissioned blockchains as a technological farce.

In my view, these extreme positions are all ignoring a simple truth – that there are trade-offs between different ways of doing things, and in the case of both cryptocurrencies and enterprise blockchains, these trade-offs are clear to see. A technology doesn’t need to be good for everything in order to succeed – it just needs to be good for some things. The people who are doing those things have a tendency of finding it.

So when it comes to both public and private blockchains, it’s time to stop thinking in binary terms. Each type of chain will find its place in the world, and provide value when used appropriately. In the case of cryptocurrencies, as an intermediary-free method for digital value transfer and an alternative asset class. And in the case of enterprise blockchains, as a new approach to database sharing without a trusted intermediary.

That, at least, is the bet that we’re making here.

 

Disclosure: The author has a financial interest in various cryptocurrencies. Coin Sciences Ltd does not.

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