What Most People Get Wrong About Bitcoin and Cryptocurrency

In almost everything I read or discuss about Bitcoin, the blockchain, and crypto, someone conflates currencies, commodities, and technologies. It’s led to a lot of misunderstanding, and at least a little Dunning-Kruger effect. I’ve spent much of my life studying economics in some form, and have been following the rise of crypto for the last few years, so I want to address a few of the stronger claims and prognostications about the space and give them a reality check. Each is addressed below.

Claim — Bitcoin is better than Dollars / Yen / Euros / [your fiat currency].

Reality — Not as a currency, no. Some stable coins probably are.

Bitcoin, and most alt-coins, are poor currencies. This is because currencies, contrary to much popular believe, aren’t actually supposed to hold value. Currencies have two real functions:

A. Provide an abstraction of value, so we don’t have to rely on the barter system.

B. Encourage people to spend said currency so the economy functions.

Bitcoin et al. fail on part B. One of the reasons we decoupled from the gold standard is that gold’s value substantially increases and decreases over time. This makes people hold gold when they think it’s going to go up, and spend or sell it when they think it’s going to go down. When money is tied to the gold standard, it functions as a proxy, and the same behavior applies. The net outcome of this is that if people think money is going to significantly appreciate, they don’t spend it, and when they don’t spend it, the economy crashes. To solve this problem, most central banks have a target inflation rate. It’s usually in the range of 1–3%. It ensures that money functions as a relatively stable store of value, but that the value declines steadily over time. This encourages spending and investment. If one believes the claims of crypto-cheerleaders, whatevercoin is a great investment. When pressed as to why it’s a great investment, they tend to point out how it’s going to replace money. But both can’t really be true, because if it’s a good investment (and it may well be, see the investment claim for more detail on why), it’s a crappy currency, and if it’s a good currency, it’s a crappy investment. Stable coins are an attempt to solve this problem, some of which are tied directly to a country’s currency. Stable coins function perfectly well as money, but for most of the developed world, they hold little advantage over fiat currency as they basically are the same thing with added complexity. But advantages are relative, and in developing markets where there’s significant inflation or high depreciation, being able to transact in *any* stable currency is superior to the alternative, and crypto provides a way to do so without exchanging physical Dollars / Euros / Yen. Bitcoin is thus a poor currency for everyone, but for the developing world, the relative stability of asset backed (stable) coins and the ease with which they can be exchanged do have significant advantages. I’ll go into those in the payments claim below.

Claim — Bitcoin is a great investment.

Reality—Maybe.

Per the above, if one believes Bitcoin et al. will replace currencies, then it’s probably not a great investment, because the price won’t keep going up (or it won’t function as a currency). Alternatively, if one believes it just an alternative commodity (like gold) then it could be, but like gold there are limited practical uses for it, and it relies on everyone believing its a store of value. There are a lot of arguments out there to this effect. Additionally, much like the stable coins above, people have decided to create crypto-tokens backed directly by gold or other commodities. Even government entities such as the Royal Mint have started to get in on the action. And there are huge sums of money in the world that are sitting in countries where local currencies are unstable, or banks are untrustworthy, or governments are likely to steal your funds, and the need for an accessible value store for these use cases is quite real. It’s unclear if that store will be Bitcoin or some other crypto currency (such as one backed by gold) but it’s likely that some version of a digital value store (or proxy) is here to stay. The “maybe” prognosis is that picking a winner is a challenge as there is nothing in the use case that requires any specific functionality other than stability and accessibility, and similarly nothing requires that winner to significantly appreciate. For the same reason that Chinese money has flooded into US real estate, as long as the money doesn’t disappear or depreciate, it’s better than the alternative. Put more briefly, some (or even multiple) form(s) of crypto-based value store will likely exist, and for a while that will be a great investment as funds flow into it / them, but there’s very limited signal as to which brand of crypto that will be.

Claim — Crypto will revolutionize payments.

Reality — Probably not in the developed world. Probably in the developing one.

Just because a technology is older doesn’t make it bad. People in crypto-circles love to talk about Visa / Mastercard and how horrible their model is, but the reality is those networks are a) incredibly reliable, b) amazingly efficient, and c) very cost effective. VisaNet has 99.99%+ uptime, handles ~2,000 transactions per second, is capable of handling more than 25,000 transactions per second, and is resource (and energy) efficient. The company made ~$15B in revenue in 2016, which seems like a lot, except that’s off of $8.9T in volume. Put another way, that’s .17%. Their actual fee per transaction is .13%. It’s a low price to pay for all of the infrastructure involved. Now to be fair, the full cost of a given transaction is 2–3%, and that margin is fat enough for there to be disruptive opportunity. Some portion of that fee compensates for charge-backs and other risks like fraud, which in theory don’t exist in crypto. But this isn’t just a bug, it’s a feature. The bank is loaning me money for the transaction, and there’s a cost for that loan in both interest for me and risk for the bank. Similarly, there’s a cost for the ability to challenge a transaction because the merchant failed to deliver, and for the rewards the credit card company provides. To understand the reality of crypto payments, let’s break it down into the different components, what they do, and who pays for them.

1. Blockchain — this functions as the infrastructure / interchange layer, in addition to a few other things. It enables a transaction, validates it, and moves funds from one place to another. Today Bitcoin’s blockchain is vastly more expensive than Visa’s infrastructure, and significantly less efficient (by design — the system is highly redundant). There are much more efficient protocols than Bitcoin’s, so in good faith we can assume that this will get more streamlined over time, but not as efficient as a centralized network. In a tradeoff for this lack of efficiency, we get a lower potential for fraud (not chargebacks — those aren’t false transactions) and verifiable proof of funds. But a) fraud isn’t actually a large percentage (~$7B in 2017 in the US) and more importantly b)both stopping fraud and having proof of funds doesn’t require the blockchain in any way. Fraud is more difficult on the blockchain because of identity verification via cryptographic signature, which is entirely implementable without any form of chain (though one does need a trusted party for verification), and proof of funds is similar (again with a need for a trusted party), but for the developed world finding a trusted entity isn’t complex or expensive (this is how debit card purchases work). So what we really get is non-reversible transactions, which are a mixed blessing. (Fraud is also not out of the question. While from a merchant’s perspective there’s a guarantee of funds available, there’s always a possibility those funds could be stolen from a hacked account.). The blockchain does a lot here, but it’s not clear how much better it is for this use case in the developed world.
2. Tokens / Coins — these are just some value store; a form of money. Bitcoin’s is inherently tied to its own blockchain, but many others run on Ethereum’s chain. There is basically no advantage of one coin vs. another unless you’re betting on price appreciation, and for this example, the coin choice doesn’t matter.
3. Banks / Merchants — Most of that 2–3% fee previously mentioned is collected by the banks, not the payment network, and most of it is “paid” by the merchant (when one pays for $100 worth of goods on one’s card, the seller of those goods gets $97). In theory, blockchain-based networks were supposed to get rid of these fees by eliminating the need for Banks. And to some degree, they have. Except people needed a consumer-friendly way of exchanging crypto for fiat currency, and for holding all of those new coins without the complexity of setting up one’s own wallet, giving rise to new bank-like entities such as Coinbase. And as of now they charge 1.49% of a transcation. One doesn’t technically need someone like Coinbase, and can hold one’s money one’s self, but even then there are network transaction fees, and for most merchants, it’s now up to the buyer to pay them. Progress! It’s also worth noting that as hinted at above, blockchain based transactions are basically the same as debit card transactions, and debit card transactions are very inexpensive.

The net for this one is that crypto payments provide very little advantage to those already with a bank account, and bring with them a number of disadvantages. However, if one doesn’t have access to this infrastructure, i.e. one is in the developing world or is otherwise unbanked, crypto payments have significant advantages as they allow for relatively large transfers with low friction, and they free people from having to use a rapidly depreciating fiat currency. I would expect to eventually see substantial adoption in these markets once the process is simplified.

Claim — It will free us from fiat currencies and create a borderless economy.

Reality — Almost certainly not.

We heard this story before in the early days of the internet. John Gilmore famously said “The net interprets censorship as damage and routes around it” and he was famously wrong. Great firewalls went up, as did national censorship programs. There’s no reason to think that this time will be any different, and a number of reasons (billions of them) to think it will follow the same path. Transactions on the blockchain are generally public, and it’s not at all a far cry to imagine a future where all wallets are registered. Governments don’t like losing control of their economies and sources of revenue, and will act to prevent this. Even if consumer demand were so strong that we collectively abandoned fiat currencies and moved to a single, fixed standard (which could be rather nasty btw — think worldwide, coordinated, depression and stagflation), governments will still want their cuts, and can still limit international transactions. The stateless economy might come some day, but it’s going to be a function of politics, not technology.

Claim — The blockchain will change the world!

Reality — In some ways, but probably not as much as some predict.

Lots of people have come up with uses for a blockchain, and a few have just thrown it in as a hail mary. But let’s do a thought experiment, and replace the word blockchain with “distributed, verifiable, database.” There are many applications for this sort of technology, but almost all of them suffer from the — Step 1. Everyone adopts it — problem. The value of the system is dependent on the network effect, and without a strong central player to enforce usage, it’s incredibly difficult to get all parties on board.

For instance, take the much touted idea of a logistics block chain (which is frequently conflated with a supply chain blockchain, but these are two very different beasts due to market dynamics and power centralization). There are a few dominant players in the logistics fields who can require at least the sending and receiving party to use a given technology, thereby solving the Step 1 problem above, and the fact that it’s public might encourage governments and other related parties (customs, insurance, etc.) to use it. But how different is that from UPS creating a centralized database that people authenticate with, and can read from and write to? Short answer, it’s not. Because it’s public or at least not controlled by one organization more parties might adopt it, but that’s far from revolutionary. Put another way, it’s not that a whole new class of applications are possible, but that existing ones, particularly ones where trust is critical, can become more efficient. The ability for multiple parties verify trust is certainly powerful, but it’s not quite the internet 2.0 the blockchain is frequently claimed to be. Both are communications protocols, but while the internet was a connectivity layer upon which anything can be built, the blockchain is a transaction layer with more limited applications.

Claim — Bitcoin and or the blockchain will destroy the banks!

https://twitter.com/alex_schaefer

Reality — Almost certainly not, though they may change a bit in form.

A fairly small portion of a bank’s operations involve currency transfers, and for many it’s a headache to them which they’d rather not deal with, not a major profit center. The blockchain could certainly destroy something like the Automated Clearing House and make wire transfers more efficient. Transactions using a currency like Bitcoin would no longer require banks to be a source of proof of funds, and the transfer of value wouldn’t require two banks to communicate with each other, but in those cases some entity (ala Coinbase) is still collecting transactions fees. If one took away ACH fees and what are effectively, per the above, debit card transfers, from banks, the impact would be minimal.

Less frequently spoken about because it’s less well understood, the major impact a switch to the blockchain would generate has to do with float, deposits, and the bank’s ability to provide and or underwrite loans. In a virtual currency world, at least for today, the concept of float is basically non-existent, and earning interest on deposits is a relatively new concept with only a few players. But for any virtual currency, there’s no reason to think the same functions wouldn’t emerge again. Let institution X hold on to my crypto and invest it, and they’ll also provide interest. Loans are a bit more complex, because there’s no concept of reserve ratios in crypto today (though it’s being thought about), but debt is critical to the functioning of our economy, so it’s fair to assume in one form or another it will continue to exist, and institutions will exist to underwrite that debt and collect interest off it. It might look a little different, but the economics will be roughly the same.

Claim — Crypto-companies are great investments (sell axes and picks to gold miners)

Reality — Some likely are, but that depends significantly on what they do.

I realize that’s a weak answer, but nuance is again necessary here. Let’s talk about a few categories and break apart the functions of companies themselves.

1. Transaction facilitation — i.e. companies like CoinBase. If one had the opportunity to invest early in Visa one would be very, very wealthy. Similarly, CoinBase could be a multi-billion dollar opportunity. The challenge in the space is a) just like any other investment, it’s difficult to pick a winner, and b) unlike modern financial networks, distributed transaction facilitators aren’t nearly as prone to natural monopolies as they’re not dependent on network effects. I have no doubt a few great investments are present in the space, particularly as it’s noisy and there will be consolidation, but as switching costs are almost nonexistent, it’s unlikely to see the kind of monopolistic winner take all returns venture capitalists love. Additionally, if there’s no inherent benefit from using one company vs another, transaction fees will likely be the primary lever determining adoption, which will lead to a race to the bottom for transaction costs. There will be a handful of dominant players in this space, but market dynamics will keep them from being very profitable or growing too big.
2. Currency creators — And here we’ll have to subdivide into two categories: A) pure currency creators like Goldmint, and B) companies like Brave or TRON or to some degree Tether and Ripple (as they’re also in the transaction facilitation business). There’s so much of a case by case basis here it’s difficult to make any conclusive statement. For instance, while Ripple issues their own token, they’re really trying to be a transaction network that uses their ownership of the underlying token as a way of preventing the lack of natural monopoly I mentioned above. Brave and the BAT are somewhat similar. All of these companies however are dependent on their token becoming some sort of global standard, and all of them would also require that token to function as a currency that would be exchanged for some other store of value. For category A, use as a currency is dependent on both low transaction fees and liquidity. For category B, use is dependent on market dominance (i.e., if it doesn’t comprise enough of a % of the market then there’s no point in using it) and liquidity. Category A is almost certainly a poor investment, as there’s just minimal opportunity to extract value from the transaction. For instance, if one could use BobGold and SallyGold, but BobGold has a .0001% transaction fee and SallyGold has a .02% transaction fee, everyone will just use BobGold. Category B is a total crapshoot. If someone does create a market dominant category there are lots of ways to extract value, but that’s the same investment profile as any other technology company.

The big difference between crypto company investments and traditional ones is that many of them have had ICOs, and these ICOs give the companies additional capital / runway without having to raise dilutive equity, so their VCs may be geniuses as they’ve figured out a way to costlessly multiply the leverage on their investments. That could turn a so-so exit into a huge one, so category 2.B seems particularly promising.

Some final thoughts

1. Overall, blockchain dynamics are good for consumers. Decentralized markets are anti-monopolistic, and that helps keep down prices. Additionally, new, less expensive business models will arise (for instance, why are we paying a percentage of transactions vs a flat fee? Are the extra bits particularly expensive?) and that’s good news for all.

2. The arguments for cryptocurrencies are particularly strong in a few use cases:

• serving the needs of the unbanked
• transactions in high inflation economies
• a value store in high inflation economies
• a value store in countries with tight capital controls

As such, I see particular promise in stable coins and digital gold, and anyone trying to make peer-to-peer transactions dirt simple. The challenge is how to get people in these economies to buy crypto in the first place and adopt it as a value store, which is why I like digital gold; it seems like a gateway drug.

3. The supply chain for high value goods (pharma, electronics, etc.) is the most promising commercial application of the blockchain. The complexity of the supply chain for those high value products, the economic value of ensuring trust and authenticity across suppliers, and the centralized power in the form of the final buyer (who can force system adoption along the supply chain), may be enough to push blockchain adoption. The advantages of such a system are, however, still relatively limited vs. a centralized one.

4. Claims should be taken with a very large grain of salt. Some winners will emerge in certain categories, but revolution is quite a ways off.