Blockchains Are For Speculation, And That’s A Good Thing

Originally published by Forbes.com on December 20, 2017.

The biggest question in the world of crypto has always been: what is the best real-world use case for Bitcoin and cryptocurrencies? Is it digital money? The new gold? A medium of exchange for the black market? Now, after the meteoric rise in ICOs and Bitcoin prices, we can say for certain: speculation.

And this isn’t a bad thing. The majority of trading in financial markets is not for the exchange of goods and services but for speculation. In the FX market, the most liquid in the world at $5T exchanged daily, over 80% of trading is speculative. Without speculators, markets would be less liquid and would function poorly.

We believe that the blockchain may be one of the greatest technologies for speculative trading in history. Not since the development of formal property systems 300 years ago, and the invention of writing 3,000 years before that, has there been a technology so capable of reducing friction to trade and creating new financial markets.

It is so powerful that we now see thriving speculative markets for assets that just a few years ago would have been unimaginable. The largest ICO to date, Filecoin, raised $250M for a coin that represents the right to store files on a stranger’s computer. The second-largest cryptoasset, Ethereum, isn’t even a currency: its token represents the right to power a web application on a decentralized virtual machine.

Granted, it was possible to purchase these “assets” before blockchains. Amazon sells you the right to store your files on their cloud with an “API key”, but has never let you trade that API key or exchange it for a Google API key. Today, this digital resource and many more are traded on global marketplaces with billions of dollars worth of daily volume, thanks to the blockchain.

What makes the blockchain such an incredible technology for speculation? Let’s first examine what makes a good speculative asset and see how blockchains help.

Desirable Properties of Speculative Assets

1. Hard to counterfeit

If you can’t be sure that the asset you’re trading is real, you will be reluctant to buy.

Resistance to counterfeiting is the most important prerequisite for asset speculation. In fact, it is why governments got involved with money in the first place: powerful central organizations are needed to establish a uniform system of weights and measurements, verify that measurement with an irreplicable but recognizable stamp, and punish fraudsters.

The anthropologist David Graeber, in his history of money and trade, shows that governments maintained financial systems of records even before coins existed, back when Sumerian Temple bureaucrats inscribed their city’s entire transaction history on tablets. And when governments were overthrown those tablets were the first to be destroyed, marking the end of a regime.

More readily counterfeited assets are still speculated upon, but not easily. With art, speculators must consult expensive authenticators or deal with established auction houses, which is one reason that only the very wealthy can speculate.

But cryptocurrencies cannot be counterfeited. They can certainly be stolen, but someone cannot spend a coin sitting in your wallet or “print” fake coins. This is the key technical breakthrough behind blockchains: they are immutable ledgers of transactions, stored not in Temple vaults but on the computers of “miners” across the world. The Bitcoin blockchain is the first scalable solution to the Byzantine Generals Problem, a long-standing problem in computer science, and the first decentralized solution to the double-spending problem. It is a remarkable achievement.

2. Easily and cheaply held

Most assets, like dollars or gold bars, need to be stored physically, which makes it difficult or prohibitively expensive to transport, especially across borders.

Bank accounts let you hold more portable representations of those assets, but 2 billion people are unbanked, mostly in the developing world. That’s one reason why two-thirds of U.S. cash is held overseas.

Cryptocurrencies are held in a digital wallet and accessible by anyone who knows its private key, a random string of letters and numbers. Private keys can be stored any way you like: in your head, on paper, or a computer. You can cross borders or flee your house in the middle of the night without fear of losing your wealth.

3. Easily and cheaply transferred

Any physical asset must be exchanged in person. Others, like stock certificates and gold ETFs, can be transferred digitally on exchanges and in certain geographies, but with restrictions. Only about 150 “members” can trade on the New York Stock Exchange, all of which are large banks and brokers.

There are hundreds of crypto exchanges around the world that accept traders after basic identity checks, but exchanges are not even necessary. Anyone can transfer a cryptoasset from one wallet to another at any time, just by knowing the wallet’s public key. No intermediaries necessary.

4. Secure

One problem with exchanging gold bars in person is that you’re never sure if the other person will rob you. This counterparty risk makes it difficult to trade large quantities, which is essential for speculators.

The Western world has a pretty good solution, what the economist Hernando de Soto calls a “system of formal property” that allows you to turn your physical assets into paper or digital representations, like stock certificates and land titles. A vast network of institutions and procedures ensures the security of your representation: public record-keepers, escrow agents, appraisers, title insurance firms, custodians.

Instead of trading bullion in person, gold traders take representations of their right to bullion to the Chicago commodities exchange and sell it in bulk, without having to move the asset. There is still some counterparty risk if the exchange doesn’t deliver the gold, but it’s much less than before.

With the immutable ledger and public-key cryptography, transferring cryptoassets 1:1 carries virtually zero counterparty risk. You must use intermediaries if you want to trade with many people at once, though. Generally, these exchanges are less sophisticated than intermediaries in U.S. financial markets, which is a meaningful security gap that must be improved upon over time.

5. Private

The largest speculators prefer to transact anonymously, through Cayman entities and behind Swiss bank accounts.

Cryptocurrencies vary in their privacy levels. Bitcoin, with its public ledger of transactions, is in many ways less anonymous than cash. But now there are new “privacy coins”, like Monero and ZCash, that incorporate breakthrough cryptography to make transactions untraceable.

For the Western world, privacy may be crypto’s greatest improvement over existing speculative assets. It is so difficult to hide your transaction history that only the mega-rich even try. Even so, it doesn’t always work — see the Panama Papers, or the New York Times exposé on the foreign billionaires buying up Manhattan real estate.

6. Divisible

Subdivision is an underrated but essential ingredient for speculation. Most people can’t buy whole factories or companies but millions of people own Apple stock. The explosive growth of U.S. financial markets in the ’80s was largely due to securitization, a process for dividing up, tranching, and repackaging assets that previously could only be traded in their entirety.

Cryptocurrencies are infinitely divisible. They are just bits, after all.

7. Programmable Contracts

People love speculating on contracts even more than assets. Consider a basic speculative contract: if the Yankees win the World Series, you give me $100. Today you cannot make this bet in much of the world and enforcement is difficult.

With cryptoassets, contracts can be programmed directly into the asset itself, called “smart contracts”. Non-crypto assets can only be items in a contract, such that traders need offline contract enforcement regimes like court systems to fulfill “if this, then that” bets. Smart contract technology is still new and will take time to develop, but for speculators it is one of the most exciting promises of the blockchain.

Note that our list says nothing about “intrinsic value”. Many skeptics argue that cryptocurrencies will fail because they have no fundamental demand — no government backing, no inescapable reason to hold the asset. That may be necessary for an asset to become “money” (although the jury is still out), but it is not necessary for speculation. Things like baseball cards, Beanie Babies, and even gold have little intrinsic value.

Where in the Arc of History?

The biggest criticism of cryptoassets is that they are only good for speculation. That’s not true: there are many reasons to buy the underlying assets, like for computing power or to transact privately. But it is true that blockchains are unusually good for speculation. The mere fact that Bitcoins are counterfeit-proof makes it better than many existing speculative assets, like the $50B art market of which 10–70% are forgeries or the Zimbabwean dollar.

And speculators have noticed. With millions of retail investors across the globe holding cryptoassets, it is one of the biggest investment trends of the millennium. On the institutional side, cryptoasset-focused funds are popping up every day. The two earliest, Polychain Capital and Metastable, are attracting capital more quickly than perhaps any first-time fund manager ever. A top ex-Fortress macro trader, Mike Novogratz, is raising a $500M fund. Goldman Sachs is allegedly starting a crypto trading desk.

But we suspect it is only the beginning. Blockchains may be just as transformational as the last major trading technology, the Western formal property system that spurred on the Industrial Revolution. As De Soto writes:

Just as a lake needs a hydroelectric plant to produce energy, assets need a formal property system to generate value. Without formal property to extract their economic potential and convert it into a form that can be easily transported and controlled, assets are like water in a lake, high in the Andes — an untapped stock of potential energy.

It was the property system that converted physical assets into capital, a thing that could be quantified, traded, and used to generate further production — what Adam Smith called the true wealth of nations. The property system drastically lowered the barriers to trade and speculation, ushering in our era of liquidity and global capital markets. Blockchains may do the same.

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By Alexander Pack and Dr. Spencer Pack.

Dr. Pack, a professor of economics at Connecticut College, specializes in the history of economic thought and political economy. Alexander invests in networks, technologies of trust, and cryptoassets at Bain Capital Ventures.

Thanks to Nader Al-Naji, Ari Paul, Olaf Carlson-Wee, and Stephen McKeon for reading drafts and edits.