November 2017
Subject: What Drives Growth of Cryptocurrencies?
To: Limited Partners of Grasshopper Capital Fund I LP
From: Ari Lewis and Sagar Rambhia
Date: 11/30/17
An Opportunity to Invest in the Future
As managers of a hedge fund, our goal is to make money for our LPs first and foremost, but at times it is important to take a step back and realize the absurdity and craziness of the products in which we invest. In the month of November, Bitcoin traded past $10,000[1], which is insane considering every mainstream economist had doomed it to fail[2]. They have called it a bubble[3], scam, and Ponzi scheme[4], but we have now exceed a valuation for Bitcoin of over $100B USD. A financial product that is not tangible is more valuable than Twitter, Snapchat Wendy’s, and FedEx combined. It is an amazing feat!
When one thinks about money, there have few innovations that have transformed currency. People used bartering as a means to exchange goods. Pastoral societies used livestock, while the Romans used cattle and salt[5]. These were known as commodity money. The next evolution was metallic money such as Gold or Silver. Then finally we had paper money which refers to notes issued by the government or a central bank. We have seen changes in paper money, such as governments moving to fiat or people accepting credit and electronic money. However, in a time when we can instantaneously contact anyone in the world via email, why can we not send them money instantaneously as well?
ACH transfers are free, but take days; using SWIFT can take as little as 10 minutes, but costs $20. This is where we think cryptocurrency can truly derive value and be a global, low-cost, instantaneous payment system. This is why a $100B valuation is anything but a bubble; rather, it is an opportunity. An opportunity to invest in a protocol that could replace our retail and institutional payment systems.
Institutional Growth
Most growth in the cryptocurrency markets has come from retail investors. If the head of CALPERS bought Bitcoin, he would be fired. It does not matter if the investment returns ten fold. No one gets fired for buying IBM. This is especially true in a time when volatility is at historic lows. Large asset allocators are afraid to take risks; even more so, they are afraid to diverge from their peers. It is not about risk in an absolute sense, but risk in a relevant sense. The downside of being wrong outweighs the upside of being right.
One remains optimistic though: CBOE and CME remain poised to launch Bitcoin futures while one of the largest hedge funds, Man Group, announced it would buy them[6]. Genesis Group launched an investment trust to invest in Z-Cash and even JP Morgan might offer Bitcoin Futures[7] [8].
Much work remains to be completed on the underlying products though. One reason pension funds cannot buy Bitcoin is that they do not have many custody options. They can hold their Bitcoin on Coinbase, but there is significant risk because they do not control the private keys. They can store it in cold-storage, but we don’t not really see the head of CALPERS creating a risk program for key splitting, hardware wallets, and paper wallets. It would be funny to think that an investment can go up 100 fold, only to realize that the first year analyst you hired is in Brazil where he has a $10-million-dollar mansion and drives a Lamborghini. (We hear it is dangerous to drive nice cars in Brazil so he would probably still drive his Prius. We would also like to believe he is environmentally conscious).
Coinbase announced a product dedicated to institutional clients like pension funds to store their cryptocurrency[9]. The minimum is $10M, which for an agency like CALPERS is nothing. But who is Coinbase to them? They are not a Goldman Sachs, JP Morgan, or Bank of America. We think stakeholders would be skeptical of trusting them with their money.
Governance of Bitcoin
The Bitcoin2x fork was abandoned. Many cheered, some cried, but most new investors were just happily ignorant as the Bitcoin price went up.
It is easy to address governance in centralized systems. There are standard practices developed in public companies around corporate governance. Typically, you have a CEO who reports to a Board of Directors, then the shareholders vote on the Board of Directors, the CEO hires few delegates, and the few delegates hire employees under them (add a few layers of middle management for flavor). Such a system of corporate governance has worked since the Dutch East India Company (minus the occasional scandal) despite the principal-agent problem[10].
Bitcoin is a whole other animal. There are two groups of stakeholders: Miners and Users. A miner is someone who validates transactions and issues new Bitcoin while a user holds Bitcoin. Yes, a miner also becomes a user when they are given a reward. Bitcoin is decentralized so one miner cannot take over the system, and it is extremely expensive to cheat. A state actor, like China, could probably take over the system, but it would be nearly cost prohibitive. A user is typically an investor who wants the price of Bitcoin to go up and the transaction prices to go down. This poses a problem. Miners want higher fees so they can make more money and users want lower fees because they do not want to pay a lot to move their Bitcoin. Obviously, this creates conflict and breeds political and ideological battle. Here is the key difference between being a shareholder in a public company and being a user or miner of Bitcoin. You can take Bitcoin and fork it. Take all the things you like and keep them while changing all the things you do not like. It is too early to see if forking a cryptocurrency will have sustained value, but Bitcoin Cash (BCH) and Ethereum Classic (ETC) have both been top 20 cryptocurrencies and continue to increase in value. This is not to turn into commentary on the fork, but rather make people aware of the innovative solutions a stakeholder now has when in dispute.
Thanks,
Ari and Sagar
[1] https://coinmarketcap.com/historical/20131124/
[2] http://reason.com/blog/2017/11/30/bitcoin-joseph-stiglitz-crypto-outlaw
[3] https://www.theguardian.com/commentisfree/2017/dec/24/bitcoin-is-a-bubble-the-technology-behind-could-transform-world
[4] https://www.cnbc.com/2017/11/14/dbs-groups-david-gledhill-bitcoin-is-a-ponzi-scheme.html
[5] http://www.ancient-origins.net/history/salt-treasure-ancient-world-and-highly-valued-currency-roman-empire-006794
[6] https://www.reuters.com/article/us-investment-summit-man-group/man-group-says-bitcoin-futures-would-draw-it-toward-cryptocurrencies-idUSKBN1DE232
[7] https://www.cnbc.com/2017/11/21/jpmorgan-reportedly-getting-into-bitcoin-futures-trading.html
[8] https://www.forbes.com/sites/laurashin/2017/11/09/zcash-investment-trust-launches-expanding-investor-options-for-cryptocurrency-exposure/
[9] https://medium.com/@barmstrong/announcing-coinbase-custody-a-digital-currency-custodian-for-institutions-907166d7af85
[10] https://en.wikipedia.org/wiki/Principal%E2%80%93agent_problem
