Paradigm Shifts in Crypto-space : Intro

Every time I explain crypto-currencies to people, one concept that is hard for everyone to wrap their heads around is — “What’s the difference between cryptocurrencies and the US dollar (or any other currency)?”

This was the question that plagued my discussion with my friend. I realized that, in order for cryptocurrencies to gain mainstream adoption, there needs to be a shift in thought paradigm in how we view money. Hence, this inspired me to write an article about the nature of cryptocurrencies, and the economics of it.

The difference between any other currency and a crypto-currency is that the monetary supply is not controlled by a government or country, but by the Blockchain. Simply put, what blockchain accomplishes (and perhaps why it is so disruptive) is the fact that it is able to create a scarce, digital resource. Scarcity is the single reason why we are able to derive value and is the fundamental concept of economics.

In a more traditional setting, the US dollar for example, the scarcity of a currency is controlled by the central bank, a trusted governance system for the economy. The central bank controls the amount of dollar bills circulating the system. It would measure the amount of money in the country’s economy (usually through some monetary aggregate) and determines a fixed number of dollar bills in the economy. For cryptocurrencies, rather than having a central bank, scarcity is all managed by code and blockchain. In order to illustrate this, I will draw from the most commonly known and studied cryptocurrency, Bitcoin. In Bitcoin, the monetary supply is initially determined by code —Bitcoin determined that, aside from it’s initial supply (called the genesis block), there would be a given monetary injection with every set of economic transaction. This code, although autonomous, can be easily hacked and hence un-trustable. This is where blockchain comes in. Blockchain, by introducing a distributed and ordered ‘change history’, allows us to implement this monetary protocol by storing a trusted account balance . The combination of trusted account balancing and hardcoded supply protocols effectively creates the first scarce digital resource.

Up until recently, currency has always been seen as pegged to the economic activity of a country. Why would you buy the US dollar when travelling to the US? This is because the US dollar is the local currency of the US. By trading your foreign currency as a local one, you’ve effectively gained the purchasing power within the country’s economic system. This sounds like a no-brainer. We’ve always bounded the value of a currency to geographical location of a country’s economy. This is the initial paradigm of how we viewed money, and this view has existed since almost the dawn of time.

The paradigm shift for cryptocurrency is not how to value this currency, but where we look to value it.

In the realm of currencies, governments and central banks can be seen as a middle-man between the purchaser and the seller. Lets take a simple process as an example — you want to buy an ice-cream and you find an ice-cream vendor willing to sell to you. In order to foster this trading, the central bank prints and gives you 10 bills labelled — “1 US Dollar”. The central bank then tells both you and the ice-cream vendor that each bill is worth $1 and that the price of a ice-cream is typically two dollar bills ($2). Since both you and the vendor trust what the central bank claims, you and the seller have consensus of how much an ice-cream is worth and you pay $2 for it. In this example, the central bank acted as the trusted middle-man by giving both you and the vendor a common-ground to engage trading — a local economy.

This middle-man is what Bitcoin and other cryptocurrencies effectively remove. In cryptocurrencies, rather than trusted a third-party, we are trusting math — the elegant combination of cryptography and blockchain. However, the removal of this middleman (AKA central bank in this case) also causes a problem — who is to decide how much 1 unit is worth? How much does it cost in bitcoin for one ice-cream cone?

Since there is now no one to decide for us, we have to decide for ourselves. The long term value of cryptocurrencies is determined directly by the utility of the system itself — that is, the value of a cryptocurrency depends on how much economic activity can be driven with it. This is no foreign concept and the central bank measures the same utility of a local economy usually through money aggregates and other indexes. However, there are two main difference is between central banks and the blockchain system. Firstly, central banks often have regulations to control how changes in sentiment of a local economy affects it’s currency prices. This allows the government to maintain a certain degree of control over the free-market. Secondly, in cryptocurrencies, because all account balances are distributed digitally, there is full transparency in the total supply of a given cryptocurrency. We don’t need to use indicators to measure our total supply like the M2 aggregate.

How do we value the utility of a crypto-system?

This is a fundamental question that is frequently discussed in economics — how much usefulness can we derive with cryptocurrencies? A simple (and yet somewhat accurate) method to break this down is by viewing cryptocurrencies through the lens of the simple interaction of supply and demand.

As mentioned above, one interesting feature about crypto-currencies is that all the monetary supply is tracked, and the injection of money is predictable through a given protocol. In Bitcoin, for example, 25BTC is injected into the system for every block updated on the blockchain. Whenever, a certain number of blocks are achieved on the system, the reward (25BTC) would halve, until the number of bitcoins reaches a max supply of 21,000,000 BTC. The supply of bitcoin can hence be modelled by simple logarithmic curve. And since the supply curve is known, we can predict with accuracy how the monetary supply would change over-time. Using basic economic principles, if we could somehow quantify the demand for a given cryptocurrency, we could arrive to a given price projection. However, in a global economy, this is a challenging topic.

Before I delve any deeper into this, I would like to mention the inherent risks and danger of cryptocurrency and blockchain. Cryptocurrencies and blockchain technology is nascent and could possibly be in a massive bubble. However, we cannot tell if we’re in a bubble or not because of the true utility of the crypto-system is unknown. As of right now, all measures of utility is purely speculative — which should raise red flags about a bubble. Bubbles are formed because the speculated increase of a given commodity causes an increase in price, which fuels more speculative increase. This cyclical feeding frenzy is dangerous as we could see from the 2008 housing bubble collapse. Hence, we need to find an indicator to assess the value of crypto-system without the consideration of price speculation.

One way we could do this is, is by determining the internal utility by analyzing the specific blockchain design, technicalities and ecosystem. Every crypto or blockchain is designed with an initial purpose—Bitcoin was designed to be a store of value, Ethereum was designed for de-centralized contracts and applications, Ripple was designed for inter-bank connectivity and so forth. Referring to these innate goals is a quick and simple way to filter out the potential of cryptocurrencies. Crypto-currencies exist purely to be used in one industry or another in the future. If we could pinpoint which market segments the cryptocurrency is trying to target, we could use a top-down approach to predict the demand and worth the cryptocurrency.

I will be dedicating the next series of my posts to break these problems in greater depth for a variety of blockchain and cryptocurrencies, ranging from large and complex ecosystems like in Bitcoin and Ethereum, to industry-specific cryptocurrencies like GAME, to perhaps even private blockchains like Fabric.

Stay tuned…