A high-level overview of the cryptocurrency phenomenon: where we’ve been, where we are, and where we might be headed.
For brevity’s sake research is hyperlinked throughout the article.
By Jonathan Kaplan, Founder at Numeris Capital
Money is a technology - created by humans - to facilitate commerce and store value for use in the future. While we aren’t sure exactly how money evolved (money predates writing and recorded history), we do know that it evolved. Just like Mother Nature selects the creatures best adapted to their environment, so too does the Invisible Hand select the money best able to store and transmit value.
Over millennia, the monies that best incorporated the ideals below won out over those less suitable, and the world eventually converged on a single commodity: gold. While paper monies eventually gained popularity as a more convenient medium of exchange, these colorful slips still mostly served as IOUs for specific amounts of gold, which retained its role as the underlying store of value.
The rise of the nation-state over the last several centuries has seen the advent of central banking and the abhorrent practice of seigniorage, as governments realized they could more easily siphon value from their subjects via the “hidden tax” of inflation than by outright taxation. Hyperinflation has since run rampant, and even relatively stable currencies like the U.S. dollar have seen their purchasing power decrease dramatically:
This toxic coupling of money and state came to a head in late 2008, as the U.S. Congress approved a massive bailout of several hundred billion dollars. American citizens watched in horror as the same banks that caused the crisis paid themselves fat bonuses while the economy slid into recession. The United States national debt would more than double over the next ten years.
Unbeknownst to the rest of the world, this financial paradigm of corrupt bankers and politicians leveraging the financial system for personal gain was about to be upended with the creation of the greatest money humanity has ever seen: Bitcoin. (Note this description isn’t a personal opinion, but an objective comparison to other monies based on the criteria below.)
Bitcoin isn’t merely more portable, more divisible, etc. than its competitors; the currency’s limited supply, censorship resistance, non-sovereign decentralized nature and programmability bring it closer to the ideals of a perfect money than anything we’ve ever seen:
Skeptics are quick to point out that after a decade of existence Bitcoin remains far from the global currency advocates insist it can be. Most technologies, though, are not unanimously adopted at the time of invention, despite what might today seem like obvious utility.
Instead, the growth trajectories of new technologies typically approximate the “S-curve of adoption,” whereby certain segments of the population adopt an idea over time. While initial use might be limited to highly technical early adopters, as the technology matures and better infrastructure is built adoption spreads quickly (and at an increasingly rapid pace):
Nearly every major technology invented in the last century saw S-curve-like growth, with adoption rates accelerating markedly for recent innovations like cell phones and internet access:
Bitcoin is no exception, having grown in only a decade from an obscure curiosity to the most powerful computer network on the planet. While this exponential progress is obvious on the long-term charts (especially when viewed in log to highlight percentage growth), it can be difficult to see on shorter timescales due to the phenomenon of the recurring Bitcoin “bubble.”
As each segment of the population buys in to the idea of Bitcoin, those investors undergo a speculative “hype cycle” (Michael B. Casey’s Speculative Bitcoin Adoption/Price Theory explains this well). The term was initially coined by Gartner to describe a general pattern of technological visibility and adoption:
While rising demand for most commodities would result in a corresponding increase in production (thus providing price stabilization), Bitcoin’s perfectly inelastic supply allows a modicum of demand to push the price higher, which then draws in speculators and media attention (leading to an even higher price), which in turn draws more investors and more media attention, etc., in a positive feedback loop that climaxes in a parabolic advance.
Eventually sellers begin to outnumber buyers as earlier investors begin taking profits (thus lowering the price), which causes panic selling from those who bought the local top (further lowering the price), which triggers stop losses and more panic selling, etc., as greed turns to fear and the feedback loop reverses. The market moves from overvalued to undervalued like a pendulum swinging back and forth, constantly readjusting in an attempt to value a network that itself is constantly growing and changing.
However, as each cycle occurs a distinct number of investors buy in to Bitcoin and refuse to sell (for the time being, at least). As the number of long-term holders increases, more bitcoin is removed from circulation and thus the price “floor” post-bubble is always higher than the previous cycle’s. Given that Bitcoin’s price is primarily decided by sentiment (and that human nature is innate and unchanging), we’re likely to see this cycle continue until full adoption is achieved (or at least until every segment of the population has participated).
This pattern of exponential adoption dovetails nicely with research put forth by Carlota Perez in her 2002 book Technological Revolutions and Financial Capital. She details how humanity has experienced multiple technological revolutions: the industrial revolution itself around 1770; the steam engine and railroads in the 1830s; steel and electricity in the 1870s; automobiles and mass manufacturing in the early 20th century; and the computing revolution which began in 1971 with the invention of the microprocessor.
Perez asserts each paradigm shift leads to a bubble as the financial sector (and inevitably the public at large) begins to adopt the new technology.
While each revolution is of course its own unique phenomenon, Perez documents a consistent pattern of boom and bust cycles by which the technologies mature and attract major investment (Allen Cheng provides a great summary of the book here):
In the Installation period, a promising new technology irrupts onto the scene and revolutionizes business activity across multiple industries and economic spheres. Having long since milked any remaining profit from the existing paradigm, institutional investors (“Financial Capital”) eagerly jump at the opportunity for outsized yields.
The ambiguity surrounding the innovative potential of the new technology results in a hype cycle of its own, with imaginative speculation quickly outpacing the nascent technology’s ability to deliver on its promises. A dearth of valuation models and investment frameworks suited to the new paradigm only exacerbates this problem.
Financial Capital soon becomes enthralled with its ability to generate massive profits in this new economy and eagerly invests in increasingly risky ventures. As paper profits grow further and further from real-world value, irrational exuberance takes over and a bubble forms and collapses.
While Financial Capital is typically derided for its role in facilitating the bubble, the attention it brings to the technology and the infrastructure built to accommodate it pave the way for the Deployment period, where a chaotic process of creative destruction dismantles the previous framework and implements a new one. This ushers in a number of widespread sociocultural, political, and economic changes, after which the technology is eventually ubiquitous and simply considered “common sense.”
We saw this quite clearly in the Dot-Com era. Rapid technological improvements to (along with increased public adoption of) the internet lead to a speculative frenzy in tech stocks, which devastated investors but simultaneously laid the foundation for a societal paradigm shift that changed everything about the way humans live, work and play.
The parallels to the cryptocurrency revolution are striking. Bitcoin didn’t merely provide us with a superior money — the creative application of its blockchain ledger by a variety of other projects has built the foundation for an entirely new financial system, one structured around the transparent and open-source ethos of the internet rather than the whims of corrupt bankers and politicians. The 20th century saw humankind build an internet of data; the 21st will see us build an internet of money.
These historical patterns delineating how institutions approach new technologies are important because Financial Capital has yet to get seriously involved in the cryptocurrency markets. The sector so far has been driven primarily by retail investors, but the last two years have seen significant infrastructure built specifically for large institutions:
- Switzerland gives green light to first cryptocurrency ETP
- Nomura, Ledger and Global Advisors partner to build a secure digital asset custody solution
- Goldman-backed startup Circle buys major crypto exchange Poloniex
- NYSE owner ICE partners with Microsoft, Starbucks and BCG to create institutional crypto exchange Bakkt
- TD Ameritrade invests in cryptocurrency exchange ErisX
- Citigroup plans to offer cryptocurrency trading
- J.P. Morgan launches cryptocurrency strategy
- Harvard, Stanford and MIT endowments invest in crypto funds
- Overstock to sell retail business, go all-in on crypto
- Fidelity launches Digital Asset Services business to help institutions invest in crypto
- Two Public Pensions Anchor Morgan Creek’s New $40 Million Crypto Venture Fund
- E-Trade is Readying Bitcoin Trading for 5 Million Customers
The 2015–2017 hype cycle, with its proliferation of speculative ICOs, corporate consortiums, and widespread media attention almost certainly marks the beginning of the Frenzy phase — and history suggests we’re not out of it yet, not by a long shot. Crypto’s internet of money will undoubtedly change our world just as much (if not more) than our internet of data, and it’s simply a matter of time before Financial Capital’s involvement kicks off the next hype cycle.
While opportunities abound for the savvy investor, the crypto space isn’t without its risks:
- The market’s cyclical nature requires strategic entries and exits; dollar cost averaging or buy-and-hold strategies are far from ideal.
- The open-source nature of most blockchain networks ensures a frantic pace of innovation which in turn necessitates active oversight. Good ideas might traverse multiple vehicles before coming to fruition, much like internet search went from Altavista to Yahoo to Google and social media from Livejournal to MySpace to Facebook.
- Crypto trades 24/7 and moves much faster than traditional markets. The smaller capitalization and illiquid nature of many assets result in whiplash volatility across the board.
- The industry’s infrastructure is still in the early stages and difficult to navigate for those without advanced technical abilities. Misplacement or theft of cryptographic private keys is common and can result in devastating, irreversible losses.
- Proper investment data is difficult to find (or nonexistent); scammers and charlatans abound and are becoming increasingly sophisticated. In many cases a legitimate project might succeed in building a useful network, but still not be a good investment due to poor token design or misaligned incentive structures.
Money is a human invention and has evolved over time, as the free market continually selects for the best technology available. Of all the monies we’ve ever seen, Bitcoin best approximates the monetary ideals (a perfectly scarce money that can’t be controlled, censored, seized or inflated) and is in the process of becoming globally adopted. As with most technologies, this process involves a predictable pattern of segmented adoption, with each segment of the population creating a local bubble as they experience their own “hype cycle.”
Furthermore, the invention of Bitcoin and its blockchain ledger has led to the creation of a new asset class, which is currently building the foundation for an entirely separate financial system (an “internet of money”). Echoing the creation of our first internet, this one similarly has enormous long-term potential but is plagued in the short term by rampant speculation. Although this attention helps the nascent industry to attract talent and built crucial infrastructure, it also makes it a dangerous investment for those lacking in technical and/or financial expertise.
The market thus far has been primarily driven by retail investors. Financial Capital is just starting to get involved, but history tells us they’re more likely to fuel a massive bubble than responsibly facilitate the technology coming to fruition.
We now find ourselves at the forefront of one of the greatest investment opportunities of all time — but there’s no escaping the myriad risks involved in attempting to navigate the crypto markets.
Numeris Capital is a cryptocurrency investment fund based in Austin, TX. For more information, visit our website or email us at email@example.com.