Why Cryptos Aren’t Necessarily Tulips
I’ve been trading options for a while now. Stock options, to be specific. A few years ago I saw this new thing called “Bitcoin”, and I saw that people were paying a lot of money to own it. I thought this had to be another example of irrational exuberance, so I looked around to see if I could find a way to buy put options on Bitcoin, since I just knew that its price would crash at some point.
Unfortunately, I didn’t find a way to trade options on crypto, so I moved on and forgot about it.
About a year later I saw the price of Bitcoin had gone up again, so once more I started looking for ways to buy put options against BTC. I still couldn’t find any, so I moved on again, making sure keep it in the back of my head to look again in a few months.
A few more months passed, Bitcoin continued to experience volatility, but ultimately its price continued to rise. As it did, I noticed that Bitcoin (the most popular cryptocurrency and the currently largest by market cap) had been joined by a few new players. Now there were these weird cryptos with names like Ether (currently the second largest) and Ripple (currently the third largest).
Part of me still wanted to trade options against the price of these cryptos. But part of me realized that these things had stuck around for a lot longer than I thought they would. Bitcoin had been trading for nearly a decade, and Ether, Ripple, and all the rest started growing like crazy.
When things stick around for that long, there’s probably more to them than I originally thought. So I resolved to go learn more about this whole fad of cryptocurrencies. What I learned changed my view of finance forever.
Understanding
The first few times that I tried to learn about blockchains and cryptos was a mess. I couldn’t get past all of the highly technical articles that focused on cryptography, double-spend protection, and the minutia of how blockchains were implemented at a very low level.
Fortunately, this time I pushed through. I read through both technical and non-technical articles, from a variety of people, including engineers, consultants, and investors. I listened to talks from the founder of Ethereum and from crypto-investors who I really respected. I read, and continue to read, everything that I can get my hands on.
I’ll admit that there are definitely articles out there that I can’t understand, but fortunately, these days there’s enough out there to get a pretty good overview of the whole crypto ecosystem.
One thing that also helped me was to focus on one specific question: how the heck could a “cryptocoin” have any sort of real world monetary value?
Or, said differently, why were all these really smart people, who clearly knew something that I didn’t, willing to spend all this money on “fake” money?
By putting aside my initial skepticism and assuming that there was something that actually gives cryptos some underlying value, I was able to understand not only why the price of cryptos is rising, but also why everyone’s so excited about them, why they’re worth anything to begin with, and along the way, I learned a lot about how they work under the hood.
Blockchains
Ultimately, in order to understand why cryptos, specifically Bitcoin and Ether, have value, you need to understand the idea of a blockchain.
Why?
Because each of these cryptocurrency’s blockchains is what provides them with their underlying value.
A blockchain is basically a list of publicly recorded and verified “transactions” that’s maintained by computers around the world. These computers are known as miners (I’ll discuss why in a second), and these transactions are guaranteed to be set in stone once they’ve been verified and added to the list by enough miners.
But how?
When a transaction is pushed out to the blockchain, it needs to be verified. For example, if someone tries to send out some Bitcoin, miners need to make sure that the sender actually has enough Bitcoin in their account. They also need to make sure that the sender isn’t trying to send out the same Bitcoin to multiple addresses at the same time (called “double-spending”).
They do all this by using information from recent and prior transactions to solve really hard math problems, problems that can only be solved if historical data about the parties involved in the transaction actually matches up with the details of the transaction that they’re trying to push through.
If there’s something fishy about a particular transaction, then it won’t be added to the blockchain. And in order for a transaction to be permanently confirmed and added to the blockchain, it needs to be verified by multiple miners. This prevents rogue miners from attempting to hijack the blockchain, since any attempts they make to push across incorrect transactions won’t be verified by other miners.
Once a transaction has been confirmed by enough miners, its information is used to verify future transactions that involve the parties that were part of the transaction in the first place. In this way, if any historical transactions were altered, future transactions wouldn’t be verifiable.
All of this is made possible by the wonderful principles of modern cryptography, which is really, really, really math-intensive, but also extremely useful and proven to work in the real world.
Miners
Miners do a lot of work. The hardware that they own costs millions (and their electricity costs to run this hardware probably gets close to that as well). So, they need to get compensated somehow.
In the case of Bitcoin and Ethereum, they’re compensated by receiving digital tokens into their blockchain addresses. When miners verify blocks (or groups of transactions), they receive a block reward and they also receive the transaction fees associated with all of the transactions within these blocks.
The size of these block rewards is set by each blockchain’s protocols. In the case of Bitcoin, the size of the reward halves every so often, and will continue to do so until there are exactly 21 million Bitcoin in existence. In the case of Ether, the current protocol specifies that no more than 18 million Ether will be created every year, but there’s no cap on the total amount in existence, and the size of the block reward stays the same.
Real World Value
So, miners are compensated for doing real world work by receiving tokens that are useful within the blockchain ecosystems that they maintain. Thus, these tokens have real world demand and some form of limited supply.
Since the tokens are necessary to incentivize actual work in the real world (maintaining and growing their blockchains), they have actual monetary value in today’s world of fiat currency.
Contrary to what I assumed before I began my research, these things actually have some fundamental value. Now, trying to calculate what that value might be is a whole different story, and I don’t think anyone has been able to do it yet. But if you bank on the blockchain ecosystem growing, then you can easily see how the demand for these coins will grow, and when the demand for something grows and its supply is limited, its value starts to skyrocket.
Growth of Blockchain Utilization
The final question now is whether the blockchain ecosystem will grow or not.
Nobody knows for sure what will happen, but there has been a lot of recent interest from governments and organizations in the use of blockchains to handle their logistics and operations, specifically in the case of Ethereum, which allows for “smart apps” to run on top of the Ethereum blockchain.
If we start to see a couple of these governments or organization move some of their daily business to one of these blockchains, then these blockchains become critical to accomplishing business or political objectives, which means that the transactions on their chains will start to grow, which means the need for their tokens will increase, which increases the monetary value of these tokens.
Long-term Value
Long-term investors that are buying up tokens today are banking on the use of these blockchains by large organizations due to the economics mentioned above. If these blockchains become widely used, the value of these tokens could truly skyrocket.
So, there’s fundamental value in these cryptocurrencies that comes from supply and demand. And they’ve maintained their value for a long time now. Longer, at least, than the duration of tulip mania.
On top of that, they incentivize real world work, they’re decentralized, are guaranteed to operate according to a well-published set of principles, and provide a common methodology for people around the world to transact without having to trust each other.
They may still be in a short-term bubble. Heck, this whole blockchain thing may fall flat on its face and result in an overhyped fad. But if it actually pans out, it will change the way the world operates, and it’s looking like that may be a real possibility at this point.
As for me, I’m all in on Ethereum now, and I think Bitcoin also has a bright future. I can’t say much for the other cryptos, but I do think that there are a lot of benefits for large organizations to use blockchain technology, so I’ve gone from being an ignorant bear to a slightly-less-ignorant bull. We’ll see how it all plays out in the long-term. But I think that if there’s anything that can surpass fiat currency as a means for transacting in this world, it’s crypto.
