Assessing the value of blockchain technology and cryptocurrency
Written with Adi Szeskin.
It is very obvious that blockchain technology has the potential to disrupt and make several industries/sectors more efficient. What is not so clear is where cryptos plays a part within that industry/sector. What should we be looking for when it comes to deciding if crypto has an utility? Market size and liquidity? Benefits of holding the coins (e.g., dividends or interest)? What other things to be aware of?
Disruptive potential, increased efficiency. The part of blockchain/crypto within industries.
To assess the potential of cryptocurrencies or of blockchain technology for a particular market or sector we first need to understand their purpose and the properties that they may have.
The purpose of blockchain technology is to allow parties to reach mutual agreement and cooperate without the need to trust each other. Even if different parties have aligned incentives it is often difficult to reach consensus and cooperate, say if the parties do not trust each other. In online marketplaces for example, even though a buyer wants to buy and a seller wants to sell, how could the buyer trust the seller to send the merchandise after being paid? Or the seller trust the buyer to pay after merchandise is sent?
This can be solved if we have a trusted arbiter, a party responsible for resolving conflicts. In the e-commerce example, PayPal is a trusted arbiter resolving conflicts between its sellers and buyers. One could say that PayPal resolves disagreements involving money and merchandise, effectively forcing seller and buyer to a mutually agreed state. But what if there is no trusted arbiter? Perhaps we don’t want one? Or there might be no single party that we all trust?
In blockchain, mutual agreement is achieved by a decentralized database. That is, a database which is stored by and whose authenticity is verified by all network peers. Since the database is decentralized, no party controls access to information or dictates the contents of the database. Instead, contents of the database are agreed upon by consensus. For details on how this is achieved see for example Introduction to Blockchains by John Kelsey, NIST. The important thing about blockchains is that, if we agree that reality “is” what the database says it is, then we do not need a trusted arbiter. The network itself then plays the role of a trusted arbiter by being the mechanism which allows us to reach consensus on the contents of the database.
In Bitcoin for example, the Bitcoin blockchain is a decentralized database which allows us to reach consensus on the Bitcoin balance each address has (wouldn’t you like to dictate that your account holds much more than it does? How could consensus in a monetary system be reached in the absence of a trusted arbiter?). Other blockchain-based cryptocurrencies may hold additional information in their blockchain, as it is nothing but a database. Ethereum for example holds a special kind of computer code in its blockchain, known as smart contracts. Blockchains may contain information other than financial or transaction information.
Now that we understand what blockchain is all about we can discuss basic properties blockchains may have. This will allow us to more easily assess the value it may (or may not) have for particular use-cases. Information stored at blockchains is effectively immutable, as attacks capable of re-writing it are impractical. This makes the information stored in it very credible, as once imprinted it cannot be faked. Visibility. In public blockchains information is visible to all. There are also permissioned blockchains, in which there are restrictions to who is allowed to read from or to write to the database. As mentioned before, blockchains may support smart contracts, a network-enforced contractual agreement. The fully-automatable nature of blockchains makes machine to machine (M2M) interactions feasible; imagine for example one computerized device trading with another. Visibility, smart contracts and M2Ms all contribute to improved synchronization, a typically difficult task when multiple parties are involved. Improved synchronization often reduces inefficiencies. To assess whether blockchain may be useful for a sector or industry, one could consider the need for such properties, as well as weigh solutions alternative to blockchain.
Synchronization is important for shipping and logistics. A freighter entering a port could handle remotely the bureaucracies involved in entering cargo. Smart contracts could automatically handle payments upon cargo receipt. Having the information visible to all of the parties involved would of course ease synchronization. See for example the papers The Blockchain Potential for Port Logistics, or Blockchain Technology for Ports.
When shopping, did you ever wonder if a product’s ingredients are really as labelled? Blockchain is a natural candidate for supply chains, as its immutability and visibility allow sharing credible information among untrusted parties. A shopper at a supermarket for example could query a blockchain for a proof that a product’s ingredients are indeed as labelled. Unlike a product’s label, information retrieved from the blockchain cannot be faked. IBM has a nice exposition on its blockchain for supply chain solution, to name one of the solutions.
Deciding if crypto has a utility?
We’ve seen applications for blockchain which are not cryptocurrencies. In order to decide if a particular cryptocurrency has utility, it is important to keep in mind that a cryptocurrency is a technology. As any other technology, a cryptocurrency better have a purpose, a problem that it solves, preferably better than competing solutions. Different blockchain based cryptocurrencies serve different purposes, just as different internet protocols do, and so there is room for a variety of cryptocurrencies.
When considering the utility a cryptocurrency has, it is important to ask what problem is it attempting to solve? Is the problem it is attempting to solve a real problem, one of importance? Does the problem already have a solution? If so, what novelty does this cryptocurrency introduce compared to the alternatives? What pros and cons does a solution have compared to the alternatives? For additional indications of the value of a cryptocurrency see here.
Picking a crypto
Before cryptocurrencies, it was not clear how open-source developers could get paid for usage of the software they developed. Cryptocurrencies enabled a new form of compensation to such development.
First, platform developers could offer a token (e.g., an Ethereum token) which could be used later on in exchange for platform usage rights. For example, golem is an open-source platform which enables users and applications to rent computer power of other users’ machines, effectively creating a decentralized supercomputer. That is, the golem token is used in order to pay for rented computer power. At their ICO, the company sold out 90% of the tokens for funds which they were expected to use for the platform’s development. The other 10% of the tokens kept by the company are an indirect compensation for the development. If the platform proves useful then people will buy the tokens to use the platform, and so these tokens will be of value. This further supports the need for creating a new specialized currency, as the company creating this platform will benefit mostly from the value of the tokens they are holding. To conclude, an ICO is nothing but a mean to fund open source development. Note that such ICOs could share crypto-coins and not only tokens.
Second, in addition to funding development, ICOs provide a mean for widely distributing coins in Proof of Stake (PoS) blockchains. Having coins highly distributed in PoS coins is important, for otherwise a 51% stake attack could be carried out, either by a single individual holding 51% of the coins, or by several individuals jointly holding 51% of the coins. For more details, see also the next question.
When coming to assess the value of a particular cryptocurrency or token, one should first ask why would it be of value? What problem is a cryptocurrency protocol trying to solve? Will the service paid for by a token be useful? In a new cryptocurrency or token, are there existing or competing solutions to this problem? For, there is no value in re-inventing technologies unless the re-creation has some significant novelty in it. When considering a new service, one could ask if it needs a new blockchain of its own? Would a token on top of an existing blockchain suffice? Further, one could consider what properties should a solution to the problem have? For example, a blockchain handling port logistics would clearly benefit from supporting smart contracts, yet it is not clear that it must be a PoS rather than a PoW blockchain.
Another common question is why shouldn’t a token or crypto-coin be pegged to US$ (or gold or whatever). Although this can be done (e.g., tether), it requires a company or entity to back any one unit of the coin by one “real” US$. This requires an end-user of the coin to trust the company in keeping its word, which is clearly not decentralized. Pegging to a currency ties the coin’s value to that of a centrally-controlled currency. Furthermore, pegging a crypto to the value of something else will require the company maintaining it to resist gaps in market valuations between the two.
Benefits of holding coins.
Holding a cryptocurrency rather than trading it away has various benefits. In order to increase price stability, many protocols have built-in rewards on long term holding. Some coins use airdrop to distribute coins to existing wallet holders. Similarly, hard-forks often grant units of a newly forked coin to holders of the old one in order to attract new users.
There are cryptocurrencies which avoid forking-related problems by allowing the network rules to be voted upon. Holding such coins grants voting rights. Tezos and Cardano are examples for such protocols.
Holding a coin is needed for participating in Proof of Stake next-block-creation mechanism. See more details in the next question.
Other things to be aware of?
Preventing loss or theft of a cryptocurrency slightly differ from those involved in fiat (“regular”) currency. The differences all stem from the fact that holding an account’s private keys is equivalent to effective ownership of the coins. See this slide and onwards for further details.
In addition, when investing in cryptos, it is important to understand that they are nothing but technologies, protocols used to communicate value (and other things). Therefore, they might be susceptible to protocol vulnerabilities, implementation security problems, hacking, and so forth.
See also PoS vs PoW coins — which is better? PoS vs PoW ASIC vs PoW GPU?