Crypto Outlaws

Adam Ludwin of Chain wrote a terrific tweet storm last week that touched on a topic I’ve been thinking about quite a bit. Amidst a bubbly crypto-currency/alt-coin/token/ICO market, which projects have long-term fundamental value? Moreover, how can investors assess the magnitude of a given crypto-currency’s potential value?

Adam says “fundamentals analysis” mostly hinges on a protocol’s censorship resistance — not speed or scalability or cost. I tend to agree, with some caveats. But before I elaborate, read the full thread here, or at the bottom of this post (reformatted with permission).

Here’s the meat of what Adam says:

[In a dapp], censorship resistance means that the transaction is UNSTOPPABLE as long as the dapp’s fee (denominated in the cryptocurrency) is paid. Thus, the “fundamental” value of a dapp = how much a given user group NEEDS censorship resistance in a given market. Who are these people? Why do they need or want censorship resistance? Will this group of people grow in size over time? If so, why?

A valuable dapp is one that has found users who are truly harmed/oppressed/taken advantage of by the intermediary in the market. And where, for whatever reason, competitive forces or government regulation either have not, or will not, solve the problem. And thus this group of users is willing to put up with all the ways in which the dapp is WORSE than the centralized option, and switches.

A+ stuff.

As a mental model for crypto fundamentals analysis, this helped clarify my own thinking.

I find it equally helpful to think about the market in reverse. I spend less time thinking about the intensity of user needs, which for crypto-currency applications tend to be somewhat static, structural, and obvious. It helps to spend more time evaluating the strength and behavior of the censors.

Who are the censors a token is used to undermine? How powerful are they? How quickly can they react? What types of transactions do they prohibit? Where do they have jurisdiction? How might they respond to growth in protocols that threaten their ability to censor certain activity at all?

Tech giants may compete with crypto-currency applications for online payments, file storage, or crowdfunding, but they are weak censors with limited enforcement powers and narrow jurisdiction.

On the other hand, governments and their proxies (e.g. regulators), are extremely powerful censors. They have armed law enforcement, courts, jails, and expansive jurisdiction. Indeed, this week’s BTC-e arrest and subsequent $110mm fine, and the SEC’s not-so-subtle reminder about the applicability of securities regulations to ICOs should have reminded entrepreneurs and investors that powerful censors are watching. And they will use their powers when they deem appropriate.

This should give us pause, because the most fundamentally valuable crypto-currencies derive significant value from their ability to resist the strongest censors — governments. Adam doesn’t highlight this explicitly in his thread, but this is problematic since government censors usually call activity that resists their rules “illegal.”

Are we all outlaws?

Technically, maybe.

Bitcoin started as an unlicensed payment network. Ethereum as an unlicensed crowdfunding platform. For years, users have been playing with possibly illegal technology.

Yet the same could have been said for Airbnb, which started as a sort of unlicensed hotel, or Uber, which started as an unlicensed taxi company.

The upside for innovators who effectively skirt certain laws or capitalize on legal loopholes is high *because* the potential legal liabilities are also high.

But it can pay to invest in technically illegal applications that undermine strong censors if a) we have a principled and popular argument for why they are ethical and necessary, and b) we assume censors will focus their energy instead on choking off more egregious rule-breakers.

That doesn’t eliminate legal risk, but it does reduce it. Intent matters.

Bitcoin entrepreneurs like to point to remittances, developing economy mobile banking, and inflation protection as ethical applications of the technology — reasons censors should be permissive of the tech despite the many overtly illegal applications bitcoin also powers. Many people will get away with technically illegal activity in bitcoin simply because censors focus on bigger and less ethical fish: money launderers and black market vendors.

We’ve seen a similar pattern play out with ethereum, where ether’s value has been almost entirely driven by speculative mania for new decentralized applications built on their “world computer.” The most popular dapps have created tokens that offer investors the opportunity to share in the financial upside of their new networks. It takes ETH (or BTC) to create a new token *because* it may be an illegal, unregistered security in many cases. No bank will run the risk of transferring funds from their regulated entity to the issuer of an unregistered quasi-securities offering, so you’ve got to use ETH.

The SEC hinted this week it’s unlikely they will attempt to stifle all or even most new token issuances. Instead, only the most flagrant and exploitative securities violators need sweat, so most ETH investors and developer appear to have nothing to worry about.

The history of censor reactions informs where we look to identify new promising tokens in a frothy market.

Of course we should look for big, growing populations of users who NEED a given token to resist censors.

But more importantly, we can look at the censors themselves and place bets according to whether we think they will ultimately give a pass to ethical, but technically illegal applications that tokens power. A blind eye from a powerful censor is a crypto investor’s friend.

Invest and you may still be an outlaw, but you’ll sleep better at night.

***

Notes:

1) Censors have a way of changing their minds when the stakes get higher. Permissiveness today could turn into a crack-down tomorrow because none of the most powerful censors have given definitive guidance on how crypto-currencies should be regulated. Pay your taxes and don’t do stupid, overtly illegal shit. Duh.

2) Probably the subject for another post, but most new tokens still need to answer the question: “why can’t you pay for this decentralized app with BTC or ETH?” e.g. Prediction markets are super exciting and will collide with strong censors, but how critical is it to *hold* tokens for those networks.

3) “Regulatory arbitrage” is a related, but much longer topic of conversation. The strength of censors and their priorities change depending on whether you are in Switzerland or Singapore or New York or North Korea (h/t Erik Voorhees), but generally speaking, people should follow US regulations if US citizens buy or use their tokens.

4) It’s common knowledge now that the bitcoin industry was bootstrapped thanks in large part to high-value, overtly illegal transactions, which were conducted with bitcoin to evade authorities. The magnitude of illegal markets’ impact was incredible. Silk Road required users to acquire and hold a vast number of bitcoin — nearly 10mm BTC spent in less than three years. SatoshiDice also required its gamblers to acquire and hold bitcoin — more than 2mm BTC staked in less than two years. During the first several years of bitcoin’s existence, more bitcoins were spent through these two sites than were in circulation.

5) I’m still convinced that the taxation of crypto combined with OFAC reporting requirements creates a no win situation for investors long-term. At some point, you have to report your crypto holdings or you’ll be breaking the law. If you disclose your holdings, they could be subject to seizure someday. If you don’t, you could be evading taxes.

I wonder if the least bad solution is to calculate tax liabilities with and without crypto gains, then report your income sans crypto income, while voluntarily overpaying vs. your reported liability to make up the difference. Probably still breaking the law. Tough one.

6) Here’s Adam’s full post:

A few thoughts on “fundamentals analysis” of cryptocurrencies…

A cryptocurrency is an asset that makes a decentralized application (“dapp”) possible. If you buy cryptocurrency you should be able to argue for why the dapp is valuable.

The first dapp was a decentralized payment network, and that network’s cryptocurrency was called Bitcoin. In general, a dapp allows you to do something you can already do today (payments, computing, storage) but without a trusted central party. Just as Bitcoin is a dapp for payments, Ethereum is a dapp for computing, and Filecoin is a dapp for storage.

You CAN’T argue that for EVERYONE Bitcoin is “better” than Visa, Ethereum is “better” than Amazon EC2, Filecoin is “better” than Dropbox. In fact, on almost every dimension — speed, cost, UX, features, governance — dapps are WORSE than their centralized counterparts. But on one critical dimension — censorship resistance — dapps are not only better, they are arguably the ONLY solution.

Censorship resistance means that the transaction is UNSTOPPABLE as long as the dapp’s fee (denominated in the cryptocurrency) is paid.

Thus, the “fundamental” value of a dapp = how much a given user group NEEDS censorship resistance in a given market.

I say “needs” and not “wants” because, as I already pointed out, dapps are WORSE user experiences; you have to overcome that friction. Most people do not feel persecuted by centralized payment systems; but for some, bitcoin truly is the ONLY way to make a payment.

Who are these people? Why do they need or want censorship resistance? Will this group of people grow in size over time? If so, why?

These questions = fundamental analysis of a cryptocurrency.

Likewise, most people are not concerned by centralized file storage; but for some, filecoin may be the ONLY way to store/transfer files.

Again, who are these people? Why do they need/want censorship resistance? Will this group of people grow in size over time? If so, why?

A valuable dapp is one that has found users who are truly harmed/oppressed/taken advantage of by the intermediary in the market.

And where, for whatever reason, competitive forces or government regulation either have not, or will not, solve the problem. And thus this group of users is willing to put up with all the ways in which the dapp is WORSE than the centralized option, and switches.

This is why people tend to point to China or Venezuela as countries where using bitcoin could make sense (I tend to disagree btw). And also why people point to black markets or illegal uses as “good use cases” for bitcoin (I tend to agree).

At a macro level, investors buy STOCKS because they believe the corporate form of organization will continue to create value in society. Those investors can also study specific companies and try to figure out which ones will create the most value. They can argue for how and why Apple or Tesla or GE will create value for people and do so in a defensible way over time.

Likewise, investors buy bonds because they think governments create value and will capture some through taxation to pay back debtors. Those investors can also look at specific governments and argue for why Venezuela or the U.S. should have a certain rate of return.

Investing in cryptocurrencies SHOULD BE NO DIFFERENT.

Investors looking for a fundamental reason to buy cryptocurrencies have to believe that decentralized apps will create value for people. If they buy a specific cryptocurrency, they should be able to argue for why that specific dapp NEEDS to exist. They should be able to articulate immediately why those people need censorship resistance and can’t use a centralized option. Ideally they should also be able to explain why this cohort of people will grow in size over time

If they CAN’T do this, they are the worst kind of speculators because they have no conviction (🎶”Jefferson has beliefs. Burr has none”🎶). They either assume a) someone else knows the why the dapp is valuable or b) someone else thinks someone else knows why it’s valuable.

Bottom line, a cryptocurrency has ZERO fundamental value if the dapp has no value to a human.

Show me a dapp that people NEED (or believes they will soon need) and I will show you the price of that cryptocurrency going up over time.

Show me a dapp that NO ONE REALLY NEEDS and together we can watch as the value of its cryptocurrency goes to zero.