Cryptocurrencies: We Have Seen It All Before!

If you are new to Crypto, you are exactly where I was two years ago. It’s fair to say that many of my smart and highly educated friends — even those who work in “Tradfi” (i.e. traditional finance) as I did — still remain unconvinced about the merits of this technology. They liken the incredible rise in the total value of the Crypto markets to other crazy asset bubbles like ‘Tulip Mania’. The hyperbolic excitement about the future ‘Blockchain Nirvana’ is inevitably greeted with disbelief by seasoned investors. As I said, I’ve been there.

Today, I would like to explain in simple terms what Cryptocurrencies are and what they can do. I hope you will see they have real fundamental value as an asset class.

If I were to summarise what they are in one line: Cryptocurrencies enable the launch of a new improved version of the internet (called Web3) with all the associated benefits we have seen before.

Controversially, to me therefore, Crypto is more like an evolution of the technological trends we have already seen for two decades rather than something new that came out of nowhere. In my mind, history is very much repeating itself here. In terms of technological advance, we have seen time and again that innovations that offer a far better value proposition have a pretty high chance of success. Crypto’s superior value proposition is evidenced by its consistently growing adoption and proliferating use cases.

Overall therefore, I think everyone should take the time to understand the Cryptocurrency ecosystem. This exciting new industry truly has the power to transform our lives and make fortunes for ordinary people in the process.

To help demystify Cryptocurrencies, I will show how this industry is evolving in a very similar way to every other big tech innovation we have seen in our lifetimes. To make it all much easier to understand, I will also explain what many of the key Crypto buzzwords that you no doubt keep hearing actually mean.

Not as New As It Seems!

The moment I realised Cryptocurrencies have the most diverse and powerful list of applications I have ever seen with any new technology is when it started to get exciting for me. It’s complex for sure: there are strange sounding terms of reference and complicated new technology to get to grips with. What’s more, there are already literally thousands of coins, tokens and decentralised applications, all with their own unique use cases and competitive strengths in this brand new world. To make things even more confusing, we are seeing thousands of new projects promising new innovations being added to the ecosystem all the time.

You may be thinking, but why are these things growing at all? Simply because Cryptocurrencies offer a vastly superior and cheaper way of transacting and connecting people. Every single time we have seen a new technology that offers a cheaper and easier way to do things, it has completely replaced what was there before. Every single time.

Typically with any new tech, there is a chaotic free for all ‘land grab’ stage, with lots of new entrants trying to gain a share and this is exactly where we are now with Cryptocurrencies. New Crypto projects are emerging all the time, trying to gain a foothold by tackling just one issue or area in this vast new ecosystem. We have seen this pattern time and again in the past: a new technology offering a cheaper and easier solution grows exponentially relative to what was there before. Think emails versus faxes, music streaming versus CDs, PCs versus mainframes. It also always happens that initially people distrust the change and think it will fade away. But because adoption keeps rising fast, there comes a point when the new way of doing things gains market leadership and acceptance. Along the way, all kinds of innovations are made on the original idea so market leadership within the tech itself often completely changes. As the tech gains traction, a wall of capital typically flows in on the back of this growth potential. Cryptocurrencies are no different in any of these regards. To me, it is clear that Cryptocurrencies represent an attractive asset class and an ever growing part of the investment landscape going forward.

Crypto 101

Put simply Cryptocurrencies are a bit like regular currencies except they are totally digital. Cryptos are identified by a bunch of numbers and letters but if you think about it, that is exactly how we identify who owns how much of any currency today: in theory, a record of all money is kept by the central bank who shares this information with smaller banks. Each person can access their account using a card with corresponding account numbers. When you deposit £10 cash, the bank branch and by extension the central bank will see that you have that much in your account. Using these numbers and security codes/pins, movements in and out of accounts are logged and shared and this is also exactly how Cryptocurrencies work.

Crypto Wallets Are Just Like Bank Accounts

A Cryptocurrency wallet address is like a personal bank account. You can transfer your coins in and out of each of your wallets. The key difference is you don’t need to provide any personal information to open your wallet like you would to open your personal bank account. This means that your identity is not attached to your wallet. The other important difference is that any Cryptocurrency held in your wallet is held by you and not custodied by a bank or other intermediary. This means nobody can shut down or block your wallet transactions. You have total control over your money at all times. The trade-off here is that if you lose access to your wallet (by forgetting your password/seed phrase etc), you will lose the Crypto within it forever. There is no bank/intermediary to call to help you recover it.

Decentralisation

Instead of banks and the government keeping track of everyone’s money and bank account balances, the blockchain (which is the ledger system for Cryptocurrencies) allows these records to be stored across all the computers connected to a Cryptocurrency network. These transactions and account balances are public and can be viewed by anyone using something called a ‘Blockchain Explorer’. Because computers can earn Cryptocurrency for processing transactions on a Cryptocurrency network, this incentivises more computers to join the network to process transactions and earn Cryptocurrency. This makes Cryptocurrency networks secure because there is no single point of failure. This is called ‘decentralisation’ and is essentially the polar opposite of the current centralised setup involving governments, banks and other intermediaries. The often used term, ‘Defi’, short for ‘decentralised finance’, is the name given to that part of the Cryptocurrency ecosystem that seeks to replace the functions of banks and financial intermediaries in this brave new world.

Types of Cryptocurrency

There are actually thousands of cryptocurrencies just like there are thousands of regular currencies. Broadly speaking there can be grouped into two types: Coins and Tokens. Cryptocurrency coins belong to cryptocurrency networks that were built from scratch. It takes a lot of time and money tocome up with the code required to create a safe and reliable Cryptocurrency network. Because Crypto networks are so hard to make from scratch, there are only a few dozen Cryptos that are actually coins. You have probably heard of Bitcoin and Ethereum and these are examples of the most widely used coins today. Crypto coins are given to computers as a reward for processing transactions on that particular network.

The rest of the universe is made up of Crypto Tokens. Tokens are very easy to create with little effort or cost. This is why there are thousands of Tokens and things like NFTs are technically also Crypto Tokens. Other examples of Tokens include one issued by US financial services company Circle called USDC which is fully backed by the US Dollar. Circle is a fully regulated and audited entity, is valued at $9bn and has revenues of over $100m.

Bitcoin

Most people have heard of Bitcoin which was the first Cryptocurrency ever invented 13 years ago. Despite all the new Cryptos created since, Bitcoin is still very popular given its finite supply, its huge adoption to date and the fact that it is so secure as a network that it has never been hacked. Bitcoin transactions still account for as much as 40% of the total Crypto market today.

Ethereum

Ethereum came next and is the second largest Cryptocurrency network today. Ethereum represented important innovations on Bitcoin: Ethereum is far cheaper and better as a means of transaction. It has therefore become the second largest network by market cap given it is better suited to making transactions. The network has also exploded as it can also be used to create the Crypto Tokens as well as new decentralised applications (known as ‘DAPP’s). All transactions required for creating, moving and interacting with these Tokens require ETH (the coin of the Ethereum network) to pay for ‘gas fees’. This means the demand for ETH rises as the Ethereum network gains adoption. Ethereum is continuing to see incredible adoption and here are some examples:

• Visa is testing payments on the Ethereum network using USDC
• The European Central Bank recently even issued a bond on the Ethereum network

Stablecoins

Stablecoins are digital Tokens that are pegged to ‘fiat’ (regular) currencies, e.g. the US dollar. They essentially act as a bridge between the worlds of digital and fiat currency. Stablecoins are often considered safer since they are backed by assets and have grown from $5.7bn in late 2019 to $155.6bn in January 2022.

As mentioned earlier, a well known Stablecoin is called USDC which is fully backed by real US dollars (i.e. the issuer Circle holds one US dollar in the bank for every USDC it creates). You can add USDC in your Crypto wallet by trading your dollars to receive USDC. You can redeem them in the same way (by giving Circle back the USDC and getting US dollars in return).

The war in Ukraine has highlighted the value and use case of Stablecoins. Not only did we see a jump in demand for the largest US Dollar-tracking Stablecoin Tether, but it started to trade at a hefty premium on the Ukrainian exchange Kuna at the end of February when the country’s central bank introduced limits on ATM cash withdrawals and also suspended foreign-exchange transactions. People can now see in practice the benefit of this alternative form of money: access to your Cryptos cannot be controlled by governments in the same way as access to your bank accounts can.

Just the New Version of the Internet?

The words Blockchain and Cryptocurrency are often used interchangeably. Technically the Blockchain is ‘the ledger’ on which the decentralised Crypto transactions are stored. Like the rail and roads infrastructure, first these networks had to be built to enable new applications (called DAPPs) and use cases to happen.

It’s useful to think of the three generations of Blockchain

• The first generation of Blockchain arrived with Bitcoin, which showcased that this new technology allowed transactions to be transparent, secure, and decentralised.

• Then, innovation led to the second generation blockchain which we know as Ethereum. Now we saw that the Blockchain wasn’t only a book on which we write things, but in fact something very usable and scalable, which we could even perform programmes and algorithms on (called ‘Smart Contracts’). However, in the event, Ethereum has become a victim of its own success and its massive popularity means it is experiencing scalability issues.

• So to solve these problems, we had developers innovating to create what we can call third-generation Blockchains, whose mission is to find solutions for second-generation Blockchain problems, with the ultimate goal of allowing Blockchain technology to become available to an even wider audience

None of it is Perfect

One interesting academic concept of note is ‘The trilemma of the Blockchain’. This was theorised by Ethereum founder Vitalik Buterin, who holds that it is impossible to combine the three major principles of Blockchain concurrently:

That is to say that the current Blockchain does not guarantee maximum power in these three aspects. There will inevitably be one that will be to the detriment of another. For example, a blockchain can be very secure and decentralised, but this will be at the expense of scalability and the number of transactions it can make per second. This is the case with Bitcoin and increasingly with Ethereum too. Conversely, it can be secure and swift, but this will be at the expense of decentralisation (like we find with Solana and Ripple). Blockchain is therefore not perfect, just a vast improvement on what we have now.

Parallels to the Stock Market Investing

We now have a fairly long history of Crypto market growth. Given that there are so many Cryptocurrencies in the ecosystem, which particular cryptocurrency investors choose is driven by their individual risk tolerance. Like in stocks and shares, the lowest risk Cryptocurrencies are the longest established ones with the highest market caps. The top ten cryptocurrencies by market cap are generally considered to be the lowest risk (i.e. they are likely to be around for many years given the large adoption they have already achieved). Again like in stocks, the nominal level of the Token price is no indication of the project’s size. Another parallel to the stock market is that the highest potential returns are often found at the smaller end of the market cap scale, where a project’s success can lead to seismic changes in its value from a low base.

Why Have Cryptocurrencies Grown so Massively

Total Crypto Market Value by Market Cap (USD)

There are a number of problems with existing financial systems which have fuelled the search for an alternative. Firstly, all major currencies have been consistently losing value in real terms since they are only backed really by the trust we have in their issuers. That trust has been eroding for decades as governments have been actively manipulating and printing their currencies to fund themselves.

Cryptocurrencies are valuable because of what they do. Obviously, they don’t all have equal value and this value is based on their perceived quality, use case and adoption potential. For example Bitcoin has a profile similar to gold, is impossible to hack and has a finite supply (new Bitcoins issued are also halved every four years). All these factors make it very valuable. Assuming demand stays the same, this four year ‘halving’ cycle in itself will lead to a doubling of Bitcoin value every four years. However, demand for Bitcoin has in fact increased over time as we realise how weak the fundamentals of regular currencies are, leading many investors to look to park their capital outside the financial system. One important factor to note is that the price action of all cryptocurrencies is highly correlated to that of Bitcoin as Bitcoin still accounts for a large part of the total Crypto market (though this has been steadily declining in recent years).

Cutting Out The MiddleMan

Long story short: cryptocurrencies totally transform the ease and cost involved in every single way that we interact. This is because they allow us to interact and transact ‘peer to peer’, i.e. seamlessly without the need for a middleman or a permission giver. The use cases are every transaction and every human interaction so the addressable market is unimaginably huge. The easy-to-understand applications are things like a much faster and cheaper way of sending money abroad (even if the recipient doesn’t have a bank account).

Innumerable Use Cases

Cryptocurrency networks make it possible to lend, save and borrow without an identity or a bank. They make it possible to do business directly with other people without a middle man taking a cut in basically every single industry. They make it possible for communities to pool their funds together and vote on how it should be spent. So banks and government institutions are rightly concerned about the growing adoption of this technology. Impossible to imagine, but even tech giants like Uber and Facebook could become obsolete as a direct result! Crypto enthusiasts hold that it is possibly the most disruptive technology ever created.

Adoption is Happening At Pace

Contrary to how it seems from the outside, the Crypto industry is surprisingly well established. What has helped has been the creation of a number of easy to use platforms and exchanges. This has led to a threefold-growth of the overall crypto-asset market capitalisation over 2021, to an all-time high of $2.5tn — roughly the same value as Apple (US:AAPL). What is astonishing is this 2.5trillion of value has been created in only a few years.

Satista Crypto Survey: percentage of cryptocurrency users in 56 countries 2019–2021

According to famous macro investor R Pal, the internet in 1997 (which he feels is a comparable place to where we are now in Crypto) was growing at about 63% CAGR in terms of the number of users. In contrast, the Crypto market is growing at 180% a year on the same basis! So 300m Crypto users right now will reach 1bn in just 18 months. On top of this, the monetisation capability that now exists with Crypto didn’t exist back in the 90s. Back then, we measured the growth rate of the new internet stocks by counting the number of people coming to look at a screen, ascribing future value to these “eyeballs”, whereas now we have a much bigger audience that is growing much faster and importantly, that can already transact between themselves.

Institutional Money is Flowing In

Every day we are seeing from investor surveys and large company announcements that more and more businesses and financial institutions are looking to gain exposure to Cryptocurrencies (initially through Bitcoin):

• Massachusetts Mutual Life Insurance took a $100 million stake in Bitcoin in December 2020. This is not a small, niche enterprise. MassMutual is a 150-year-old institution.
• Financial technology innovator Block (formerly Square) put a portion of its treasury — $50 million into Bitcoin back in 2020.
• Likewise, IT services firm MicroStrategy moved a whopping $425 million into Bitcoin in 2020. As of December last year, it held 124,391 bitcoin, worth roughly $5.4 billion
• El Salvador made history in September 2021 by becoming the first country to make Bitcoin an official currency alongside the U.S. dollar. It now holds over 8,000 Bitcoin.
• And even Tesla has gotten in the game, holding nearly $2 billion worth of Bitcoin at the end of 2021
• A Goldman Sachs Investor Survey late last year showed that the largest hedge funds in the world plan to allocate 2% of their total assets to Cryptocurrencies this year

I believe this is still just the beginning of a larger wall of capital targeting the sector. All indications are that many more large companies and even nations will be added to this list in the years ahead.

Even Governments Want to Use the Tech

In the past, several regulators, governments and financial institutions have portrayed Cryptocurrencies as dangerous and illegal but at the same time, governments are looking to use the benefits of this technology for themselves. Several countries — including China — have issued CBDCs (digital currencies issued by sovereign states). The Central Banks of many others — such as the US, Canada, The EU, Japan, India and the UK — are all exploring CBDCs.

It’s important to note that although Cryptos and CBDCs use very similar technology (even if not all CBDCs will be using distributed ledger technology), they are completely different beasts. The first are independent currencies whose value is largely defined by supply and demand. The second is a macroeconomic tool that can be directed to address the issuer’s political and economic objectives. They are (or will) both be traded on specialised exchanges that are most certainly going to be regulated due to many reasons: to make the trading parties feel protected, to fight illegal traders and for the governments to be able to tax transactions.

Regulation remains perhaps the most uncertain and complex issue facing anyone involved in this space. Greater regulation may actually be welcomed by some, including traditional asset managers who will feel they can deploy far larger amounts of capital into Cryptocurrencies when the playing field is clear. Perhaps surprisingly, many of the Crypto exchanges also welcome the validation regulation would bring: though it may cause short term constraints, it could well lead to a real extension of their addressable market.

Why So Much Scepticism?

So given the familiar and exciting new tech roadmap ahead, we come back to the widespread scepticism surrounding Cryptocurrencies. Over the past decade, we have heard many high profile investing and banking industry veterans denounce all Cryptos as without merit and valueless. Despite this, not only has Crypto adoption continued at breakneck pace but they have outperformed every other investable asset in the past decade. But things are definitely changing and erstwhile high-profile sceptics like Jamie Dimon at JP Morgan are reversing their negative stance. I believe we are only at the beginning of this process, while adoption shows no sign of reversing.

Hacks and Criminal Activity

Crypto Exchange Hacks 2019-present

We have all seen the headlines about the hacks and criminal activity happening in the Crypto space. While there are always hackers looking to trick a Cryptocurrency network to gain access to the tokens and coins to steal, it’s no different to what is happening to banks and corporations on a daily basis. When hackers succeed, the bank or company in question beefs up its cybersecurity to prevent that particular chink in its armour being used again. The same goes for Cryptocurrency. The positive implication of this is that Cryptos that have been around for years are thoroughly battle-tested as a consequence of always being under attack by bad actors.

What I think most people don’t realise is just how hard it is to hack into an established Crypto network. If you want to corrupt one of the largest Crypto networks (given that transactions are validated across a decentralised network of computers), you’d literally have to hack into more than half of the individual computers connected to that network at the same time. Understandably, this is basically impossible to do if we are talking about a network like Bitcoin which has millions of computers around the world connected to it.

That said, some Cryptocurrency networks have fewer computers processing transactions so they are obviously more vulnerable to these attacks. The same can be said for centralised Cryptocurrency exchanges which is why most Crypto hacks happen at the exchange level. Hacking these exchanges is not only easier but more lucrative from the hacker’s point of view. Investors can protect themselves from this risk by storing their Crypto on personal ‘hard’ wallets rather than at the exchange.

The other stories we increasingly hear about in the corporate world are ransom demands by hackers. Despite popular myth, Cryptos aren’t particularly useful as a means of ransom demand. The fact is that Bitcoin and other large Crypto networks have publicly viewable transactions and wallet balances. This makes Bitcoin transactions very easy to trace by the authorities, even more so than regular currencies. So it makes no sense for most criminals to actively choose Crypto as it is so easy to track. In addition, people worry that all the activity in Cryptocurrency markets are linked to criminals. Given the traceability of transactions however, the reality is that the overwhelming majority of Cryptocurrencies are not used for criminal purposes. There are however just a handful of ‘privacy’ coins which cannot be traced and so these coins lend themselves to criminal activity.

Volatility and Risk

I see three types of risk with investing in Crypto. The first is that we are in the typical early ‘land grab’ phase of this technology and as such, as we saw with the advent of the internet, some (most?) projects will inevitably not succeed. Against this, there will be some spectacular success stories.

It’s also important to also know that there are numerous worthless Token projects and even outright scams in the ecosystem. This is primarily because crypto tokens are so easy to create to defraud unwitting investors. Understanding and researching projects fully helps to protect against this risk.

The primary source of risk for me comes from the extreme price volatility in Crypto. Again, if we look at the share prices of emerging tech companies in the early days of the internet, we can see that price volatility was also extremely high. As critical mass increased and adoption rose, price volatility materially decreased. For example, we are seeing wild swings in the price of Bitcoin but we also saw that with Amazon stock two decades ago: there was big orders of magnitude waves in the stock price as people questioned ‘is Amazon just a book company?’ and ‘can it survive these huge losses?’, etc. Over time, the amplitude of Amazon’s price volatility shrank massively as its network became more proven and larger. Similarly, I believe as the value of transactions on the blockchain grows and it starts to penetrate enterprise more, I think we will see the same pattern that we saw with Amazon (as size gets bigger, volatility gets less).

An Attractive Addition to Investment Portfolios

BitCoin/GOLD Price Performance

Overall, what does the breakneck speed of adoption alongside the exploding number of applications in numerous industries mean in investment terms? In the past, this has usually been a foolproof recipe for massive price performance! To me therefore it stands to reason that most investors will start to allocate a portion of their assets to this exciting and fast growing asset class.

PTLIB is co-founder of Dragonfly Asset Management

DISCLAIMER: This content is for EDUCATIONAL AND ENTERTAINMENT PURPOSES ONLY and nothing contained in this blog should be construed as investment advice. Any reference to an investment’s past or potential performance is not, and should not be construed as, a recommendation or as a guarantee of any specific outcome or profit.