Pomp’s newsletter this morning prompted me to write this, as I feel that there is a lot of confusion around the Petro, even around the people that should know better. This is my attempt to clean up the narrative around it. I guess it is hard to understand the level of deceit that the Venezuelan regime is capable of unless you have lived through it. That said — let’s explore why the Petro is a scam.

The Venezuelan regime (specifically, Maduro) has sustained a continued attack on its people by printing the Bolivars that it uses to promote “more social programs” and “pay increased salaries.” The world bank recently reported Venezuelan inflation reached 500,000% in September of this year. It is important to note that in most countries, there is a veil of independence in their central banks. This is not the case in Venezuela. The regime effectively controls every single organism that should be independent. From the electoral council, to the central bank, to the supreme court. There is really no one else to blame.

The regime’s complete disregard for human rights has been the focus of many conversations at the OAS, UN, and pretty much every other inter-government body over the last 2 years. It is very hard to stop a rogue government that systematically dismantled the country’s electoral system. As an example, the last election was called — not to consult whether the country wanted to re-write the constitution, but to select who within the regime would re-write it. The massive attempts to stop the election were met with weapons, and despite the boycotting of more than 60% of the country’s voters, the vote went ahead and the government gained “super-powers” while it is being re-drafted.

That criminal act in particular would ignite a wave of sanctions to prevent the government from accessing international funds from “like-minded” political partners (primarily Russia and China). They had consistently bailed out the regime because of their sunk investments in the country that would likely not be honoured by a new, reputable government.

And so, this brings us to the Petro. The Petro is nothing but an attempt to suck in valuable currency from clueless believers overseas. To start, it rests on the beacon of justice that is the Venezuelan legal system — good luck winning a case against the regime. Further to that, those of us that read the legal document through which the Venezuelan Petro legally came to be, have been screaming to the world to READ THE FINE PRINT.

As per the document below, the Venezuelan Petro will be redeemable to the Venezuelan Government, for a barrel of oil or “any other commodity that the Venezuelan regime deems fit.”

To summarize, to believe in the Petro you have to believe in Venezuela’s rogue regime, the Venezuelan legal system, and the ability for them to deliver on what it has not been able to do for 20 years. If you still think this is an attempt to increase cryptocurrency adoption in the developing world, I commend you and suggest that you go visit Venezuela for yourself.

These notes were intended to be my personal summary of the book’s main ideas. I wanted to create a list of the many analytical tools that I knew would be available in it. I also included links to all the resources they use to research. I decided to make a post out of it as it would force me to keep it short and coherent.

Chris and Jack’s book is incredibly insightful. No summary could possibly do it justice. Their arguments are thoroughly researched and backed with empirical data and citations. They cover the entire cryptoasset ecosystem in a systematic and comprehensive way.

The book presents a wealth of tools (frameworks and formulas) useful for new and advanced investors. They share their personal valuation methods and the due diligence research process they use. I personally got tremendous value from this book — it is one I that I hope to see on shelves of my business partners.

Note: This summary is largely based on the ideas that resonated with me. Others may find different parts of the book more valuable. Purchase a copy of the book here.

CRYPTOASSETS: The Innovative Investor’s Guide to Bitcoin and Beyond

Introduction:

The term Cryptoassets is presented early on. The writers explain that not all investable digital assets are currencies — there are also commodities and polished digital goods on the blockchain. Therefore, they argue, cryptoassets is a better fitting term.

Part I — WHAT

Chapter 1: Bitcoin and the Financial Crisis of 2008

The Origins of Bitcoin

The book lays out the context in which Bitcoin was originated. The financial crisis of 2008 set the stage for Satoshi Nakamoto’s brainchild to flourish. The Bitcoin whitepaper was released on October 31st, 2008 — six and a half weeks after Lehman Brothers filed for bankruptcy. Lehman’s bankruptcy took the global capital markets down with it. Bitcoin was

“The first known attempt at a decentralized ‘trustless’ transaction system with no central server or authority had come at a serendipitous time.”

Satoshi Nakamoto, an anonymous developer(s), rallied the support of world-class cryptographers for the project via emails and forums. On January 12th, 2009, the first Bitcoin transaction ever was recorded between Satoshi Nakamoto and Hal Finney. Nine months later, the first exchange rate was set for Bitcoin at USD $0.00125/BTC.

Chapter 2: The Basics of Bitcoin and Blockchain Technology

Bitcoin with “B” refers to the network (the software, miners and nodes — the chain itself)

bitcoin with “b” refers to the native coin that is used to transact

“Blockchain technology facilitates transactions in real-time. The world is increasingly real time.”

“Bitcoin’s Blockchain is: Distributed, Cryptographic & Immutable. Proof-of-Work ties the three together and is the only feature that is inherently new about blockchain. It is how the network reaches consensus, incentivizes participants and distributes rewards.”

I wrote a post detailing Proof-of-Work here.

https://medium.com/@mauriciodibartolomeo/the-future-of-bitcoin-mining-pow-vs-pos-whats-the-natural-way-to-mine-45f01f1a567

Chapter 3: “Blockchain, Not Bitcoin?”

Bitcoin’s Popularity Surge:

Google Search Trends are a good way of getting insight on what is grabbing mainstream attention. The authors argue that the popularity of the search term “Blockchain” was still increasing steadily at the time of writing — in part due to influential articles published by The Economist and Bloomberg discussing the potential of blockchain beyond Bitcoin and separating the 2 concepts.

Note: Below is an updated chart of the search terms compared. Bitcoin still dominates the mainstream’s attention. Search volumes for “Blockchain” have also gone down significantly since.

“SATOSHI NEVER SAID BLOCKCHAIN”

This one really stuck with me. It reinforced how important proof-of-work is, and how much of a challenge it will be for any developer(s) to improve on it. It made me shift my investment approach. I am very much skeptical of anything that is not proof-of-work at the time of writing.

Media has tried to disassociate Bitcoin from Blockchain — however, Chris and Jack rightfully assert that only public blockchains like Bitcoin with “native assets that incentivize the build-out of a robust network of miners” Are synonymous with blockchain. Other variations may exist, but Bitcoin & Blockchain cannot be divorced conceptually.

“A private blockchain is typically used to expedite and make existing processes more efficient […] the value creation is in cost savings, and the entities that own the computers enjoy these savings. The entities don’t need to get paid in a native asset as reward for their work, as is the case with public blockchains.”

“for Bitcoin to incentivize a self-selecting group of global volunteers, known as miners, to deploy capital into the mining machines that validate and secure bitcoin transactions, there needs to be a native asset that can be paid out to the miners for their work. The native asset builds out support for the service from the bottom up in a truly decentralized manner. Public blockhains are not so much databases as they are system architectures spawned from the bottom up to orchestrate the creation of globally decentralized digital services.”

Bitcoin Hype

In an attempt to discern where we are in the hype cycle, the authors introduce the Gartner Hype Cycle framework.

As per the writers, Bitcoin is about to exit the through of disillusionment, ICOs are in the Peak of Inflated Expectations, and “Blockchain” is somewhere in between.

Gartners’s Hype Cycle for Emerging Technologies

Chapter 4: The Taxonomy of Cryptoassets:

On what constitutes money:

“A currency fulfills three well-defined objectives:

1. Means of Exchange

2. Store of Value

3. Unit of Account”

Bitcoin’s Digital Siblings:

Litecoin:

Founded: 2011

Founder: Charlie Lee, MIT (worked at Google)

Features: Blocktime is 4x faster than BTC, Supply 4x as much as BTC, reward halvings are further apart.

Algorythm: Scrypt (purportedly ASIC resistant)

Ripple:

Founded: 2004

Founder: Ryan Fugger

Features: N/A… goal is to help banks do what they already do.

Algorythm: Centrally mined by company

Dogecoin:

Founded: 2013

Founder: Jackson Palmer

Features: Initially it started as a joke, it evolved to a coin that is very cheap and used to tip in blog sites and online services. It has strong community support.

Algorythm: Scrypt

Privacy Coins:

Bitcoin transactions are pseudonymous — they go to a wallet visible to the public. It may not be directly associated with a particular identity, but users could track the wallet transactions and potentially find out who the wallet belongs to.

Privacy coins like Zcash, Monero and Dash are coins that allow for anonymous transactions using advanced cryptography.

Monero (formerly known as Bytecoin):

Founded: 2014

Founder: N/A

Features: Privacy (ring signatures) — algorithm favors CPUs for mining. Adam Back mentioned it was the only idea outside of Bitcoin that had a “defensible rationale for existence”

Algorythm: CryptoNote

Dash

Founded: 2014

Founder: Evan Duffield

Features: Based on Bitcoin, with a two-tier incentive network, known as Masternodes. Darksend includes the ability for fast, annonymus payments.

Algorythm: Q11 (Not in the book)

Zcash

Founded: 2016

Founder: Zooko Wilcox

Features: Based on Bitcoin, private transactions with “zero-knowledge-proof” cryptography. Top tier developer team behind Zcash. Highly experimental technology.

Algorythm: Equihash (Not in the book)

Chapter 5: Cryptocommodities and Cryptotokens

Ethereum:

Ethereum is a decentralized world computer upon which globally uncensored applications can be built. The Ethereum Virtual Machine is made up of volunteer nodes. These nodes run/support its native blockchain and receive Ether, its native asset, as a reward.

This decentralized virtual computer paved the way for decentralized applications that run on it — creating a brand new ecosystem. A full list of Ethereum dApps can be seen at http://dapps.ethercasts.com/.

The DAO:

The DAO was a complex dApp that programmed a decentralized venture capital fund to run o Ethereum.

“Holders of The DAO would be able to vote on what projects they wanted to support, if developers had received enough support from DAO holders, they would receive the funding.”

Despite experts sounding off about the risks of such a high-stakes undertaking, the project went ahead and the raise was a huge success. It surpassed the original amount raised by Ethereum by almost one order of mangiture (USD $168 Million DAO vs. USD $18.4 Million for Ether). Through the raise, the price of Ether skyrocketed. When it was all said and done, the DAO held 11.8 Million ethers, roughly 15% of all ether that had been created by then.

The DAO was hacked due to a security flaw causing chaos in the Ethereum community. In a landmark move, the Ethereum community leader Vitalik Butterin, decided to fork the Ethereum network and restart the network at a point in time right before the hack and “undo” it. The move was not without some backlash but the fork went ahead and created 2 networks from that point on, Ethereum and Ethereum Classic (for those who did not agree with the fork). Both still exist today.

Interesting dApps, Cryptocommodities, Cryptotokens:

Augur: Seeks to provide a platform for users to wager on the outcome of events.

http://www.augur.net/

Gnosis: Similar to Augur

https://gnosis.pm/

Rootstock (RSK): An Ethereum-type virtual computer on Bitcoin

https://www.rsk.co/

Tezos: Self-governing ecosystem (not in book)

https://www.tezos.com/

Lisk: Platform for developers to build blockchain applications on JavaScript (not in book)

https://lisk.io/

Note: The book spends a significant portion explaining portfolio theory, Bitcoin historical returns, Sharpe Ratio, Diversification, and other topics that I will skip. For full details read section II: WHY of the book.

Part II — WHY

Chapter 6: The Importance of Portfolio Management and Alternative Assets [not summarized]

Chapter 7: The Most Compelling Alternative Asset of the Twenty-First Century [not summarized]

Chapter 8: Defining Cryptoassets as a New Asset Class

Note on what defines an asset class: A set of assets that bear some fundamental economic similarities to each other, and that have characteristics that make them distinct from other assets that are not part of that class. The authors argue that cryptoassets do not fall in any of the classically accepted asset classes. These are:

· Capital Assets

· Consumable/transformable assets

· Store of value assets

They successfully argue that cryptoassets do not fit in any of the above classifications.

Chapter 9: The Evolution of Cryptoasset Market Behavior

Authors go through the evolution of Bitcoin exchanges, trading volumes and looking for potential signs of maturity within the cryptoasset ecosystem.

They identify the existence of trading pairs for a particular crypto asset as a sign of maturity for it. I strongly agree with this. They also argue that the volatility decreases as the asset matures.

Correlation between asset classes: The authors argue that while the asset class is first emerging, it will show little correlation with the broader capital markets because there is little overlap between the early adopters and market participants. As more people join, there will be more overlap, hence, a stronger correlation.

Graphs show that cryptoassets are uncorrelated with the S&P 500, Gold, U.S. Real Estate, Oil, and U.S. Bonds, (as expected).

Chapter 10: The Speculation of Crowds and “This Time is Different” Thinking

Understanding crowd mentality in the context of investments: “Psychology expert Gustave Le Bon, in his book The Psychology of Revolution writes that:

‘Man, as part of a multitude, is a very different being from the same man as an isolated individual. His consius individuality vanishes in the unconscious personality of the crowd. […] Affirmation, contagion, repetition, and prestige constitute almost the only means of persuading them. Reality and experience have no effect on them.’”

Basically, we are not the independent thinkers we like to think we are when everyone around is screaming “BUY” or “SELL” — and that is very important to be cognizant of that fact, and compensate for that biological urge through discipline.

Lesson: Bitcoin (and cryptoasset) bubbles are inevitable. Bubbles are part of human nature. Remember that. This time is NOT different.

“Within the periods defined as Bitcoin bubbles, the average decline from peak to through price was 63%.”

Chapter 11: “It’s just a Ponzi Scheme, Isn’t It?” [not summarized]

Part III — HOW

Chapter 12: Fundamental Analysis and a Valuation Framework for Cryptoassets

As a foundation for cryptoassets fundamental analysis, Chris and Jack propose that an investor should evaluate:

1. Project’s Whitepaper: Should outline the problem the asset addresses, where the asset stands in the competitive landscape, and what the technical details are. Stay away from white papers with vague language.

2. Decentralization Edge: Is there an advantage for this to be on a decentralized blockchain? If not, it has no real edge over the existing solution and will have trouble succeeding.

3. Valuation: Value is made up of speculative value and utility value.

o Bitcoin’s Utility Value can be determined by assessing how much bitcoin is necessary for it to serve the Internet economy it supports. (Note: Or any other economy it serves, like a part of Venezuela’s) To find this value, one must make assumptions on Bitcoin’s use. The authors provide sufficient data for the rest of the equation:

“Roughly 5.5 million bitcoin, or US $5.5 billion at the price of $1,000/coin, is held by the top 1,000 addresses on the Bitcoin blockchain. […] Future utility value can be thought of as speculative value, and for this speculative value investors are keeping 5.5 million bitcoin out of the supply.”

§ Money Velocity in the context of Bitcoin: It is important to understand velocity in order to get a better picture of Bitcoin’s demand. The velocity of money is the frequency at which one unit of currency is used to purchase domestically-produced goods and services within a given time period. The velocity of a currency is calculated by dividing the Gross Domestic Product for a certain period over the total monetary supply. Currently, the velocity of the USD is a little north of 5.

“About US$500 billion is transmitted annually thought the remittances market. Assuming bitcoin serviced that entire market, then to figure out the value of one bitcoin, one would need to assume its velocity. Say bitcoin’s velocity is 5, similar to that of the U.S. dollar. Then dividing that $500 billion by a velocity of 5 would yield a total value of bitcoin of $100 billion. If, at this point, we are at the maximum of 21 million bitcoin, and this is the only use for bitcoin, then that $100 billion divided by 21 million units would yield a value per bitcoin of $4,762.”

· NOT IN THE BOOK: I believe bitcoin’s “chain velocity” can be estimated by dividing the total amount of bitcoin transacted over a year over the 21 million bitcoin supply. If we do it for 2017, we get that a total of 95,968,973.73 BTC exchanged hands — if we divide this by 21,000,000 — we get an approximate velocity of 4.57. Source: Blockchain.info

§ I have deliberately skipped over the time-value discounting of money for the context of valuation as I believe it will confuse more people than it will help. The concept to understand is that a dollar today is worth more than a dollar tomorrow because people could “save” that dollar and earn an interest rate.

4. Community & Developers: Research the asset’s developer team and see how active the community is. Resources to check are www.Reddit.com , www.Twitter.com , www.Slack.com , www.MeetUp.com

5. Relation to digital siblings: Is this a fork? Is it entirely new? Is it an asset built on another platform? Will it positively or negatively affect the host platform? Can the host platform handle it?

6. Issuance Model: There is no perfect model — the issuance should allow a fair shot to investors, if there is any favoritism, whether to founders or other investors, the market will clue in. These actions put dark clouds over projects as investors loose confidence.

Chapter 13: Operating Health of Cryptoasset Networks and Technical Analysis

1. Miners: Miners are the computers that support proof-of-work blockchain networks. The more miners are working on a network, the more secure it will be. In order to attack a network, an attacker would have to set up an equal amount of computers to gain control. Hence, the more computers are participating, the more expensive to attack.

A way to calculate the cost to attack the network (or the capital securing it) is for an investor to investigate the cost of each computer, how much it produces (the returns). To calculate the cost of the network, divide the total network by the computer’s hash rate (to get the approximate number of computers) and multiply it by the cost of the computer. Examples below:

“Using $660 million for Bitcoin and $294 million for Ethereum [referring to estimated value of mining hardware supporting each network], while the network values for the two cryptocurrencies are respectively US$17.1 billion and $4.7 billion, we get a range of 3.9 cents to 6.3 cents of capital expenditure per dollar secured by the network. This range is a good baseline for the innovative investor to use for other cryptoassets to ensure they are secured with a similar level of capital spend as Bitcoin and Ethereum, which are the two best secured assets in the blockchain ecosystem.”

Miners should be decentralized — although the authors argue that decentralization can be measured by way of mining pools, I believe geographic distribution through different jurisdictions makes the system more robust. (This point is made in the book)

Nodes and miners used to mean the same thing. A [Bitcoin] node is merely a point of connection to the network. As mining hardware became more specialized, the two concepts became divorced. A node needs to have a miner behind it, whereas a miner need not be a node.

Difference between miners and nodes:

“Not all nodes are made equal. A single node can have a large number of mining computers behind it, hence capturing a large percentage of the overall network’s hash rate, while another node could have a single mining computer supporting it, amounting to a tiny fraction of Bitcoin’s hash rate.”

2. Software Developers: Initial “pedigree” of developers is important. Long-term commitment is equally important. Open source software platforms like www.GitHub.com & www.OpenHub.com allow investors to track developer involvement. www.CryptoCompare.com has also created a developer involvement index.

3. Company Support:

Investors should check:

a. How many places/companies accept the cryptoasset? One way to do this is to research websites that show the number of places that accept them, such as www.spendbitcoins.com. This is not as important for cryptocommodities as it is for cryptocurrencies.

b. Has the project raised venture capital? If so, how much?. www.CoinDesk.com provides some information about this.

c. How many exchanges accept the cryptoasset? How many currency trading pairs does it have? Check regulated exchanges first such as Bitstamp, GDAX, and Gemini — listings on regulated exchanges are positive signs as they are rigorous to accept new assets.

4. User Adoption:

Investors should check:

a. Number of wallets — some networks list the total number of active wallets and users on their networks. This is more difficult for Bitcoin as there are many wallet providers.

b. Google Search Trends on the asset: Research by Willy Woo proposes that Bitcoin user growth is doubling every year. It should grow by an order of magnitude every 3.375 yearas.

c. Number of Transactions: Most network scanners display this information. www.blockchain.info and www.etherescan.io

i. Dollar value of those transactions.

A POTENTIAL VALUATION METHOD FOR CRYOTOASSETS

“One valuation method we are considering is to calibrate how much the market is willing to pay for the transactional utility of a blockchain. [To calculate] we divide the network value of a cryptoasset by its daily transactio volume. If the network value has outpaced the transactional volume of that asset, then this ratio will grow larger, which could imply the price of the asset has outpaced its utility. We call this the crypto ‘PE ratio’”’.

“Upside swings in pricing without similar swings in transaction volume could indicate an overheating of the market and thus, overvaluation of an asset.”

“It appears that bitcoin has a comfortable base when its network value is 50 times its daily transactional volume. Maintaining a price that keeps the ratio near 50 could indicate that the asset is being fairly priced, and wide swings beyond that range can signal bearish or bullish trends.”

Personal note: Bitcoin spent most of 2017 hovering at around 100. Today, this ratio for Bitcoin is hovering at around 200, suggesting that it is overvalued. Interesting insight.

Technical Analysis — I will deliberately skip this part of the book. It covers basic technical analysis terms/indicators on trading charts — arguing that they can provide good entry/exit points to investors. Pay attention to trading volume.

Chapter 14: Investing Directly in Cryptoassets: Mining, Exchanges, and Wallets

Mining: Mining investment returns are a function of hardware costs, operating costs (hosting), and the earnings of the machine. Profitability of miners can be checked in websites like www.cryptocompare.com

Not in book: ASIC hardware prices can be checked on manufacturers websites such as www.bitmain.com

Cloud mining: Some websites allow investors to rent mining hardware and earn the returns that they generate. Some of these websites are www.genesismining.com and www.nicehash.com

Staking: Staking is a way of “mining” on proof-of-stake networks. Investors “stake” funds for a fixed period and earn a yield.

Cryptoasset Exchanges:

Over The Counter (OTC) Exchanges: Private exchanges where large amounts are transacted (commonly used by large miners and large investors). These private exchanges do not display the orders to the public-facing exchanges.

Exchanges: Open to the general public — have fiat onboarding ramps/capabilities. Many exist now — some regulated and some are not.

When selecting an exchange, it is important to check:

1. Security: How do they store your cryptoassets? Protection from hacking.

2. Access: How many cryptoassets do you have access to?

3. Reputation: What is the reputation of the exchange?

4. Are there extra capabilities offered? Like Derivatives or Margin Trading?

5. What funding mechanisms are available to open an account?

6. Is the service geographically constrained?

7. What are the Anti Money Laundering and Know Your Client Requirements?

8. Does the Exchange provide insurance?

Popular exchanges: Gemini, GDAX, Bitstamp, Kraken

Wallets:

Wallets can be divided into Hot and Cold wallets — this refers to whether the wallet’s private keys are stored in a device that is connected to the internet or not.

In “hot” wallets, the private key is located in a device connected to the internet. It can be in a computer/device, or a third party online wallet provider.

Cold wallets are wallets that store the private keys in locations that are not connected to the internet — such as paper, offline computers or devices.

In both cases, the private keys can be held either by the end-user in the device, or by a secure third party (as is the case with cryptoassets under custody of large institutions). They use vaulting services like Xapo.

· Hot Wallet

· Investor Controls Private Key

· Hot Wallet

· Third Party Controls Private Key

· Cold Storage

· Investor Controls Private Key

· Cold Storage

· Third Party Controls Private Key

Hot wallet examples: Exchanges, most web wallets, Blockchain.info, Coinbase.com.

Cold wallet examples: Hardware wallets such as Trezor, Ledger Nano S, KeepKey and paper wallets.

Chapter 15: “Where’s the Bitcoin ETF?”

Cryptoasset Investing in Capital Markets:

GreyScale Bitcoin Investment Trust (GBTC in the OTCQX market)

https://grayscale.co/bitcoin-investment-trust/

ArkInvest ETF — ARKW (owns shares of the GreyScale Bitcoin Investment Trust — also known as BIT)

https://ark-funds.com/arkk

Cryptoasset custodial services:

Xapo it is a company that offers vaulting of crypto assets for large institutions. It provides maximum security cold storage for cryptoassets.

https://xapo.com/

Tracking Bitcoin Price in the Capital Markets:

New York Stock Exchange bitcoin pricing index NYXBT (https://www.nyse.com/quote/index/NYXBT)

Chicago Mercantile Exchange Bitcoin Real Time Index:

(http://www.cmegroup.com/trading/cf-bitcoin-reference-rate.html)

Tradeblock Index (XBX):

(https://tradeblock.com/markets/index)

Chapter 16: The Wild World of ICOs

Note: I will largely skip this section aside from the tools that they share to research and track ICOs.

Authors prefer the term “Initial Cryptoasset Offering” as most recent offerings include much more than just “coins” or “tokens”.

Keeping Track of ICOs:

Smith + Crown is a well-respected firm that positions itself as an information source for the ICO world. https://www.smithandcrown.com/

Countdown http://www.icocountdown.com/

Cyber-Fund https://cyber.fund/radar

CoinFund ICO Slack channel: https://coinfund.slack.com/

The Howie Test for Discerning If an ICO is a Security:

“If an asset meets the following criteria, it will likely be considered a security:

1. It is an investment of money.

2. The investment of money is in a common enterprise.

3. There is an expectation of profits from the investments.”

Personal Note: Investors can take a margin of safety by assuming that all ICOs can be treated as securities.

Chapter 17: Preparing Current Portfolios for Blockchain Disruption [not summarized]

Chapter 18: The future of Investing is here [not summarized]

Chris and Jack’s Go-To Crypto Resources:

www.BitcoinMagazine.com

www.BitInfoCharts.com

www.Blockchain.info

www.BravevNewCoin.com

www.CoinCap.io

www.Coin.Dance

www.CoinDesk.com

www.CoinMarketCap.com

www.CryptoCompare.com

www.coursera.org/learn/cryptocurrency

www.Etherescan.io

www.Exchangewar.info

www.Google.com/alerts

www.BitcoinandBeyond.com

Twitter Handles:

Chris Burniske @cburniske

Jack Tatar @JackTatar

My personal twitter handle is @Cryptonomista

Chris and Jack, if you read this — thanks again for a great book.

To everyone else, thank you for reading. Feel free to share if you found this useful.

Mauricio

Do you even Proof-of-Work bro?

Bitcoin mining is a high-stakes game with asymmetric returns built into it. The network protocol pays rewards to participants (aka miners) in exchange for the computer power they contribute to it. Every day, roughly 1,800 Bitcoins are issued to miners as rewards for their work. A miner’s rewards can be ball-parked by dividing the hashrate it contributes to the network by the total network’s hashrate. All mining computers are not created equal — some are faster, and more profitable than others. It’s an arms race between miners to develop more powerful and efficient equipment, and to operate in the lowest cost structures globally.

As the price of Bitcoin goes up, so does the dollar value of the rewards. Juicier rewards motivate more participants to join and existing ones to grow. Since miners cannot be built and installed as quickly as Bitcoin price rises, the installed miners will experience asymmetric gains during sharp rallies. Conversely, if more miners pour in at a faster rate and the price of Bitcoin collapses, many will experience losses. The network is regulated by market incentives that allow for boom-and-bust cycles.

The recent run-up in Bitcoin prices from November 2017 to January 2018 motivated an onslaught of new mining investments totalling over a thousand megawatts. Some mining companies even went public (Hive, HashChain, CryptoGlobal), raising millions to buy more computers and set-up sites.

The power demand from miners is seen by some as ludicrous. This has led to people debating other ideas of reaching network consensus. Prominent developers are already working on one potential solution that gets rid of power-hungry miners — a new consensus algorithm called Proof-of-Stake.

Proof-of-Work Mining: A tragedy-of-commons, sort of

The POW algorithm in Bitcoin provides economic incentives for anyone who contributes computing power to verify and post transactions to the network. Literally anyone with a computer can participate. When new transactions are broadcasted to the network, computers compile them and compete to write them into a new block. The computer that first hashes the correct answer will earn the right to write the block and be rewarded 12.5 Bitcoin.

Each proposed block solution must include: all of the transactions in the previous block, new transactions in the last 10 minutes, and an acceptable “nonce”. This “nonce” is an artificial complication built into the protocol. It is intended to make the hash solutions harder as more miners join. By regulating the difficulty of the nonce, the network ensures that blocks will be written every 10 minutes and pay the exact same fees, regardless of how many miners are participating. The difficulty of the nonce gets adjusted every 2,016 blocks or roughly every 14 days.

As mentioned above, mining returns are a function of equipment cost and operation costs.

Miners that bought equipment and were profitably mining Bitcoin at $5k will be much more profitable if Bitcoin goes to $10k in 2 weeks. But miners that set up profitable operations with Bitcoin at $10k may not be profitable if Bitcoin goes to $5k. Let’s use examples to illustrate:

On July 1st, 2017 Bitcoin was at $2,514 USD. Bitmain Antminer S9s were priced at $1,415 USD — and colocation rates for miners in North America were around $0.11/kWh. If you started mining on delivery date (September 1st, 2017) — and depreciated the S9 over a year, you’d get approximately 1.44 BTC over the course of 1 year*, at an all-in cost of $2,721. This equals a proxy value of $1,947 per mined BTC. A 22% discount to outright purchasing the coin on the same July 1st, 2017.

Let’s fast-forward to December 1st, 2017, Bitcoin was trading at $15,006. The same S9 was priced at $2,730 (yes, exact same one, in the exact same website). Colocation rates were up to $0.15/kWh, if you could find any space. Assuming that you started mining February 1st, 2018 and depreciated the S9 over a year, you’d get 0.41 BTC* at an all-in cost of $4,474 — or $10,859.11. That price was a great discount to the price in December — but not so much right now when you can buy Bitcoin outright for $7,800 at the time of writing.

This arrangement almost guarantees asymmetric gains to miners in periods where Bitcoin price and adoption outpace the growth in the hash rate. Many are drawn to these expansion gains — unaware of the pain that can come during market corrections.

Mining can be a great business, if you have access to the best equipment (at cost), and a facility in the lowest cost hydro jurisdiction in the world. In the absence of either of these 2 conditions, outsized returns (or returns overall), will be temporary.

POW is not a perfect system but it works. And it works very well because the “wins” and “losses” are contained to a few market participants. Yes, it lends itself to centralization. Yes, it favours those with ASIC building capabilities and abundant natural resources asymmetrically. But that is how nature works — and containing the wins and losses keeps individual participants honest, providing temporary outsized incentives to innovate and accelerating the death of the inefficient ones in downturns. It makes POW a very antifragile and robust complex system.

If there is any value to Bitcoin, someone somewhere should find it profitable to mine the next block.

Proof-of-Stake to the rescue

The most anticipated Proof-of-Stake upgrade is Ethereum’s. It is a network with a market capitalization of $44 Billion USD that is scheduled to switch from POW to POS as early as this year. Its creator, Vitalik Buterin, described his POS design philosophy back in December 2016 and I have been trying to understand how it would play out since.

As I understand Vitalik’s concept (feel free to correct me), the idea sounds …simple? Participants would deposit their own funds into (presumably) a staking account. Staked funds would be inaccessible during a fixed period of time. Stakers would then be rewarded for good behavior or penalized for malicious conduct. Details have not been released but, presumably the network rewards and transaction fees would be evenly distributed amongst the stakers. Again, details are not released but let’s assume that stakers would be rewarded proportionately based the amount staked and the length of the stake. Kind of sounds like something I’ve heard before. Let’s dig deeper.

For simplicity’s sake, let’s assume that there are 3 stakers in the network during month 1. All of these participants are behaving well, in order to get their rewards. This would be a good time to mention that under Ethereum’s POS, the penalties would be asymmetrically larger than the rewards to prevent attacks. Ok — so 3 participants all staking different amounts over the same period of time. Assume the staked amounts below:

Month 1 Funds at Stake: 1,011

Participant A: 1,000

Participant B: 10

Participant C: 1

Now, assume that over month 1, a total of 3 Ethers were collected in fees and rewards. The bounty would then get divided as follows:

Participant A: 98.9% of the bounty (2.97 ETH)

Participant B: 1% of the bounty (0.3 ETH)

Participant C: 0.1% of the bounty (0.03 ETH)

That works out to the same interest rate for everybody (3/3,031 = 0.29%) for the month. Equivalent to a 3.5% annualized return (0.29% x 12 months = 3.49%).

This sounds great so far — let’s see what happens if we randomize one of the inputs like, say, the network rewards or the value of the amounts staked:

Assume that the same participants remain staking for month 2, but that due to a fortuitous event, many people decided to buy and transact in Ether during that period. A total of 100 Ethers were collected during that time.

Month 2 Funds at Stake: 1,031

Month 2 Network Rewards: 100

The effective annualized return for the stakers in month 2 would be 116%! This would, in turn, cause many more people to stake. As staking could be done immediately, people would rush to buy Ether to stake.

Now, let’s assume that for month 3, ten times as many people staked and the staked amount went up to 10,310 Ethers. Later in the same month, unfortunately, people found it too expensive to transact in Ether and rewards took a huge 10x dip.

Month 3:

Funds at Stake: 10,310 ETH

Network Rewards: 10 ETH

Effective annualized interest rate: 1.16%

People that bought Ether looking for 116% staking returns will not be happy with 1.16%. They will likely sell their holdings and cascade the price down.

This is an extreme example, just to see what would happen under volatile environments. This type of staking, unaltered, welcomes wild swings in Ether demand and price as the interest rates go up and down (much like FIAT). Some would argue that these the peaks and troughs can be “smoothened out” artificially. What would that look like?

Proof-of-Systemic-Risk

Options include, creating a central authority to regulate on a “normal” interest rate. To ensure the rate was kept, it would collect excess rewards in up times, and issue new Ethers to ensure enough rewards are paid in down times. I have many issues with this solution. For one, its central banking all over — and second, artificial tranquility comes at the expense of large asymmetric shocks in the long run (think of it as a grand “bust” cycle made up of all the contained “little busts”, compounded) — idea borrowed from @nntaleb’s Black Swan.

Ok, so what?

My central argument is that boom and bust cycles are part of nature and therefore necessary. Said cycles tend to distribute rewards asymmetrically — and that bothers some, but it is the most efficient way we know of to keep a complex system thriving. Think of nature, the smartest and most complex system of all.

Trying to reduce asymmetries of returns between participants will simply transfer the shock of an asymmetric risk to the system itself. Making the it much more vulnerable and risky.

I am all for innovation, and especially for the conservation of nature. I would love to see consensus algorithms get faster and more efficient. However, think Proof-of-Work mining itself is a huge breakthrough and gets a bad rep. I think it is going to be around for a while — until we figure out something better.

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Refereces:

Bitcoin. Becker et al. [14] estimated the typical cost structures in Bitcoin network and discussed the general viability of proof-of-work approach.

• Bitcoin Network hash rate & Price data from www.blockchain.info
• Assuming that difficulty of September 1st, 2017 remained constant at 888,171,856,257
• Assuming that difficulty of February 1st, 2018 remained constant at 3,007,383,866,429