On Bitcoin and Cryptocurrencies
Having spent the last year or so digging deep into Bitcoin, Ethereum, and Crypto in general, thought it would be a good time to put down my thoughts on the current hype.
Bitcoin is for real:
As a store of value and non-correlated asset, BTC is for real. Most importantly, 2017 is the turning point for Bitcoin — as more and more family offices and high net worth individuals seek entry into this space — the building blocks will be ready in 2018 to allow enormous inflows into the currency. Within the next few weeks, both the CME and CBOE will have launched BTC futures — which will substantially add to the liquidity of the market. Goldman Sachs is exploring setting up a trading operation in BTC. And at the Consensus: Invest conference last week I saw multiple custodial solutions that will finally (hopefully) enable broad based institutional investing in this asset class. Talk to any financial advisor and they are fielding multiple calls a day from clients looking to get into this asset. There is a huge wave coming in 2018. And as one of the conference speakers Michael Novogratz said, unlike oil, when if it goes to $150 all of a sudden you invest in fracking, with Bitcoin, supply is limited and cannot be increased without consensus (51% of the miners).
Further evidence of 2017 as a turning point is the plethora of hedge funds investing in crypto — over 90 (!) as of this writing. And many of the top VC funds in the country have also invested in these hedge funds — as a way to get crypto exposure without needing to solve the custodial issues. And these hedge funds are trading in crypto in a world where there are no derivatives (soon to change) and most cryptocurrency is too nascent to truly value. So it’s hard to see how the BTC price doesn’t continue to rise significantly based purely on supply and demand.
There continues to be significant risks in Bitcoin that must be accounted for and in some cases are not discussed nearly enough in my opinion.
First, is concentration risk. The top five miners of Bitcoin are all based in China. One phone call from the government in China to these five miners could theoretically shut down the network for all intents and purposes. Mitigating this risk is that although China has shut down BTC trading many times it has allowed the miners to continue and this represents a vast source of wealth for the Chinese government and it is in their best interests to keep it going.
A second risk is the development of new, alternative currencies and/or forks that incent miners to switch, which, when coupled with the concentration risk above, can results in significant network degradation in a very short period of time. On the heels of the Segwit2x cancellation, with the launch of Bitcoin Cash, BTC lost 80% of it’s hash rate in one day, as miners shifted their setups to a higher paying reward that shared the same SHA256 algorithm. Until Bitcoin algorithmically adjusted the proof of work algorithm for the new reduced hash rate, the Bitcoin network was impacted. The continued increase in value of BTC mitigates this as it provides more value ultimately to support BTC; but in a declining market there is no such mitigation.
A third risk is regulatory — every payment a bank and financial institution in the US makes must be checked to ensure recipients are not in the terrorist and criminal database (the OFAC list). It is naive to believe that this regulation won’t also come to Bitcoin transfers — just last week a federal judge ruled Coinbase must supply the IRS with information on some users. That in and of itself shouldn’t shut down BTC; but there is no question that much of BTC’s early adoption was due to the anonymity of the network.
ICOs: Do You Understand What You’re Actually Buying?
So what’s really up with Initial Coin Offerings? While I remain bullish on Bitcoin and several other more mature cryptocurrencies that have existing strong networks and use cases (Ethereum, XRP (Ripple), Zcash, Litecoin, among others), the vast majority in my opinion of these ICOs make zero sense as an investor.
It makes sense why new types of decentralized companies would be built on the blockchain; and it makes sense why these companies would want to issue cryptotokens early in order to get the decentralized network incentivized to participate as nodes. And it makes sense why a VC who funded the original business wants to also own tokens in the network. But for an individual investor, one must work through exactly what has to happen for these tokens to have any real monetary value at all:
- The technology has to be built (vast majority of these are issued via whitepapers)
- The technology has to be launched into the wild.
- Nodes and network participants need to get online
- Ultimate end users need to adopt the product offering. Often switching from existing incumbents who already enjoy network effects and moats.
- The holding company needs to have enough cash on hand or be profitable enough with user adoption to continue to operate as an ongoing concern.
If these items, 1–5, happen — then, maybe, the cryptotokens underlying the network could conceivably attain real economic value as Bitcoin did. But the risk is not commensurate with the reward. Steps 1–5 are the same risks that all seed stage investors and really Series A or B venture investors take — but they typically get governance, preferred equity, and a whole host of other economic and other protections. Even then, the success rate of seed stage deals is very very low. If you believe 1% of seed stage deals raise a series A, and 30% of Series A stage deals make money, than 0.3% of seed deals make money for investors. In the ICO case, not only does the holder have zero governance or other rights (must be the case so as not to run afoul of securities laws), but the holder has zero claims to any future cash flows from the entity (as opposed to equity). The holder of an ICO is betting that at some point in the future, after the very low probability of steps 1–5 happen, the cryptotokens will have have enough usage and market participants to attain perceived economic value. This is a very very risky bet, to say the least.
So what’s happening? The ICO market is dominated by speculators who have zero understanding of the economic underpinning of these tokens. It’s all about the quick flips.
But what about the Blockchain — isn’t that for real as the greatest technological innovation of the past 10 years?
Yes, and no. Clearly solving the double-spend problem via advanced crypto techniques is an amazing innovation. And the more you look into it, the more mind-blowing it can be. But as a pure technology — blockchain doesn’t scale, yet. Think about credit card payments. Which is more efficient — have one logical database to both validate and store transactions, or having tens of thousands of nodes making complete encrypted copies of every transaction that ever occurred on the network? Now there is a lot of money and innovation working hard to scale the blockchain — Lightning Network is one example — but it’s not there today. For certain types of business formation — think the mutuals or cooperatives of days past — the use of a blockchain to validate and control the network that is owned by the network participants without the need to provide returns to capital — can make sense. But it is a relatively small percentage of all businesses out there, in my opinion. And can the blockchain provide competition to force existing incumbents to lower prices? Yes. But the vast majority of businesses both online and offline as we know it will not be affected.
Note: This blog (the “Blog”) is published and provided for informational and entertainment purposes only. Under no circumstances does the information presented in this Blog represent a buy, sell or hold recommendation on any security, commodity or other asset. The information in this Blog constitutes the author’s own opinions, and none of the information in this Blog is intended to provide any tax, legal, investment or trading advice.