What Warren Buffet Doesn’t Know (Yet) About Cryptocurrencies… and Proof

Warren Buffet, the world’s third richest man, doesn’t like cryptocurrencies very much, or at least he doesn’t think he does. Mostly this is because he sees cryptocurrencies as an asset class akin to commodities… And here’s what he has to say about commodities:

“The problem with commodities is that you are betting on what someone else would pay for them in six months. The commodity itself isn’t going to do anything for you….it is an entirely different game to buy a lump of something and hope that somebody else pays you more for that lump two years from now than it is to buy something that you expect to produce income for you over time.”

Regarding cryptocurrencies specifically, he goes on to say (albeit in a different venue):

I can say almost with certainty that they will come to a bad ending

He and I have different definitions of cryptocurrency. Makes sense… I find myself in this scenario because Bitcoin and cryptocurrency have kinda been synonymous for quite some time. While Bitcoin is marvelous for the transparency of its network, decentralized consensus processing capabilities, and laying the cryptocurrency groundwork, there has emerged a cryptocurrency industry as diverse as the travel business itself: space ships, self-driving cards, bicycles, Ford F-150s, shoes for marathon runners… like the business of travel, the industry of cryptocurrencies has broadened quite a bit.

Ya see…

It was back in the Spring of 2017. I bought a cryptocurrency called TaaS for 75 cents/TaaS. I bought a few thousand coins. Each quarter since then, the ownership of this cryptocurrency has generated returns in the form of Ether, while the coin itself has increased more than 5-fold (and that’s during this beary bear market). Even if the value of my TaaS holdings went to zero, the income the TaaS holding have generated is much greater than how much I paid for the coins in the first place. That’s because there is a team behind TaaS that is investing in other digital assets and using the transparency of cryptocurrency/blockchain technology in order to distribute returns. They even use blockchain technology to prove the transparency of their investment executions to calculate returns. More than I can say for your traditional fund. Meanwhile, surely bitcoin can be seen as a commodity (while my lovely cryptophiles will swear to the end of the earth it’s a currency). Meanwhile, Ether (on the Ethereum blockchain), the second largest cryptocurrency by market capitalization is changing how its blockchain works soon, so that coin holders can “stake” their coins to earn rewards from the network along with miners for helping to drive trustlessness and decentralization… not so much a commodity play, as it evolves. And then there is Proof. We have a decentralized exchange on the way (this Spring, if our development team still agrees!), along with a special coin pegged to fiat-currency (in a trustless fashion, similar to MarkerDAO stablecoins) that generates rewards for Proof token holders based on transaction volume within the exchange. Special note to those on regulation: the system is completely decentralized and autonomous, and managed by rules in smart contracts, as opposed to humans. Not so much a commodity. Side note: I love this industry for this sort of weird awesomeness.

Whereas there is an active management team behind TaaS returns, Proof’s ecosystem is autonomous, whereas Ether is different in that… You get the picture. It goes on and on. Crypto is a technology, more than it is an asset class. However, in this post we will play along somewhere in the middle of these two definitions, as that’s what’s probably most suitable. While Ethereum’s core development teams are mostly focused on driving adoption via forums, github repos, events and competitions, our core development team is focused on driving adoption specifically for our purposes by partnering with large asset managers into (and moving into) crypto through our latest “bloomberg for crypto” platform. This solves problems for us, like fair valuations in markets that are much more bazaar than cathedral (revolution OS reference). Ultimately, no matter how much the industry of cryptocurrencies is driven by autonomous, trustless systems, there are still businesses being built, pulling from traditional methods, as well as newer frameworks made possible by this wonderful world of blockchain. Dear Mr. Buffet, and those who also follow the Benjamin Graham school of thought, this post is for you (and my lovely cryptophiles as well). Because we’re all going for the same thing in the end.

At the end of the day, whether we’re talking about sandwiches at your local deli or equities trading on the NASDAQ, price is derived from supply and demand. When we talk about traditional financial instruments, like stock or debt instrument, we hear the words “undervalued” or “overvalued” when it comes to today’s price. When it comes to investment vehicles, price is a culmination of market participants expectation of future returns, but matched with price manipulation schemes of savvy investors (traders illegally front-running, corporations legally buying back their stock, speculators in the middle of “pump and dump” schemes… the list goes on). However, price is still today’s demand (whatever the motive or activity) with respect to the rate of creation and existence of that thing (or “demand”). But price isn’t value. Many argue, and I think correctly, that value wins out in the long run, at the very least when there’s no standing army enforcing a price, but that’s a different discussion.

Regarding cryptocurrencies, many of the partners we work with (and the greater global investment community in general) are asking: how do we value this stuff? A stock is valued by its quarterly earnings, its management, the market potential its future products have, its acquisition activity, its debt-to-earning ratio… this list goes on… how its competitors are valued… how a particular activist investor is taking an interest in it…

I wrote this blog post to lay the groundwork for a larger piece, but to lay out a few of the areas I think are important to understanding the actual “value” of a cryptocurrency, as it relates to a price.

As not-so-conspicuously stated before: cryptocurrencies vary. I think the utilization of blockchain, or more broadly distributed ledger technology, will one day be seen literally as mostly the tech and not as much the asset class. Today though, cryptocurrencies are typically seen as their own asset class, so, as promised, we’ll stick with thinking of them kinda like a hybrid asset-class/settlement-technology for now. Valuing these different kinds of cryptocurrencies in one bucket is a bit tough, so some of the following four metrics I’m exploring apply more to some cryptocurrencies than others.

  1. Ecosystem Fee Pricing & Volume

About 2 months ago, if you wanted to process a simple bitcoin transaction ($1 to $1,000,000+… doesn’t matter…, it would cost you more than $15 if you wanted that transaction to confirm and be accepted by a vendor/exchange within an hour. That’s when transaction volumes were very high and the price per coin was more than double what it is at the time of this writing. Today, you can get a transaction confirmed many times over in less than an hour for $.06 (yes, six pennies) or less. This means miners, the guardians and air traffic control of the bitcoin blockchain, are making much less to process transactions, and getting a lower return-on-investment for their expensive equipment. To note: Fees are double-edged swords. The higher the fees, the more people flock to alternatives, like Bitcoin Cash in the instance of Bitcoin “Core”, because Bitcoin Cash has lower fees and larger block sizes (more scalable). For Bitcoin Core, with very low fees and low traffic, miners are not making much money, which means (because they are also getting block rewards separately, and the value of the coin is lower these days), they have less incentive not to liquidate the coins they earn into other currencies, dropping the price, as they are they ones who get all of the created coins every day. The people/exchange (akin to large banks doing business with central banks for this examples) buying these coins from the miners (akin to the central bank, producing more supply of cash, for this example) watch their liquidation rates, and determine the coin price based on supply and demand metrics.

Regarding the second largest cryptocurrency by market capitalization, Ether: miners recently saw a reduction in block rewards by the network for processing transactions, but increased demand, with more people needing to leverage the payment rails of Ethereum for games like Cryptokitties and initiatives like ICOs. As ICOs have become less popular, there has been less demand for the Ethereum ecosystem in that category, while dApps (Casinos, games, funds, tokens) running on the Ethereum platform have increased, yet not yet at the rate to replace the volume that ICOs were getting. As more games go viral on the Ethereum platform, demand for Ether will increase, driving up fees given the limited blocksize, meaning people will pay more… We will get to this more in the ecosystem demand portion of this.

There is Ethereum Classic which has lower fees and operates the same way as Ethereum. The caveat is that Ethereum Classic does not have as many miners/validators, nor the size of the community. It’s all a balancing act. This is why ecosystem fees are so important. Tokens that sit on top of blockchains like Ethereum, which are also cryptocurrencies, each have their own set of rules around fees, while most of them simply require one to pay a fee in Ether, not in the token (cryptocurrency). So this particular metric applies more to cryptocurrencies native to a blockchain (blockchain-native cryptocurrencies), rather than token cryptocurrencies (smart contract-based cryptocurrencies) that sit on top of said blockchains and require fees in the blockchain’s underlying cryptocurrency to process. The exceptions are token coins like Raiden, which require you to pay fees to utilize certain utilities. There are many others that do this. And for those, similar concepts apply as they do with blockchain-native cryptocurrencies.

2. Inflation

The beauty of blockchain really derives from its transparency, in the sense that there are immutable rules that govern how cryptocurrency is created. Regarding bitcoin, there is a date in over 100 years from now in which the Bitcoin blockchain will stop rewarding miners with coins, leaving them only with transaction fee rewards. The Ethereum blockchain will not do that, and will reward miners every block forever but at a rate agreed upon by the miners. Early last year, that rate was 5 Ether per block. Now, it is 3, but there are more blocks. These rule changes, like with most blockchains is based on governance protocols shared by the thousands of computers keeping the network running. For different blockchains the rules are different, but the rate of supply creation and the governance around supply creation amendments is a key factor to the value of a coin. Regarding tokens that are not mined, but instead live inside of smart contracts on a blockchain (like our own Proof tokens, Raiden tokens… TaaS coins), there are different kinds of rules, as coins are not mined, but instead typically begin with a fixed, immutable supply. There are exceptions to this rule for token cryptocurrencies, with some driven by a voting system that determines inflation.

3. Ecosystem Utility Demand

The next, and perhaps most important metric, is the utilization of a blockchain or a tokenized smart contract that the underlying cryptocurrency powers. This is similar to the fees & volume metrics, but is more specific to the end-user application that leverages growth leverages a blockchain. For example, Bitcoin does not have smart contracts and therefore the application utility is focused on third-party payment solutions. There are many issues here, obviously, because the price fluctuates so rapidly and greatly. When it comes to the Ethereum blockchain, which has smart contracts, there is much more potential for utility. For example, when a game launches and leverages smart contracts and ethereum-based tokens or Ethereum’s own Ether cryptocurrency, then the quality and adoption of those games drives fees and volumes up, causing a rise in the overall value of a cryptocurrency. This is more of the “intrinsic value” that many equity investors are looking for. However, unlike a stock, there are typically no dividends driven by the operational revenue of the company (many exceptions to that rule in blockchain world), but by the utility of the “pipes”. The closest idea of this is Visa. Every transaction earns revenue for the company which is leveraged by management to grow the operation and then return capital to shareholders. For cryptocurrencies, the value increases based on the demand of people needing the particular crypto in order to participate in ecosystem powered by said cryptocurrency.

4. Rules & Consensus

The next most important metric when it comes to valuing a cryptocurrency are the rules and consensus protocols. For example, blockchains can “fork”, meaning that when something unexpected happens to the blockchain or within an application on the blockchain that is not good for the overall ecosystem, the miners (and sometimes holders of smart contract-based cryptocurrencies) can vote to amend allegedly immutable records that they all store. This rarely happens, but is a topic of much debate. This has led to a variety of Bitcoins and another Ethereum (Ethereum Classic). Ethereum Classic emerged in the early days of Ethereum in 2016 when a smart contract had a loophole in it that allowed a hacker to make off with over $60million work of cryptocurrency. The Ethereum community of miners voted to overturn the hack so that the funds the hacker took were locked. Furthermore, there is the question of how decentralized or distributed a blockchain is. This has less to do with smart contract-based tokens, and more to do with native blockchain-based cryptocurrencies. If a native blockchain-based cryptocurrency has a concentration of miners that control the entire chain (voting and governance), malicious attacks on the blockchain are possible. New rules can be set against the ethos of the original blockchain, transactions of others can be redirected or cancelled, funds within certain wallets can be removed, and more. Once a blockchain becomes centralized it loses much of its value as a trustless system that people can rely on. The more decentralized a blockchain is, the more guarantees of trustlessness, which ensures (perhaps counterintuitively) that people can trust that the rules and transaction histories can be relied upon with their funds. This is obviuously a huge, if not pre-requisite, factor to value in the crypto world.

5. Community Management

Finally, there is the community and management of the community that leverages, builds, and maintains a blockchain. The “leveragers” are the people building applications that use a blockchain/cryptocurrency and their users. This is your Coinbase and their millions of users, your Ethroll (casino), your Bitfinex (exchange), your CryptoKitties (collectibles game) and their fanatics. The “builders” are your core developers that bring the cryptocurrency to like (your Satoshi Nakamotos, Ethereum core developers, etc). And then the “maintainers”: your miners, or the people using their compute power and storage, or financial resources to ensure a blockchain lives on. Without validator, typically “miners” for Proof-of-work algos that the majority of blockchains depend on. How this community works in harmony is critical to the future development and adoption of a cryptocurrency, which produces future value. Last year, during the “craze” this was one of the most important valuation metrics. However, as the markets have developed, people have begun looking not only or over-weightedly (new word) at this metric, but also the others mentioned above.

By truly understanding this areas of a cryptocurrency, the value, in my opinion, can be deduced. The price, however, is something based purely on supply and demand. However, overtime, and especially has more sophistication and volume enters the market, value and price will begin to come a little closer. Something that will be very good for this burgeoning industry.