After many friends and family members asked me to explain my investments in blockchain assets, I decided to write an email. That email turned into this blog post.
The following post is intended for the uninitiated, but I hope those familiar with the concepts will benefit from this lucid overview. So here is a (very) brief overview of the history of blockchain with key takeaways that I think are important for investors to understand. I do gloss over some of the more technical aspects for clarity’s sake.
Caveat: Before diving in, please understand that Bitcoin and blockchain, though often used interchangeably, are not the same thing. We’ll discuss this in more detail.
In 2008, Satoshi Nakamoto (the pseudonym for an as-of-yet unidentified individual) published a white-paper called Bitcoin: A Peer to Peer Electronic Cash System. In this paper, he argued that he had solved the issue of double-spend for digital currency via a distributed database that combined cryptography, game theory, and computer science. Double spend is simply the idea that digital currency can be spent in two places. Satoshi’s creation was a huge innovation because it enabled one entity to confidently transact value directly with another entity without relying on a trusted third party to stand between them.
To illustrate the issue of double-spend, consider purchasing a book from Amazon with a credit card. You are using digital cash to purchase that book. Because digital cash consists of a digital file (like a PDF) it can be duplicated, which is why an institution (often a bank) needs to verify these transactions. Sending a bitcoin is more akin to paying for a hotdog at a hotdog stand with a $20 bill. You hand it over and you no longer possess it. In this sense, Bitcoin was the first native digital medium for the exchange of value. Remember, money is not just coins or banknotes, it’s basically trust. Anything can be used as money, provided that there is mutual trust. The value of money depends on our trust, not on the actual worth of the materials. Money is arguably the most efficient and universal system of mutual trust ever invented.
Below you’ll see a diagram of how a Bitcoin is minted. Please note, there is more than one blockchain. A blockchain is simply a shared, distributed ledger. There is the Bitcoin blockchain, the Ethereum blockchain, and many private blockchains. We’ll get into those shortly.
Investor Opportunity: Bitcoin was the first killer app of the blockchain, as email was to the web. Bitcoin has had a volatile ride since 2008, experiencing a massive multi-year crash and recovery, from $173 to $2800+ respectively. Most importantly, however, it has survived and the core tenets have been proven out. In countries such as Argentina and Venezuela where inflation is astronomical, Bitcoin is used to pay for some goods. Bitcoin may become a de facto store of value similar to Gold and can be viewed as a hedge against instability and inflation. The way Satoshi set up the protocol, Bitcoin is issued every 10 minutes until the total supply equals 21 million Bitcoins. There will only ever be 21 million Bitcoins, a hard money rule similar to the gold standard (i.e., a system in which the money supply is fixed to a commodity and not determined by government) and roughly two thirds have been released. Given the set number of bitcoins in circulation and the expected future funds pouring into the asset class, it’s possible that Bitcoin could reach a price 10–20 multiples higher than its current value. Bitcoin is largely uncorrelated to other asset class, which means a movement in another asset class will not strongly affect Bitcoin. In an era of political uncertainty, this makes Bitcoin an attractive investment. The exhibit below outlines Bitcoin’s correlation in regard to other asset classes:
Risk: Many consider Bitcoin’s meteoric rise to be a bubble and the Bitcoin price to be heavily inflated. The primary risks are:
1.) Bitcoin faces scaling issues. Currently, the Bitcoin blockchain can process roughly 7 transactions per second. For context, Visa can do 1000s. Without getting too deep into the technical details, the Bitcoin community is split over how to solve this scaling issue. A new method of computation has been proposed by some but others have threatened to copy and paste the Bitcoin codebase and start a rival coin, if this new method of computation is adopted.
2.) Government regulation poses a big risk. Both the SEC and EU have indicated their intention to regulate Bitcoin and Japan recently introduced some legislation to do the same. It’s unclear whether Bitcoin will be regulated as a currency and how governments will react.
3.) A few investors known as “whales” own enough Bitcoin to move the market at will. Chinese investors own a significant portion of Bitcoin.
4.) There aren’t many places you can actually spend Bitcoin while going about your everyday life. You can’t, for example, buy a coffee at Starbucks using Bitcoin.
It’s Blockchain That We Love!
Around 2014, technologists and investors shifted their focus from Bitcoin to blockchain, bitcoin’s underlying technology. Though Bitcoin and blockchain are often referred to interchangeably, that’s incorrect. Bitcoin is built on a version of a blockchain. A blockchain is an open, decentralized ledger that can record transactions between two parties efficiently and in a verifiable and permanent way without the need for a central authority. The key qualities of this distributed ledger are that it is time-stamped, transparent (anyone can see the ledger of transactions), and decentralized (the ledger exists on multiple computers, often referred to as nodes).
Many have hailed blockchain technology as revolutionary and claim it has the potential to dramatically lower the cost of transactions, just as the protocols of the Internet lowered the cost of connection. Take, for instance, a typical stock transaction. The transaction can be executed in microseconds but the settlement — the ownership transfer of the stock –usually takes a week. This is because the parties have no access to each other ledgers and therefore can’t automatically verify that the assets are in fact owned and can be transferred. A number of intermediaries (i.e. banks, escrow & credit card companies) act as guarantors of assets as the transaction is verified and the ledgers individually updated. See below for the transaction process as of June 2017 compared to the future:
The realization that blockchain could be uncoupled from Bitcoin and used for all kinds of other inter-organizational cooperation catalyzed a mad dash of investment. Entrepreneurs and managers set about applying blockchain technology to everything from supply chain management, to hospital records, to digital rights music management. In the frenzy, the term “blockchain” has been bandied about with such frequency as to lose much of its potential meaning.
It’s important to distinguish between a public and a private blockchain. A public blockchain is one that anyone in the world can read, send transactions to, and participate in the consensus process. The most prominent examples are Bitcoin and Ethereum. Fully private blockchains are centralized to one organization. Microsoft, for instance, might have a private blockchain for its supply chain. Consortium blockchains are where the consensus process is controlled by a pre-selected set of participants. For instance, J.P Morgan, Goldman Sachs, and Credit Suisse may create a consortium blockchain for inter-bank trading purposes.
Examples of Public versus Private Blockchains:
It’s early, but in 2017 it seems that investors’ exuberance for blockchain applications has outpaced the technology. There is early evidence of blockchain’s impact in the financial sector as startups such as Chain, Ripple, and Abra set out to reinvent settlement, trade finance, and remittance respectively by partnering with major financial institutions. But the jury is out on whether these blockchains (mostly private or consortium blockchains) truly increase efficiency. And whether they are truly blockchains, given that they’re not fully transparent or decentralized. Indeed, some argue private and consortium “blockchains” are nothing more than databases with a facelift.
Investor Opportunity: The challenge is to see clearly through the hype. A useful framework for evaluating blockchain apps is provided by HBS Professors, Marco Iansiti and Karim Lakhani. They argue that blockchain applications will first be single use, then localized, then substitute for existing processes, and finally transform society and economic activity. In short, they argue that because blockchain technology is foundational and requires coordination between many parties, it’s likely that the adoption will be gradual and steady rather than sudden. The below table outlines this evolution of innovation on the blockchain through comparison to the Internet, the last world-changing protocol.
A Roadmap for Blockchain Innovation:
In my opinion, blockchains will decentralize trust and value transfer just as the Internet decentralized the manner in which we share, access, and store information (Wikipedia, Google) and media (YouTube, Facebook). They will create new foundations for our economic and social systems. I predict the impact will be enormous in developing countries where financial infrastructure is sparse and mobile wallets are the main vehicle for money transfer. In the future, blockchain will be an invisible technology layer, like the Internet; consumers will not talk about the blockchain even though it may power large parts of their lives. The question is how this will evolve, how long this will take, and which of the blockchains will dominate.
Risk: Is this a technology in search of a problem? Are blockchain solutions actually 10X better than current database solutions? Is a public blockchain, open and distributed, really suited to many functions where privacy rather than transparency is more highly valued? Will there be a single blockchain to rule them all or multiple blockchains? Where are we in the hype cycle?
The Rise of Ethereum:
If Satoshi is the Muddy Waters of digital assets, wunderkind Vitalik Buterinis the Rolling Stones. An initial contributor to the Bitcoin codebase, Vitalik became frustrated in 2013 by Bitcoin’s programming limitations. A rebel with a cause (though arguably a much higher IQ than James Dean), Vitalik faced resistance from the Bitcoin community as he pushed for a malleable blockchain. Vitalik decided that Bitcoin’s protocol was designed too prescriptive so he decided to build public blockchain 2.0, which he called Ethereum.
Vitalik created a programming language for Ethereum that is more malleable than that of Bitcoin. Unlike the Bitcoin blockchain, which only allows for Bitcoins to be recorded, the Ethereum blockchain allows for the transfer and recording of other assets like loans or contracts. Launched in 2015, this second-generation blockchain system can be used to build “smart contracts” around exchanges. A “smart contract” is a set of programmed instructions for an exchange. Consider the stock transfer example we discussed earlier. A “smart contract” could automate that whole process based on a predetermined set of rules that were coded into the Ethereum blockchain.
Another important concept is “ether”, the token (aka digital asset) that is associated with the Ethereum blockchain. Ether is the “gas” that programmers need to purchase to run applications on the Ethereum blockchain. “Ether” is to Ethereum applications as “gas” is to a car. Therefore, as successful applications are built and run on top of the Ethereum network the demand for “ether” will rise and, consequently, so will the price. This is what is attracting speculators and investors to purchase “ether.”
Etheruem’s recent ascent has been meteoric given its short existence. Since the beginning of 2017, the price of Ethereum has risen from ~$5 at the beginning of 2017 to a height of ~$410, an increase of over 80x before settling back to ~$250 in recent weeks.
Ethereum Price (2017):
So, what is behind this monumental rise in the price of the Ether token? Corporations such as Microsoft, UBS, and BBVA are interested in the smart contract functionality as it may save them time and money in managing, securing, parsing, and storing information. Ethereum has also been used as crowdfunding platform for Initial Coin Offerings (ICOS), which have exploded in the last two months. And finally, good ol’ speculation that the price will continue to rise is driving up the price.
Investor Opportunity: If there were to be a single “blockchain” to rule them all, it seems likely that Ethereum will be it due to its faster processing time, corporate acceptance, and coding flexibility. As an investor, you can participate in Ethereum’s rapid ascent by buying tokens of “ether.” The continued ascent in “ether’s” price is dependent on its future adoption and the number of successful applications that are built on top of the Ethereum blockchain, which will drive demand for “ether”, the network’s gas. Ethereum, however, does not have a limited number of supply, there are 89,752,192 “ethers” (ETH) currently in circulation, and no theoretical cap limiting supply, which could deflate the price. From what I can tell, the number of “ethers” in circulation will be determined by Vitalik and his comrades.
Risks: Firstly, any hack on the system, such as the DAO hack in 2015, would send the price crashing. Ethereum’s coding flexibility and openness to applications means that there is more surface area for a hacker to attack. Secondly, Ethereum also has a scaling issue not too dissimilar to Bitcoin’s, which was exposed when a deluge of ICOs strained the network. Another issue is that both the Bitcoin and Ethereum blockchains are highly energy inefficient, given that each transaction is recorded and replicated on multiple computers / nodes. And finally, Ethereum is heavily reliant on its co-founder Vitalik Buterin. A hoax that reported Vitalik’s death in a car crash sent the price of Ethereum tumbling.
Fat Protocols, Tokens, and Decentralized Business Models or “WE’RE GONNA ICO LIKE IT’s 1990!”
Since the beginning of 2017, Initial Coin Offerings (ICOs) have become the hottest new trend. An ICO is a fundraising event where a group of technologists or entrepreneurs raise money by creating and selling their own “tokens” through a crowdfunding event on a blockchain, usually Ethereum. A token is sort of like a share in a company but without many of the characteristics and protections. The money raised from the tokens is used to build new blockchain-related projects and the holders of the tokens own a stake in these projects. As blockchain technology is expanding far beyond bitcoin to power emerging networks, companies, and activities people are purchasing tokens to participate in this innovation.
Confusion abounds regarding these ICOS. Are they Ponzi, get- rich schemes emblematic of the 90s dot-com manias (as the FT argues)? Or are they simply a more efficient way of raising private capital that skirts the red tape of the SEC?
Some of the smartest thinkers in this space are USV’s Fred Wilson, A16Z’s Chris Dixon, Founder of Coinbase Fred Ehrsam, and Polychain founder Olaf Carlson-Wee. They provide an intellectual underpinning to the fervent interest in ICOS.
The general argument revolves around the idea of “fat protocols”. A protocol, in this context, is a shared set of fundamental rules that enables applications to be built. One of the most important protocols of the Internet era was HTTP, a protocol that defines how information is sent over the web. On the back of this protocol, programmers built applications like Facebook and Google. But while these shared protocols created enormous amounts of value, most of that value was captured by the applications built on top of the protocols. The computer science professors who created HTTP are not billionaires… Mark Zuckerberg is… and many of the fundamental open-source protocols of the Internet era are now run and maintained by not-for-profits, such as the Linux Foundation.
Value Capture Analysis between The Web and Blockchain
By contrast, value will be captured by those building and investing at the blockchain’s protocol layer because of the financial incentives (tokens) that are baked into these network’s design. Network participants (users, core developers, third-party developers, investors, service providers) are incentivized to maximize the growth of the blockchain network because if the network expands, the token asset appreciates as demand for the network increases. Therefore, entrepreneurs can monetize open source networks at the protocol level, which wasn’t possible before blockchain technology. Investors seeking returns need to invest at the protocol rather than the application layer. An example of such a network is Steem, a decentralized Reddit where people are paid to contribute news and content, in the form of tokens. Value accrues to the network’s contributors rather than a centralized owner, a la Zuckerberg.
If you are confused, don’t worry. It’s not simple. Perhaps, an analogy will help clarify the argument.
These “fat protocols” are like the virtual real estate for Internet 3.0 (aka the internet of value). Investing in these protocols is akin to a real estate developer purchasing potentially lucrative land by the beach and building a hotel. But rather than raising financing, the developer decides to give all the contributors to the development (i.e. builders, architects, financiers, and early tenants) a stake in the underlying property asset. Everyone is incentivized to maximize the outcome of this “shared development.” Blockchain networks, with their tokens, possess this incentive structure by design.
Investor Opportunity: These ICOS are undeniably frothy and this is a speculator’s game. The recent growth of the market cap of tokens has been bubble-like. Frothiness is fuelled by the easy liquidity of the market. But the potential of these new blockchain networks is also enormous. In a world where the Big 5 tech companies have monopolistic advantages, this decentralized model represents a shift that could bend the advantage back towards start-ups.
I think investing in ICOs is akin to investing in penny stocks. It’s very high risk. But the skillset required to evaluate ICOs is closer to that of a highly technical venture capitalist than an equities investor. You need to be able to evaluate the core protocol, the lead developers and surrounding community, and the white paper. You also need to use common sense to determine whether decentralization actually makes sense for the use case or is a burden. Despite the current hype, centralization can be more efficient than decentralization in many cases. Nevertheless, the returns for some in this space have been spectacular. Gaining exposure to this upside is likely best achieved via a diversified portfolio of blockchain assets weighted towards less risky assets such as Etherum and Bitcoin.
Risks: Firstly, as a retail investor, you have a huge informational disadvantage. Most of the information relevant to ICOs is discussed in secret slack channels and private forums. Secondly, it’s unclear when the SEC will get involved and how this will impact ICOS. Finally, many insiders are getting rich from the ICOs before the product has attained any degree of success. Insiders are pre-sold tokens before the ICO which amounts to a risk-free trade for them. This is new territory with many opportunists so buyers beware.
Final Thoughts: It’s nearly impossible to predict the day-to-day movements of the digital assets and traders with far more sophisticated technology are on the other side of the trade, often manipulating the prices. You will likely not win if you are day trading. But if you believe in the promise of the fundamental technology, I believe it’s worth investing in the asset class (at the right price) and holding. (N.B. The IRS grants you capital gains if you hold for a year). Clearly, the risk is high and the journey will be bumpy but the return could well be worth it. If money is simply a story that exists in the human imagination, as Yuval Noah Harari argues in his remarkable book Sapiens, then this space is certainly a story to watch.
Full disclosure, I have made investments in BTC, ETH, and LTC, and am an investor in Olaf Carlson-Wee’s Polychain.
BIBLIOGRAPHY & FURTHER READING (not exhaustive):
· An Introduction to Cryptoeconomics
· TechCrunch on how Blockchain technology enables decentralized business models
· Techcrunch on Business in the Age of Ethereum.
· Coinbase’s Fred Ehsran on Scaling Ethereum to Billions of Users and application-specific tokens
· Fred Wilson of USV on the golden age of open protocols
· USV on how value is created at the protocol level in the blockchain space
· Thoughts on Tokens by Bijan S. Srinivasan
· Polychain’s Olaf Carlson-Wee on A16Z Podcast discussing Blockchain Tokens.