The is the second article in a series on crypto-currency. If you landed here and don’t feel like you have a good understanding of what crypto is I would encourage you to read part one. I wrote that after I got frustrated with attempts of others to explain the concept to me.
Recap – trust by design and its implications
So to recap from the last article, crypto is really about helping people exchange either money or some other good or asset via a system where trust is built in by design. Why? Because all crypto-currencies are backed by a form of blockchain, a distributed digital ledger that ensures that the asset you are exchanging is what you think it is (the “what” of the trust promise), is actually held by the other party (the “where” of the trust promise) and that you are dealing with the party you thought you are dealing with (the “who” of the trust promise). The “chain” part tells us something about provenance (ie. where something came from) which might be useful for some applications. We can think of the “currency” part as bolted to the “crypto” part in order to incentivize the actors who help maintain the blockchain (in the case of many other crypto protocols). In the case of bitcoin it also represent a store of value.
Trust is essential for the exchange of anything —trust that dollar bills you are receiving are not counterfeit, that a Gucci bag you are buying is actually a Gucci bag, that the property you just bought wasn’t previously sold to someone else, that the person you are hiring actually went to Stanford, etc. Without a history of previously dealing with someone, to reduce risk you have to rely on a third party trust provider like an escrow agent, a background check company or a government agency. Doing so is costly — in that you either take a risk, or you pay for those 3rd party trust services or you don’t transact at all.
Now we get to the logical leap that I want to examine today. Because almost all exchanges of stuff require trust and because blockchain provides trust by design, then, crypto-currency advocates would have us believe, there is potential blockchain company for any exchange. As a result we have so many new blockchain based solutions cropping up every month that it is hard to keep up with them.
In this article, I want to examine that assertion and see under what conditions it might hold up. From there we will be much better equipped to figure out the strengths and weaknesses of each crypto company or ICO.
Let’s not yet evaluate protocol tokens, yet!
Lets start by ignoring tokens that are protocol-level or purely designed for the transfer of wealth. These are a little harder to evaluate because these likely succeed and fail based on various technical factors (security, speed of transaction processing/confirmation, transaction costs, etc), your belief in the success of tokens system that are built on top of these protocols and “animal spirits” that places faith in the value of the protocol token as a store of wealth.
Just so you are clear about what I mean by this I will mention an example.
Ethereum is a protocol token that actual serves two purposes.
First it is a token that the market seems to value as a store of value. This is due in no small part to the fact that its development was directed to address some weaknesses of Bitcoin (namely, slow and costly transactions).
Second, it is also a smart contract system. What are smart contracts? These are zero-denominated transactions which encapsulate a set of instructions. In its most basic form (and this represents > 99.9% of all smart contracts at the moment), those instructions describe a transfer of some other token from one person to another. So if I wanted to create a new token called AndrewCoin, instead of creating my own blockchain infrastructure I could just decide to build it on top of Ethereum. Any transfer of AndrewCoin would simply be described in a Ethereum contract which would be added to the Ethereum blockchain. By abstracting all the hard crypto stuff, Ethereum has made it really easy to make a crypto token. So easy that Ethereum gives you instructions and other websites are popping up to help you create a cryptocoin in seconds. Ethereum is happy to provide this service because it generates a small transaction fee to help pay their miners and that drives growth in the use of their protocol.
And ,if the protocol grows, the price of Ethereum coins will increase (as supply is more or less fixed). And if people perceive that Ethereum is growing in adoption then people are more likely to see it as a store of value (which also creates positive pricing pressure because more people hold their coins, reducing supply). A nice positive feedback loop.
Heads up, I like protocol coins, but more on that in another post.
The great unwashed masses of non-protocol tokens
Lets first get out of the way the ridiculous coins that really don’t deserve a place on the face of the earth. That many of these hold some sort of value is a testament to the hype in the market.
Let me give some prime examples (it would be impossible to give an exhaustive list).
Dentacoin … a cryptocoin that is accepted as payment in some dental clinics (market cap: $138M)
Unobtanium … a cryptocoin whose only purpose is to be rare (market cap: $40M)
Trumpcoin … a cryptocoin that is somehow supposed to help Trump’s agenda (market cap: $625K)
Whoppercoin … a cryptocoin that you can use to buy Whoppers at Burger King in Russia (market cap: worthless but still trades)
BitCoen … a Jewish cryptocoin (apparently successful but can’t find the market cap because Google thinks I am misspelling Bitcoin)
Incredibly, people are investing in these and other similarly dubious crypto coins. Worth checking out is yetanotherico.com that auto-generates an ICO website. This would be pretty damn humorous if not for the sad fact that people are investing in these things.
If only there was a way to short crypto coins …..
What about coins that purport to serve some sort of trust-related purpose?
Then there is a long list of coins that articulate a reason for being.
I’m now reading more “white papers” than when I was in unversity
Usually the best place to look is the top righthand corner of their website where there is usually a link to the “whitepaper” for the coin. This should explain what the coin is designed to do and why it is better than the pre-crypto alternative. Some of these are written as marketing copy while others are more technical. Most serious investors take the time to read these because they tell you a lot about the quality of the team and the technical underpinnings of the crypto system that they propose to use. (Unfortunately many these are of poor quality, leading to commentators openly drawing comparisons between crypto white papers and toilet paper (see here for example), with the primary difference being that only toilet-paper comes pre-rolled. )
When I review whitepapers, the principle question I try to answer is “what problem is crypto trying to solve?”. And not just solve but solve considerably better than the existing market. In entrepreneurship, the adage goes that you either should be making a whole new market or need to be 10x better than the alternative in an existing market. There is no reason why this equation shouldn’t hold also for any new crypto business. Blockchain might be the beginning of internet 3.0 but we shouldn’t forget that there is an Internet 2.0 that is doing reasonably good in many areas. In other areas, blockchain could really step things up. The key is to figure out which areas.
So lets talk about some lenses of “trust”.
Trust that the asset actually exists (the “where” of trust)
Bitcoin is unique in that it is entirely encapsulated by the protocol. It defines how bitcoin is created, it defines what it is, it defines the only way it is transacted and it defines the only way it is stored. Nothing exists outside of the system. In fact the only moment of trust involved is when you fund a wallet with money from your bank account (was the money yours? is it clean money? etc). And the bitcoin network doesn’t take that risk, bitcoin wallet companies do.
As people have sought to bring blockchain to other areas of commerce, there is a provenance problem that is hard to overcome. Let me refer back to an example I gave in a previous post – that of BRICKS, a blockchain for transfer of real estate. Lets assume it is universally adopted.
While my blockchain could irrefutably prove that I am the owner of a house at 10 Emu Flats Drive in Darwin, Australia, how do you know for certain that there is actually a house at that address, or even that that address exists? You are placing faith in the person or entity who created the asset in the first place. Such a problem exists whenever blockchain is designed to facilitate the transfer of physical assets or services. In those cases ownership ≠ existence. You’ll still need to involve an escrow agent or other 3rd party to ensure that that asset exists.
This is not a contrived example. Take Syscoin (market cap: $220M), for example, marketed as the Ebay of crypto. You list your goods and other people buy them for Syscoin. Their value proposition for the customer is that there are no transaction fees. But there is similarly no guarantees that the product you are buying exists and transactions once undertaken cannot be reversed.
Trust that the asset is actually owned by me ( the “who” of trust)
Bitcoin by design ensures that you cannot sell the same bitcoin to more than one person. It does this two ways. First, the only way you can transact bitcoin is via their blockchain. Second, for a transaction to be accepted on the blockchain, the person sending the bitcoin needs to have enough in their wallet.
Lets say I sell you my house on the BRICKS exchange. You are comfortable that the house exists as you have visited and seen it with your own eyes. You are ready to transact. There is a problem however – I have already sold the house to another party outside of BRICKS. The BRICKs blockchain doesn’t know this because that transaction was “off the chain”. Once again the only solution is some form of escrow or land title registry, which is exactly the trust entity that you were looking to avoid by moving to blockchain.
There are many ICOs underway that seek to implement such title transfer systems for houses, cars, boats, etc. But if you cannot ensure that such a system is the only way to trade (which would require a government-backed solution) then this problem is hard to address.
Trust that the asset is correctly described (the “what” of trust)
Bitcoin as a system encapsulates precisely what a bitcoin is. As a unit of exchange such a description isn’t particularly descriptive but includes two really important elements – first, a numerator, and second, a denominator. Any time you look at your bitcoin wallet you know what you hold and you can also know how many bitcoins are in circulation and how many are trading at any one time.
Ever bought an item on Amazon marketplace that wasn’t new? For example, something that was described as “like new” but when it arrived you discovered that it looked like it had been chewed up by a dog? Amazon or the marketplace vendor will refund that for you, something which is paid out of the margin they earn selling the item. How does that function in the blockchain world?
Take for example, Blocklancer, a blockchain based marketplace for the freelance services. I execute a smart contract that describes I will pay $1000 for a piece of code for a website I own. The smart contract is executed once the code is delivered. But what if the code isn’t fit-for-purpose? How do I ensure the quality of the service that is delivered. Their solution, at least so far, is that they help “vet” the exchange of services. Which is, once again, putting a trusted 3rd party into the transaction. The “what” of the exchange is not encapsulated perfectly by the transaction (and if it was you wouldn’t need the developer in the first place) so you have to trust a 3rd party.
And to illustrate the importance of understanding the system that a coin would trade in lets talk about Astrum, a new token that is designed to be a medium for payment for fashion items. Any tokens you hold are something of a claim on the network they would create — the more the network is adopted, the more valuable the coins. But recall that transactions for fashion items can happen off-the-chain as well with good old cash. So how can you really understand demand in a system where there are substitute transaction paths. Said a different way, if everything that would be sold using such a crypto-currency also has a way to be transacted in US dollars then the value of the crypto-currency is effectively pegged to the US dollar. The only reason for a movement in the currency would be pure speculation.
So what? Are there some principles to follow?
It might seem that I am pessimistic on blockchain and crypto. I am not! I believe that it can solve some fundamentally interesting the situations. But it isn’t a solution for every trust situation and it scares me when I see crypto-currencies in the market that have valuations north of $50M that can’t explain why they are significantly better than the alternative . I wouldn’t invest in those businesses as an angel investor and so I don’t see why someone would invest in their tokens. A lot of people are going to lose money.
There is no golden rule to separate a good blockchain company from a poor one. There are a few rules though that have proved helpful for me:
- Digital over physical. Digital assets just seem to be more able to be encapsulated by a blockchain system. Some examples might approaches to managing digital identities, digital asset management (eg. images, audio, video), managing your own privacy and data, monetizing your online attention.
- Where provenance is a big issue. Often quoted examples include supply chain solutions for rare things like diamonds, artwork, high fashion, etc. The difference in value between real versus fake (or for example ethical versus blood diamond) is high, so solutions that help mitigate some of that risk (even if not all of that risk) have the potential to be valuable.
- Consortium approaches. I’m much more excited by solutions where existing players with a large part of a market are willing participants in a solution. For example, a blockchain for high fashion could work if major players were foundational members and agreed to create an entry in a blockchain for every item that is manufactured.
- Solutions that bring existing collateral. Too often blockchain companies assume that that other stuff that is not “trust” is not necessary for creating value. But companies like Ebay are not just trust marketplaces – they provide features, UX, liquidity, and much more, that is valuable. New crypto-based solutions would also need to build these in order to create value. Now if Ebay said they were going to put their user and reputation system on a blockchain and open it up for others to build on, that would be a really interesting idea ….
Help me complete my list. If you have another principle that is helpful, please let me know.
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I hope that this has been helpful if only to reinforce that it is important to approach companies and ICOs in the crypto space with a healthy dose of skepticism.
Next in the series will be a review of protocol coins and how to assess value in them.