I got frustrated by people being unable to explain crypto to me, so I wrote this.

A simple an explanation for crypto, why it is a currency, and what are the beliefs that drive value.

Next year cryptocurrency will celebrate its 10 year anniversary. It has jumped from being a fringe “something” supported by anarchists, to an investment category for VC and hedge funds to something that your average Uber driver is likely to bring up on a trip. It has grown from nothing to >$300B in market cap making countless millionaires in the process. And, yet its still really hard to get a simple, understandable explanation of what is it and why should it be important?

I’m a rationale s-o-b. The only times I got detention in primary school was when I kept asking “why” questions in class. I want to know why things work the way they do or why people hold the beliefs that they do. This doesn’t mean that I need to know the future with perfect clarity.  In the investing world, if something is 100% crystal clear then you are typically too late. But I find that if you ask enough “why” questions you will at least arrive at a clear fork in the future road and as an investor you can at least make an informed choice about which future you want to invest in.

So this is my evolving take on crypto. I hope it helps you in your evaluation of the space.

What is crypto?

Most confusion about crypto stems from the fact that it is actually not one thing but two.

An alternate currency system

Crypto-currency started around the time of the global financial crisis primarily as a reaction to two things. First, the fact that governments control the monetary system and the means to debase the currency through printing more of it. At the time, governments around the world had just lowered interest rates to record lows and there was a lot of fear that this would spark inflation, thus inflating away the value of the currency you held. Second, the financial system was seen as getting increasingly complicated with an intricate web of lending, leveraging and so on (often referred to as the fractional lending and (re)-hypothecation system ). There was a fear that if things really went south, the money that you had stashed in a bank may not actually be there when it came time to withdraw it.

Crypto developed as an attempt to solve these two problems.

First, it avoided the problem of inflation because the rate of growth in the crypto money supply is often predetermined or fixed. In the case of the bitcoin market there were two predetermined constraints on growth in the money supply. First, new bitcoins are created when bitcoin miners (actors who are also responsible for maintaining the bitcoin transaction register – more on this later) successfully solve a mathematical problem that gets increasingly more difficult as more miners and processing power is added to the bitcoin network. Second every 4 years the reward for solving this mathematical problem halves until a total of 21 million bitcoins is reached and new mining is stopped.

Second, it avoided the problem of assets not being there when you wanted to withdraw them by creating a distributed ledger to record exactly who owned which bitcoin (or fraction of a bitcoin). That the ledger was distributed made it much harder (basically impossible) for your bitcoins to be moved without your consent/knowledge. The same could not be said about the traditional banking system in the 21st century. This ledger is what is referred to as a blockchain, an endless linked set of transaction blocks through which you can determine the provenance and ownership of bitcoin.

It was not surprising that early adopters tended to be the same sorts of people who believe that we should return to a gold standard for much the same reason. Physical gold would hold its value because you could only mine it so fast and you could hold it in your hand. But unlike gold, crypto was more easily transferred between parties and didn’t require a vault to store its value. It was, for all intents and purposes, a digital version of gold.

A trust system

Not long thereafter, it became apparent that this distributed ledger was itself an important innovation. Traditionally, any successful exchange between parties requires trust. There were typically three sources of trust – you either had a history with the other party that mean you knew you could trust them, you relied on an objective/impartial third party (like an escrow or custodian service) or you relied on the government (for example, a government land title registry to certify title to property). All three of these trust methods is expensive to establish (as measured in either cost or time).

Trust is even more important in a digital context. Digital assets can in theory be reproduced infinitely. The use of a blockchain removes this characteristic and confirms that each unit of value was transferred only once, solving the long-standing problem of double spending. Thus blockchain itself could be seen as a fourth trust alternative. One where the system itself by design creates trust between parties. And because transactions on the blockchain can be verified inexpensively, this should be competitive cost-wise against other approaches to trust.

A number of applications have been proposed that take advantage of this potentially lower cost trust based approach. For example, the Sweden Land Registry is currently piloting a blockchain-based approach to registering land sales, with the aim of demonstrating the effectiveness of the blockchain at speeding such land transfers. Another company, Publiq, is using blockchain to validate authorship of content to help combat fake news. Other solutions have been proposed that track provenance of goods, ensure diamonds are conflict-free, track food as it moves through the supply chain. The list goes on.

The hype about such solutions is real and it is fueling, to a large extent, the smart money that is moving into this space. Attend one of this talks and you’ll find most “commentators” on the space will refer to the trillions of dollars of enterprise value that Facebook, LinkedIn, AirBNB, Alibaba and UBER command for “essentially providing trust networks”. I’ll let you judge how much you believe this assertion. While it is clear that “trust” would seem to be a necessary condition for the success of those businesses, is it sufficient on its own or are there valuable features to each of those products that have made them successful?

The judge is still out as so far none of these blockchain based solutions has yet been commercially adopted.

Why does the “currency” in crypo actually exist?

This is a great question that I don’t think gets asked enough. In its purest form, crypto currency exists mainly to compensate those companies that maintain the ledger for the service that they provide for doing so. And to some extent the fee that is set depends on the scaleability of the underlying algorithms that power the currency. Bitcoin, one of the earliest protocols, is also one of the most expensive to maintain, with each transaction costing on average $23 dollars to process. Later protocols are less expensive to maintain and therefore in theory cost less to transact with. For example, Ethereum (or Ether) costs $0.33 per transaction.

As no actual currency is exchanged, that transaction cost is allocated in units of cryptocurrency. And for that cryptocurrency to be converted into dollars so that  companies that maintain the blockchain can power their servers, there needs to be a market  for converting crypto-currency to actual currency.

At least until the entire world runs on crypto-currency and you can pay those bills in bitcoins. So the proponents would dream!

What is the market value of a cryptocurrency?

So now we know why it exists, the next question is how do you value what it is worth? This turns out to be a not an entirely impossible question to answer.

“Mining” a new bitcoin requires a tremendous amount of electricity and computing power and that can be measured in dollars and cents. For example, it is under $4,000 in Louisiana and over $9,000 in Hawaii. (Sadly the entire bitcoin mining industry is now consuming the power required to supply 2 million houses. This is not a clean tech.) So there is something of a supply curve for bitcoins that are mined, that is a range of miners who have different mining costs based on the equipment that they use and the cost of their electricity.

Thus, if the value of a bitcoin goes up, low cost miners might add more computation to mine more bitcoins or higher cost producers of bitcoins can come online. If the rate of mining increases then the computing power required to mine a bitcoin also goes up (recall that this is a feature of bitcoin to ensure that the upper limit of of 21m bitcoins is not exhausted before 2040). If more bitcoins are mined then this should add supply and create downward pressure on the price of bitcoin.

Said differently, whenever the price of bitcoins exceed significantly the cost of mining a bitcoin, there is a natural tendency for the two values (price and cost) to converge. Such a relationship also holds when the price falls below the cost to mine.

This is not a feature unique to bitcoin. As the gold price or the oil price increases it becomes economical for gold or oil producers to mine more fields or increase production. As that increased supply hits the gold or oil markets it tends to create downward pressure on the market price.

Unlike gold and oil however, it is infinitely easier to hold bitcoin. While large hedge funds can afford to fill oil tankers and float of the coast of the US waiting for such a convergence, such strategies are generally not available to ordinary investors.

So what are the risks of investing in crypto-currencies?

While easier to hold, crypto-currency has a few disadvantages that are no immediately obvious.

First, crypto-currency doesn’t have the same sort of stopgaps that exist in those other commodity markets. There is not a natural demand for bitcoin in the way that there is for oil or gold. The price of oil will never fall to zero simply because (i) we need oil to power our economies and (ii) the cost of oil production will always have a floor above zero. The same can be said for other commodities and precious metals. Bitcoin is really only intrinsically worth as much as people value it (more on that point in a second).

Second, bitcoin mining supply can be increased or decreased relatively quickly. Certainly more quickly than oil fields can start or stop production or gold mines can ramp up or down their mining. It would follow that this would tend to increase the speed of convergence between price and cost. And if the velocity of convergence is sped up, this would tend to lead to overshooting in either direction. Hence, much more volatility.

But does bitcoin really have no intrinsic value?

You got me. I wasn’t totally accurate when I said that bitcoin is really only intrinsically worth as much as people value it. There are a few possible sources of intrinsic value. So lets investigate them.

1) Cryptocurrency as a solution to people wanting to do illegal things

While the bitcoin blockchain is public – that is, you can see which bitcoin address owns which bitcoins – the bitcoin system does not require that the identify behind each address be public. It offers relatively anonymity.  Banks on the other hand, in most jurisdictions are required by law to KYC their customers and often are required to report unusual transactions and customer identities to tax and criminal government authorities.

Being a global system, bitcoin facilitates the international movement of illegal money that otherwise wouldn’t be possible without professional money laundering. Think planes flying lower over borders carrying bearer bonds, gold or good old fashioned greenbacks. Why take all that risk when you could simply transfer bitcoin?

For sure this creates demand for crypto-currency, but how sustainable is it?

Governments are very actively trying to close down this money laundering route. How might this affect the price of crypto-currencies? Well, when the Korean government announced a crackdown on crypto-currency on 23 January 2018, the price of bitcoin dropped 25%. So it is pretty clear that either actual illegally-derived demand (or the perception of it) is helping drive the value of crypto-currency.

But it is also clear that the value crypto as an effective way to launder money will decline over time.

2) Crypto-currency as a tax-free investment class

In 2017, people who were early in crypto-currency made a killing. Ether was up 13000%, while bitcoin notched close to 1400% returns. Now if crypto-currency was actually a currency then these returns would essentially be considered tax free and most jurisdictions don’t tax currency gains and losses unless you are a professional trader! Not having to pay tax on your gains is a pretty cool source of intrinsic value.

Unfortunately, in recent months the IRS (and most other tax jurisdictions) have indicated that they are treating crypto as a tradeable asset and thus subject to capital gains taxes. They have also indicated that they are stepping up enforcement activities. Large crypto-wallet companies are being made to verify the identity of their customers and report users who make excessive gains.

So the tax-free window on crypto-currency is rapidly closing as will its contribution to intrinsic value.

3) Crypto-currency as a way to transfer money internationally with greater ease

The argument goes that the international monetary system is a slow and costly drag on the international movement of money. As an entrepreneur who has run a multi-national startup (as opposed to a multi-national!) I have felt viscerally the pain of having to transfer large sums of money. Even the latest generations of international payment companies like Transferwise charge 0.5-1% in fees to facilitate a currency transfer when the underlying spot FX market spread is barely 5 basis points (0.005%). Surely crypto-currency can help with that?

Well, we are soon to see as there are a number of new crypto-backed money transfer startups. My hypothesis is that this will fizzle. Why? Well the majority of costs for a money transfer company are customer acquisition, compliance/fraud and treasury management. All of these would exist for a similar crypto-backed company, especially if governments require the same diligence on such money transfers. Those costs ultimately have to be born by consumers.

Then to be effective such transfers would either have to be denominated in crypto-currency or else someone is taking a significant cross-currency risk. Take for example a money transfer from USD to EUR. If the transaction was conducted sequentially then there would be USD-to-bitcoin and bitcoin-to-EUR risk; if it was conducted simultaneously then there would still be USD-to-EUR risk. And you would still be able to move only as fast as the networks you use to move currency to and from the user’s bank.

Layer on top the fact that crypto-currencies tend to move more rapidly than actual currencies. If that risk is held by the consumer then that adds significant variance to a money transfer; if held by the transfer company then they would have to pass that cost on to the consumer. There is no such thing as a free lunch when it comes to exchange risk – someone always has to pay.

4) Crypto-currency as a lower cost “trust-based” transaction method

Recall that trust is built-in by design in a crypto-currency, and this surely has value. In the future, I possibly won’t need to pay for a land title search or engage an escrow company to facilitate a transaction with a party. Valuable, yes!

So what is that worth? A report by Allied Market Research indicates that this market could be worth $5.3B by 2023. Small fees received for transactions in blockchain distributed ledger apps, the elimination of third parties escrow/custodians in business deals, and a reduction of fraud & identification costs will be the main factors driving growth, the research said.

$5B is not small by any means!

It does, however, pale in comparison to the approximately $300B market cap of the global crypto-market.

5) Crypto-currency as a way to profit from growth in demand for the underlying protocol

The last argument is that crypto-currency should be seen less as a currency rather as a way to essentially monetize underlying protocol. Think of it as more like equity.

Let me take a stab at explaining. Say I create a crypto-ledger to track property ownership and transactions. Lets call my currency BRICKS. As I created the protocol, I can set the rules as to how many BRICKS there are, how they are created and how companies that help maintain my ledger are compensated. If I can become the defacto blockchain for real-estate transactions, then any real-estate transaction would need to be registered on my blockchain.

As registering each transaction would require some amount of BRICK, more transactions would require more BRICKS. As I control the supply of BRICKS, if the growth in transactions exceeds the growth in BRICKS, the price of BRICKS would increase.

Say you like my company and want to invest in it. There are two ways you could do that – first you could buy equity in my company for $$$ (the traditional way). Second, you could exchange another crypto-currency  for some of my BRICKS. Either way you profit if my protocol gets adopted.

The same argument is true for companies focused on building a crypto solution as a source of stored value (eg. bitcoin) or building a trust solution (eg. my BRICKs company). The main difference is that in the former your bet is slightly more based on animal spirits while the latter is a bit more based on features that might help drive commercial adoption.

So what is an ICO?

An ICO is an initial coin offering. This is essentially the the second case described above – the case where you are investing in my crypto-currency because you believe my solution will be adopted and therefore the price of the token you are buying will increase. So an ICO has equity-like features but is not strictly equity.

But like equity it will rise of fall based on the adoption of the underlying protocol. In the end, many of these currencies will be worth little to nothing and there will be several winners. Given the significant overlap in value propositions across many offerings, expect a shakeup.

I plan to follow up this article with an analysis of some of the different ICOs and tokens.

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I’ve learn a lot in simply writing this short article. I hope that you find it helpful. Feel free to comment if you think I have missed anything or am misrepresenting anything. Like most of us, I am still learning about this space.