How To Think About Investing In Cryptocurrency Part 2 of 4: What *needs* to exist.

++Part 2 of the 4-part series “How to Think About Investing In Cryptocurrency” starts exploring the economic forces that will drive market segmentation to help us identify the future industry leaders.  It’s best to start by asking, what needs to exist?  What services does the world need that can best be provided by a public blockchain?

++First, let me try to convince you that cryptoccurency isn’t “winner take all”, although some specific niches within the crypto world probably are.  Imagine if Uber tried to offer term life insurance?  Imagine if Lloyd’s of London tried to sell virtual reality headsets?  Imagine if McDonald’s tried to offer a 12-course $400 dinner with wine pairing?  Imagine if Nordstrom tried to compete with Walmart with rock bottom pricing?

++Some business models are natural fits for particular products.  People want to buy their insurance from stable, long-lived, boring companies.  And the companies best suited to compete on cutting edge technology offerings are generally smaller, leaner, and have an ethos of “move fast and break things.”  IBM is a good example of a huge stable company that appears superficially to be a tech business, but really is a consulting firm that just happens to consult on tech.  Similarly, Apple used to be a nimble tech innovator, but is now a consumer brand company, more comparable to something like Coca-Cola.  The winning cryptocurrency in a niche will usually not be decided predominantly based on marginal technological differences relative to competitors.  Launching a new cryptocurrency that aims to copy a market leader with a slight improvement is kind of like saying I’m going to create a product to compete with the Iphone with a better camera, or that I’m going to launch a competitor to Coca-Cola that tastes the same but with 10% fewer calories.  I’m unlikely to get very far because the specs and price are just one small part of their success.

++Turning back to cryptocurrency, there’s a critical idea that’s often overlooked: the role of community.   In cryptocurrencies, governance is driven by that cryptocurrency’s community (developers, miners/stakers, users, service providers, etc).  There’s often a positive feedback loop that makes the community more homogenous over time.  Consider Ethereum’s hard fork after the DAO bug was exploited.  Many of the community members (holders of ether, miners, developers) who strongly opposed the fork abandoned the ETH chain.  Alternatively, people who liked the philosophy that led to the hard fork were attracted to the ETH chain.  The result was that the community post-fork was substantially more homogenous than the community pre-fork.  The community is often a key feature of a cryptocurrency because it contributes to governance via game theory.  While the community can certainly change over time, it needs to be thought of as a core part of how a cryptocurrency functions, almost on par with the scripting language.  To put it simply – the community makeup of a cryptocurrency directly influences how that cryptocurrency behaves.  Cryptocurrencies are differentiated not only by their code, but also by their communities.

++Bitcoin has a community that is mostly committed to stability.  To the majority of Bitcoin users and developers, Bitcoin is IBM, it’s Lloyd’s of London.  This makes technical innovation at the protocol layer very difficult in Bitcoin, but also lends it a great deal of stability.  By “stability”, I don’t mean price stability, but rather protocol stability.  If I buy 1 bitcoin today, I can be fairly confident that in 5 years I’ll own pretty much the same thing.  In contrast, the Ethereum community has adopted a “move fast and break things” mentality.  Ethereum is Uber, it’s Facebook 10 years ago.  This community facilitates breakneck technological progress, but increases the risk of bugs, and makes it impossible to know what ownership of 1 ether will mean in 5 years.

++We see a similar dichotomy in the protocols themselves.  Bitcoin has a very simple scripting language which makes it difficult to build new features, but also relatively easy to avoid devastating bugs.  In contrast, Ethereum has a complex Turing complete language which lets it do pretty much anything, but greatly increases the chance of serious error.

++I don’t view one of these communities or scripting languages as superior to the other.  Rather, each is optimized to fulfill a particular need.

What does the world need?

++The world needs “digital gold” – an unseizable store of value, with great liquidity, a high market capitalization, stable protocol, and great security.  While it would be nice if the cryptocurrency that filled this niche also had a quick confirmation and low fee, those things are not core to the value proposition, and those factors are unlikely to determine which cryptocurrency dominates this niche.  I think this niche is likely “winner take all.”

++The world also needs cheap, fast, and private, monetary transmission.  Much of the infighting in the Bitcoin community today stems from the growing realization that it might not be possible to optimize a single cryptocurrency for both the “digital gold” and “monetary transmission” niche.  For Bitcoin to do both well will probably require a secondary layer like the Lightning Network.  Alternatively, the “monetary transmission” niche may be best served by an entirely separate cryptocurrency that may eventually be made interoperable with Bitcoin via parachains.  Cryptocurrencies like Monero, Litecoin, Dash, and Zcash are primarily competing for the “monetary transmission” niche.  For this niche, protocol stability and extreme defense against doublespends, is less important than speed, cost, and/or privacy.  I don’t need $1 billion worth of security if I’m only paying an $80 restaurant bill.  Because there are different levels of security demanded for different transactions, this may not be a “winner take all” niche.  I can imagine a scenario where there are 3+ cryptocurrencies providing varying combinations of speed-security-cost-anonymity for monetary transmission.  For example, Zcash may offer the best anonymity, but relatively slow execution if you’re on a smartphone since the algorithm is so intensive – this might be a welcome tradeoff for some uses, but highly inefficient for others. We may soon have a world were crypto A is used for maximum speed and lowest cost, crypto B is used for perfect privacy, and crypto C is used when users want a hybrid compromise.

++The world needs a platform for decentralized applications (dApps).  The cryptocurrency to provide that platform has to have a complex and evolving scripting language, and a community that embraces constant innovation (at least for the next few years until the technology is more mature). This is such a new area that I find it impossible to predict if the equilibrium is one dominant platform or multiple competing platforms with different network architectures and communities.

++So far I’ve only explained why Bitcoin and Ethereum are the two biggest cryptocurrencies by market capitalization by far.  I can’t say if Bitcoin and Ethereum will remain the dominant players in their respective niches forever, but if they get replaced, it will probably be by something that looks very similar to the incumbent in terms of both the code and the community.

What *else* does the world need?  That will be the topic for Part 3.

About Ari Paul

Ari Paul is co-founder and CIO of BlockTower Capital. He was previously a portfolio manager for the University of Chicago's $8 billion endowment, and a derivatives market maker and proprietary trader for Susquehanna International Group (SIG). Ari earned a BA in political science from the University of Pennsylvania, and an MBA from the University of Chicago with concentrations in economics, entrepreneurship, strategic management, and econometrics & statistics. Ari is a CFA charterholder.
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21 Responses to How To Think About Investing In Cryptocurrency Part 2 of 4: What *needs* to exist.

  1. Jon says:

    Another good post, but stuffing Monero into a fast, insecure monetary transmission category is just plain wrong. First in importance for XMR is privacy, security tied for first or second and speed last. It is likely more secure in its privacy than Z Cash because it uses cryptography that is tested to obscure transactions. Z Cash is using bleeding edge that may or may not end up working. Also, Monero anonymity is now mandatory on all transactions. Not Z Cash.

    Liked by 2 people

    • Ari Paul says:

      Hey Jon, thanks for the feedback. By “security”, I didn’t mean the security of an individual transaction against bugs/hacks, but rather the security of the network against something like a doublespend by miners. I edited the article for clarity. Thanks for the constructive criticism!

      Liked by 1 person

    • Jon says:

      Despite the unfair treatment of XMR, I think the series is excellent so far.

      Liked by 1 person

  2. Carolus says:

    Thank you for this interesting articles! I appreciate your analysis of the communities role.

    I appreciate your article also because i don’t agree with your thought that there can be niches, and that’s thought stimulating! Don’t you think that an efficient second layer’s protocol of bitcoin will make most alt useless? When we look at the real world use of most alts, one can say that they are mostly speculative assets. Except maybe Monero with its mandatory privacy, indeed : but then monero has the potential to be a competitor to bitcoin as value reserve and currency, if it can reach the same hashrate.

    You say that “The world needs a platform for decentralized applications” : why do you think so? I don’t see any real world need for this except for money (bitcoin / Monero) and a worlwide public timestamping ledger (bitcoin).

    Liked by 1 person

  3. Ari Paul says:

    Thanks Carolus.
    It’s really hard to forecast where dApps and altcoins will play a role – kind of like asking in 1985 for what functions the internet would be important. Few predicted that social media like Facebook would become one of the most dominant uses of the internet. A quick look at current dApp projects and altcoins shows a wide variety of promising projects. Some examples:
    Edgeless – A decentralized trustless casino.
    Golem – allows users to rent out their CPU when not using it to create a global supercomputer
    IPFS – Kind of a replacement for http protocol that’s more efficient and secure and resilient.

    I’ll have a lot more on this coming up.

    Like

  4. Thanks for your thoughts Ari,

    I used to agree with you that there would be one player that would emerge to dominate the store of value/digital gold usecase. However, recently after thinking a lot about portfolio theory and the need for diversification – my thesis is that many of the top coins will (and are) serving this function.

    As they say in economics ‘Diversification is the only free lunch’.

    Chinese are clearly trying to diversify outside of their depreciating currency. The masses around the world are going to continually wake up and realize that not matter how diverse their fiat portfolios are – they are still priced in fiat, not properly diversified, and are at risk with respect to the rise and fall of fiat currency.

    Once they start moving value into crypto it will need to be diversified as well – it’s not sufficient to just be in one crypto-asset which makes me think the digital gold premium will (and is) being spread over multiple coins. (An example – there are reports that Koreans are buying up eth b/c they are worried about the brewing conflict with North Korea.)

    This premium distorts prices – we are witnessing some insane market caps and it challenging to evaluate projects on their fundamentals (which there are few to speak of). As a result I’ve been thinking a lot about the internet boom. Without the store of value/digital gold premium we could be headed for a pets.com scenario – but with it, I think we can see that the bull run is only just beginning and there is much more room for growth in the long-term.

    Related to ‘part 1’ in your series:

    If we’re playing with middle school basketball players this assumes that crypto traders are making an error in judgement that NBA players (professional traders) wouldn’t. But whose to say which side they are erring on bear side? It’s equally (and I’d argue potentially more) likely that they are erring on the bull side and overvaluing projects in the short term with respect to their risk/fundamentals/long-term utility.

    I’m seeing a lot of people throw up their hands and say ‘this is a new asset class – we can’t evaluate it with traditional metrics!’ Yes, it is a new asset class – which makes valuing it challenging. But it gets dangerous when we stop trying. (Professional trader’s wouldn’t!)

    To that point – I’d be cautious buying up coins that have already done there ICO, are now trading outside of the top 10, and are pumping just b/c eth and btc are pumping. These coins should be valued on a USD basis with only moderate beta to BTC & ETH. This is because in the long term I don’t think all coins get the store of value/digital gold premium and will be subject to the brutal realities of their fundamental utility eventually which are probably distorted at this point in time.

    But there just aren’t enough basketballs to go around to adequately price in the store of value/digital gold premium for those coins that are lucky enough to have the network effects/critical mass/marketing prowess to adopt it.

    Liked by 1 person

    • Ari Paul says:

      Thanks for the thoughtful response Dustin. A lot of people (myself included) are indeed somewhat desperately looking to diversify outside of BTC and ETH. What else do you think is likely to gain meaningful market share as “digital gold?”

      One issue is PoW – it means that security scales linearly with hash power which produces a natural monopoly. As PoS becomes more popular, I think that will open up more room for competitors in the “digital gold” space.

      I agree that the error traders are making aren’t one sided. Some of the recent ICOs (like Gnosis) were stupidly overvalued, and there are some totally dead projects where the market cap remains $10m+.

      Happy to trade an email or phone call to talk in more detail. https://twitter.com/AriDavidPaul

      Like

  5. ethought says:

    Great post. Is part 3 coming soon?

    Liked by 1 person

  6. Chris says:

    Excellent series Ari. Hope you find some time to continue with part 3.

    Like

  7. Joshua Philips says:

    Bump!

    This is *real* thought leadership, Ari.
    Please publish #3!

    Happy to get lunch in Chicago to discuss some ideas for what the world does need next.

    Like

  8. Rene says:

    Looking forward to part 3
    Keep up the good work

    We need more fact-oriented down to earth information about crypto!

    Like

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