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.

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How To Think About Investing In Cryptocurrency (Part 1 of 4): Why Exceptional Opportunities Exist

++ In this series, I’m going to start with high level investing concepts in part 1 and get increasingly specific and detailed through part 4.

++Part 1 is an exploration of why extraordinary investment opportunities exist in cryptocurrency. To an engineer, that might seem like an obvious and uninteresting question, but professional investors generally start with the premise that it’s nearly impossible to find the kind of returns that we’re seeing. This is the essay that uses traditional financial theory to explain to your broker or pension fund manager why such a great opportunity exists.

++Professional investors think of markets as mostly efficient most of the time. This comes from both academic research and experience. While market inefficiencies certainly occur, there are thousands of brilliant traders and investors competing to immediately exploit and eliminate those inefficiencies. It’s hyper competitive. This makes it extremely difficult to beat the market consistently. 90% of mutual fund managers and hedge fund managers underperform a passive index, and these are mostly brilliant and very hard working people. Competing in public markets is like playing in the NBA – you’re competing against a field of amazing athletes in what is effectively a zero sum game: for every outperformer there has to be an underperformer (and usually many more than one because of expenses).

++But what if instead of playing in the NBA, we had the option of playing in a middle school recreational basketball league? What if we found a league where the best basketball players in the world couldn’t, or wouldn’t compete against us?

++My personal investing idol is Seth Klarman of Baupost group – one of the best performing, most insightful, and most ethical investment managers. Klarman notes that investors are compensated by the market for taking on market risk (i.e. beta), and for illiquidity. Many investors stop there, but Klarman notes that we’re also compensated for complexity, operational challenges, and “psychological risk.”
Why do such compelling investment opportunities exist?

1. They’re complex along many axes: understanding the technology often requires a degree in cryptography and engineering (for which I depend on a growing network of professional blockchain developers). They’re also complex economically; similar to investing in Facebook before there was any serious monetization plan. Few people have thought seriously about how to value a cryptocurrency fundamentally – there’s no textbook to reference, and currently no consultants to query. And lastly, they’re complex in execution.  Consider Initial Coin Offerings (ICOs) – every ICO is unique, but they increasingly require submitting customized data to an Ethereum “smart contract.” This complexity – in technology, in economics, and in execution, scares off much of the competition.

2. They’re operationally challenging. There are no established regulations, operational procedures, or accounting standards to deal with investments in cryptocurrency. Best practices for securely storing cryptocurrency are constantly evolving and the storage cannot be delegated. Storing cryptocurrency in a way that is both extremely secure, but redeemable in case I’m incapacitated, is a very time consuming process. These operational challenges discourage many potential investment managers.

3. They entail “psychological risk.” In 2008, many of the largest US bank stocks lost 80% of their value, some lost 100%. The stocks of big US companies are risky, but we don’t perceive them as such – if you lose your money owning Citibank or AIG, you won’t feel all that foolish and as a professional investor, you probably won’t be fired. In contrast, cryptocurrency investments are risky, but if we size the position appropriately for our portfolio, they’re no different from any other volatile asset. The main concern many people have is psychological. If someone ran a pension fund and lost 15% of their portfolio in financial sector bonds in 2008, they were “unlucky.” If that same pension manager loses 2% of the fund in a cryptocurrency pool, they fear they will be fired for being foolhardy. As investors, we’re surprisingly well compensated for the risk of appearing foolish. it’s a risk that most of the biggest money managers refuse to take, and thus they leave many of the best investment opportunities on the table.


++ Investing in cryptocurrency is currently like playing basketball in a middle school rec league. Most of the best basketball players aren’t yet in the game. This allows us to earn outsized returns by providing capital to the best cryptocurrency projects. In a few years it will be far harder to earn such returns because there will be a great many talented investors competing to provide capital to the same projects. As we see in the traditional venture capital industry today – this competition drives up the entry price, and drives down expected returns.

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Scaling Bitcoin

++ Your mother taught you not to discuss religion or politics in polite conversation.  Bitcoin scaling is far more contentious.  The debate over how to enable the Bitcoin network to handle more transaction volume has divided the community into factions that hurl accusations of treason and conspiracy at one another and even launch DDOS attacks at “enemy” full nodes.  If you’ve been following the debate for the last two years, you’re probably exhausted or bored by it by now, quite understandably.  But it’s a debate that just won’t die because of its important practical implications for an $18 billion asset and the risk of a contentious hard fork.  If you’re a crypto expert, you’ll probably find my next post more interesting.  If you’re moderately familiar with bitcoin, skip to ” Technological and Game Theory Concerns.”  For those unfamiliar, start with “Background” and I’ll provide a little history and explain some of the jargon.

Background

++ Bitcoin blocks are created about every 10 minutes. Miners all over the world compete to solve a complex math problem, and whoever solves it first gets the right to mine a particular block.  Mining a block enables the miner to collect the “block reward” of newly created bitcoins, as well as to collect any fees associated with the transactions they include in the block.  Miners generally want to include as many transactions as possible to maximize the fees they collect.  Any transactions not included in a particular block can be included by other miners in a later block.

++ Back in 2010, bitcoin’s creator Satoshi Nakomoto (a pseudonym for an unknown developer) put a cap of 1 MB on bitcoin blocks.  That means only about 3500 transactions can be included in each block, about 6 transactions per second.  At the time Satoshi introduced it, there were hardly any transactions at all, so the limit had no practical effects on the network; it was just intended to prevent a malicious actor from flooding the network with spam.  Over the last year however, bitcoin volume has been growing strongly and we’re now consistently at the 1 MB limit.  When people submit more than 3500 transactions, how do miners decide which transactions to include?  They pick the transactions with the highest fees.  Users can specify the fee they want to pay for their bitcoin transaction.  At times of peak network demand, the fee today exceeds $0.75 per transaction.  While that might sound small compared to a wire-transfer, it’s substantially more than many credit card transaction fees, and it makes paying for coffee with bitcoin uneconomic.  And since we’re at the upper bound of network capacity, every small additional increase in demand for transactions produces a large increase in fees; everyone has to compete to get their transaction included in the blockchain.

++ Why not raise the 1 MB cap?  One of Bitcoin’s core value propositions is that it is decentralized.  “Decentralized” can refer to a bunch of different things.  Here, I’m referring to the backbone of the network – full node operators and miners.  A full node is just a computer running software that propagates and validates bitcoin transactions – a $25 raspberry pi can do this.  Miners add blocks to the blockchain and secure the blockchain from doublespends (spending the same bitcoin twice.)  As long as there is one full node and one miner, the Bitcoin network is up and running.  By having full nodes and miners located all over the world, it makes the network resilient from both natural and man-made destruction.  If all of the nodes were in the US, the US government could more easily shut down those nodes and kill bitcoin.  So the bitcoin community greatly values having as many full nodes and miners as possible, located in as many distinct political jurisdictions as possible.

Technological and Game Theory Concerns

++ Currently, there are about 7000 full nodes globally.  Some of these nodes are run by bitcoin businesses that need to be able to validate transactions, but many node operators are just bitcoin hobbyists.  These hobbyists are willing to invest the time and money to keep a node running with no economic incentive.  The biggest cost associated with running a node is bandwidth: 1 MB every 10 minutes adds up.  For node operators in developed economies, this might be a small burden.  But handling that bandwidth in rural India or rural Peru is already prohibitive for some.  Raising the block size would directly increase the cost of running a full node.  I have yet to see a good estimate of how many nodes would fall off the network with an increase to, say, 2 or 4 MB, but it’s non-zero.  Many in the Bitcoin community are reluctant to raise the block size because it would likely result in a loss of full nodes in the most scarce areas: rural emerging and frontier market locales.  The vast majority of full nodes are in Western Europe, Japan, the US and China, so losing even a few of the full nodes in other countries would represent a meaningful loss in decentralization.  Additionally, a miner who solves a block receives a slight head start on the next block; other miners have to wait for the solved block to propagate to them.  Much larger blocks might take longer to propagate to some miners, which could encourage mining consolidation, a further loss of decentralization.

++ Further complicating the situation are second order effects.  The current cap on bitcoin transactions reduces its usage.  This may reduce the number of bitcoin businesses operating and the number of merchants that accept bitcoin (and are thus incentivized to run full nodes), so it may be that reducing the fee to transact in bitcoin would indirectly increase decentralization by encouraging adoption and thus the creation of full nodes.

++ Additionally, some economic uses may be priced out of utilizing the bitcoin network, which may encourage the growth of Bitcoin competitors.  For example, a pharmacy may not be happy with $0.75 transaction fees and might choose to utilize another cryptocurrency like Monero that costs less than 1/10 as much to transact.  These marginal use cases may give competing cryptocurrencies a foot in the door that helps them achieve network effects and eventually makes them generally competitive with Bitcoin.

++ This is mostly a timing issue.  All cryptocurrencies face similar scaling issues, but other cryptocurrencies have much less demand on their networks currently.  Eventually, all successful cryptocurrencies will have to utilize new scaling technologies or scale off-chain, but those solutions aren’t yet ready for widespread adoption.  So this is really a debate over how to handle the 6-18 month period where Bitcoin transaction demand exceeds the network cap, but other solutions are not yet available.

Solutions

++ The Core team (a group that includes a plurality of Bitcoin developers) is trying to implement a slight increase in block size via a more complex change called “Segregated Witness” or SegWit for short.  SegWit can be implemented via “soft fork” which will not produce two competing chains.  SegWit would eventually be the equivalent of an increase in block size to 1.7 MB.  The SegWit soft fork also includes a number of technical improvements, including an end to “transaction malleability”, and an improvement in the efficiency of sighash operations.

++ The simplest immediate solution is to “hard fork”, to change the block size to 2 MB or 4 MB, but this may result in some reduction in decentralization.  Additionally, there is a concern that a hard fork could create confusion for consumers and investors by producing two competing blockchains.  Lastly, even for those who believe that the pernicious effects of bigger blocks on decentralization are unlikely to be felt at 2 MB or 4 MB, scaling via hard forks to bigger blocks is an inherently unsustainable approach, since we hope that demand for transaction volume will increase far faster than bandwidth costs fall.

++ Attempts to produce such a hard fork over the last 2 years have appeared in various software and marketing implementations and failed to gain traction.  The latest version is “Bitcoin Unlimited” and includes some additional important changes to the network.  Bitcoin Unlimited allows for miners to decide block size dynamically, which is viewed as particularly dangerous by some analysts because of the possible feedback loop in which the largest miners might enlarge the block size, encouraging miner centralization, thus giving themselves more power to push for additional block size increases.

++ Lastly, there’s a “hybrid” approach: adopt SegWit and hard fork to 2 MB.  Such a hybrid solution would provide Bitcoin with some room to breathe while longer term solutions like the Lightning Network can be rolled out, but it still stokes the fears related to hard forks in general.

The Politics

++ Some of Bitcoin’s earliest supporters were self-described cyberpunks and anarchists.  Many hoped (at least in Bitcoin’s first couple years) that Bitcoin would eventually replace all fiat currency.  Those who hope for Bitcoin to replace the US dollar recoil at the rising transaction fees that make such a replacement all but impossible.

++ Most of the Bitcoin community accepts that Bitcoin can’t compete with fiat for transactions until sustainable scaling solutions are in place (off-chain scaling, or other technological innovations).  The rising fees are viewed as an acceptable nuisance.  Some Bitcoin investors think of Bitcoin as though it was IBM – a big established company, with much to lose; they are risk averse and view hard forks as inherently risky.  In contrast, other Bitcoin investors view Bitcoin like Uber – a young upstart with little to lose and lots to gain.  Technologies generally have to “move fast and break things” to avoid obsolescence, and some members of the bitcoin community fear that Bitcoin will be left behind by newer cryptocurrencies if it fails to aggressively upgrade its protocol.  Other investors think that Bitcoin is unlikely to ever be able to compete with younger competitors on features or technology, and must compete instead on the strength of its stability and network effects.

++ There’s also a rift between people who believe that bitcoin decision making should be viewed amorally as a process of game theory including the inevitable politics, while others believe that decisions should be driven by consensus based on the technical merit of the proposal.  The former group accuse the latter of centralizing control of the Bitcoin network in the hands of a few developers.  The latter accuse the former of pushing their self-interest over the superior technical solutions that would benefit the network as a whole.

++ At first analysis, everyone in the Bitcoin community wants the same thing – the price of bitcoins to appreciate.  This is because most of miners’ income comes from the “block reward’ (a fixed number of bitcoins awarded to miners for solving blocks, currently 12.5 BTC per block) not transaction fees (currently averaging 1.6 BTC per block).  But in a couple years, transaction fees may be greater than the block reward.  Miners eventually want lots of on-chain transactions and high fees.  But miners understand that if fees get too high, it will incentivize the creation of off-chain scaling solutions.  Additionally, miners are competing against one another, and the largest miners may view Bitcoin Unlimited’s dynamic scaling as a way for them to gain an advantage over smaller miners.  There may also be perverse economic incentives for some Core supporters.  Some of the most prominent Core developers are employees of the private for-profit company Blockstream.  Blockstream profits by providing services related to off-chain transactions, so they may benefit from constraining bitcoin’s on-chain bandwidth.  I have no special insight into the motives of the players – I’m summarizing the political issues as perceived by major groups in the Bitcoin community in this paragraph, and nothing here should be interpreted as impugning the character of miners, Core developers, or anyone else.

The “Crisis”

++ Some of the biggest miners are threatening to hard fork the bitcoin network by supporting Bitcoin Unlimited.  Many Core supporters have said they will view any such hard fork as an illegitimate competing cryptocurrency, and even as an “attack on Bitcoin.”  Some Core supporters have said they will attack the Bitcoin Unlimited network via “zero day attacks.”  One miner who supports Bitcoin Unlimited threatened to spend $100m to attack the Core branch in the event there’s a fork and things get ugly.  The fear is that the two resulting blockchains might destroy one another, or at least produce general confusion and uncertainty that permanently impairs bitcoins as an investment.  Additionally, most miners are currently signaling that they will not implement SegWit, which means that even a modest on-chain scaling improvement may be far away or even politically unattainable.

The Future

++ I think it’s unlikely (<35%) that bitcoin suffers a contentious hard fork of any consequence in the next year.  Miners have too much to lose and too little to gain from such a hard fork.  In the event miners do HF the network in support of Bitcoin Unlimited, I think it’s likely to be a relatively minor event that doesn’t impair (economically or operationally) the Core branch for more than a few months.  I think it's about 50% that SegWit is implemented via soft fork in the next 12 months.  In the meantime, we are likely to see fees continue to rise substantially.  If SegWit is not implemented, I view that as a detrimental outcome, but one that does not fundamentally change the Bitcoin value proposition nor the investment opportunity.

Conclusion: Bitcoins (BTC) as an Investment

++  There’s an almost daily announcement of a new exciting cryptocurrency project.  Some are competitors to Bitcoin, but most are not.  Some of these projects offer interoperability between blockchains, decentralized file storage, or trustless casinos.  Many of these projects are exciting and a few are great investment opportunities, but I think over the next 12 months, Bitcoin will remain one of the top investments in the cryptocurrency world.  I have about 37% of my cryptocurrency portfolio in BTC.

++ There’s a huge amount of capital poised to enter the cryptocurrency markets over the next year, and much of that will flow to Bitcoin due to capital market availability and liquidity – Bitcoin is the only cryptocurrency with exchange traded funds (GBTC in the US, XBT in Stockholm) and a liquid futures market.  While rising fees make Bitcoin unusable for small transactions, I think this is relatively unimportant in the short-term.   In the next 12-24 months, the vast majority of cryptocurrency demand is likely to come from speculative investment, not consumer usage.  And if someone wants to buy or transfer $5,000 worth of BTC for long-term investment, whether the fee is $0.05 or $5 is unimportant.

++ I’ll provide a lot more detail for how and why I expect capital to flow into Bitcoin in an upcoming post.

 

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Welcome!

Investors,

I’ve been writing investment commentary for nearly a decade now.  My previous site, www.riskoverreward.com started as an email list in 2008 to warn friends and family of the impending financial crisis and then became a general investment blog with the help of value investor Arun Rao.  Recently, the blog became more and more focused on cryptocurrency and I felt guilty for inundating my readers with such a narrow strain of commentary.  If you’re here, it means you *want* to read about cryptocurrency.

I’m not an engineer, nor a cryptographer.  What can I contribute to the crypto space?  I work as a portfolio manager for a $7.5 billion endowment and spent most of my career as a professional derivatives trader. While the crypto space has plenty of brilliant programmers, there aren’t many people who bring the perspective of a professional investor to the space.

The primary purpose of this blog is to provide insights that will contribute to profitable investments in the cryptocurrency space.  These investments will include venture capital style investments in the equity of crypto companies, shorter term trades of publicly listed tokens, and purchases of initial coin offerings (ICOs).

The secondary purpose of this blog is networking.  Cryptocurrencies represent a fascinating intersection of cryptography, game theory, computer science, economics, technical trading, and even marketing.  I’m only an expert in two of those things, and so I rely heavily on the expertise of engineers and cryptographers.  Even in the areas in which I can call myself an expert, I’ve learned the usefulness of leveraging other investors’ research, analysis, and information flows to improve my own decision making.  So please, reach out!  Use the “Contact” page to introduce yourself and let’s dive deeper.

The third purpose of this blog is to falsify my own ideas.  I love nothing more than when someone says, “bullshit!” and explains why I’ve ignored some important aspect of an investment thesis.  My current understanding of the crypto space is the result of many such cries of “bullshit!”, and I ask you readers to let me know when you disagree with my logic or even when you dispute basic facts.

Welcome, and let’s dive in.

-Ari

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