This week TAMIM and Robert Swift delve into Bitcoin, blockchain and cryptocurrencies. This article should viewed as a excellent source document for those seeking detail and understanding on cryptocurrencies and blockchain.
We wrote in January that we couldn’t believe that Bitcoin and other cryptocurrencies would not be subject to regulation and that since we didn’t yet know the regulation, but knew that big government and regulation was currently the norm, it would not make sense to invest in any of them until we did know. We also pondered that the technology on which the currencies were based, blockchain, was actually open source software and consequently free to anyone to use. It wasn’t the software that was the franchise value but the belief that cryptocurrencies would be a reliable, commonly used, and government free, store of value and transaction tool. In short, inflation proof and anonymous money. A form of digital gold if you like.
Since then, and really we didn’t have any particular insight on the timing of the price falls of crypto currencies nor the legislation, there has indeed been a fall in the price of the crypto family and a plethora of restrictions placed on crypto trading by stock exchanges in South Korea, China, Japan, Australia and Tel Aviv. In the UK the obsession appears to be with how to tax capital gains on the trading – such is the rapaciousness of the current political climate there. China of course has been the most draconian and decided to turn off power to cryptocurrency miners and to prevent access to foreign trading platforms. Presumably they fear capital flight via crypto trading? The USA and Europe are pondering similar moves.
In short the world of cryptocurrencies appears to have moved beyond ‘early adopter’ high % gains, to the next, and more regulated, stage. Is it ‘game over” for the currencies or is there something in the blockchain technology which can be turned into a defendable business strategy with patents and barriers to entry – even if it is open source?
Since we “know people” (!) we decided to ask an expert to contribute to this article. We may be value investors and like dividends, but when something has fallen so quickly; appears to have traction; and is about to be made legitimate by regulation, we become interested. The article below is written by a crypto currency trader with a PhD in Artificial Intelligence.
Without wishing to reveal the conclusion, we are spending a bit of time on a blockchain dependent non crypto investment opportunity.
Please read on.
In 2008 a whitepaper was posted online by an unknown group or individual calling themselves Satoshi Nakamoto. The paper provided a solution to a difficult technical problem – that is, how consensus on the state of a ledger can be reached in a network that potentially contains adversarial actors, without relying on a central authority – and outlined a new online payment network and digital currency, called Bitcoin, using this technology.
Under the Bitcoin system, each participant in the network holds a copy of the full transaction history (called the “blockchain”), from which the current state of the ledger can be determined. Payments are submitted to the network and processed by miners, who group transactions into blocks and add another block to the end of the blockchain every 10 minutes on average. Miners compete with each other for the right to create blocks, by supplying computational power that validates new transactions and secures the network from outside attack. As a reward for their work, new Bitcoin is issued at every block creation to whichever miner created that block – with an emission that decreases over time until a total of 21 million Bitcoin has been created in around the year 2140. Users can also choose to add a fee when they send their transaction, which is paid to the miner that creates a block containing this transaction – when all 21 million Bitcoins have been emitted in 2140, it is envisioned that fees will provide a full incentive for miners.
Many early users and contributors were driven by the desire for a smaller state, and in particular wanted an alternative to the central banking system under which the money supply can be inflated and debased. With Bitcoin, payments are made directly between users in a peer-to-peer manner (i.e. without a middle man or central authority that can control the flow of transactions), and the ledger is immutable such that transactions are permanent and irreversible once they are included in the blockchain. Furthermore, Bitcoin’s finite supply and emission schedule can’t be changed without the consent of a majority of network participants, and its mining process (which requires a verifiable expenditure of energy to release new supply, called “Proof of Work”) was intended to model a sort of “digital gold”. As a payment network, this new system offered users the ability to perform global transactions that were confirmed with 10 minutes and virtually free to send.
Given the open source nature of Bitcoin (the software is freely available for anyone to copy, change, and launch their own competing cryptocurrency), there has been a large amount of experimentation on both the technical side as well as with monetary supply dynamics.
Under the Bitcoin protocol, new supply can only come into existence as a reward for mining (the process of validating new transactions and securing the network). Alternative consensus protocols have emerged under which users with stake (funds), rather than miners expending energy, drive the creation of new blocks. While these energy-reducing consensus protocols have become increasingly popular, their security guarantees have been questioned by some.
In contrast to Bitcoin’s emission-by-mining model, many newer projects have opted to create a certain amount of supply at launch by decree, sometimes then distributing further issuance in the usual manner as blocks are created. This has been seen most notably in the recent trend for “Initial Coin Offerings” (ICOs), in which companies create an initial supply of coins for their network to sell to the public (typically keeping some portion of this initial issuance for themselves).
Another criticism that Bitcoin has faced is its suitability to function as money given its deflationary nature – and alternative currencies have over the years thus experimented with various types of inflationary emission.
Moreover, the cryptocurrency space has evolved in scope beyond Bitcoin’s vision for a distributed and decentralized payments ledger. Broadly speaking, cryptocurrencies can now be classified according to five (mostly distinct) categories: basic currencies, privacy-focused currencies, smart contract platforms, utility tokens and securities tokens.
Basic cryptocurrencies are either clones of Bitcoin or closely-related protocols, which focus on currency payments but make some (usually minor) alterations. An example is Litecoin, which was launched in 2011 with a reduction in the time between transaction blocks and a slightly different mining algorithm.
All Bitcoin transactions are visible on the public blockchain, which means that the flow of payments can be tracked if identities can otherwise be associated with addresses. This might be seen as an positive feature to some (e.g. governments, law enforcement), but as undesirable to others (e.g. high net worth individuals, those living under repressive regimes, or companies not wishing to disclose the details of business contracts to competitors). It also means that Bitcoins are not technically fungible (i.e., identical and mutually interchangeable), which is considered by some to be an important property of sound money. Privacy-focused projects such as Monero address these issues by obfuscating the sender, receiver and amounts associated with a transaction: unlike with Bitcoin these details do not appear on the public blockchain, and users instead have the option to selectively disclose their transaction information to a third party.
Smart contract platforms such as Ethereum go beyond the notion of a payments ledger to enable decentralized, distributed computation more broadly. This means that, in addition to the simple payments afforded by the first generation of cryptocurrencies such as Bitcoin, software programs (smart contracts) that run on these networks can be endowed with logic to allow for (for example) timed, conditional, or split payments, or any combination of these. They also commonly allow for the creation of custom tokens that function on top of the underlying infrastructure. Since this functionality is at the network layer, the same guarantees of Bitcoin’s basic payment protocol typically apply to smart contracts (e.g. immutability and censorship resistance). In addition to functioning as a currency, the native Ethereum token is used as a fee for the execution of these smart contracts on the network – demand for decentralised computation might therefore arguably make the Ethereum token a better store of value (and thus form of money) in the long run. This extra functionality comes at a cost however, and Ethereum faces more difficult technical scaling challenges than Bitcoin.
Utility tokens are typically issued on top of a smart contract platform by a company (although sometimes they are issued on a completely separate and dedicated blockchain), and allow access to a product or service that the company provides. An example is Power Ledger, whose token on the Ethereum network serves as the currency for its blockchain-based electricity trading platform. Although smart contracts can allow for automation of certain functionality at the network layer, it is not always clear why certain platforms require a specific utility token over and above a more general cryptocurrency.
Finally, an emerging trend for 2018 is towards the creation of securities tokens, which aim to tokenize ownership of assets such as real estate, bonds or equities. The programmable nature of tokens will potentially allow for the automation of functions such as dividend payments and governance, and the tokens can be traded globally 24/7. One notable project is Polymath, which is creating a platform to allow for the easy creation of securities tokens and regulatory compliance.
Regulatory stances towards this burgeoning space vary across the globe and are quickly evolving. In China (which was for a long time the largest driver of demand), authorities have spoken positively about blockchain technology but remain suspicious of the idea of decentralization. The last few months has seen a fairly strong crackdown, with ICOs and exchange trading of cryptocurrencies both banned (although OTC trading is still permissible) . Instead, Chinese authorities seem to have a vision for centralized cryptocurrency that can be controlled . This contrasts with the more permissive stances taken in other Asian countries such as Japan and South Korea.
In Europe, the head of the European Banking Authority (the EU’s banking regulator) Andrea Enria has recently called for an EU-wide approach, and for the regulation of institutions that hold or sell cryptocurrencies (and the limiting of their exposure) rather than the assets themselves [3, 4]. While cautioning against actions that might stifle innovation, he warned that companies dealing in deposit taking and lending will need to be regulated.
In the United States, Commodity Futures Trading Commission (CFTC) commissioner Brian Quintenz recently spoke in favour of self-regulation [5, 6], while the Securities and Exchange Commission (SEC) and Financial Crimes Enforcement Network (FinCEN) have both recently begun to target ICOs. In particular, the SEC has warned that many tokens that have been sold during ICOs classify as securities and that cryptocurrency exchanges dealing in these tokens need to be regulated under existing laws [7, 8]. They are additionally rumoured to have recently begun issuing subpoenas to non-compliant ICOs. Meanwhile, FinCEN has declared that developers and exchanges offering ICO tokens need to be registered as money transmitters . It thus currently appears that much of the regulatory burden will fall on exchanges and those seeking to conduct ICOs.
Which cryptocurrencies will survive and thrive?
Given its open source nature and the (to date) relatively low regulatory oversight, the cryptocurrency space has low barriers to entry. As a result, the market is very competitive and new projects are frequently launched. With this in mind, how might one try to determine which of these projects have the best prospects for value growth?
The first point to note is that cryptocurrencies should be thought of as networks of participants, and that they are thus subject to network effects in terms of both user base and security. As these networks become more established, and the infrastructure is further built up, users and businesses will become less likely to switch to alternative networks unless these alternatives can provide significant improvements in user experience (e.g. speed, lower fees) or desired functionality (smart contracts, privacy). Furthermore, as networks such as Bitcoin grow and attract more mining power, they become ever more secure against outside attack. These network effects can be gauged with publicly available data on mining contributions, transaction volumes, and engagement rates with social media and community websites. Bitcoin currently has a large network effect, but since the space is still fairly nascent it would not seem to be an insurmountable lead. Furthermore, while the software protocols defining the properties of a cryptocurrency can be upgraded and evolve over time (subject to the approval of a majority of network participants), Bitcoin has historically been fairly conservative in adopting new innovations.
When there is disagreement within a cryptocurrency community over the direction that the software should take, some community members might opt to start a new project to fulfil their alternative vision. Rather than starting this new cryptocurrency from scratch, they can opt to “hard fork” from the existing project: which means launching a new currency with a clone of the blockchain up to the point of the divergence. This means that all users of the forked-from currency will now have an additional, equal stake in the new currency (although the two networks are distinct and separate, and funds cannot be sent between them). Bitcoin hard forks became an increasingly popular phenomenon in 2017 amongst develops and community members wanting to upgrade the Bitcoin protocol and at the same time take advantage of its large network effect and user base. This would suggest that it might be prudent to keep stakes in the more established cryptocurrencies such as Bitcoin, even if they might seem relatively reluctant to innovate, since this innovation might be delivered in the form of a hard fork.
One particularly important technical consideration is the problem of scaling; an issue that confronts all of these networks to varying degrees. During 2017, Bitcoin in particular became overwhelmed by a sharp growth in transaction volumes – blocks became routinely full, which meant that users were required to pay relatively large fees to get miners to include their transactions in a block. Bitcoin has opted for second-layer scaling solutions in the form of payment channels (called the “Lightning Network”) that periodically settle onto the main blockchain, choosing to leave the underlying protocol (and thus the limit on the number of transactions per block) unchanged. This approach has been criticised by some as deviating too far from the original vision for peer-to-peer payments, in that these payment channels require deposits to operate and might lead to the emergence of centralised liquidity hubs. On the other hand, a hard fork called Bitcoin Cash will pursue on-chain scaling by increasing block capacity in the underlying protocol, which has been criticised by others as technologically infeasible as a long term scaling solution. It remains to be seen which of these approaches will win out. Ethereum, which faces even tougher scaling challenges than Bitcoin, will pursue an aggressive, multi-strategy approach to scaling that combines various first- and second-layer methods. They face strong competition from the Cardano and EOS platforms which are attempting to solve Ethereum’s scaling issues from the ground-up, along with projects such as Rootstock that aim to provide smart contract functionality on the Bitcoin blockchain as a second-layer solution.
Another consideration is regulatory risk. In particular, projects that had ICOs and are now deemed to be securities by the SEC, but did not comply with existing law, face a potentially uncertain future. It is significant to note here that projects such as Bitcoin, Litecoin and Monero should be largely unaffected by securities regulations, since they are fully decentralised networks that grew organically as the coins were mined into existence over many years. Cryptocurrencies that focus on privacy and fungibility such as Monero, Zcash and Zcoin fulfill potentially large demand for a ‘Swiss bank account in your pocket’ (and meet arguably important criteria for sound digital money), however they would likely be the first targets of any concerted regulatory effort demanding the ability to track cryptocurrency payments. Smart contract platforms such as NEO, which sacrifice a degree of decentralization, are likely to be the most resilient against further potential regulatory crackdowns in countries such as China, where authorities will demand a degree of control.
The value of utility tokens is driven largely by demand (actual or speculative) for the product or service that the token offers access to, and so it is important to assess these on an individual basis. If an existing company is attempting to tokenize their products or services and move them to the blockchain, then another pertinent question to ask is what tangible benefits this decentralization brings to their business model. While many utility tokens (and indeed other types of cryptocurrencies) might struggle to retain value over the long term, the network effect suggests that those projects which provide efficiencies, manage to scale, and gain significant traction could win big.
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