I’ve been pretty disparaging about bitcoin in recent months. In a nutshell – I think the whole thing is ridiculous. I’m also aware that I potentially haven’t been taking it seriously enough. In order to get a better understanding of the value proposition of cryptocurrency and the blockchain, I turned to Patrick O’Shaughnessy, host of the excellent “Invest Like the Best” podcast. In particular, Patrick released a series of episodes focusing on cyrptocurrencies and the blockchain called “Hash Power”. You can find them here, and I highly recommend them.
I listened to the first two episodes over a couple of days (they are dense!) and a hash power single about the valuation of cryptocurrencies later in the week. Here are my notes.
The Concept of the Blockchain
The blockchain has always seemed like the most interesting part of the rise of cryptocurrency to me. SO what exactly is a blockchain? As Jeremiah Lowin explains, a blockchain is an append only database, just like a ledger. The reason blockchain is special is because it is distributed – hosted by many different computers in a peer to peer network. No one person has control of it, and it is, in theory, tamper proof.
The contribution of the original bitcoin paper was to create a methodology that allows users to trust the database, even though we don’t know who is contributing to it.
Why is the Blockchain Important?
The blockchain is important because it provides a way to own a digital asset. Previously, digit assets had been hard to own. A digital asset is simply a bunch of ones and zeros – and this means that digital assets can generally be copied.
So how does a blockchain protect a digital asset? The blockchain, if we all agree shows the true state of the world, allows a user to own, and prove that they own a digital asset. Because everyone has already agreed that I own it.
The example Patrick provides is a digital key for your house. Even though everyone may possess the same ones and zeros that comprise your digital housekeep, because the blockchain has agreed that I am the owner of the asset, only I will be able to use the key.
Blockchain is a way to track the digital ownership of assets. Importantly, blockchain allows the concept of digital scarcity to exist.
The blockchains have allowed the creation of digital currencies. These currencies are means of exchange within a contained network, of which each network incentivises some users to provide value (things like storage, for file coin, or solar energy).
ICOs typically don’t have their own blockchain, but are programmed into ethereum
Investing in Cryptocurrencies
The second episode was a little bit more interesting in my opinion. By interviewing three cryptocurrency investors, Patrick manages to deliver some insight into what makes a particular cryptoasset valuable.
As it currently stands, Bitcoin and Etherum represent 75% of the total market cap of crypto assets. These two, bizarrely, have the same market cap as IBM (which has ten billion in earnings).
One of the reasons I thought I might try to understand cryptocurrencies a bit better was highlighted by one of the participants, Ari. Ari highlighted the Mt Gox incident – an incident which saw a number of bitcoins essentially disappear.
Ari noted that when an asset doesn’t die (and it may have, after Mt Gox), and it doesn’t, there is something underlying the asset that is worth taking a closer look.
One thing I have always struggled with is the use case for Bitcoin. Ari notes that this sin’t a problem for people in the US or Australia – but imagine if you were a wealthy person in India. Earlier this year, you had fiat currency – and it was confiscated. We are lucky here that we don’t have to worry about this, but for some people this a real and present danger. Ari notes that “you can cross borders with a billion dollars in your head”, which could certainly be very attractive in some situations.
What makes a good crypto asset?
A good crypto protocol:
- Resource provided by participants is similar
- Resource verifiable
- Resource provided by distributed participants
An important question to ask with new coins: does this need to be a separate coin.
Interestingly, all participants noted that there a very good arguments against specific blockchains, and in fact, all coins may be bad investments. The money quote from this section: “They might be worth a bunch, They might be useless.”
Indeed, you can be positive about cryptocurrencies but still be worried about prices! Jordan Cooper, a Venture Capitalist, believes 80-85% of the projects that he has examined are zeroes. A lot of those projects have $20m-$2b market caps. He has spent a decade investing in early stage companies but still believes some of these are incredibly risky. He also notes that investing in crypto indices right now is a poor idea, stating that you are currently indexing at highly inflated prices.
network effects
Valuing Cryptocurrencies
Cryptocurrencies may just be a store of value. BTC has no utility value, so its only value is store of value use case. This might be attractive, as it is “highly likely that it keeps its store of value proposition”. Is it a positive that your currency also having an industrial value? Gold can store value but also has industrial utility; Ether can store value but also has industrial uses. Maybe its more like silver or gold.
The only thing I would say here is there are no cashflows here. There is no traditional way to value these tokens. One thing that may be worth looking at further, if you are interested, is the Fat Protocol theory – this theory states that the value of blockchains will accrue to token holders, not app makers. For example, Coin Base is worth $1.6b and is the biggest company in the space, but BTC is worth $100b!
There are incredibly strong network effects with protocols. It is likely that one token will dominate each particular use case. A potential solution suggested for those looking to speculate in these instruments would be to invest in your favoured token in each base use case. Alternatively, think to yourself: what sort of tokens may be useful and still around in 10-15 years?
Blockchains are here to stay. The fact that Bitcoin is not tethered to underlying utility, may mean it’s a better investment. Pretty wild.
Not so fast
The passion with which these participants talk about Bitcoin and other tokens is infectious. Nonetheless, I still remain highly sceptical.
A quote from Josh Brown at the Reformed Broker:
“In many ways, Bitcoin represents the perfect mania – as there are zero cashflows or dividends or earnings involved with this asset class, there is literally no traditional way in which to value it.”
It is unlikely that anyone will ever be able to find a satisfactory way to value these tokens. While I may eventually buy an extremely small amount of some of these coins to familiarise myself with the process, its difficult to argue that putting any money in to these tokens is anything other than speculation.
Despite the fact that Bitcoin is definitely not for me, I still highly recommend Patrick O’Shaughnessy’s podcast – they are generally fantastic.