Section I

Section I

What’s Wrong With The Cryptocurrency Boom?


On the challenges of evaluating cryptocurrency for investors and portfolio managers.

“To me, it’s just dementia. It’s like somebody else is trading turds and you decide you can’t be left out.”

— Charlie Munger on cryptocurrency, May 5, 2018

Cryptocurrencies have made headlines, despite some obvious contradictions. These contradictions include:

  • No clear utility, despite the enthusiasm. There is over $200 billion of USD value held in cryptocurrency, spread across 2.9 - 5.8 million Internet users worldwide.[2] It is hard to apprehend a clear use for them, but enthusiasts boast about their long term value.
  • Hated by exactly half of Wall Street. Bitcoin is condemned with vigor by traditional investors like Warren Buffett, who said “[Bitcoin] is rat poison, squared,” and Chase Bank CEO James Dimon, who called it “a fraud.” Yet it has been been embraced by high-tech heavyweights like Jack Dorsey, Peter Thiel, and ICE; banks including Goldman Sachs and Morgan Stanley have announced cryptocurrency desks.
  • Dominated by a single IPO. The only notable public offering to come from the cryptocurrency industry has been Bitmain, a three-year-old company that makes Bitcoin mining hardware. Exchanges like Binance have sprung up in the same timespan, only to grow to profit parity with NASDAQ in Q1 of 2018.[3]
  • Copied by the world’s brightest entrepreneurs. Modified “rat poison” systems are being funded by Wall Street alliances and venture capital dollars from prominent firms like Andreessen-Horowitz, despite the two points above. $6.3B was raised in token offerings in Q1 2018 alone.[4] Facebook and Google both have blockchain divisions.[5] [6]
  • Fraud aplenty, but no killer apps. Mainstream computer scientists say Bitcoin is a step forward in their field, bringing together 30 years of prior work on anti-spam and timestamping systems.[7] [8] There remains no “killer app” in sight, but the SEC has subpoenaed no fewer than 17 cryptocurrency sellers, issuers, and exchanges since 2013 for using the technology to defraud investors.[9]
  • Massive popularity in troubled emerging economies. Bitcoin has hit all-time-highs in price and trading volume in struggling economies in South America such as Venezuela, Colombia, and Peru.[10] [11] [12]

How should investors make sense of these contravening narratives?

Obstacles to understanding cryptocurrency

IT systems is a $3.7 trillion dollar industry worldwide.[13] As we will show, commercial software companies compete directly with free-to-license software systems such as Bitcoin, and have strong incentive to try to reframe their utility in order to make their proprietary systems appear better.

Bitcoin, and many copycat cryptocurrencies, combine a series of previous innovations in cryptography and computer science to form fully-featured digital currency systems, which have different properties from the currency systems in wide use today.[14] Transaction records are held in “triple entry,” by both participants and the network itself; changing the network’s record would take an enormous amount of computing power and capital.

Bitcoin’s “immutable” append-only data structure (colloquially called the “blockchain” or “distributed ledger”) has been kidnapped into the pantheon of enterprise technology fads along with jargon like “cloud,” “mobile,” and “social,” with enterprise software marketing downplaying its original use-case in currency systems, promulgating instead its virtues in niche, segmented commercial use-cases.

Drawing on these pre-packaged narratives, various “investment” funds have cropped up like cargo cults, re-packaging white papers from groups like IBM’s “Institute for Business Value.” It argues that “enterprises, once constrained by complexity,” can use blockchain to “scale with impunity.”[15] It sees blockchains as useful for transactions between institutions, promising “the tightening of trust” and “super efficiency.”[16] Many of these investment advisors seek to launch individual “tokens” or “crypto-assets” for privately-operated networks, designed for niche enterprise “needs.”

We will show that cryptocurrency is the result of a retaliatory movement against the “impunity” of large “trusted” institutions. Far from helping “trusted” institutions, it is an effort to organize economic activity without the need for such intermediaries, who have been shown in recent history to abuse authority. Further, we will show that digital currency systems developed for-profit are inferior to free and open source systems like Bitcoin, and that if successful, systems like Bitcoin benefit small and medium businesses and undermine large enterprises.

Uncomfortable questions about Bitcoin’s creator

The creator of Bitcoin, Satoshi Nakamoto, was solving a very particular problem when he or she designed a blockchain-based currency. Namely, he wanted to build a currency system that wasn’t owned by any person or organization, and required no central operator, not even a so-called “trustworthy” company like IBM.

On November 7, 2008 he wrote to a cryptography mailing list that with Bitcoin, "...we can win a major battle in the arms race and gain a new territory of freedom for several years. Governments are good at cutting off the heads of a centrally controlled network like Napster, but pure P2P [peer-to-peer] networks like Gnutella and Tor seem to be holding their own." [17] [18]

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Figure 0: Distributed (left) and centralized (right) network architectures.
(Credit: Wikimedia)

Who is “we,” and why is there an arms race over cryptographic network technologies? Nakamoto expects the reader to know the context. On June 18, 2010, Nakamoto tells the Bitcointalk forum that he has been working on Bitcoin since 2007, and that the peer-to-peer aspect was his biggest breakthrough: “at some point I became convinced there was a way to do this without any trust required at all,” he says, “and [I] couldn’t resist to keep thinking about it.”[19]

In earlier digital currency experiments, counterfeiting was a common problem, but so was reliability. Participants in the system had to trust that the central issuer of the digital currency was not inflating the supply, and that its systems wouldn’t fail, losing transaction data.[20] Nakamoto believed that Bitcoin would be most useful as a peer-to-peer network wherein the participants in the network could operate ad hoc, without knowing one another’s real names or locations, and “without any trust” between them. This, he believed, would create a network where participants could operate privately, and could not be shut down by regulating or bankrupting a central operating group.

The system Nakamoto built was more than a proof of concept. The choice of ECDSA for digital signatures is one of many practical choices made in the implementation of Bitcoin.[21] In the same post on June 18, 2010, about a year and a half after the network’s launch, Nakamoto said: “Much more of the work was designing than coding. Fortunately, so far all the issues raised have been things I previously considered and planned for.”[22]

Nakamoto pictured that Bitcoin was destined for either mass success or abject failure. In a post on February 14, 2010 to the Bitcointalk forums, the creator of Bitcoin wrote: “I’m sure that in 20 years there will either be very large [Bitcoin] transaction volume or no volume.”[23]

Nearly a decade into Bitcoin’s operation, it now transacts $1.3 trillion of value per annum, more dollar volume than PayPal.[24] This is a significant feat by the standards of Bitcoin’s creator, and by the creators of its predecessors, and yet portfolio managers have not developed strong explanations for its meaning and impact.

What’s wrong with current investment narratives

Bitcoin was one of many experiments in independent digital currency systems, but the first which has produced a valuable, widely-traded asset. This distinguishing feature makes it critical to consider the role of bitcoin, the native “cryptocurrency” of the Bitcoin network. (Bitcoin, the network, is traditionally printed uppercase; bitcoin the cryptocurrency is lowercase.)

Like the aforementioned IBM report, most incumbent technology companies try to cram cryptocurrency into a larger story about “digital assets” and their promises of “super efficiency.” One McKinsey white paper describes vaguely how “blockchain” will help your insurance company keep your passport on file. [25] These incoherent stories typically place cryptocurrency into one of several pre-existing sectors:

Enterprise software. In which blockchain technology is analyzed through a venture capital lens, despite the fact that the most widely-used cryptocurrency protocols are classified as “foundational” not “disruptive” technologies, and are free software.[26]
Capital markets. There is a movement to “tokenize everything” from debt to title deeds. However, these assets are already highly digitized, so this amounts to suboptimization.[27]
App economy. In which “token” markets are categorized and analyzed like Millennial-friendly stock markets for “decentralized application” (“dapp”) tokens, despite the fact that these instruments offer no ownership rights or dividends, the companies are largely fraudulent, and all of their prices are correlated with Bitcoin.

These three misleading narratives create problems for investors, who can see the asset class growing, yet cannot find a sensible explanation. Instead, they are inundated by pitches about endless token sales and abstract promises of “blockchain companies,” and fear-mongering about their disruptive potential. Any temptation to invest in these schemes should be tempered by three obvious facts:

Over half the asset class is one product, Bitcoin, a currency system which is still not widely understood by institutions or the retail public.
This product is an ownerless currency, yet most “blockchain companies” are not building general-use currency systems, but far more niche systems for businesses.
Bitcoin has not been exceeded in use or market cap by any of these subsequent systems, public or private, even after thousands of attempts.

Explanations of Bitcoin’s promise have lacked the requisite context needed by investors. Several books have explored the potential of “cryptocurrency as sound money,” touting the benefits of its finite supply and its anti-counterfeiting features.[28] [29] [30] But the motivations of the participants who create these systems are rarely discussed.

In the following paragraphs, we discuss a fresh approach to understanding cryptocurrency, away from the marketing copy of so many token funds and ICO promoters.

New qualitative approaches are needed

Many useful quantitative studies have been done on blockchain and cryptocurrency, presenting data on the number of wallets in use, currency flows, transaction throughput, and price action, as in studies by Cambridge University and the World Economic Forum.[31] [32] However, these studies stop short of explaining why the pursuit of a functional cryptocurrency was interesting to technologists in the first place. What behaviors, exactly, are these systems enabling?

When behavioral phenomena are driven by the promise of new territory or industry, the kind of “territory of freedom” alluded to by Satoshi Nakamoto in his or her letters, the promise of such territory can be hard to measure empirically. Roger Martin, dean of the Rothman School of Management, argues that “the greatest weakness of the quantitative approach is that it decontextualizes human behavior, removing an event from its real-world setting and ignoring the effects of variables not included in the model.”[33]

Several pertinent questions can lead us in the right direction: [34]

  1. Framing the problem as a phenomenon:
    1. “What’s wrong with the cryptocurrency boom?”
  2. Collecting information about key participants:
    1. “What is the historical background behind the phenomenon?”
    2. “Why is it emerging now?”
  3. Finding patterns and insights:
    1. “How do the key participants organize themselves?”
    2. “Where have they been successful, and how do their tactics work?”
  4. Hypothesizing about potential impact:
    1. “Where does value accrue?”
    2. “Where should investors allocate?”

This essay is intended as a high-level primer for investors, to answer these questions and more. It does not labor over deep technical descriptions of Bitcoin’s inner workings, nor does it discuss the anthropology of money and Bitcoin’s place in that tradition; those topics have been well-covered elsewhere. Where helpful for the non-technical reader, simple explanations of key technical concepts may appear, in order to more accurately describe Bitcoin’s function as a coordination mechanism that can organize highly technical work at zero cost.