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    November 16, 2017

    Getting started with cryptocurrency: an investment thesis

    Bitcoin 5000 crypto

    With the recent explosion of alt coins and ICOs I’ve been thinking about a strategy for investing in alt-coins that fits with my assessment of the current crypto landscape.

    This post is an attempt to distill my current view of the industry so I have something to come back to when I make investment decisions. Below is a list of statements I currently believe are true and have a bearing on how I think about investing in crypto assets. I am almost certain I have not included everything of relevance. I’m also pretty sure I’ve got some of these wrong and will change my mind later. Please get in touch if you think I missed anything or disagree with my assessment.

    I don’t explain all my statements in great detail but wherever possible I have linked to sources that do so.

    Blockchains are interesting because they are open, peer to peer and decentralized

    Because of the peer to peer decentralized nature of blockchains they allow for open, borderless and permissionless operation. Any blockchain that is permissioned, closed and centralized misses the point entirely.

    Distributed consensus algorithms are complex, expensive and slow compared to centralized alternatives. This complexity and computational cost is worth it because it gives you an open and decentralized network that doesn’t rely on trusted third parties. If you introduce a trusted third party into the equation blockchains are no longer the optimal design decision.

    There are 3 general classes of cryptocurrency

    Currencies

    Money was the obvious first use case for cryptographic tokens and is the most successful application of blockchains to date. Coins like Bitcoin, Litecoin, Monero, ZCash etc play in this space. The potential market size for these tokens is massive.

    Platform tokens

    Platform tokens represent a scarce platform level resource (computation, disk storage, identity, etc). These tokens typically have their own blockchain and incentivize the participants in the network to provide the resource represented by the token. The total market size for these coins depends on the demand for the resource they represent.

    Application tokens

    Application tokens are tokens that represent access or utility in an end user application (Steem, Wings etc). These tokens often depend on platform and currency tokens.

    Money and the monetary system are not the same thing

    We have gotten so used to the current monetary system that we sometimes forget that the monetary system is not the same as money.

    The monetary system is the system that manages the creation and flow of money and credit. In our current system the major actors are the central banks which manage the creation and circulation of new money and banks which provide credit.

    Money is the language we use to communicate value. Over the centuries money has taken on many forms. Shells and feathers, carved stones and shiny bits of metal have all served as a money in the past. It’s even possible to teach monkeys to use money. The important thing to remember is that money is useful because it allows us to honestly signal what we value. and provides a mechanism to transfer that value to another individual.

    For something to be used as money it needs to have certain properties that help it satisfy the 3 main uses cases for money (see below). The monetary system is merely the system we have agreed on as a society to ensure the properties of money hold.

    Use cases for money

    There are three major uses cases for money:

    Store of Value

    Money has to be good at storing value over the long term. Gold is very good at this use case while the USD is not as good a store of long term wealth because of inflation. Bitcoin is starting to show some signs of being a good store of value although it still needs to build a longer term track record.

    Means of Exchange

    A way to transfer value in return for goods or services. Fiat currencies are very good at this use case. Gold is not nearly as good as a means of exchange (just try pay for milk in gold at your local super market). Bitcoin lags far behind on this use case since so few merchants accept Bitcoin

    Unit of Account

    A standard numerical unit of measurement of market goods, services and other transactions.

    Properties of Money

    To satisfy the use cases above any currency needs to have the following properties:

    • Fungible One unit is viewed as interchangeable with another
    • Durable Must be able to be used repeatedly
    • Divisible Can be divided into smaller units of value
    • Portable Can be carried with you and transferred to others
    • Acceptable Everybody must be able to use the money for transactions
    • Limited in supplyConstrained supply of money in circulation ensures values remain relatively constant.
    • Uniform All versions of the same denomination must have the same buying power

    Bitcoin along with a number of other crypto currencies exhibit the properties listed above to varying degrees. As the technologies improve and gain more adoption they should satisfy these properties to a greater and greater extent.

    Blockchains are a new way to organize society

    While blockchains are currently closely associated with crypto currencies it is becoming clear that they are a general-purpose information technology (similar to the internet and the microprocessor). The disruptive effect of blockchains is already spreading to other industries. Seen in this way blockchains will lead to massive wealth creation and an explosion of new applications across multiple industries.

    There is another, potentially more powerful, way of thinking about blockchains: as a new institutional technology of governance. What makes blockchains different from previous information technology revolutions is that they are both an information technology and an alternative way to govern the actions of groups of people. As a technology of governance, they compete with other economic institutions of capitalism, namely; firms, markets and relational contracts. There is also a case to be made that blockchains compete with governments as can be seen with Bitcoin which is a non-sovereign currency.

    When you compare blockchains as a governance technology to firms, markets and relational contracting it becomes clear that it will be a better at organizing certain types of collective behavior (open source projects for example) and it will also enable new kinds of collective behavior that have been impossible in the past (DOAs, Futarchy etc.). Some activities will migrate to blockchains, some will remain in the existing types of institutions and some new activities that weren’t possible or practical before blockchains will emerge.

    For more a more in depth exploration of this topic see Blockchains and the Boundaries of Self-Organized Economies: Predictions for the Future of Banking

    Crypto currencies provide an alternative monetary system

    For emerging economies that are struggling with corruption and a general distrust for government crypto currencies offer an exit ramp out of the current system. The combination of stable rules, no central control, borderless operation and censorship resistance is compelling.

    Even in developed economies distrust for the current monetary system has grown in recent years. Over time as cryptocurrencies build a reputation and become more stable they will become more and more attractive options for the general public.

    ICOs bring a capitalist funding model to open source projects

    Most of the large internet companies of today are built on top of a set of free protocols (FTP, SMPTP, HTTP, HTTPS, TCP/IP) and open source projects (Linux, Apache HTTP server, MySQL, etc). These protocols where developed between the early 1970’s and the mid 1990’s, primarily through government and academic funding. Open source projects like Linux and Apache are still in active development but many of the developers who work on these projects don’t make an income directly from their contributions to these projects.

    In recent years there has been a battle between open and closed software development. For the most part, the closed system has won. Largely due to the fact that closed source software development has a better business model. In this model startups raise VC capital with the aim of doing an IPO allowing investors and founders to capture the majority of the value created by these companies. Open source projects on the other hand have to go begging (look at Wikipedia’s donations campaigns as an example). This means most of the value is captured within companies and not in open and free protocols. Combined with the strong network effects seen in web technologies this has led to the centralization of power and resources in a small number of technology giants. At the same time, hardly any new protocols have been developed.

    The invention of cryptographic tokens and the ICO has brought a capitalist funding model to open source development. For the first time, it is possible for an open source project or network to:

    1. Raise funds from a global pool of capital to develop their project.
    2. Capture the value created in the network as a token.
    3. Create economic incentives usually only seen in startups (salary + equity).
    4. Kick start network effects by rewarding early adopters for the value they bring to the network.

    We are already seeing a massive influx of capital into open protocols. The first truly public, open and decentralized internet infrastructure is being built with this capital.

    For more information see below:

    We are building a (re)-decentralized internet

    The original vision for the internet was for a global decentralized network free from centralized control. In many ways, we have achieved this but we still have a lot of work to do. Due to the strong network effects seen on the web companies like Facebook, Google, Amazon and many others have built global monopolies. They own our data, activity and identity and sell this information to the highest bidder. We have become a product.

    Blockchains represent a return to the decentralized vision of the internet. As blockchains mature value will drain from companies into these new “fat protocols”. This will likely lead to a large number of network protocols where the value of the networks will be distributed on a log scale. The biggest networks will be extremely valuable.

    We are still in the installation phase

    Techno-economic paradigm shifts go through 3 major phases as they develop (Perez 2002).

    Installation period – Exuberance

    During the first part of the installation phase (Irruption) we see the birth of the new technoeconomic paradigm; old industries start declining and unemployment starts to rise.

    The very intense activity of the new paradigm carriers contrast more and more with the decline of the old industries. A techno-economic split takes place from then on, threatening the survival of the obsolete and creating conditions that will force modernization.
    -Carlotta Perez

    Next comes the frenzy. In this period, there is an influx of investment into the new paradigm leading to a small number of people making a disproportionate return on their investment. During the frenzy, the market gets greedy and we see a bubble form.

    It’s hard to say exactly where we are in the cycle but I estimate we are in the late stages of the irruption, we are seeing ICO’s raising hundreds of millions in minutes, 70 hedge funds that include crypto in their portfolio waiting for approval and hints of ETF’s coming soon. At the same time, we haven’t seen any major disruptions in existing industries as we would expect if we have passed through the irruption phase.

    Turning point – When the bubble pops

    The bubble pops and the market comes crashing down. All technoeconomic paradigm shifts go through this phase. Many of the projects that where started during the installation phase fail but some survive. No matter how promising a crypto project looks during the installation phase it faces some tough challenges:

    1. Technological hurdles – this is new territory; there might be some fundamental technological breakthroughs needed to make some of these networks possible.
    2. Unrealistic ambitions – some of these projects might just be impossible.
    3. Bad timing – the project is a good idea but came too early.
    4. Political challenges – crypto protocols challenge the power of nation states who might decide to ban them.

    Even though the huge inflow of capital from the previous phase dries up the underlying infrastructure that was built leaves fertile soil for the golden age to follow.

    Deployment period – The golden age

    By now the infrastructure needed for mass adoption has been built, there are large pools of skilled people who have experience with the new paradigm. During this phase of the internet revolution we saw the birth of companies like Facebook, Snapchat, Uber, Airbnb, Twitter and many more.

    Invest in infrastructure protocols not applications or companies

    Since we are still in the installation phase of the shift to blockchain (and potentially other peer to peer cryptographic protocols) we are still building the infrastructure layer needed for later consumer facing applications. However, unlike the internet revolution it is possible to invest in the underlying infrastructure protocols.

    Investing in protocols and not companies means your investment success is not tied to a specific company but instead to a more general-purpose protocol. Additionally, these protocols are open source so even if the companies that are currently developing them go bankrupt the code and IP does not die with the company. This might mean that compared to the dot com crash more of the early protocols survive over the long term.

    Some areas that could be considered infrastructure level technologies are:

    Technical infrastructure

    1. Distributed computation
    2. Distributed data storage
    3. Distributed naming system (DNS)
    4. Distributed identity
    5. Smart contracts
    6. Block nets (Polkadot, etc)

    Financial infrastructure

    1. Store of value
    2. Means of exchange
    3. Unit of account
    4. Distributed exchanges

    Organizational infrastructure

    1. Distributed governance

    Blockchains are not intrinsically good or bad

    Blockchains are a tool built by humans. Just like any other tool they can be used for good or bad. A hammer can be used to build a house for somebody in need or it can be used to attack a rival. Certain properties of blockchains (decentralization, fixed monetary policy, censorship resistance etc) seem to be answers to many of the problems we are currently facing as a society. It’s important to remember that along with solutions blockchains will bring new problems that we will have to deal with.

    Building secure cryptographic peer to peer protocols is hard

    To build robust, secure peer to peer cryptographic protocols require skills in:

    1. Economics
    2. Game theory
    3. Computer Science
    4. Cryptography
    5. Formal verification

    These skills are still scarce in the market. The tools available to developers are in their infancy making the job even harder. If you are going to invest in crypto protocols you have to bear this in mind.

    Take money off the table on the way up

    If the theory that we are in a bubble that is yet to pop holds how should you invest? It’s worth remembering that it is very difficult to predict exactly when a bubble is going to pop. If you sit it out completely you could miss out on years of growth. On the other hand if you over commit you can suffer significant losses when the eventual crash comes.

    How to handle it?

    1. Never borrow money to invest in crypto
    2. Don’t take leveraged positions
    3. Take money off the table on the way up and build reserves to re-invest after the pop

    As with everything the devil is in the details, there are still some questions I still don’t have good answers to:

    1. How much money to take off the table and when?
    2. Into which asset classes?

    For more information see Albert Wanger’s post: Some Lessons I Learned from the Dotcom Bubble for the Coming Crypto Bubble

    Follow an angel investment approach

    Given everything stated above it is clear that there is a huge opportunity to invest in the early stages of the next technological paradigm shift. It also becomes clear that there are huge risks. Projects are getting funded on nothing more than a PDF white paper and raising millions of dollars in minutes. Nobody knows what’s going to work and what isn’t and we are probably in a bubble that might pop tomorrow or in 5 years.

    So how do you invest in this environment? When you are investing in very early stage projects in the traditional angel investing model you face many of the same challenges seen in crypto today.

    My personal approach is:

    1. Identify sectors that have potential
    2. Determine potential market size for that sector
    3. Identify all protocols that play in that space (invest only in protocols and not companies)
    4. Eliminate the protocols that don’t have a chance of succeeding
    5. Make small investments and hold long term (3-5 years minimum)
    6. Adjust position periodically based on adoption metrics and market movement
    7. Build cash reserves by taking money off the table on the way up
    8. Re-invest after the bubble pops

    Conclusion

    Please bear in mind that none of this is investment advice. It’s just my attempt at seeing the forrest for the trees. Please get in touch if you have anything to add or disagree with me on any of the points above.

    Listen in to our latest podcast!