Some thoughts on cryptocurrencies

December 19, 2017

To anyone living in the West the purpose of Bitcoin and the blockchain can seem opaque because we have functioning legal systems, rule of law, no capital controls and respect for property rights. However, that is not the case in many countries.

My interest in Bitcoin and cryptocurrencies started because of my connection to Argentina. I helped co-found Deremate.com in 1999, which ultimately became Mercadolibre which is headquartered in Argentina. OLX also had most of its employees in Buenos Aires during the bulk of its history, especially the technical, product, QA, customer service and content moderation teams. As a result, I lived 2 to 3 months per year in Argentina between 2006 and 2013.

Between 1999 and 2015 I observed the forced conversion of dollars to pesos at an artificially inflated rate of 1 to 1 in 2002 after the currency board failed. Over the next decade, the Kirchners faked inflation statistics, introduced capital controls and nationalized the pension funds. This created a large difference between the black-market rate for dollars (which approximated the ‘market’ rate) and the official rate starting in 2012.

Bitcoin triggered my attention during the first bubble of 2011 when the price hit $30. I was intrigued by its possibility of being a store of value for those facing arbitrary confiscation or devaluation of their assets. Gold can and has also served this purpose, but it’s inconvenient to buy, sell, and hold, especially in the very markets where you need it the most. Diamonds, art and other assets also have cons.

Being an avid gamer, I always own many PCs with very powerful GPUs so I decided to try mining some Bitcoins for fun. The only real memory I have of that experience is how painful it was to do – and I am technically savvy and was doing this for fun. Even the creation of an account on BitStamp at the time was inordinately painful (Coinbase did not exist yet). The only lasting impression I had was that as inconvenient as gold was, mining, buying and safely keeping Bitcoin was even more inconvenient.

That said, it did not deter many Argentine entrepreneurs, like my friend Wences Casares. He also recognized the potential of Bitcoin as a store of value and identified its flaws. He decided to build Xapo to address some of them, especially to be able to store your Bitcoin safely in a “Vault” and to spend it with their debit card.

Over the years whenever Bitcoin would hit a new high, it would pique my interest again and I would mine some coins and add them to my wallet on Xapo. That said, after ASIC miners were released in 2013 (as GPUs were way less efficient for the task) the amount of Bitcoin I mined kept declining.

Note that I never saw, and still don’t see Bitcoin as a currency. A good currency needs to have stability in value, be generally accepted and inexpensive to transact in. Bitcoin is none of these things. Bitcoin was built for resilience in the face of potential government opposition, not for efficiency. It’s far too expensive, energy inefficient and slow to calculate and settle Bitcoin transactions for them to be a replacement for a payment system like Visa which can handle more than 50,000 transactions per second. Also, its intentional deflationary nature, increasing value and extreme volatility make it a bad currency, even if a second layer solution like the Lightning Network significantly decreases transaction costs.

However, its resiliency, portability and deflationary nature make it a good store of value, one more akin to gold. It’s truer today than ever before as there are exchanges like Coinbase that make buying and selling Bitcoins (and other cryptocurrencies) easier and more accessible than ever before

That said, it’s still early days and you need to take security measures if you own Bitcoin that most people have probably never considered. There are no easy ways to store and insure your Bitcoin. If you leave them on an exchange you risk that exchange being hacked as Mt. Gox famously was. In 2014, they handled 70% of all Bitcoin transactions worldwide when 850,000 bitcoins belonging to customers were stolen. They subsequently filed for bankruptcy and went out of business.

You face the same risk with other exchanges. Even if the exchange is not hacked, you risk your personal account being hacked and having all your crypto currencies stolen as happened to me a few months ago. I will detail that event in a subsequent blog post. Even if you store them offline you face the risk of having your wallet stolen, losing it as in The Big Bang Theory’s “The Bitcoin Entanglement” episode this season, or simply forgetting your password as infamously happened to Wired writer Mark Frauenfelder in his epic tale of hacking his own wallet.

Like many early observers of Bitcoin, I became interested in alt coins reasonably early, especially Ethereum. Both Bitcoin and Ethereum are blockchain based networks. However, they have very different uses. Bitcoin is built to allow online bitcoin payments and the blockchain tracks ownership of the bitcoins. Ethereum is a software platform that enables developers to build and deploy decentralized applications. Miners work for Ether and the Ethereum network focuses on running the programming code of any decentralized application. I suppose it also did not hurt that GPUs were more efficient at mining Ether and Litecoin than Bitcoin 🙂

Ethereum is useful because it’s the building block for many decentralized systems, but again we are very early in the deployment of applications. The most relevant products like Augur, OmiseGo, Kyber Network, 0x, and Golem are essentially building blocks for decentralized applications. Given both the lack of ease of use and of fundamental scalability of the applications, we are at least two years away from mass market blockchain applications. Fundamental products like proper custodian services for institutional investors have yet to be built.

I have been putting some thought into what marketplaces to build on the blockchain. Unlike some crypto enthusiasts I don’t think decentralized systems will take over the world and replace all existing marketplaces. Centralized marketplaces play an important role in terms of verifying the quality of suppliers and consumers, providing customer service, improving the product, investing in marketing to build liquidity, etc. The commission that the centralized platform takes is less important than whether the platform has liquidity. You can build a free version of Airbnb, Uber or eBay, but given that sellers would not find buyers for their products and buyers would not find what they are looking for, no one would use them.

In other words, decentralized marketplaces on their own are unlikely to replace existing centralized marketplaces that have liquidity. However, there are cases where a marketplace can benefit from decentralization, an immutable public ledger, the use of tokens to incentivize early use to create liquidity, and where there are no strong incumbents (or incumbents charge commissions far in excess of the value they provide).

In this case, a token (unique to the platform) might make sense to incentivize early users to provide liquidity to the platform. The use of tokens is a method of kick-starting platform liquidity, whereby those on the supply-side are paid a small number of tokens (from a fixed supply, similar to Bitcoin) by the platform for effecting a transaction. Different platforms deploy different economic models, but in a simplistic example those on the demand-side would pay for services using the same token. So, as liquidity on the platform increases, the tokens appreciate in value and thus early users (having been paid in tokens at a lower value) are rewarded. ICO’s are really just the sale of some percentage of the fixed supply of tokens, with proceeds used to finance the development of the network, and with investors hoping to benefit from the same appreciation that platform success will lead to.

Many believe that the use of tokens will replace the marketing role a centralized platform would typically take. In reality, while this feature should serve to attract initial users more easily than a centralized platform, traditional marketing methods will also need to be deployed to grow the network. As a bit of a non-sequitur, decentralized does not necessarily mean that the platform will take no commission as some crypto enthusiasts imply. Often, these platforms build in mechanisms through which they earn a small amount in tokens for every transaction facilitated so that they can cover the costs of running the platform and/or providing value-added services.

Many markets would benefit from having an immutable public history/ledger. For example, the cost of pulling land/building title from the land registry authority is expensive and the registry requires a large infrastructure to maintain, so having a public immutable ledger would reduce the cost of maintaining infrastructure (reduced government budget), and decrease the cost and increase the speed of buying/selling homes.

The MLS is a great example of why you’d want this to be on blockchain. Only brokers have access to the MLS and so if anyone wants to know what recent transaction prices of similar homes were, or to publish their home sale listing for others to see, they would need to pay a broker a 6% commission on their property value. In some US states, consumers have won, and this MLS data can be published widely (but you still need to be a broker to post a listing), whereas in other states and in Canada the data is totally private and thus consumers are taxed for the right to access it. However, it’s unlikely to happen, because the MLS is owned by the brokers and publishing the data would eliminate their ability to earn fees disproportionate to the value that they provide. Registries that don’t yet exist are more likely to be created on blockchain rather than replacing existing ones.

The crypto world as it stands today

I am extremely bullish on the future of the blockchain and cryptocurrencies. However, I also believe that most of the coins in existence today will go to 0. Many of them have no fundamental reason for being. The application they support does not fundamentally require a coin. Moreover, there is a large amount of fraud and frankly ludicrous projects that have ICO’d. ICOs will not replace venture capital. Only blockchain applications are being funded by ICOs and frankly most of the companies that ICO’d would not have been funded by proper investors. What is creating the frenzy in ICOs right now is a fundamental imbalance in supply and demand. You have large crypto holders in countries like China who are looking for assets to buy, the easiest of which are other crypto currencies. That bubble will eventually burst, though I am not foolish enough to begin to pretend to know when that will happen. Bubbles tend to last longer than people “in the know” suspect.

When the Internet bubble burst, hundreds of companies failed. However, they left behind the infrastructure and some of the companies that ultimately led to the Internet revolution we are still experiencing today. The current crypto bubble will also burst. It will wipe out the value of many coins and companies, but it will have funded the creation of the building blocks of future successful crypto and blockchain applications.

Of late the ICO market has cooled, but a similar bubble is forming in the private pre-sale market. A similar supply / demand dynamic is driving the increase in the price of Bitcoin. The total ultimate supply of Bitcoin is limited and the increase in its rate of supply declining. Yet as the price has increased more and more people have become interested in owning some. As both retail and institutional investors increase demand for Bitcoin the price rises.

How FJ Labs plays in the crypto space today

Historically, the best and easiest way to play the crypto space was just to own Bitcoin and Ether. Any project built on top of the blockchain essentially assumed the success of either. So instead of taking business risk on top of market risk you were better off just owning the currency. As the market cap of crypto currencies topped $500 billion, we changed our approach.

By sheer luck, I implemented that change and sold all my crypto right before I was hacked and whatever I had left was stolen (only 0.01 BTC 🙂 though many of us still have direct crypto ownership.

As I mention in my nontraditional approach to wealth management, I usually recommend against investing in hedge funds because the fees eat all the return. However, in the currently unregulated crypto world there are real arbitrage opportunities and immense information asymmetry (i.e. markets aren’t efficient). We invested in Blocktower, which actively trades crypto assets. They have their finger on the pulse of the market and have deep finance expertise. We felt they would be better traders than we are. We also invested in Metastable Edge which is one of the first crypto funds. Lucas, Josh and Naval are an amazing team.

More relevantly, we started investing in crypto companies. We are investors in Basecoin which aspires to be a price-stable cryptocurrency. We invested in SAFTs (simple agreement for future tokens) in TrustToken, Orchid and Biddable.

TrustToken is trying to be a bridge between blockchains and the $256 trillion worth of real world assets. Orchid is a decentralized, open-source technology for an Internet free from surveillance and censorship.

Biddable is a decentralized registry for art and collectibles. It’s a perfect example of market infrastructure that makes sense to be on the blockchain. Biddable has a consortium of industry stakeholders behind it, including Live Auctioneers and Auction Mobility which will be providing much of the art transaction history data that informs authenticity. It’s a market where a registry does not currently exist and where there is a lot of value for one to exist in the blockchain. At the same time, it’s currently hard for crypto owners to buy real world assets, including art and it makes a lot of sense to allow them to invest in the asset class.

We are thinking of building a dedicated crypto fund. We have good deal flow and are continuously evaluating new investments. There are still clear inefficiencies in buying Altcoins. Even if you know which ones to buy, you need to first buy Bitcoin, then transfer them to an exchange that allows their purchase. Then you transfer them off exchange to avoid counterparty risk and store them securely. All those steps are reasonably painful, and we had to develop that expertise.

It’s very early days. The current ICO and private pre-sale bubble is eventually going to pop, but like the Internet bubble before it, this bubble will lay the groundwork for the future successful blockchain applications. We’re only at the very beginning of an exciting journey and I can’t wait to see how it plays out.

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