Cryptocurrencies: Theory and practice

(En español aquí)

We have seen that the blockchain is the next step in the evolution of information technologies. Blockchain allows for inmutability, auditability, resistance to tampering, decentralized trustless sharing, smart contracts and much more. Blockchain as a technology has many different use cases. It has been used for birth registries, banking technology, identification systems, supply chain transparency, diamond tracking and much more. However, the “killer app” for now has been cryptocurrencies and that is what has been in the news.

Cryptocurrencies have now a market value of over 100 bn €s (fluctuating wildly every day) and have become a force to reckon with. Global CEOs criticize it. Most of this value is in Bitcoin and Ethereum which represent two-thirds of total value, with the top 5 coins representing over 80%. There has been a continuous launch of new cryptocurrencies through Initial Coin Offerings or ICOs, which China recently banned at least temporarily.

Blockchain technical advantages are uniquely suited to create cryptocurrencies as next generation mediums of exchange and stores of value. Immutability, auditability and resistance to tampering allow creating a “coin” that is immune to the counterfeiting or debasing of physical coins. Cryptographic security means coins are safe and there is no stealing possible (at least while the private keys are safe). Smart contracts and programming create great flexibility in its functioning going beyond simple money. Algorithmically limited supply of coins allows guaranteeing there will be no inflation.

Cryptocurrencies have two types of value, a utility value and a medium of exchange value. The utility value represents what some tokens can do natively. Some tokens like Ethereum give you access to computing power, others like StorCoin J allow you to store information. The medium of exchange value is based on shared belief, if someone will accept a cryptocurrency as payment layer, then it has a value now. Of course, the moment that shared belief disappears, the value disappears. Bitcoin has no utility value, only exchange value. It is arguably the first currency that has achieved its status without either government fiat (e.g. post-gold standard dollars) or utility value (e.g. gold). Of course, like its critics like to point out. it could lose its value in an instant when confidence is lost, much like fiat currencies sometimes do (think the Bolivar, not the dollar).

The bear case for investing in crypto currencies is related to its exchange-value only nature:

  • Volatility, potentially down to zero. Having no utility value and no government fiat means that Bitcoin and many other cryptocurrencies could drop immediately to zero value just based on loss of confidence or a swift move to a better alternative.
  • Proliferation and fraud in the long tail. There is an increasing number of coins, many of which have been put together by very few individuals. Can any of this coins be the “bitcoin-killer” destabilizing current market caps? Will many of them be pure Ponzi schemes?
  • Need to preserve the private keys. A cryptocurrency is totally safe as long as the private key is safe. However, the person holding the private key is human whether it is an exchange (Mt. Gox) or an individual that loses the key or is swindled from it.
  • Sensitivity to regulation and protocol evolution. Regulatory actions, like China’s ban of ICOs, or protocol evolution, like Bitcoin’s hard fork in August, can have strong destabilizing effects on their values.

The bull case for investing in cryptocurrencies can be summarized in just one phrase: “cryptocurrencies are just one new asset class for people to have in their portfolio”. If this is the case then the question is what percentage of the portfolio will people have in cryptocurrencies. Total wealth in the world is estimated at 250 USD Trillion so current cryptocurrency capitalization of ~125 billion USD represents 0,05% of total wealth. If you think people will hold 1% of their assets in crypto you have still a 20x rally in price (given that supply is limited). If you think the number is 10% as some commentators have ventured you have a 200x, just enough to reach the $1 million Bitcoin some of the most bullish promoters defend.

Investing in Cryptocurrencies

Investing in cryptocurrencies used to be extremely difficult and reserved to the technically savvy, but a host of startups are working to make it really easy. These startups include exchanges (Coinbase, Kraken, Bittrex…) in which you can buy and sell criptocurrencies, wallets to help you store them (Jax, Parity,…) and other utility players (Shapeshift, Prism,…).

I personally believe that while cryptocurrencies are an extremely speculative investment they might have their place in a portfolio. Investing in crypto is also a way to get to understand a bit better a very different world that is emerging. To invest in crypto it makes sense to go through several stages, based on my own experience and that of some other people I know that invest I would think the following could be appropiate

  1. Invest a trivial amount in Bitcoin and Ethereum through the app of one of the most user-friendly exchanges even if commissions are high (in my case it was Coinbase). That will give you the feeling for the volatility.
  2. Understand more about Bitcoin and Blockchain with some of the great resources on the internet. The 10 papers in this article are a great starting point.
  3. Make a speculative investment mainly in Bitcoin and Ethereum, and if you feel like it Litecoin and Bitcoin Cash, through one or several of the more cost-efficient exchanges (e.g. Kraken). Invest only what you can afford to lose completely, consider it tuition fees.
  4. Finally, you can go deeper into the rabbit hole and start investing into exotic coins. This requires in depth investigation and specialist knowledge. You might want to do things like joining the slack channel of the developers and reading the white paper.

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