Publications

- November 1, 2019: Vol. 6, Number 10

Breaking the bank with digital currencies

by Reg Clodfelter

Ever heard of “flying cash”? No, it’s not an over-marketed form of frequent flyer miles, but one of the oldest recorded uses of paper money, introduced along the Silk Road around 800 CE. True to its airborne moniker, “flying cash” took off among Chinese merchants because it made transacting, especially over long distances, much easier than with cumbersome government-issued metal coins. The name came from the paper notes’ tendency to blow away in the wind, but could have also referred to the Chinese government’s repeated attempts to blow it out of popular use. Despite its efforts, the utility of the revolutionary technology proved too great, and eventually the Song Dynasty capitulated, issuing its own paper notes in 1024 CE.

Could Bitcoin — itself a superior method for transacting over long distances — follow a similar path? Will it become the “flying cash” of the future, a rebellious technology eventually co-opted by its greatest detractors?

Cryptocurrencies have certainly excelled at being rebellious in their first 10 years of existence, drawing the ire of banks, regulators and finance news pundits for years. But blockchain, the underlying technology behind Bitcoin, provides real value to financial operations. Just last year, two parties reportedly completed a transfer of $99 million worth of Litecoin, another cryptocurrency akin to Bitcoin, in 150 seconds for just 40 cents in fees. The savings on transfers like these are even greater when making international transactions and speak to the benefits the technology can provide.

The big banks that Bitcoin was designed to thwart may be wise to adopt blockchain technology themselves, and some companies in the corporate world have started. J.P. Morgan, Visa and, most famously, Facebook have all taken a dip, either creating their own blockchain or investing in others. Institutions are no longer shying away either, earmarked by David Swensen reportedly steering the Yale Endowment into a crypto fund this past year.

These moves by major players in the global economy have left some retail investors wondering if they are missing the boat. But a brief jaunt through the world of crypto-YouTube and its talk of “HODLers” and “Lambos” can easily give the impression that it is not a serious space. Add in crypto’s earned reputation for fraud and theft, (both of which have combined for more than $4 billion in losses during the first half of 2019 alone, according to CipherTrace), and cryptocurrencies, even digital assets writ large, have become a no-go zone for a lot of investors. But there is more to digital assets, and the blockchain technology underpinning them, than meets the eye, and gaining a deeper understanding of what the technology does is essential to making a call on whether they have a place in your portfolio.

A PRETTY PENNY?

When Satoshi Nakomata, whomever he or she is, anonymously released the Bitcoin white paper in 2008, they likely did not see Bitcoin becoming one of the best-performing assets over the past 10 years, bar none. Bitcoin was designed to be a peer-to-peer medium of exchange that used cryptography and a decentralized network of computers to control its creation and manage transactions. Or, in plain English, electronic cash that is not controlled by a financial institution.

While Bitcoin itself, born in the heart of the 2008 financial crisis, took aim at negating the control of major financial institutions, the blockchain technology behind it is proving to instead be a tool they may use. At its core, blockchain replaces intermediaries and brokers trust between parties with auditable computer code. Our current financial system entails each financial institution holding its own proprietary databases, requiring reconciliation with the proprietary databases of other counterparts and intermediaries every time they interact, an expensive and time consuming process. Blockchain eliminates that process, saving time and money and rooting out substantial inefficiencies throughout the economy.

“Right now, we have a digital economy that, from an information perspective, moves at light speed, but utilizes an underlying financial infrastructure that still moves at analog speed,” says Jeremy Epstein, an executive with the Crypto Futura Fund. “It makes no sense that it takes three seconds to send an email but three days for an ACH transfer. We need value to move just as quickly as information.”

Bitcoin was intended to act as a medium of digital value exchange, but its proclivity for rapid swings in value make it hard to use as a daily currency. Gumming up the works even more is the fact that Bitcoin is currently classified as an asset subject to capital gains in the United States, making it entirely impractical to use as a currency. It instead functions more as a store of value — a digital gold.

But other attempts are being made to create a true global currency built on a blockchain. Facebook is taking a swing with its recently announced cryptocurrency, Libra. Libra’s value will be based on a basket of low-risk financial assets, which the company hopes will stabilize the value. But it still needs federal regulators to classify it appropriately if Facebook would like its coin to be usable in daily transactions, and there is no guarantee at this point the feds will comply.

Another blockchain network, Ethereum, is not aiming to be a global currency at all. Ethereum is a public blockchain like Bitcoin, but with the increased functionality that comes from the addition of smart contracts. Smart contracts are self-executing contracts with the terms of the agreement directly scripted into lines of code. Essentially, “if X then Y” statements that allow the terms of a contract to be set and later executed when a specific requirement is filled. (Think of putting up capital until escrow is fulfilled.) Adding smart contracts into a blockchain ledger allows the technology to replace even more trusted third parties with a faceless computer program, upping the ante on financial interactions that can be blockchain-based. The Ethereum network also allows other projects to be built on top of it, creating a network of different apps all running on Ethereum and utilizing its blockchain and smart contract capability.

Despite sharing the same underlying technology and all being some form of “token” or “coin,” digital assets don’t really act like one asset class. Some are most like a currency, some a store of value, and some function like a technology bet on a network’s ability to grow. But even more important for investors than how they act may be how the federal government classifies them, an issue that has not had a lot of clarity.

“From a federal government perspective, it’s all about anti-money laundering and how they will collect their taxes at the end of the day,” says Ryan Griffiths, an economic adviser at New Direction Trust Co. But determining how exactly the federal government will act to collect those taxes may be anyone’s guess. That regulatory uncertainty is also one of the biggest challenges facing the space in the near term.

Complicating attempts to classify digital assets further, we are now seeing the tokenization of traditional financial assets and even real assets such as real estate. In 2018, ownership stake in a luxury student residence in South Carolina was broken up into tokens and put on a blockchain for investors to buy and sell, creating the first tokenized REIT in the United States. Owning these student-housing tokens should be seen as no different than owning shares in a similar REIT, all that is changed is the mechanism for storing and transacting the ownership stake.

Investors would be wise to approach these different types of tokens with an understanding that they may not act like one asset class. Sure, tokens writ large behaved that way during the great crypto crash of late 2017, moving up and down in near unison. But, as the speculative fever that engulfed cryptocurrencies has broken, digital assets can begin forging their own path uncorrelated from their often very different brethren.

TU-LIP OR NOT TU-LIP

Nothing scares an investor more than catching a falling knife. With the crypto bubble of late 2017 firmly in the rear view, some investors may see engaging in the asset class as more akin to picking the knife up off the ground and stabbing yourself. But the fate of the underlying technology is not intrinsically tied to that initial rise and fall.

“One misunderstanding about cryptocurrencies is that because the asset class is volatile, it therefore must be a bubble, it must be a tulip bulb,” explains Mike Alfred, co-founder and CEO of Digital Assets Data, a fintech and data company focused on the cryptoasset ecosystem. Alfred adds that, if you looked at the volatility of tech equities in the late ’90s, you may have also made the incorrect assumption that the internet wasn’t important. Indeed, Amazon stock losing 90 percent of its value in the early 2000s did not change whether or not the internet was a revolutionary technology.

Still, the investment funding driving blockchain projects forward has slowed significantly in 2019. Total funding was $3.38 billion through August 2019, down from $12.8 billion in 2018, according to Crunchbase. VC funding through June 2019 was less than $800 million after eclipsing $4 billion in 2018, according to CB Insights. While those numbers indicate a significant drying of funding, they don’t show a capital desert. There is still a trickle of life, and savvy investors know to be greedy when others are scared.

If a retail investor thinks now is the time to take the plunge into digital assets, how do they spot a good digital asset? Many traditional metrics for judging equities or commodities do not translate. Sources for this story listed a range of metrics they use when judging the quality of a token investment. These include the token’s velocity (the number of times that those tokens change hands every day), the total number of wallets holding those tokens, or the amount of applications being built on the blockchain network in the case of something like Ethereum. Some analysts use the network-value-to-transactions ratio (the ratio between the token’s market cap and the total value of all transactions in the past 24 hours) as a proxy for the P/E ratio and a way to measure the likelihood that a token’s price is based on speculation. Others can get even more adventurous in their pursuit of the next great token.

“We also look at some of the softer things, like the size and engagement levels of the community supporting each crypto asset,” explains Epstein with the Crypto Futura Fund.

Other “soft” measurements include the number of commitments from programmers on the token’s GitHub, indicating the amount of technical work being done on the token by the community. There is no single set of metrics that experts agree on for judging different tokens, which can make investing in them feel like the wild west, for better or for worse.

The benefit is that the data is there, it is all transparent and available, the challenge is getting value from it. Though, in general, most agree that you want to find a token with the widest base of real use. For that, none beat Bitcoin. Sources for this story were divided on the proper weighting Bitcoin should have in investors’ portfolios, but everyone agreed that, if you are going to invest in digital assets, you have to have Bitcoin.

“For the average person, buying Bitcoin and just closing your eyes for 10 years is probably going to be the best decision,” says Mike Alfred, explaining that, for many of the current blockchain networks, the best early investors are going to be very involved in that network, especially in its nascency. This involvement could include everything from staking and delegating to building infrastructure and actively engaging in operations. If that seems daunting to an investor, then making a large bet on an obscure blockchain network may not be the best path for them.

Simply spotting the most compelling use of blockchain technology may not be a sure bet either. For example, many have pointed to medical recordkeeping as a field ripe for disruption from blockchain ledgers. But the regulatory thicket surrounding the medical industry may make it too challenging to pervade. A regulatory stranglehold could squelch the revolutionary promise of blockchain in general. But lessons from the past indicate that keeping that stranglehold in place is easier said than done, especially over the long haul.

YOU SAY YOU WANT A REVOLUTION?

I am certainly not the only writer who has referred to blockchain as a revolutionary technology. But, if this is indeed the case, what is the revolution? It may be the democratizing of access to typically obscured financial data.

“Anyone can go and validate any of the transactions on the chain and verify that they occurred. Try doing that with the U.S. economy or with a bank; you can’t do it,” says Ryan Alfred, president of Digital Assets Data. Blockchain “is the most transparent mechanism for transferring money that has ever existed.”

The revolution may also simply be putting our current financial institutions on a blockchain instead of replacing them entirely. A “revolution” that would not satisfy many of the crypto die hards, but is certainly a possibility — maybe even a likelihood.

“I would not be surprised if in the next 10 years all NASDAQ and NYSE securities are put on a blockchain. It is just an easy way to reconcile, it is more transparent, it is cheaper,” says Griffiths with New Direction Trust Co.

But, for those who live outside of stable economies, the revolution is less about access to data or whether the stock exchange is on chain and more about wrestling monetary control away from government authorities. Take Venezuela, for example. In 2018, when many countries were seeing a decline in Bitcoin adoption after its dramatic price drop, South and Central America saw Bitcoin purchase volumes increase threefold. Much of this adoption was concentrated in Venezuela, according to Ryan Alfred, and pointed to a natural response among the Venezuelan populace to the monetary instability experienced by the Bolívar. Similar responses have been seen in Argentina and Nigeria. Satoshi Nakomata’s dream of people using a truly independent monetary system may still come to fruition as long as we are willing to look outside the United States.

“I think you will see a leapfrogging to a true digital economy in places like South America, akin to what we saw in Eastern Europe with the leap frogging straight to cell phones,” explains Epstein.

Still, there are nuggets U.S. investors can glean from what they have seen in places like Venezuela. Namely, that Bitcoin has been a countercyclical asset, and it could act as a hedge if economic instability begins to spread beyond its current scope.

There is no consensus on what the “crypto future” will look like, or what the revolution behind this revolutionary technology will be. But, the one thing that nearly everyone involved in blockchain does agree on: They all want to change the world.

If it happens, the flying cash of the future may have wings built of ones and zeroes.

 

Reg Clodfelter is a freelance writer in Berkeley, California.

 

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