Bitcoin, cryptocurrencies, and the underlying technology that have enabled the growth of the cryptocurrency and the token market, Blockchain, have exploded into the public consciousness over the last six months. Since the beginning of the year, the price of a Bitcoin rose from $900 to nearly $3,000 at its peak a month ago. The surge of the price of Ethereum, the second most popular cryptocurrency by circulating market capitalization, was even more impressive. From $10 in the beginning of 2017, the price of Ethereum surged to $400 a month ago. Ethereum is currently trading at around $200, half its price of a month ago but still up 1,900% since the beginning of 2017.
Cryptocurrencies’ underlying technology, the Blockchain, originated from the concept of “linked timestamping” to better secure documents as first proposed by Stuart Haber and Scott Stornetta in 1990. The rationale was to create a more secure system than the public-key signature based time-stamping. This made the document’s timestamp impossible to change after the fact. A subsequent improvement replaced the concept of linking documents individually into a collection of blocks, all of which were then linked together in a chain. Instead of a linear connection, the documents within each block are linked together in a tree structure, which utilizes less resources for the positioning verification of a document in the history of a system. Bitcoin combined the idea of linked timestamping and the usage of computational puzzles to regulate the creation of new currency units. Under the Bitcoin regime, a hacker cannot realistically change the history of transactions unless he or she can compute computational puzzles faster than all Bitcoin participants combined. This ensures the security and integrity of the Bitcoin regime. This was a breakthrough in that for the first time, it solved the dilemma of potential “double spending” within a decentralized, digital payments system.
The idea of a secure, frictionless, and decentralized system for settling cross-border payments and storing/sharing information is beginning to gain momentum for global businesses. This is especially the case for emerging market countries, where there is a profound lack of large, reliable centralized financial clearing/payments systems. E.g. a group of Indian banks that includes the State Bank of India and ICICI Bank recently agreed to use Microsoft’s Azure blockchain-as-a-service solution to host their distributed ledger systems. Similarly, Bajaj, the Indian subsidiary of Allianz, just began to implement a Blockchain solution to speed up insurance claims for travelers and motorists. Similar Blockchain-based initiatives which aim to expedite international, cross-border capital transfers include:
- 60 banks are now commercially deploying enterprise software developed by Ripple, a San Francisco startup. In April, BBVA successfully completed a series of money transfers between Spain and Mexico through the company’s proprietary distributed ledger technology. According to American Banker, the transfers took seconds, compared to the four days they normally take. So far, Japanese banks have had the greatest uptake, with a consortium of 59 Japanese banks having successfully completed a pilot with the software. 40% of all Japanese customer banking accounts will have access to the Ripple-based blockchain solution by October this year;
- Backed by Goldman Sachs and Baidu, Boston-based Circle Internet Financial launched an international money transfer service last month allowing zero-cost, cross-border transfers between the U.S. and Europe through its Blockchain-based peer-to-peer payment network;
- In May, Bank of Tokyo-Mitsubishi UFJ began testing its own cryptocurrency (MUFG coin), which will allow users to instantly transfer money on a peer-to-peer basis via the app or to purchase goods and services at affiliated stores. Currently, around 200 of the bank’s employees are testing the MUFG coins; the bank has plans to expand the trial across its branches by the end of 2017.
Despite my long-term constructive outlook on Blockchain, however, I believe the recent surge in prices and the number of initial coin offerings (ICOs) represents significant exuberance (for this article, I will use the terms “cryptocurrency” and “tokens” interchangeably). As shown in the following chart, the total market capitalization of all cryptocurrencies embarked on a parabolic move beginning in January 2017. From $5.6 billion as of January 1, 2015 ($4.4 billion of which is Bitcoin’s market capitalization), the aggregate market capitalization (based on circulating supply) of all cryptocurrencies surged to $115 billion as of June 14, 2017. As of this writing, the aggregate market capitalization (encompassing the value of 811 cryptocurrencies) totals $80 billion.
In addition to the influx of capital and the rising number and size of ICOs (the record $232 million Tezos ICO being the latest to take advantage of such investors’ exuberance), there are other red flags which suggest that investors should be cautious of the cryptocurrency space:
- Lack of transparency: In a regular U.S. initial public offering (IPO), the SEC requires the company issuing shares to file a Form S-1, where information is provided regarding the use of IPO proceeds, the company’s business model and competition, as well as a prospectus disclosing the names of the company’s principals and financial information. There is no similar process in the cryptocurrency space. E.g. Tezos published an 18-page position paper and a 17-page white paper describing Tezos as a “generic and self-amending crypto-ledger” and that it “supports meta upgrades,” i.e. “the protocols can evolve by amending their own code.” In other words, Tezos aims to be the be-all and end-all of the cryptocurrency world, but details are lacking. Even during the “irrational exuberance” days of the technology bubble, there was much more disclosure. Presumably, the founders of Tezos will get filthy rich once the token starts trading;
- The ease of new ICO creation: A recent article asserts the “hard cap” on the lifetime supply of Bitcoins (21 million) and Litecoins (84 million) is inherently deflationary, i.e. both Bitcoins and Litecoins may be considered a long-term store of value similar to gold, New York real estate, or farmland. While Bitcoin and Litecoin have been in existence since 2009 and 2011, respectively, such track records are still comparatively short in the context of monetary history. With new and more innovative cryptocurrencies being created all the time, there is no guarantee that either Bitcoin or Litecoin will retain their value over time. The creation of truly anonymous cryptocurrencies such as Zerocoin may also render existing cryptocurrencies such as Bitcoin and Litecoin less attractive over time.
- Lack of recourse: An investor that has purchased the debt or equity of a company has a legal claim and resource on the company’s assets in the event of a bankruptcy filing. Should the value of a cryptocurrency plunge to zero for whatever reason, there is no legal resource whatsoever.
The excitement of the future impact and practical applications of the Blockchain technology has no doubt driven the latest exuberance in the cryptocurrency market and the hunger for new ICOs. While I believe Blockchain will change the way we fundamentally do business, store/exchange information, and move capital across borders, history has demonstrated that most early investments into a new technology typically do not work out. E.g. the vast majority of start-up auto companies in the early 20th century/internet companies in the late 1990s went out of business, leaving investors with nothing. Specifically, based on my research, I would avoid the following three cryptocurrencies/tokens:
Ripple (XRP): XRP is designed as a “bridge currency” for use when a transaction between two currencies on the Ripple protocol cannot be made because one or both currencies are rarely traded. In other words, the Ripple protocol is designed primarily to be a currency exchange, enabling “secure, instant and nearly free global financial transactions of any size with no chargebacks.” Should liquidity between currency pairs on the protocol increase over time, there will be a decreasing need for XRP. In addition, of the 100 billion XRPs issued, more than 60 billion is being held by Ripple Labs. While Ripple Labs has locked up 55 billion XRPs through a series of 55 “smart contracts” (with one contract expiring every month for a period of 55 months), it does not change the fact that the creators of Ripple still own the majority of XRPs and would stand to benefit the most from a surge in the cryptocurrency.
Numeraire (NMR): In February of this year, one million Numeraire tokens were issued to 12,000 data scientists as an incentive to create a profitable global long-short equity fund constructed with algorithms via a collaboration between the 12,000 data scientists. According to the issuing firm, Numerai, financial data is “transformed and regularized” and is then fed to its data scientists through an encryption process. This idea has three major red flags. Firstly, there are hundreds of quantitative funds which have been designing algorithms utilizing financial data for global equities for many years, if not decades. Financial data is a commodity and is readily available through Compustat or FactSet; unstructured data such as granular, real-time weather forecasts (which is highly valuable if one was speculating in agricultural futures) or Twitter feeds gauging real-time traffic at Starbucks’ locations are unique, but based on public information, Numeraire is purely using financial, and thus, commoditized data. Secondly, there is an asymmetry of information between the data scientists and the public, the latter of which could also purchase NMR. Presumably, the data scientists working on the algorithms should have a better understanding of their utility, and could buy or sell NMR in advance to take advantage of this information asymmetry. Finally, the top data scientist on the platform is currently limited to a $54,000 annual payout, which is hardly an incentive for the most talented data scientists to work on the project, even on a casual basis..
Litecoin (LTC): While the Litecoin protocol has lower transaction fees and faster times than that of Bitcoin, many speculators bought LTC recently due to an expected August 1st launch of an MIT project related to LTC. My sense is that this countdown page purportedly created by MIT is a hoax and its primary purpose is to pump up the price of LTC going into August 1st. The cryptocurrency space is unregulated. This means there is no process for prosecution if crypto-investors find out on August 1st that MIT isn’t launching a product, after all. Secondly, it is out of MIT’s character to create such suspense when they know this will lead to greater speculation in LTC ahead of the August 1st date. The group behind MIT’s Digital Currency Initiative, along with Charlie Lee, the creator of Litecoin, have said they do not know anything about the countdown page. Since any MIT student can create a subdomain on MIT.edu, the perpetrator may be an MIT student or someone related to an MIT student who is speculating on the price of LTC. Buyer beware.
