What We Often Get Wrong About Cryptocurrency

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What We Often Get Wrong About Cryptocurrency
June 26, 2018

Claim — Bitcoin and or the blockchain will destroy the banks!

 

Reality — Almost certainly not, though they may change a bit in form. A fairly small portion of a bank’s operations involve currency transfers, and for many it’s a headache to them which they’d rather not deal with, not a major profit center. The blockchain could certainly destroy something like the Automated Clearing House and make wire transfers more efficient.

 

Transactions using a currency like Bitcoin would no longer require banks to be a source of proof of funds, and the transfer of value wouldn’t require two banks to communicate with each other, but in those cases some entity (ala Coinbase) is still collecting transactions fees. If one took away ACH fees and what are effectively, per the above, debit card transfers, from banks, the impact would be minimal.

 

Less frequently spoken about because it’s less well understood, the major impact a switch to the blockchain would generate has to do with float, deposits, and the bank’s ability to provide and or underwrite loans. In a virtual currency world, at least for today, the concept of float is basically non-existent, and earning interest on deposits is a relatively new concept with only a few players.

 

But for any virtual currency, there’s no reason to think the same functions wouldn’t emerge again. Let institution X hold on to my crypto and invest it, and they’ll also provide interest. Loans are a bit more complex, because there’s no concept of reserve ratios in crypto today (though it’s being thought about), but debt is critical to the functioning of our economy, so it’s fair to assume in one form or another it will continue to exist, and institutions will exist to underwrite that debt and collect interest off it. It might look a little different, but the economics will be roughly the same.

 

Claim — Crypto-companies are great investments (sell axes and picks to gold miners)

Reality — Some likely are, but that depends significantly on what they do.

 

I realize that’s a weak answer, but nuance is again necessary here. Let’s talk about a few categories and break apart the functions of companies themselves.

 

1. Transaction facilitation — i.e. companies like CoinBase. If one had the opportunity to invest early in Visa one would be very, very wealthy. Similarly, CoinBase could be a multi-billion dollar opportunity. The challenge in the space is a) just like anyone else, it’s difficult to pick a winner, and b) unlike modern financial networks, distributed transaction facilitators aren’t nearly as prone to natural monopolies as they’re not dependent on network effects.

 

I have no doubt a few great investments are present in the space, particularly as it’s noisy and there will be consolidation, but as switching costs are almost nonexistent, it’s unlikely to see the kind of monopolistic winner take all returns venture capitalists love. Additionally, if there’s no inherent benefit from using one company vs another, transaction fees will likely be the primary lever determining adoption, which will lead to a race to the bottom for transaction costs. There will be a handful of dominant players in this space, but market dynamics will keep them from being very profitable or growing too big.

 

2. Currency creators — And here we’ll have to subdivide into two categories: A) pure currency creators like Goldmint, and B) companies like Brave or TRON or to some degree Tether and Ripple (as they’re also in the transaction facilitation business). There’s so much of a case by case basis here it’s difficult to make any conclusive statement. For instance, while Ripple issues their own token, they’re really trying to be a transaction network that uses their ownership of the underlying token as a way of preventing the lack of natural monopoly I mentioned above.

 

Brave and the BAT are somewhat similar. All of these companies however are dependent on their token becoming some sort of global standard, and all of them would also require that token to function as a currency that would be exchanged for some other store of value. For category A, use as a currency is dependent on both low transaction fees and liquidity. For category B, use is dependent on market dominance (i.e., if it doesn’t comprise enough of a % of the market then there’s no point in using it) and liquidity.

 

Category A is almost certainly a poor investment, as there’s just minimal opportunity to extract value from the transaction. For instance, if one could use BobGold and SallyGold, but BobGold has a .0001% transaction fee and SallyGold has a .02% transaction fee, everyone will just use BobGold. Category B is a total crapshoot. If someone does create a market dominant category there are lots of ways to extract value, but that’s the same investment profile as any other technology investment.

 

The big difference between crypto company investments and traditional ones is that many of them have had ICOs, and these ICOs give the companies additional capital / runway without having to raise dilutive equity, so their VCs may be geniuses as they’ve figured out a way to costlessly multiply the leverage on their investments. That could turn a so-so exit into a huge one, so category 2.B seems particularly promising.

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