Cryptoassets

The Innovative Investor’s Guide to Bitcoin and Beyond
Chris Burniske and Jack Tatar McGraw-Hill © 2017

                        By This Book: 
                        

About the Author

Chris Burniske is a co-founder of Placeholder Ventures, a firm that focuses on cryptoassets. Jack Tatar is an investor in and adviser to cryptoasset start-ups.

Summary

The Origins of Bitcoin

Bitcoin shot onto the world’s radar just as the United States’ financial system was breaking down in 2008 amid the fallout from collateralized mortgage obligations (CMOs). In October of that year, an individual using the pen name Satoshi Nakamoto released a paper detailing a currency called bitcoin and explaining the blockchain software that underpins it.

Nakamoto had created an alternative to the centralized arrangements used for electronic financial transactions. He designed the system to have “decentralized autonomy”; that is, the masses rather than the government would oversee it. Ostensibly, Nakamoto’s blockchain, had it been available earlier, could have tracked the mortgages in CMOs and surfaced the linkages among them, thereby increasing the securities transparency and perhaps mitigating the widespread financial crisis that erupted.

Nakamoto’s real identity and his whereabouts remain unknown. But bitcoin and blockchain have caught on and given rise to a flourishing number of cryptoassets.

“Bitcoin lets anyone be their own bank, putting control in the hands of a grassroots movement and empowering the globally unbanked.”

The ABCs of Bitcoin and Blockchain

In general, the term “blockchain technology” refers to its components, “hardware, software, applications and users, in relation to a personal computer.” Bitcoin currency is the product of the particular software coding that constitutes the bitcoin blockchain technology. Bitcoin software is open source, meaning that anyone can access the technology to generate bitcoins or to alter the algorithms and create other cryptoassets. The software is a distributed, digital record keeping ledger. No one can alter or erase the records in a chain. Data updates occur in subsequent entries. The technology uses encryption to ascertain the bonafides of those making transactions. Blockchain is transparent; anyone can view the details.

“Miners” are individual computer users who compete to record transactions on Bitcoin’s blockchain. Their “proof-of-work” is how the different computers group the transactions into a block and the blocks into a chain. The miners must solve a “cryptographic puzzle” to gain access to append to the blockchain. For their efforts, they receive pay in bitcoins.

The process boosts the supply of bitcoins, and the awarded coins motivate users to mine.

Blockchains can be either public or private: Public blockchains are open to anyone on the Internet, while private blockchains are akin to intranets, available only to authorized users.

The Evolution of the Currency and the Technology

In its short existence, bitcoin’s price increases have been impressive. An initial purchase of $100 in bitcoins on July 19, 2010, at the start of bitcoin trading, would have soared to a mind-boggling $1.3 million by January 2017. In comparison, over this period, $100 invested in the S&P 500 would have grown to $242. Similarly, bitcoin delivered returns well in excess of those provided by the technology stalwart FANG stocks – Facebook, Amazon, Netflix and Google.

“As a small portion of the innovative investor’s overall portfolio, alternatives are an effective way to balance risk.”

Bitcoin also did better on a risk-adjusted return basis than the three major indices the S&P 500, DJIA and NASDAQ 100. However, not everybody bought into bitcoin at its inception:

Those who purchased $100 worth at a peak price of $1,242 per bitcoin in November 2013 would have seen that $100 investment whittled down to $83 by January 2017.

“Bitcoin’s blockchain is a database that records the flow of its native currency, bitcoin.”

Early in 2011, bitcoin captured the attention of a wider audience and of criminal

elements with the debut of the dark web’s Silk Road online marketplace, which chose the cryptocurrency as its coin of the realm. Drug dealers quickly overtook the digital Silk Road. Another spike in bitcoin’s profile, along with an almost 700% increase in its value, happened in April 2013. Some observers speculate that this leap in demand for bitcoins was the consequence of a financial crisis in Cyprus, which led to Cypriots losing money in their bank accounts. Bitcoin holders would not have been susceptible to such sovereign losses, because bitcoin is outside a government’s control.

Then, in November 2013, bitcoin burst onto the global stage due to rising demand in China.

The People’s Bank of China noticed this activity and promptly clamped down on the use of bitcoin. At the same time, authorities in the United States caught up with the founder of Silk Road and closed down the website. A long, steep and rocky decline in bitcoin’s value followed.

Subsequently, blockchain became more prominent than bitcoin as a "general purpose technology" that, like the steam engine, has the potential to change the world. As 2017 began, the inventory of cryptoassets grew to more than 800 offerings, including Litecoin, Ripple, Zcash and Ethereum. However, bitcoins worth $17 billion at the time made up the lion’s share, roughly 70%, of the total value of cryptocurrencies.

“Each time miners add a block, they get paid in bitcoin for doing so, which is why they choose to compete in the first place.”

What Cryptoassets Can Do for Investment Portfolios

Cryptoassets are alternative investments, as are investments in real estate and commodities.

Alternatives help diversify portfolio risk, since they have low correlations with traditional capital assets. 

The three main categories of cryptoassets are:

•  Cryptocurrencies – These function, like money, as a "means of exchange, store of value and unit of account."

• Cryptocommodities – These encompass the parts of the digital infrastructure, such as bandwidth and storage.

•  Cryptotokens – These vouchers enable user access to "digital goods and services" such as social networks and games.

An investment in these assets can help bring down the overall risk of a portfolio, since their correlation with mainstream capital assets is near zero. This unusual circumstance is likely because cryptoassets are so new that their pool of investors does not overlap much with those who invest in conventional securities.

"A private blockchain is typically used to expedite and make existing processes

more efficient, thereby rewarding the entities that have crafted the software and maintain the computers."

What Differentiates Cryptoassets from Other Investments

In 2017, the US Securities and Exchange Commission issued guidelines to classify cryptoassets as securities. However, as of early 2018, the SEC has not approved any cryptoasset’s applications for exchange trading, nor is it required to do so. Aside from the status of SEC approvals, a good way to understand cryptoassets is to consider the investment class in which they’re categorized, but the multiplicity of their functions as currencies, commodities and tokens makes cryptoassets complicated to classify. The US Commodities Futures Trading Commission sees them as commodities, and the US Internal Revenue Service has referred to them as property. Traditional assets fall into the broad groups of "capital assets, consumable/transformable assets or store of value assets." Cryptoassets are somewhere between a commodity and a store of value, unlike metals such as gold, which are both. Cryptoassets are a distinct asset class for the following important reasons:

• They have a unique form of governance. Developers, owners of mining computers, the companies that intermediate cryptoassets, the asset holders and the end users all participate in oversight and accountability.

• A computer code issues the assets in a way that intentionally maintains a scarce supply. For example, releases of new bitcoins occur on a progressively decreasing schedule. The maximum number of coins, 21 million, will be in circulation by 2140. After that date, holders will receive transaction fees, similar to those credit card companies pay.

• Cryptoassets offer uses that other asset classes do not, and these will evolve as technology changes. Most notably, bitcoin serves as a “decentralized global currency.” Some people invest in these new assets for their intrinsic utility, such as bitcoin’s ability to settle financial transactions. This purpose might be difficult to distinguish from an investor’s “expectation of profit,” a condition met by SEC regulated securities. Speculation is another motive for holding the assets, just as occurs with some traditional instruments.

"If [the SEC] feels there are still not enough consumer protections in place for bitcoin and other cryptoassets, then it has no obligations to approve any exchangetraded products."

"While exchanges, by default, will store the assets they trade, that is not always the safest place."

"Over time, next to zero bitcoin will be issued, but the aim is for the network to be so big by then that all contributors get paid a sufficient amount via transaction fees, just like Visa or MasterCard."

Trading Cryptoassets

Because they are new investment vehicles, cryptoassets trade on exchanges separate from those of conventional securities. As an alternative to mining, an investor can acquire holdings of existing assets or make ground-floor purchases of newly created cryptoassets through an initial coin offering. These issues might be announced in a private network, on social media or on listing sites such as CoinFund. Exchanges have proliferated, from one in mid-2010 to more than 40 in early 2017. Trading volume has taken off as a consequence; the worth of bitcoin trades reached more than $11 billion in January 2017. With greater capacity, liquidity has increased and the value of trades has jumped. In January 2017, the price of a single bitcoin shot past $1,000. Similarly, other cryptoassets such as Ethereum have seen increases in their trading volume over time. Of course, external factors, including regulation, affect the market. As of 2016, better than 90% of the global trading in bitcoin took place in China. In 2017, the People’s Bank of China’s restrictions caused bitcoin’s price to plummet from its $1,000 peak, just as happened in 2013, the first time the currency hit the $1,000 mark. However, bitcoin’s value recovered more quickly in 2017 due to the greater number of exchanges.

The availability of exchanges for trading cryptoassets is a sign of "market maturity," as is a decline in volatility. And as specific new assets develop their features, their performance will better correlate both with other cryptoassets and with conventional securities.

The market for cryptoassets is making progress in these areas, but it has a way to go to reach maturity. Importantly, the assets have attracted masses of speculators and experienced wild market swings. Some new asset offerings have turned out to be fraud schemes presented to investors with false information. As with most new assets, investing in cryptomarkets calls for a great deal of caution.

"When a cryptoasset is skyrocketing, it can be hard to resist the urge to jump in

and ride the rocket. However, the timing can be precarious, and spotting the end of a bubble is not easy."

"Any cryptoasset worth its mustard has an origination white paper."

Evaluating Cryptoassets

Cryptoassets appeal to innovators, and they offer investors many opportunities for early participation in start-up companies. Blockchain technology applications can substantially change or disrupt the way business works in many sectors of the economy. In the financial services industry, speedy and low-cost bitcoin payments could replace companies like Western Union for sending remittances across borders. "Business-to-business payments" likewise could flow more readily with cryptocurrencies. Distributed ledger technology can smooth the insurance industry claims process. Supply chains, health care and real estate information access, and delivery tracking are all targets for more effective redesign using blockchain.

As with traditional offerings, fundamental analysis is a good place to start an investment evaluation of a cryptoasset. The creators of a cryptoasset provide a "white paper" with the specifics of the asset, the problems it solves, its competition, its technical information and the plan the developers have for its issuance. The asset should have a "decentralization edge," which is a legitimate reason for this standalone product. A white paper should contain detailed descriptions of the asset’s utility and its competitive advantage. Value also derives from the supply of the asset relative to the demand for it. Speculative activity affects the asset’s potential value. An asset’s turnover, or its velocity, is another indicator of value. Additionally, it’s preferable to have the computers mining the cryptoasset spread far apart geographically rather than clustered together, so that they are not subject to any single jurisdiction.

Technical analysis, based on price and volume, can supplement fundamental metrics.

Cryptoassets require storage after their acquisition. Options include deposit accounts at a trading exchange; a "hot wallet," giving an investor access to the asset through the Internet; and "cold storage" of the asset in an investor’s offline device.

"If the miners for a cryptoasset are all in a single country, then that cryptoasset could be at the mercy of that nation’s government."

"Even though the rules regarding taxation of these assets may change, one thing is clear: as with any other asset, the IRS is watching.”

"Goldilocks Years of Cryptoassets"

Though Wall Street still remains largely on the cryptoassets sidelines, some large corporations and financial institutions are beginning to test the feasibility of using blockchains. Millennials, however, could make this the moment for investing in cryptoassets, given their greater comfort with the concept, its practices and its promise.