An analysis of cryptocurrency investing from the value school perspective

This is an analysis of what are the reasons someone could consider to invest or not in any of the thousands of cryptocurrencies out there.

The logic thread I will follow to explain my rationale is to first start by going through 1 why in my opinion it may make sense to invest in Bitcoin, 2 why it could make sense to invest in other cryptocurrencies and then define who are each others’ competitors in order to conclude whether there is a sufficiently large moat to protect those investments, just trying to emulate what value investing gurus do when deciding their next move.

Why a Bitcoin allocation makes sense

Means of exchange are valuable because they enable both sides of a voluntary transaction to be better off after it than they were before it. That’s the power of subjective value and voluntary exchanges.

We have nowadays all kinds of means of exchange that enable the intertemporal transfer of value, that is, to exchange the value of one’s production into future consumption with a good that hopefully can have the minimum value-loss in that transfer. This is also known as saving.

Factors that affect value-loss in savings in asset X are its:

-? ? ? ? Rate of inflation

-? ? ? ? Rate of deterioration

-? ? ? ? Cost of maintenance

-? ? ? ? Counterparty risk

These factors determine the willingness of actors to hold that asset. Holding assets in your portfolio is what gives them value because if there is demand, there will be buying orders and, if they are held, the selling orders will be few, thus

high demand & low supply (low number of selling orders) = big price upside

This is the reason why, even if China and many other countries decide to pay for oil in a currency other than USD, it’s really not disruptive for the USD as long as right after getting paid, the receiver turns Chinese Yuan (or whichever other) into USD right away. It’s what you hold that matters, not what you pay with.

I said that we have all kinds of means of exchange for intertemporal transfer of value but in all of them you have to make a very fundamental assumption:

laws protect your private property

Counterparty risk is sometimes big even when laws work. Unfortunately laws don't work well in a very large share of the world’s economy and frequently even if they do, everything can change almost overnight as it is the case for refugees and other people that have to flee their country for all kinds of human or nature induced reasons.

With regards to human induced reasons, a big chunk of the world’s population doesn’t trust their government:

• Many States are so weak that they can’t even get rid of guerrillas that wreak havoc across the country.
• Other States are very strong but the power balance is so centralized that individuals lack a way to counter balance it, rendering those States totalitarian.Citizens in the latter two countries are subject therefore to plunder from either mafias or the totalitarian State itself.

Finally, there is a small percentage of countries where there is a reasonable decentralized power balance among executive, legislative and judicial powers and where ideally there is true freedom of speech (arguably the 4th power).

What keeps these powers in check is the rule of law but, again, rule of law is poor or non existent in most of the world and that part of the world needs means of exchange that can protect someone’s wealth from external threats.

That means of exchange must be even immune to laws in very totalitarian states or, at least, enable your family and yourself to vote with your feet towards more friendly jurisdictions with a share of your wealth in the form of a set of words.

That’s Bitcoin in a nutshell: a trust minimized system that enables private property (by turning it into a secret) and uncensorable exchanges, regardless of what governments could try to enforce using (bad) laws.

There are other reasons for owning Bitcoin like its uncorrelated volatility compared to other assets or its usefulness for cross border payment settlement, but it is not the purpose of this text to provide an exhaustive list of reasons to own Bitcoin, just the ones I consider most relevant.

More about Bitcoin as a trust minimized asset

Critics frequently say that Bitcoin is way too volatile for it being desirable to be held and, while I agree that in the long run it’s likely to stay volatile and that it doesn't make sense to have an exposure that is way too high, that critique doesn’t make sense if you think that the threat you’re under could wipe out 100% of your wealth instantly.

A 70% drawdown is therefore preferable under those circumstances than a 100% one, for at least a share of your wealth.

For all of the aforementioned reasons, I believe it makes sense to keep a part of your portfolio in Bitcoin for a part of the world’s population, a bigger percentage the poorer the rule of law in your country.

This demand is not insignificant: the amount of wealth that is offshore looking for better property rights is estimated to be somewhere between USD $20 and $30 trillion. And that's demand from wealthy individuals alone.

But there’s another reason to hold Bitcoin within your portfolio.

Even if you don’t feel a direct threat from your government or your local mafia, if we assume that the average demand of Bitcoin for the aforementioned reasons is within a range of X%-Y% of the world’s nominal GDP, as this GDP grows, the demand for Bitcoin should grow as well and given that its supply is strictly inelastic, we should see an increase in its price over long enough periods of time.

If that’s the case large chunks of the population would probably like to have exposure to such an asset with minimum intertemporal exchange friction thanks to its minimal and decreasing inflation, its minimum deterioration (transactions can’t be reversed), minimum cost of maintenance (either with self-custody or 3rd party custody) and minimum counterparty risk (if self-custodied or with a very well reputed counterparty).

But investors could ignore the counterparty risk of a 3rd party custodian if the investment was attractive enough, that’s why an ETF with a well reputed custodian makes sense in my opinion.

Also worth mentioning that Bitcoin's volatility has low correlation with traditional asset classes, meaning that a small allocation to Bitcoin actually lowers overall portfolio volatility

Why it could make sense to own other cryptocurrencies

If on the other hand a means of exchange is used a lot but held in small amounts because it has a higher counterparty risk than bitcoin, higher deterioration because of the technical risk behind it or unprecise inflation, that means that the number of buying orders will be high, but the number of selling orders will be high too thus making the price way smaller.

high demand & high supply = limited upside

But even if held at very small amounts, an asset can have some value.

Just as with the USD and the Chinese Yuan, it may make sense to use a particular cryptocurrency but that doesn’t mean at all that the the more it is used (because the underlying project is good) the more value it should accrue. There is very little correlation between one and the other.

Usage doesn’t mean value then. It means demand, but in order to determine a price you need to take the supply side of things into consideration as well.

True decentralization in other chains

You only need true decentralization if your goal is to be resistant to (poor) laws. If your goal is to build interesting financial applications decentralization can be in fact pretty irrelevant and even counterproductive because security means the need for small throughput and longer settlement times.

More about the topic of true decentralization and here

Making private property possible without the need for laws has only been achieved by Satoshi when he built Bitcoin and particularly when he disappeared off the face of the Earth without sharing his identity.

This has not been replicated by any single other cryptocurrency. In every single other there’s a team in charge that if it were to disappear, the entire project would disappear as well. Consequently laws can attack those single points of failure in charge.

Moreover, Bitcoin's true decentralization is very hard to replicate because if a new coin were to emerge with very interesting technology enabling that true decentralization with the same intertemporal exchange frictionless features, how can it get popular enough in an ocean packed with thousands of other cryptocurrencies? The only way to achieve that goal would be by having centralized departments of marketing, advertising and leaders making decisions, but that would be ultimately detrimental to its decentralization.

Additionally, if that technology was interesting, nothing would prevent Bitcoin developers to copy it and implement it on Bitcoin itself.

This means that the value proposition of Bitcoin has a huge moat, very big barriers to entry for any potential competitor. That is not the case in any other cryptocurrency.

And network effects could be relevant if:

a) value of assets issued on a network and liquidity could be relevant compared to the traditional financial system, but they are a drop in the ocean at the moment

b) security were not critical. In my opinion mature high value financial applications are not going to move in relevant amounts to chains that haven't been properly battle tested.

Interesting financial applications, can be done by “any blockchain”?

If you are going to build financial applications, issue security tokens, transfer them, build smart contracts in sandboxed environments, there are dozens of blockchains where you can build.

All of them followed the example of Ethereum, betting on increasing adoption by implementing the account based model and a high level programming language for easy-to-implement smart contracts.

So, if you agree with the argument in the section above, you realize that the price of an altcoin necessarily has to be low since there will be very small incentives to hold it in large amounts.

But if what explains its demand can be claimed by dozens of other tokens, it means that ultimately the demand will be divided many times over.

Additionally, since true decentralization is actually not that needed if you don't want to be protected from laws, it means that blockchains built by financial institutions could achieve the same goals and divide the demand for altcoins even further.

Bottomline:

Bitcoin has value and a very big moat

There are very few reasons to hold large amounts of altcoins and that demand is additionally divided among the many altcoins and even blockchains built by financial institutions themselves.

Actually Bitcoin’s codebase is better for financial applications

It’s very interesting that Vitalik recently published a blog post where he explains that if scalability, privacy and smart contract wallets were not achieved in what he called “the three transitions”, the Ethereum project could fail.

And it’s very interesting because that’s the kind of trade offs that Bitcoin developers warned him about nearly a decade ago. Bitcoin developers were always aware of the fact that layer 1 blockchains can’t have scalability, security and extra-features on the same layer. It’s an impossible trilemma. You can only desire one of the three.

This is exactly what has happened to Ethereum by trying to have everything on the same layer. It didn’t scale with PoW so it moved to PoS and so has lost the remaining decentralization it still had, so it can’t keep pretending to compete with Bitcoin in terms of unconfiscability (spoiler alert: it was never a competitor).

But account based model chains and/or those using the EVM face other additional challenges:

In an account based model, the transaction validity depends on the moment of evaluation. This means that invalid transactions can be confirmed despite being invalid. As an example, in March alone, 2.7% of Ethereum’s transactions were invalid, 0.9 million of them. (check in any block explorer with invalid transactions enabled).

An additional consequence of this is that transaction’s validity can’t be cached since that validity can change and the transaction reordering that Account based models enable means that MEV is possible in that kind of blockchains.

In UTXO models, that is impossible because transactions can only happen if there is an amount in the unspent output. That means that the transaction's validity is contained within the transaction itself. This is a very important achievement by Satoshi that in my opinion is frequently overlooked.

Also, the child/parenting relationship creates a well defined offline transaction ordering, which can be batched and submitted to the network with predictable results. This means that UTXO model based chains can use Lightning Network style payment channels, enabling significant increases in transaction throughput.

UTXO models have another advantage which is allowing the trade of multiple assets among different parties in one single atomic transaction. Besides, UTXO tends to disaggregate information, which makes implementing confidentiality techniques easier. That's the reason ZK range proofs have been running already for the last 5 years on the #liquidnetwork and the reason why techniques like bulletproofs++ will be possible too in a very short timeframe both on liquid and Bitcoin itself. Confidentiality is critical to avoid investor's front running in a financial system based on public chains.

Additionally, Ethereum based chains do not support native multisig; every transaction originates from a single account with a single signing key associated with it.

This means that to effect multisig policies, you must create smart contracts that hold coins in escrow and accumulate multiple approvals before releasing them. This is hard to reason about and extremely fragile as the parity multisig hack worth $30m clearly demonstrates.

An implication of using EVM is that its smart contracts can’t be formally verified. In financial applications in sandboxed environments where you can reverse a transaction, that’s not a big issue.

But in an environment in production with high value financial applications it definitely is and we have confirmed that technical teams in tier 1 banks are aware of it. Basically without formal verification, you can’t be sure that a smart contract can be bug free and when millions are at stake, this is a huge deal.

And if you add a 3rd party to audit your smart contract, you are basically adding intermediaries that are security holes in the system.

If we want to adapt current institutions like money or financial markets for the digital age as it was the goal of #cypherpunks, we need more social scalability in our institutions, not less, so the road is trust minimization, not the contrary.

Some conclusions

Bitcoin is on its own in terms of enabling private property resistant to (bad) laws, thus, it has no competitors and it is hard to foresee a way that can change.

Since we can expect demand to be significant both from the censorship resistance point of view and the investment thesis point of view and since we can be confident that its supply’s limit will remain the same for a long time, it makes sense to have an allocation in this asset for a significant part of the world's population.

Other cryptocurrencies face way bigger challenges: their value proposition is shared among many cryptocurrencies and even blockchains developed by banks. This means that their demand is divided among many cryptocurrencies and even bank developed blockchains.

Additionally, it is frequently the case that we can’t even be sure about what their supply is.

But not only that, even in technical terms, is not a good idea to develop high value financial applications on top of account based and EVM based chains; it’s a way better idea to do it on Bitcoin layer 2s like the #liquidnetwork with UTXO based models and low level smart contract programming languages that are mathematically verifiable.

Please let me know your thoughts in the comments, I'm curious if you share this opinion.