Investing Responsibly In Cryptocurrency

Given the tripling of the cryptocurrency market cap in the last few months and the 3- to 10-fold increases in virtually every major altcoin, cryptocurrencies like Ethereum and of course Bitcoin have been getting a stunning amount of attention in the press. If you follow the cryptocurrency world closely, you know that there have been a huge amount of dubious ICOs (initial coin offerings) on the market recently. It's an explosive time in crypto.

Everyone is a genius in a rising market. It's hard to go wrong these days in crypto. Even coins of dubious merit like Ripple, Dogecoin, Stellar, NEM were pumped 5 times without any fundamental change. Speculators/investors have thrown money at crypto indiscriminately and efficient markets have 100% broken down. The altcoin pump right now is roughly comparable to the Dot Com crisis of the early 2000s in many ways;

• New tech promises to change the world
• Investors jump in on hype and promises
• A surge of IPOs (ICOs) occurs to capitalize on this
• "Greater fool" traders pile in, thinking they can make money even if the underlying is unsound (I am guilty of this)
• Analysts claim "this time is different" while seasoned old hands refuse to participate
• Tech is proven not to be as developed as everyone thinks, market tanks
• Select few decent companies survive, all the trash is destroyed
• Tech eventually fulfills expectations, 10 years later, but none of the investors from the early days make money on it

However, canny (and skeptical) investors can still make money on crypto, as cryptocurrencies are inevitable, and will continue to expand and proliferate, even when the altcoin crash comes.

Something to realize first of all is that the crypto market is heterogeneous. It has straightforward cryptocurrencies (bitcoin, Litecoin, Dash, Monero), smart-contract cryptos (Ethereum, Ethereum Classic) and a whole bunch of crypto tokens that follow dedicated platforms (Golem, Augur, Steem). Not mentioned are ripple and stellar because they aren't really cryptocurrencies at all.

The investing thesis for all of these categories is radically different. The measure of success for a currency or store of value is adoption, merchant use, low volatility, a large network, and real world acceptance as something worth owning. Bitcoin has this right now, which is why it's more than 50% of the ecosystem, and none of its competitors are even close. Monero, Zcash, and?Dash are a special case in that they try and make transactions anonymous and privacy, allowing for use cases on the darknet markets, for instance.

The tech underlying bitcoin is essentially sound, although it is having a scalability crisis. It can't right now serve as a currency which will buy you a cup of coffee - the transaction fees are too high. However if you want to send $200,000 from Mexico to Indonesia or China to the Philippines, you can do it within 20 minutes, and with fees of a few dollars. And if you want to store your wealth in a vault that is totally secure, and cannot be debased by a central bank, bitcoin is a good bet. This is highly relevant to folks in India that recently had cash abolished, to Venezuelans, to Argentines, to Cypriots, to Nigerians, anywhere local currencies are weak and volatile. The potential value of a competing cryptocurrency lies in whether it can improve materially on bitcoin, whether it means incorporating off-chain scaling (segwit with Litecoin), making it more private and fungible (Monero), automating governance (decred), and so on.

Then there are cryptoassets that incorporate smart contracts. These – Ethereum and its derivatives – exploded when the SEC denied the Bitcoin ETF back in march and bitcoiners got worried and started diversifying. This is the market segment that is highly risky, even by crypto standards, in my opinion. Ethereum is a protocol that allows contracts to self-enforce. Programming power to run the contracts is paid for with Ethereum. Two parties agree to a contract, and it then self-executes. It's secured by a decentralized computing network of Ethereum miners, so the contracts cannot be shut down by a government or corporation. It was this capability that eventually led to lots of decentralized apps being funded, via token sales – bringing me to my point of investing responsibly. So what does it take to invest responsibly in cryptocurrencies? It requires at least a basic understanding of three disciplines: public-private key cryptography; programming, and how open-source projects function; and economics, particularly game theory and the quantity theory of money. This is why it is so difficult to apprehend easily: because very few people actually boast a sincere understanding of these three topics. I certainly don't.

You need to be able to determine whether the tech is actually going anywhere, and whether the task the developers have set themselves is possible or realistic. You need to know how open source networks are governed, and which models strike the best balance between efficiency of decision-making and fair consensus. You need to be able to measure the inflation schedule of the cryptocurrency, and see whether your coins are going to inflate away. You need to be able to make plausible guesses about the potential market for the crypto and estimate future values. Note that the payoff structure is not equity-like. It's more like early stage venture capital.

• Does the project offer a significant improvement over its nearest competitor, or a reasonable chance of success in its stated aim? Is there a demand for this project? Does it have a concise and reasonable goal? (Narrower goal: higher likelihood of success).
• Is the development team competent? Are they committed to the coin? What's their track record? Do they have an active development team? Do they have a road map for the future? Are they transparent about goals?
• How is the development team funded? Is the currency corporate-backed? Is the funding transparent? Was the coin significantly pre-mined? (Usually bad) Are developers paid via iterative community project crowdfunding? (Usually good).
• What is the governance structure of the currency? Who holds ultimate control over decision making? How are decisions made? Are they transparent? Are mining & developer incentives aligned?
• Does the asset have acceptance and use today? Does it have a functioning use case? If it doesn't, does it have a decent chance of being accepted?
• Has the asset's "market cap" tripled or quintupled in the last few months? Was this based on any fundamental changes (new software releases, etc) or just speculation?
• What are the transaction volumes like? (Hint: divide market cap by monthly averaged daily on-chain tx volume to find a consistent ratio) What's the ratio of on-chain transaction versus exchange speculation? Has price gone up independent of transaction volumes?
• How long has the asset been around? Older is usually better.
• What's the community like? Is there censorship? Does it have an active subreddit? Do the developers answer questions? Are they accessible? How big is the github community? (Hint: you can divide market cap by github commits to find a comparable ratio).
• Are you psychologically able to hold this coin in a 90% downturn? Is this a high conviction thesis or are you betting on being able to sell it to a greater fool?

Cryptos are an asset class that is both radically different from anything that has existed before. They are also incredibly heterogeneous, as I argued above. It also leads to cultism – so bitcoiners generally take a dim view of Ethereum, and vice versa. Monero fans generally don't like dash, and so on. You have to keep your mind open to understand new opportunities as they arise, and to stop yourself becoming too mentally invested in your project of choice. The vast majority of projects will fail within 5 years, so becoming overly certain of the success of one will probably devastate you. If you can stay balanced, stay honest about your cryptos chances of success and adoption, not get tunnel vision, and not take overly risky positions, you have a good chance of not losing everything. Remember the payoff structure. Heavily rightward skewed. A ton of cryptos earn no return and a select few earn an absurd (1,000-10,000x) return.

None of this is necessary if you just want to invest randomly in one of the top ten cryptos. That's the strategy of 95% of investors today. Pick a coin and go. If it's not bitcoin, be assured you will lose money.?