What You Should Know About Blockchain and Crypto Assets #1

Since 2013, I have thought that bitcoin, blockchain and all things crypto were a bubble.

I graduated in '99 and remember the last tech bubble well.

But year by year, the blockchain has not only survived, but seems to have gotten stronger.

It made me think of the Lindy Effect and I realized it was time to learn more.

Starting September 2017, I gave myself the task of reading 2-3 hours every week about the blockchain. I figured being a computer science major, and working in finance I should know what all the noise is about.

I dove into all the blogs, white papers and books I could find (some of the best ones at the end).

BACKGROUND:

Here are the three big ideas it's built on.

Fat Protocols:

The internet and basically our entire online world is built on a lot of pretty simple protocols - things like HTTP, TCP/IP, SMTP to name the basics.

The protocols provide the structure, the bedrock upon which everything rests. Early programmers created these protocols, but gave up all the upside to the companies that built the application layer on top. In addition, given non-existent compensation mechanisms for programmers to benefit from creating stronger protocols, we were left with very basic protocols which have started to bump against their limitations.

This article by Joel Monegro from Union Square Ventures illustrates the protocol discussion well.

The new protocols such as blockchains (bitcoin), ethereum are examples of fat protocols - where more value will be captured in the protocol layer versus the application layer - since the protocols are 'smarter'.

We call them fat protocols because they are much more complex and more data is stored in the protocol layer versus the original protocols invented in the 80's.

The Ledger:

One of the most powerful inventions humanity made in the 1400's was double entry accounting - basically: Assets = Liabilities + Equity.

Now we could keep track of who owed whom, and how much.

This gave rise to accounting and banking, but also brought about the importance of middleman who could maintain the ledgers and maybe hold the assets on our behalf. That's effectively what banks, trustees and custodians do for us. They hold a ledger of our assets and liabilities, and then process and balance them for us as transactions occur.

Double-Spend Problem:

When the internet was invented and society moved online and began to focus on digital goods and services, we found that our online lives were still tied to an offline ledger.

We were online, living at the speed of light in the 21st century. But our ledger, our accounting system still relied on a central counter party to hold and look after our ledger.

This gave rise to PayPal in terms of money transfer, Facebook in terms of our social graph and Uber when it came to coordinating our travel needs, to just mention three services that rely on a centralized authority.

Many programmers had worked on taking money online, but since digital goods can be easily replicated, you have the double-spend problem become an impediment to a fully digital currency is the fact that you need a online decentralized ledger which can track transactions and maintain balances, and ensure that 'money' isn't copied, duplicated, used twice. That online money behaves just like offline money.

Satoshi Nakamoto effectively solved this problem using Bitcoin, which is discussed in his original white paper here (HIGHLY RECOMMENDED).

Given the three inventions above, you now have fat protocols such as blockchains and ethereum (smart contracts) that allow for an online ledger using a decentralized network where balances (and other data) can be maintained.

Our means of measurement and exchange can now exists online, without the need of a central counter party (banks, credit card company or anyone else). That's a big deal, I'll explain why.

WHAT DOES IT MEAN:

The big idea when it comes to the currency or asset nature of cryptocurrencies is that for the first time, we have a technology that creates a verifiable ledger distributed among many computers on the network.

When some people think about crypto currencies, there first reaction is to think of it just as an asset like Gold or US Dollars, it can be that, a number of people are using it either as a speculative instrument or as a store of value (that just happens to appreciate at the same time !).

Other people think of it as a means of exchange. A tool to send money across borders between counter parties. Currently there are barriers to this occurring in the same way MasterCard, Visa or the ACH network can facilitate transactions. Those barriers have to do with the computation required to verify transactions in the distributed ledger and it's something programmers are working to enhance.

I believe that at the moment most people think of crypto assets as either a means of exchange or a measure of value - but from what I see being built, the most important idea is the underlying network you get access to.

The picture associated with this article gives you a snapshot of network and the tools built on that network. That's where it's value comes from.

WHAT IS IT WORTH:

Professor Aswath Damodaran @ NYU did a great job of discussing this idea on a recent post and I agree with him.

I don't think bitcoins or other cryptocurrencies are assets quite yet.

They are probably closer to Gold or currencies. Things that can be traded, maybe even priced. But not valued.

But there are some ways to understand the direction of travel of the various cryptocurrencies:

1. Supply Constraints: For example, based on current design the total number of Bitcoins outstanding cannot exceed 21 million (though if a majority of users want to change this, it can be modified) and about 80% of the maximum amount are already outstanding (mined). Current inflation will run at 4% until about 2020, at which point it will go down to 2% till 2024. It will then go to ~1%. It's worth understanding the supply curve of the crypto currency you are looking at.
2. Software Developers: As we discussed at the top, all the cryptocurrencies are living, breathing protocols that are still changing. This means the software developer community around them is key. There are a number of ways to understand and measure developer quality and value creation. The protocol with the best brains behind it will probably do better.
3. Mining Network: The mining network makes the network work. The key concept of a distributed ledger is that the network allows verification to occur without the need of a middle man. The miners are critical to this, since they get paid to make sure transactions on the network are verified and correct.
4. Number of User and Transactions: These are living, breathing networks. If users and transactions are growing both in size and number than your asset is probably more valuable.

READ THIS:

CryptoAssets (ESSENTIAL)

HBR on Blockchain

McKinsey on Blockchain

Thoughts on Tokens by Balaji Srinivasan, Board Partner at a16z

Blockchain and the dawn of the Decentralized Business Model by Fred Ehrsam

Mapping the decentralized world of tomorrow by Alex Lange

LISTEN TO THIS:

Hash Power podcasts by Patrick O’Shaughnessy (ESSENTIAL)

Why Crypto Tokens Matter

WATCH THIS:

Don Tapscott's TED talk

Wired Magazine's Blockchain Video

?I look forward to your recommendations and ideas on where to learn more.

The purpose of this article was to share some of the building blocks of the decentralized world we are headed into and share what I have found useful on my journey.

None of this should be seen as a recommendation or advise to buy or sell any securities.