Thoughts on Crypto

June 24, 2021

We recently gave a webinar going over the crypto landscape and our overall thoughts on all of it. The replay can be found on our page here. It is the video titled “June 2021 Market Review.” On this post I want to review some of the things we went over in the webinar and provide some further clarification on some of the topics. I also want to add the caveat that I am by no means an expert in this space. I have been aware of the space since about 2013 and I have been following crypto with a reasonable degree of regularity since 2017, but since it is such a rapidly evolving space with new projects being started every day, I cannot possibly know everything that has been developed and is being developed. Even experts in the space aren’t aware of every development. Despite this, I do believe that I have a reasonable degree of confidence in my assessment.

When many people think of crypto, the main thing that comes to mind is the various cryptocurrencies that are out there such as Bitcoin or Dogecoin, but the space could be described as everything that is operated using decentralized, blockchain technology. The applications for this technology are expanding every day, but some of what is available in the crypto space today includes currencies, borderless payment processing, insurance, medical data processing, tokenized marketplaces, and organizational structuring. All these things already exist outside of crypto in some form, but crypto is different in how it connects everything together. Decentralized finance is probably the easiest to understand for how this works. If we were to think of borderless payment processing, for example, the current method to transfer money from your account in the US to someone else’s account in another country would involve going through your bank or a third-party money transferring service such as Western Union and then transferring the funds into the recipient’s bank account. That whole process involves several layers of transactions, each layer requiring trust. The same transaction done on the blockchain would not require any of these layers. Funds from your wallet on the blockchain would go straight into the recipient’s wallet without having to go through any intermediaries. The transaction would be verified, executed, and recorded as part of a new block on the blockchain. It essentially accomplishes the same thing as the traditional method, but rather than going through centralized intermediaries, the transaction can be done without any intermediaries. It gets a little more complex with other applications, but the overall concept is that it is taking applications that are done now via centralized providers and making them decentralized. The culmination of all these developments would lead to what could be described as Web 3. Web 3 would connect everything to the Internet on one decentralized platform. The main points used to describe the benefits of Web 3 are that it would be open, trustless, and permissionless. Looking at how the internet operates now on an application like Facebook, users have an account specific to Facebook that isn’t transferrable to other applications (nothing that happens on Facebook impacts Fortnite), they have to trust that what they are seeing on Facebook isn’t being manipulated (Russian bots actively controlling narratives), and they need approval to use Facebook (Facebook is banned in China and other countries). Everything that occurs on Facebook is centralized by Facebook. If you were to purchase a digital asset on Facebook it wouldn’t be able to transfer over to something like Fortnite. It would be exclusive to Facebook. Web 3 would remove the centralization so that you would basically have one account for the Internet, and everything would be connected on one blockchain or across connected blockchains. Rather than the applications you use owning your data and having possession of your digital assets, you would directly own your data and digital assets and you would be able to interact with applications on the blockchain without giving them up.

As you can see by how this all works, the whole ideology behind crypto is that it seeks to wrest control from governments and large corporations. Because this is the driving force behind crypto, it tends to be more popular in countries where trust in institutions is much lower.

A hole in this structure is that governments and corporations are what fund all these applications and the initiatives that we have now. By how it functions, Web 3 would not be able to be funded in the same manner. How it all gets funded is where cryptocurrency comes in. The use of the various applications either grant or remove cryptocurrencies by certain actions. It can be compared to the currency system in a video game like World of Warcraft. Some cryptocurrencies are designed for this purpose, while others are designed to be replacements for the global fiat currency system. Bitcoin was designed to be a replacement for global fiat currencies and wasn’t really designed for much else initially, but applications are available now that incorporate it into the broader decentralized blockchain universe.

Bitcoin is believed to be the first cryptocurrency and it is what started the wave of developments in this space. The idea for Bitcoin came about after the Great Financial Crisis as a solution for many of the perceived problems that are believed to have occurred due to the adoption of the global fiat currency system in 1971. As you can see in some of the following charts since that adoption the standard of living has not kept up with the pace of economic growth. This has created various financial bubbles and as a result has created an environment where there is no safe place to grow invested assets.

Bitcoin and some of the cryptocurrencies are ultimately hoping to be a return to the gold standard but instead by using technology rather than physical objects that pose barriers in terms of accessibility, convenience, security, and transportation. Bitcoin is hoping to accomplish the following:

• Remove control of money from governments

• Allow payments to be anonymous

• Improve financial infrastructure

• Create yield opportunity

• Eliminate inflation by having a limited supply, creating scarcity

• Be a store of value

Whether cryptocurrencies accomplish these things or whether it has the potential to accomplish them is where the question lies. My view is that there are serious flaws that will prevent cryptocurrencies from being able to achieve their purpose.

First of all, the scarcity argument is completely refuted by the fact that there are now over 5,000 cryptocurrencies. Bitcoin may have a set number to be produced, but that does not prevent additional cryptocurrencies from being created and challenging Bitcoin.

Another flaw is that the value of cryptocurrencies is highly volatile. A phenomenon has occurred where the cryptocurrency market has gotten even more volatile as it has grown, not less volatile. An asset cannot function as a currency if its value changes by 5% or more every 24 hours.

A third flaw is that cryptocurrencies also more easily enable terrorism and money laundering. We have seen a massive rise in cyberattacks over the past year. These cyberattacks are made easier and more profitable by cryptocurrencies. Prior to cryptocurrencies, a ransomware attack could be made on a business, but there would be no easy way to extract money from the attacker’s target. A bank won’t just send money to a terrorist’s bank account and even if it did that would give away the terrorist’s identity, but now terrorists can just request a crypto transfer to an anonymous wallet where they then deposit the funds into an app like Tornado Cash which eliminates the ability to track the crypto transfer and then withdraw them completely anonymously.

A fourth flaw is that cryptocurrencies require massive amounts of energy to function and be produced. This is something that they are working on right now. Both the Bitcoin and Ethereum blockchains are set to receive updates soon that will improve this. Their updates are designed to reduce the energy cost of transactions, but the energy cost of production would not be reduced, still requiring large amounts of energy. In the case of bitcoin, it has a halving cycle that reduces the amount able to be mined every four years, which would slowly reduce the energy usage over time, but in the meantime, it will be using massive amounts of energy.

A flaw that could potentially be fixed in the future is just the overall efficiency of the system. Because cryptocurrencies rely on blockchain technology, the volume of transactions they can process is very low. Visa, for example, processes around 1,700 transactions per second and is capable of processing more than 65,000 transactions a second. In its current state, Bitcoin can process about 7 transactions per second. Right now, this is probably the biggest flaw. If every country in the world decided to make Bitcoin the global currency, it would not be possible. Bitcoin would likely not even be able to support a single city’s transaction capacity. They are working on improving this, but right now there are a lot of hurdles that blockchain technology must overcome to get close to the point of it being used as a regular currency.

In addition to these flaws, there are also multiple risks associated with the use and ownership of cryptocurrencies.

The first main risk is the lack of regulation. The financial system has multiple layers of regulation that are designed to protect those who participate. The crypto space is basically fair game now for anything because there are no restrictions. Since the space is so new and not well understood, it is rife with scammers taking advantage of this. The FTC reported that over $52 million was lost in the first quarter of this year by crypto participants due to getting scammed. A major news story just came out today about two South African brothers that stole $3.6 billion in Bitcoin.

Another risk is how cryptocurrencies are stored and possessed. Since cryptocurrency is decentralized, it means that the owner of the cryptocurrency is completely responsible for it. With fiat currency, that responsibility is shifted to the banks. If you can verify who you are, they will be a safeguard of your wealth. There have been many cases where people have lost massive sums of money because they forgot their password, or they threw out the wrong hard drive. When this happened, there was no way for them to recover their wealth.

The largest risk is government intervention. Governments around the world benefit a lot from having control of their currency. Some countries, such as El Salvador, have authorized Bitcoin as legal tender, but countries like Turkey and China are going the opposite direction. It is very possible that more jurisdictions around the world will see cryptocurrencies as threats and either make them illegal or heavily restrict their usage. One development that many central banks are working on is Central Bank Digital Currencies (CBDCs). CBDCs would be a tokenized form of currencies that already exist. They would have many of the benefits that cryptocurrencies have, but rather than being decentralized they would be centralized and would allow governments to better enact monetary policy. While it is not a certainty that CBDCs will come to fruition, it would be hard to imagine decentralized cryptocurrencies being allowed to exist in a future where CBDCs are the main currencies.

While I am overall very bearish on cryptocurrencies, Web 3, on the other hand, could have a lot of potential. Progress is being made across the Web 3 space every day. The main flaws with Web 3 are that much of what is created on Web 3 is funded by cryptocurrency arrangements and that as of right now it is still a lot worse than what Web 2.0 offers. I believe that for Web 3 to succeed it would have to be able to be funded without cryptocurrencies, which have serious flaws, and it would have to prove that its applications are better than what we have in place now. It seems entirely possible that we may not determine whether Web 3 is a viable successor to Web 2.0 for another decade.

The potential of the crypto space has drawn a lot of investor dollars over the last few years and has resulted in massive returns for those that got in on the ground floor.

Source: Coinbase. Data as of 6/24/2021.

However, as we all know, just because the price of an asset has gone up significantly in the past, that does not imply that it will continue to go up with the same level of growth in the future. Overall, as an investment, I see the flaws and risks outweighing the potential reward that this space provides. This is why I remain bearish on the crypto space, but I am continually monitoring the developments to see if there are any changes or updates that warrant a change in my stance.

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