Blockchain: A lot of money, momentum and hope… but what is real?

This ‘note’ is to help me (as a long-term investor & entrepreneur considering an investment of time and other-peoples-money) know what variables to consider before moving forward with a blockchain &/or cryptocurrency project.

<These notes assume you understand Bitcoin, Public/Private & Permissioned/Permissionless & federated blockchains, consensus concepts, side chains, ICO/STO, stable-coins, utility/app-payment/security tokens and smart contracts.  If you don’t please review the following notes.>

I’m sure we will look back on this time and ask how we got here… History may likely unfold something like the following:

  • 2010: Bitcoin engendered the anti-establishment types
  • 2012: Bitcoin’s growth engendered the speculators
  • 2013: Bitcoin’s blockchain technology and opportunity caught the eye of the Silicon Valley entrepreneurs (‘can we build a better cryptocurrency’ and ‘what else can we do with blockchain’)
  • 2014: Marketers and VCs saw the opportunity then smart money became interested
  • 2018: Smart money gets in
  • 2018: Everyone is talking about “Blockchain” regardless if they understand it or not
  • 2019: The market went boom and the bubble burst
  • 2020: Startup-survivors, corporation and governments began to use the technology for huge productivity gains

…but who will survive and why?  What variables do we need to keep an eye on to ensure we are not a casualty of an impending market disruption.

Variable 1: Trust: Bitcoin engendered the anti-establishment types

Nakamoto’s Bitcoin whitepaper pushed on a major anti-establishment hot button by pointing out that Bitcoin operates outside of government control: “The root problem with conventional currency is all the trust that is required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust”.

Other’s hope that the underlying technology ‘Blockchain’ will allow for any transaction or data transfer to be completed through peer-to-peer computer networks, with no need for third parties like Central Banks, Amazon, Facebook or Google (see more here). Early on, it attracted those who distrust established authority.

However, it’s not just fringe anarchists any more… Citizens across the globe are losing trust in government, media, and businesses.   Just take a look at Edelman’s latest Global Trust report.

It could be the perfect time for a bit more flattening of our world by software…  Trust in the institution is a variable to keep an eye on – as it is at the heart of what drives blockchains success.

Variable 2: The amount of money speculators are investing in the market

From a cryptocurrency market cap perspective, we are talking about billions of dollars. See here.

…but we are still nowhere near the size of the problem we had in 2000-2002 (Dotcom bubble).  More here. However, the speculators continue to move the momentum forward regardless of risks of the market.  This momentum in many ways helps make the hard changes required a possibility.

Variable 3: Developer interest

If you follow the developers, you will know where the tech market is going.   Here is a quick graph from Google Trends that shows blockchain job searches versus devops job searches—currently there is a lot of growing demand.

Variable 4: Venture Funding

From https://www.coindesk.com/bitcoin-venture-capital/ you can see that there is a healthy growth curve:

Variable 5: Smart money (Institutional Investors)

Keep an eye on what groups like Fidelity (more), Wellington (more), Morgan Stanley (more) and others are doing in the crypto space.

As an example, Barclays and Mastercard are both filing and getting awarded patents (more here and here).

Variable 5: “Blockchain” hype – everyone must have one…

In looking at Google Trends again you can see a clear hype cycle with blockchain in regard to searches in general as compared to other technologies shaping our future such as IoT and Machine Learning.   Clearly, mid-2017 was the start of the generalist mania.

Never forget what a blockchain provides: an immutable & decentralized ledger and a blockchain needs to keep those properties using a decentralized network with the following prerogatives:

  • Distribute the ledger — Validate
  • Append to the ledger — Work
  • Incentivize the user’s needs — Token

If it’s anything else, be skeptical…

I always say follow the developers but in this case, it’s tricky because so many entrenched camps have formed primarily due to how much money is at stake.  Once the big money (examples: Tim Drapers, Andresen Horowitz, financial svc) get involved they promote what they have invested in and then the social networks/media outlets jump on the marketing bandwagon.

The key to seeing through the hype is to follow the key mindshare leads in each area and not the media/venture capital/financial market promoters.  Follow key industry projects as close as possible (examples). Follow what governments are doing around the world.

You also must understand the tension that blockchain and cryptocurrencies create in the marketplace and watch how they respond to the threat.  Some examples:

  • Centralized institutions that are vulnerable to disruption, such as banks, will dig in. They are protected by existing regulations, which are ostensibly imposed to keep them honest but inadvertently constitute a compliance cost for disruptive technology. Those regulations, such as the burdensome reporting and capital requirements that the New York State Department of Financial Services’ “BitLicense” imposed on cryptocurrency remittance startups, become barriers to entry that protect incumbents.
  • Large companies like Google, Facebook and Amazon won’t sit idly and let their central portals be replaced by decentralized platforms. (more here)
  • Government’s won’t allow their currencies to be replaced by cryptocurrencies. Especially those government’s whose currency is the reserve currency.
  • Government’s won’t let their privacy laws be broken, for example, the new General Data Protection Regulation in the EU.

Variable 6: Timing – we are early!

In general, you must be cautious when:

For now, let’s go with Victoria Lemieux’s definition from the Verge article linked above until we have something official from the ISO: “In general, if the transactions are gathered together in blocks, and it is blocks that are secured on the chain using cryptography, and it is designed to be tamper-resistant and produce immutable records, the system qualifies as a blockchain.”

Variable 7: Count the REAL ‘use-cases’

For a list of blockchain use-cases refer to this article—you can choose if they are REAL or not.

In general, what can we do now, that we could not do before?  For example, before Bitcoin, nobody could own an asset in the digital realm. Since copying digital content is easy to do and difficult to stop, providers of digital products such as audio files or e-books never give customers outright ownership of the content, but instead lease it. Bitcoin showed that an item of value could be both digital and verifiably unique. Now we can represent any property title or music track as an entry in a blockchain transaction.

Variable 8: Architecture flaws in the underlying platforms

Always keep in mind that paradigm shifts have architectural issues—but it doesn’t mean those issues will stop the momentum—these issues just need to be understood and risk assessed.   For example, the internet was built on an insecure foundation, Linux had platform fragmentation issues, Open Source had many issues.   As you see with all elements of crypto and blockchain there are strong arguments about underlying flaws across the board.  For example:

  • Ethereum & block size – Ethereum has an architectural flaw that may catch up to it and all that runs on it—its’ no cap on block size https://hackernoon.com/the-ethereum-blockchain-size-has-exceeded-1tb-and-yes-its-an-issue-2b650b5f4f62 –What does this mean for all the tokens built on top of Ethereum? More here on Ethereum’s scalability issues.
  • Bitcoin’s block time – The average block time for Ethereum is significantly less than Bitcoin’s: 12 seconds versus 10 minutes. This translates into more block confirmations, which allows Ethereum’s miners to complete more blocks and receive more Ether.

Variable 9: Decentralization

Blockchains need three properties:

  • Scale – The ability to support many users
  • Consensus – The agreement between each node on the validity of transactions.
  • Decentralization – A state of affairs in which there are many nodes and no one entity controls the system

In most cases, blockchain developers are only able to focus and succeed in two of the three properties necessary for decentralized blockchains.  For instance, blockchain developers can have a system that scales and reaches consensus, but it will be at the expense of full decentralization.

Its relatively easy to see how distributed the major coins are in the crypto-market (here is a good example: https://arewedecentralizedyet.com/ ) but what are the right ratios for new tokens or permissioned networks?

As blockchain matures measuring decentralization will be key.  Read here and here and here for more.

Also, keep in mind that decentralization is at multiple levels–for example, ~70% of the Bitcoin (12k) nodes are in China (more).

Variable 10: The single point of failure

When building a private blockchain you must look closely at the architecture and the business model to see if there is a ‘single-point-of-failure’ (SPoF).   For example, if you are using Hyperledger’s ‘ordering service’ does it create a SPoF—some think so?  What’s the value of a distributed database if there is a SPoF?  You have to also look at the business model –as an example: In a regulated environment the regulator has to be able to roll back a trade and that inherently makes them a SPoF.

Variable 11: ‘Store of Value’

Old school billionaires like Gates and Buffet say cryptocurrency has no ‘store of value’ so they are not currencies.   Others challenge the argument (more here and here).

The US Federal Reserve Chairman Jerome Powell made it clear (here) during testimony in front of Financial Service Committee of the U.S. House of Representatives (“The House”) with the following comments:  “if you think about what currencies do, they’re supposed to be a means of payment and a store of value, basically, and cryptocurrencies are not really used very much in payment. Typically, people sell their cryptocurrencies, and then pay in dollars… In terms of a store of value, look at the volatility, and it’s just not there.”

From a worldwide banking perspective, you can review the Bank for International Settlements (BIS) Annual Economic Report found here where they specifically call out “The second key issue with cryptocurrencies is their unstable value”.

Variable 12: Is the token/coin a security? (The SEC on tokens and Howey test)

The US take at the moment (from SEC William Hinman) is that Bitcoin and Ethereum are not ‘securities’ but most all ICO tokens likely are..  What does this mean for companies like Ripple with XRP?  Who knows but the impact of how the SEC deals with these companies and regulations needs to be watched closely.

Variable 13: The success of tokenizing a physical asset

There is a lot of discussion around tokenizing physical assets such as land, art, diamonds etc. however there are many issues such as how different countries laws impact ownership of assets.  Many of the issues are outlined in this article: here.

 

Using Ripple to understand valuation, risk and the SEC in the brave new world of blockchain

Given XRP is one of the more successful cryptocurrencies and Ripple (the XRP sponsor) has an incredible list of backers/board members and has been in business since 2012, they seem like a good company to use to take a deeper dive into the mechanics of the crypto market and analyze where some of the liabilities exist.

First, let’s go through a little background-In September of 2016 it was announced that Ripple raised $55 million USD in funding at a valuation of $410M USD.  The XRP token according to Chainfx was trading at $.007 USD on Sept 1, 2016.  Given there are 100B total tokens & 39.25% are in the market.  The market cap of XRP would have been $700M near the time of the valuation.  Today the XRP market cap is near $53 billion USD.

More from Quora.com on Ripple’s valuation from David Schwartz, Chief Cryptographer at Ripple  “As Michael Nadolillo point out, Ripple did not create XRP. XRP existed before Ripple did.

As for how you value a company like Ripple, it comes down to two components. First is how to value the XRP that Ripple holds. The second is how to value whatever else Ripple might do that might materialize as shareholder value.

Presumably, the current price of XRP reflects some fair prediction of the value of XRP. If it was an unreasonably low estimate of XRP’s value, we’d expect people to buy it and cause the price to rise. Similarly, if it was an unreasonable high estimate, we’d expect people to sell and cause the price to drop.

So we can take the amount of XRP that Ripple holds and multiply it by the price of XRP to get a fair market estimate of the value of Ripple’s XRP. But you have to remember that Ripple will have to use some of the value of that XRP to incentivize partners, pay employees, and so on. It will not all materialize as value to Ripple’s shareholders.

Of course, some of that expenditure may translate into revenue beyond XRP for Ripple. For example, Ripple might trade XRP (or use revenue from XRP sales) to acquire equity in other companies. Ripple might use XRP (or revenue from XRP) to form new ventures that generate value from sources other than XRP.

So some multiplier has to be used to represent what fraction of the value of Ripple’s XRP you think will materialize as shareholder value. The challenging thing is that there doesn’t seem to be any good, objective way to agree on what this multiplier should be. I’ve seen knowledgeable people place it at 15% and I’ve seen them place it at 85%.

The market cap of XRP is not really a meaningful number for computing Ripple’s value though it does give a general idea of the economic importance of XRP compared to other digital assets. Ripple doesn’t own all the XRP, so the value of all the XRP doesn’t really relate to Ripple’s value.”

Ripple is essentially a high-value service that provides the ability for institutions to send money globally using the power of blockchain.   They have the RippleNet messaging systems for enterprises to use for cross-border payments and it does NOT require XRP–Ripple execs have even mentioned that XRP is not essential to Ripple’s business case (it’s just an add-on).  The execs have also mentioned that the ‘old’ cross-border payment systems cost ~20 basis points but with Ripple, customers could have a 6-basis point improvement using their platform without XRP.  With XRP there is an additional 2-basis  savings (note: this doesn’t take into account volatility of the XRP currency).

You have to wonder, does Ripple want to be the first non-sovereign private central bank leveraging cryptocurrency?

Ripple says they have 100 banks using their platform however it’s difficult to tell if those institutions are just kicking the tires or are they building out production systems.   You would think that these customers already have a ton of resources engaged in the ‘old’ way of moving money around for multi-national corporations and they make a ton of money doing it the ‘old’ way.   Also, these old-school banks and corporations are mostly risk-averse and if they think there are regulatory issues they will wait until those are clearly worked out.

Is XRP centralized or decentralized?

As opposed to Bitcoin, XRP does not seem all that decentralized–that may be a huge problem for the SEC… or maybe not.

  • Ripple says they are committed to decentralizing the XRP ledger and divesting operating control and giving up control of their validator nodes.
  • Bitmex did a report on Ripple / XRP where they downloaded the node software and all keys came from Ripple and they are in control of the consensus system.
  • Past CEO Chris Larson (17% of total) and current CEO Brad Garlinghouse (6.3% of the company) own a large share. (see here)

The most important point here is that most all cryptocurrency projects are going to start out centralized and then go to decentralized—it just seems to be taking Ripple a while to get there (it must be difficult). What makes this troubling is the market cap is huge and MOST IMPORTANTLY – the SEC has recently reported the following.  In this speech, William Hinman emphasized that “decentralization” is what makes Ethereum and Bitcoin NOT securities (absence of a “central actor” or third party who meaningfully determines “the enterprise’s success.”).  That can’t be good for Ripple.

Does Ripple need XRP?

Ripple may be a different animal (if they are really building a non-sovereign private central bank) however their platform seems like a permissioned system (private Blockchain) and tokens are not even necessary given the actors involved trust each other.   A permission-less system needs a token to incentive behavior because there are no middlemen.

If this is the case, the issue here is that they sold XRP to retail investors when was meant to be used by banks.

Is having a cryptocurrency worth the headache?

I guess all this boil down to is having XRP worth all the hassle when it only provides a 2 basis point saving for customers?

It seems that Ripple already has a great deal of interest and momentum from industry (MoneyGram is even interested). However, the cryptocurrency model seems to have lead to plenty of legal headaches (beyond what the SEC may bring in the future).  There is a lawsuit with R3 where Ripple granted options for billions of XRP at less than 1 cent in 2016 to incent R3’s banking network to adopt the platform.  Ripple canceled the option and now it’s in court.  There is also a class-action lawsuit against Ripple (see Bloomberg article here).  And there are other strange troubling issues–See the case of Jeb McCaleb family member froze funds at node level to get 1m back…

On top of all this, it also seems that even with all the success this company is having they are having difficulty getting listed in the most powerful exchanges (more here).

Bottom line – it may be worth the headaches IF the currency is what is funding the growth and the company can use this momentum to actually change a giant old school market.   It’s difficult to tell from the company’s quarterly reports where the revenue is coming from but you have to believe (after reading some of the background articles listed below) that the primary source of revenues is from the sale of XRP.

Net Net: If Ripple can steer clear of the SEC then maybe it was worth it and they will accomplish a sea change in the financial market.   …and just maybe the SEC sees the long-term upside in having this industry change!

Background reading: