Crypto is not dead, it just smells funny

Paraphrasing from the classic Frank Zappa quote about Jazz, it has been a tough year for cryptocurrencies.  Bitcoin has shed over two thirds of its value after reaching a peak price of $19K last year.  Other cryptocurrencies, such as Etherium, suffered even worse losses.  However, even after these declines, early purchasers of cryptos still enjoy substantial gains and mining operations continue to be profitable.  Where do blockchain and cryptocurrencies go from here?  Will they ever move from speculative technologies to a key part of our digital lives?

Bitcoin’s 78.8x return from September 2015 to the peak in December 2017 surpasses the 9x return of Internet stocks from 1997 to 2000 and even the 37x appreciation of perhaps the greatest historical financial bubble, the French Mississippi Scheme of the early 18th century.  Bitcoin, however, remains substantially smaller in size than these earlier bubbles.  The value of the major cryptocurrencies today- around $200 billion – is about on par with the market cap of Coca-Cola, currently the 27th largest stock in the S&P 500.  This is not a lot of money compared to the $30 trillion market capitalization of the US stock market.  Put another way, cryptocurrencies could all disappear tomorrow without disrupting global financial markets.

One can find quite extreme pronouncements about the potential of blockchain technology from enthusiasts.  Venture capitalist Tim Draper, a backer of companies such as Skype and Tesla, claimed blockchain “is bigger than the internet. It’s bigger than the Iron Age, the Renaissance. It’s bigger than the Industrial Revolution”.   Why do (otherwise) smart people believe this?  At its core, blockchain is a database technology.  Instead of a single, centralized database with an administrator responsible for maintaining its integrity, blockchain is a database distributed among a network with rules encoded that require agreement of the members of the network to update information.  This feature allows the existence of cryptocurrencies such as bitcoin as the technology prevents double spending or hacking.  The promise of blockchain is that the technology can be applied to all sorts of transactions such as property titles, intellectual property rights, insurance claims, etc.  While none of this seems to offer a more important advance than, say, learning to make things out of metal, there are perhaps potential benefits in improving the efficiency of electronic transactions.

While much research and experimentation is currently underway on private blockchains, which are controlled by a single entity, such as a bank, this discussion is limited to the idea of unmanaged, distributed blockchain applications such as bitcoin, where no central administrator is present and economic incentives have to be provided for those who supply the computational power to maintain the network.

From an investment standpoint, a distributed blockchain application has to meet two criteria; the first is the obvious one that the technology has to work.  Second, it has to offer a compelling value proposition over existing centralized database technologies.  Not enough attention has been paid to this second issue.  The current status quo, while not perfect, actually works quite well.  Importantly, when it does not work, people can fix the problem.  Forgot your PIN on your bank account?  With proper ID you can reset it.  Lost your key to your bitcoin wallet[1]?  Sorry, tough luck – your bitcoins are lost forever.  A recent study estimated that somewhere between 17% and 23% of existing bitcoins, worth around $20 billion at current prices, are irrecoverably lost.[2]  A man in the UK recently made headlines petitioning his city council to let him look through the landfill for his old hard drive which stored his wallet key to a horde of bitcoins now worth $75 million.

Because the data is distributed across the network, blockchain databases are inherently more computationally intensive than traditional centralized databases.  For a distributed blockchain to work, it needs a sufficiently large network of ‘miners’.  ‘Miners’ is a term used to describe those who provide the computing power for the blockchain network and they require compensation for maintaining the network.  With bitcoin and other cryptocurrencies the compensation comes in the form of new units of the cryptocurrency.  If there are too few miners, the blockchain system can be compromised in what is called a ‘majority attack’.  This can occur if a party controls over half of the computing power of the network and would allow the attacker to double spend coins.  This happened this May, with Bitcoin Gold, the 26th largest cryptocurrency.  A bad actor or group of actors took control of a majority of the network’s computing power and stole, through double spending, over $18 million worth of the cryptocurrency[3].

Eric Budish, a Professor of Economics at the University of Chicago Booth School of Business, outlined the economics of blockchain in a recent paper[4]. In a very elegant way, he outlined that a not only must a blockchain network reward miners, it must pay them an amount above what they could extract if they colluded to form a majority attack.  He finds these costs of running a distributed blockchain network to be quite expensive.  However, to be economically viable, a blockchain network has to be both more secure and less expensive than a traditional centralized database.

To get an idea how expensive a blockchain system can be to run, the website has been maintaining an estimate of global bitcoin mining revenues and costs. As of the writing of this, bitcoin mining revenues are estimated by at $4.9 billion and costs estimated at $3.7 billion, which equates to a hefty 32% return for miners. Against bitcoin’s current market cap of $110 billion, the $4.9 billion in mining revenues translates to an ‘expense ratio’ of around 4.5%. Most of the costs stem from the estimated power consumption of 73 Terawatt hours, which is approximately equal to the annual power consumption of the entire country of Austria. For this expense, the bitcoin network currently processes under 100 million transactions per year compared with over 140 billion annual transactions processed by Visa. Visa’s 2017 operating expenses were $6.2 billion – 67% higher than bitcoin but with over 1,400 times the transaction volume.

Like everything else, blockchain is bound by the postulates of the dismal science.  In order to deliver something to society other than a speculative bubble, a blockchain must generate both a return on capital for those operating the system (i.e. revenue for miners) and deliver a competitive value proposition for users.  Whether blockchain can deliver on this promise remains an unproven proposition and the real risk prospective investors face.

[1] A 256 bit hexadecimal number such as E9873D79C6D87DC0FB6A5778633389F4453213303DA61F20BD67FC233AA33262, for example.  Anyone, including a hacker, that has the key can spend the bitcoins in the account.