“Nothing so undermines your financial judgement as the sight of your neighbor getting rich”.
These sage words by J. Peirpont Morgan are a perfect summary of my feelings on the current obsession with crypto currencies.
I see perfectly logical people suddenly plunging headlong into this unusual new world of investments. The breadth of interest in crypto was brought home to me recently by an older relative who reached out to me to try to help him recover more than $10,000 he had lost in a crypto scam.
This ‘wild -west’ aspect of crypto currencies is one of the reasons for my own distrust of crypto ‘investing’. My assumption in 2017 was that it was a passing fad, and I outlined the reasons in a blog I wrote that year. Bitcoin crashed from $19,377 in December 2017, to $3,122 a year later. An 83% decline justified my views, and Bitcoin appeared to be in the dustbin of history along with Tulip Mania the South Sea Bubble and various other manias.
But no, unlike these prior mania bubbles, the subject that was written off as dead has risen from the ashes like a phoenix. So, for the sake of some logical argument on the topic, this blog is my attempt to make some sense of this somewhat foreign world. At the end of reading, please post your own thoughts and comments.
Crypto becoming mainstream
In recent times, crypto currencies have gained legitimacy on a number of fronts. Commonwealth Bank is trialing crypto trading via its banking app. Vimal Gor, the head of fixed income strategies at Pendal Group is on record as saying that bitcoin could go to $100,000, $200,000 or $1,000,000.
In recent times I have engaged on Twitter with Mark Carnegie. Mark is a well known corporate deal maker and activist investor – certainly someone I would rate as superior intellect. His current interest is in a coin called Smooth Love Potion, the currency of a game called Axie Infinity. I seriously wondered if he had lost his marbles. Why would an ultra successful investment banker get involved in game based crypto? Then, just last week, we saw a comment by REST Super, that they were ‘considering’ crypto currencies as an investment for the fund. The cynic in me thinks this may be an appeal to their mostly young member base, holding out the hope of improved performance as they just scraped through the last APRA test. JP Morgan, the bank founded by the aforementioned J. Pierpont Morgan, is now offering crypto trading and investment for their clients. Old JP must be rolling in his grave!
Are your biases blinding you?
To come to this point, I had to look inwardly. To consider my biases, and make sure they don’t blind me to opportunities.
As some of you may know, I was not a ‘silver spoon’ child. My working class parents struggled to get by; rabbit meat and wild duck were often the weekly protein on our table. Busy working to make ends meet, there was little time for games, art or even music for that matter. What did matter was a job well, pride in ones work, honesty, not making ‘un-earned’ gains.
Now you know my biases. It probably shapes why my investing style leans towards value vs growth, and why I find crypto billionaires repulsive.
The crypto boys and girls would tell me ‘have fun staying poor’; one of their favorite comeback lines when critics ask them to explain the actual use-case for the particular crypto that they are pumping. But for all that, I am not blind to the revolution. With that framework, I want to now dive into a few areas of the crypto world that are intriguing.
- Proof of Work vs Proof of Stake
- Digital Gold – Scarcity
- Valuing Crypto Currency – Metcalfes Law
- Virtual Worlds
- Monkey Business
- DeFi, DAO & NFT’s
Proof of Work vs Proof of Stake
Bitcoin is the original Proof of Work crypto currency. A proof of work is a piece of data which is costly and time-consuming to produce but easy for others to verify and which satisfies certain requirements. The power requirements to mine (create) each successive bitcoin is always rising, making that last few coins in the 21 million total bitcoin money supply harder and harder to extract.
This high energy cost and relatively slow transaction time is why it is hard to believe that Bitcoin itself will become a sole world crypto currency, even though it does have first mover advantage.
Enter the Proof of Stake concept. Proof of Stake (PoS) in its most basic form relies on more than 50% of nodes in the network agreeing on a transaction. While proof of work requires vast energy use, proof of stake requires node operators to put up some of their own currency as security for the privilege of being able to operate a node that is able to verify the blockchain transactions.
Bitcoin operates on a Proof of Work system, while Ethereum uses a Proof of Stake system.
Digital Gold – Scarcity
Some proponents make the claim that Bitcoin is simply digital gold. That concept has some validity. Gold pays no interest and has no dividend, it just sits there, looking shiny! The supply is somewhat limited, and the cost to find it and bring it into a pure state costs a lot of money and burns a lot of energy. Just like Bitcoin. So in some ways I understand the ‘digital gold’ argument. One source says that total global debt is $253 trillion. If for every debt there is a corresponding lender, and all that value is considered ‘currency’ it paints an interesting picture of how much each of the 21 million bitcoins would be worth if the bitcoin maximalists had their way. You get to a figure of $12,047,619 per coin! I find it inconceivable that all money could be replaced by Bitcoin, given its transactional inefficiencies.
However, that scarcity brings us to another issue, Valuations.
Valuing Crypto Currency – Metcalfes Law
One of my hesitations on Bitcoin and Crypto in general is that I like to be able to ‘value’ something. In traditional terms we value things relative to the risk free returns on a government bond, issued in our home currency. Over a long history, the average equity risk premium when investing in shares has been around 6%. That is to say, on top of the current 1.7% rate of return on an Australian bond, a broad portfolio of equities needs to return another 6%, for a current total return around 7.7%. Much of that comes from dividends.
With no dividends from a Crypto Currency, we find it hard to value it. Normally, in a ‘currency’ we like to see a stable store of value, that doesn’t change too much from day to day. That is not what we see in Crypto and is another reason I have kept away from it.
However, there is a method of valuing crypto, which while not perfect, is better than any other explanation I have seen.
Metcalfes Law states that the value of a communications network is proportional to the square of the number of users connected to the system. George Gilder initially applied it to a network of fax machines. As an example: If you have two telephones you can have one connection and only one connection. But, if you have five telephones, you can have 10 connections. 12 telephones can make 66 connections.
In the 21st century the concept of Facebook might be more relevant. We call it the network effect. It is not a linear increase in value, but an exponential increase in value.
Studies have seen a fairly close correlation between the number of unique bitcoin wallets, and the increase in the value of that crypto. Given the limitations within the Bitcoin Proof of Work protocol, versus Ethereum’s Proof of Stake system, I think that the network effect of Ethereum is more attractive on this valuation metric and may lead to wider adoption.
Flows to Bitcoin, or any asset with limited supply are also going to have a major effect on its price. With the recent noise around major players moving into crypto we could be at the start of a massive wave that takes on a life of its own. To date, my casual observation is that crypto uptake has been limited, and one needed to enter the world of hot wallets, cold wallets, crypto exchanges and a very unregulated underworld to participate.
With the advent of banks like the CBA enabling crypto on already widely distributed banking apps, this could accelerate quickly. Add to that Crypto ETF’s and banks like JP Morgan also getting in on the act, and the demand could overwhelm supply. Using gold as the benchmark, all the gold in the world today is worth $15 trillion. 21 million bitcoin would be worth $714,000 each if as much was invested into bitcoin as is held in gold.
These are crazy numbers, but this is a crazy world, much of which I don’t understand.
Virtual Worlds
Many of the 13,000 cryptos (total market value of $2.37 trillion) that exist are related to gaming and virtual worlds. This is also something I don’t get. And being aware of my biases, I just wanted to point that out. I don’t do video games, never did, and to me it is a complete waste of time. Recall my childhood was focused on fulfilling basic needs (cue the small violins). So I have blind spots here.
When I came across Mark Carnegie in the crypto world he was promoting Axie Infinity. Google it, it looks pretty meaningless to me. But Carnegie’s defense of it was that this virtual world was creating a system where poverty stricken individuals in places like the Philippines and Venezuela can play and get paid, lifting them out of poverty and providing opportunity.
In genuine curiosity I pressed him for more on the ‘economy’ of the system. IE; is there something tangible produced or problem solved? No! Is it a zero-sum game, where someone loses and someone wins? The explanation of that was only that this gives the less privileged a great opportunity. A follow up question was on who owns this thing? The reply, “Half the tokens are distributed to the community. Infinitely more economics than in a network VC [venture capital] deal”. Ah, that is the clincher. The founders do stand to make out big if there is wide adoption of their platform. Once an Investment Banker; always…
Without being too cynical, it brings to mind the plot for The Matrix. All these humans, thinking they are leading a normal life, but in reality are all hooked up to machines to supply energy to the artificial intelligence (machines). I wish it was different, but I could see nothing else in this Axie Infinity game. Keep in mind I am a gaming luddite, so maybe there are other benefits I am blind to.
Monkey Business
Another term you will come across as you venture into the Crypto jungle is ‘rug pull’. I could go into detail on some recent ones, but you can google it. Perhaps the best explanation was sent to me last week by a savvy client of ours.
Not long ago a merchant found a lot of monkeys that lived near a certain village. One day he came to the village saying he wanted to buy these monkeys! He announced that he would buy the monkeys at $100 each. The villagers thought that this man must be crazy. How can somebody buy stray monkeys at $100 each?
Still, some people caught some monkeys and gave it to this merchant and he gave $100 for each monkey. This news spread like wildfire and people caught monkeys and sold them to the merchant. After a few days, the merchant announced that he will buy monkeys at $200 each.
Then the lazy villagers also ran around to catch the remaining monkeys! They sold the remaining monkeys at $200 each.
The merchant then announced that he will buy monkeys for $500 each!
The villagers start to lose sleep!…..They caught six or seven monkeys, which was all that was left and got $500 each. The villagers were waiting anxiously for the next announcement. Then the merchant announced that he was going on holiday for a week, but when he returns, he will buy monkeys at $1000 each! He also said that his employee will be in charge, and would take care of the monkeys he bought pending his return.
The merchant went on holiday!
The villagers were frantic and very sad as there were no more monkeys left for them to sell at $1000 each as was promised by the merchant. Then the merchant’s employee contacted them and told them that he would secretly sell them some monkeys at $700 each.
The news spread like wildfire. As the merchant promised on his return that he would buy monkeys at $1000 each, they would achieve a $300 profit for each monkey.
The next day the villagers queued up near the monkey cage. The employee sold all the monkeys at $700 each. The rich villagers bought monkeys in large lots. The poor borrowed money from money lenders and bought the rest of the monkeys!
The villagers took care of their monkeys & waited for the merchant to return!
However, nobody came! Then they tried to find the employee but he was not to be found!
The villagers then realized that they have been duped buying the useless stray monkeys at $700 each, and were now unable to sell them!
That my friends is the basis of a ‘rug pull’.
DeFi, DAO and NFT
OK, for all the negatives, there has to be a positive. Decentralized Finance (DeFi) and the Distributed Autonomous Organization (DAO) and Non-Fungible Tokens (NFT’s) are possible gamechangers opening up a lot of disruption and new ways of doing business.
The most simple explanation of DeFi is that it aims to remove intermediaries to provide the world with a globally inclusive financial system. With the many banking scandals and misconduct that seems to be a laudable goal. We would go from a centralized system with a few trusted players like banks, to one where the confirmation of ownership of an asset is decentralized. The social mood at present is one of deep mis-trust in banking institutions, so it is understandable that this concept is gaining traction, especially in younger generations.
At present, most of the transactions I see in the DeFi market are unsecured loans in the traditional sense. That is to say, that title or security is not held over a car or house. They rely on pledges of other crypto assets or regular dollars that are converted into Stable Coins (like Tether) in order to borrow. The nature of the ‘smart contracts’ that are built into the networks enable a form of automatic margin call or asset liquidation if the position is outside the allowed margin limits. I stand to be corrected, but the language around most of these loans implies that the purpose of borrowing is further speculation or ‘staking’ in cryptos.
More intriguing is the concept that this form of DeFi could one day replace share registries. If you have ever had to deal with a share registry over something as simple as a slight variation in name, or a mislaid holder identification number, you might welcome this change. Imagine if stock exchanges and share registries were one day replaced by a decentralized register, where all you need to supply is your unique identifier for all your records to be updated.
Distributed Autonomous Organisations are another interesting concept. Think about a normal organization which likely has a CEO, Chairman, Secretary and board of directors. The organization may outlive those persons, but at any given time, the positions are still held by single individuals. Those individuals may be given to un-democratic and conflicted decisions. The idea of a DAO is to completely democratize the organization and the decision making. Taking it a step further, it means that all stakeholders vote on every decision and it takes a majority to confirm. Not as humans, but as the application rulebook provides. In my brief search I was not able to find any DAO’s that related to products other than Crypto, but in time we could see these Smart Contracts find their way into the real world of buying and selling cars, houses, and even shares in real companies that make stuff we actually need!
Non-Fungible Tokens are a way of establishing ownership and tracking a virtual asset. While it has initially been applied to digital art works and sports photos, it will also have application in music copyrights which ever since digitization have been plagued by pirates. In the past it has been possible to buy the royalties. David Bowie in 1997 sold the royalties for his pre-1990 albums for $55 million to a group of investors. Non-fungible tokens along with DeFi are a way for artists to similarly allow investors to back them and get potential profits from new music, or to sell existing art.
NFT’s could also become a way of buying shares in the neighbourhood coffee shop or panel beater. At present securities legislation means it is not viable for small companies to raise capital from the public, but blockchain technology could change all of that. We are already seeing some crowd funding used to raise capital and in time blockchain restrictions that reduce the transactional and administration friction could open the doors to smaller businesses to gain funding from a wider audience. For now however, there is too much monkey business in NFT pricing for it to be of interest to me.
Conclusions
Absent an economic melt down and positive real interest rates, the sheer weight of money may continue to move crypto currencies higher. Central banks have provided over abundant liquidity to fight COVID. We are in a period of war-like fiscal spending and money printing. The indebtedness of consumers and governments makes it near impossible to raise interest rates by much at all. Property prices are out of reach for many young people today. The social mood is ripe for upheaval and mis-trust of our old institutions is behind the urge for an alternative society and monetary system.
I do hold shares in one company that has a subsidiary in blockchain technology pertaining to share registry and asset trading and securitization. I could be convinced to dabble in bitcoin or Ethereum at some point. But for now, I still prefer ownership of real assets which either produce income, or which I can live in, or which gives off a shiny glow under the light.
Please post your views, comments and enlightenment if you have something to add to this already long post.
