January 10th, 2019 | The Basics of Crypto Investments.

Hereby, I am listing a few basic things I learned about cryptocurrencies and investing in cryptocurrencies. I have also posted this content on Medium and LinkedIn.

HOW CAN YOU EXPLAIN BITCOIN?

Imagine that you are a part of a distributed network, which does not have any central authority. This might be, for example, an online community gathering together owners and fans of old Chevrolets from the 1940s. There is a finite number of Chevrolets with that old metric, and new pieces cannot be added to the pool.

Therefore, Chevrolets are a scarce asset distributed across this community. The members of the community can make transactions by selling cars to each other, but there are no central parties (such as a central bank or legal authorities) to supervise the process and chase potential crooks. How to make sure that such a distributed system can be trusted: that no party is faking a car’s metric or trying to sell a car in a very bad condition, sell another car as a Chevrolet, or even trying to get away without delivering any car?

Let us consider yet another scenario, often referred to as a Byzantine Generals problem. Imagine that a number of Byzantine generals, each of them leading their own army, bring a city under siege. The generals need to reach a consensus on whether to attack or retreat, but they do not have physical contact with each other. How to reach the consensus under such circumstances – given that some of the generals, as well as some of the porters, might be traitors of double agents?

In general, this problem is unsolvable. However, the consensus algorithm known as Proof of Work (PoW) adapted by Satoshi Nakamoto in 2008, was proposed as a probabilistic solution to this problem. In PoW – just as in any other consensus algorithm – every node of the network needs to agree on the same global state of the network, and in that sense, it addresses the Byzantine Generals Problem. The name ‘Proof of Work’ comes from the fact that the process of confirming the current state of the network requires a considerable investment of energy (referred to here as ‘work’).

PoW is a protocol that needs to be maintained by a number of users, further related to miners. Mining is a process of confirming transactions between the network users, based on the concept of a hashing function. In Bitcoin, this function has a formula unknown to the users and produces strings of 256 bits from any string input.

Miners compete with each other by finding unconfirmed blocks of transactions and validating these blocks. Validation is performed by reading the header of the block, and using computational power to find the nounce of that block: a number which, combined with the header of the block, becomes an input to the hashing function that gives an output with a desired number of zeros.

After a miner announces a validated block, other miners immediately verify it (by simply launching the hashing function on input containing the proposed nounce). The desired number of zeros at the beginning of the output string is a measure of current mining difficulty and can be changed by the community depending on the traffic in the network.

After adding the new block to the blockchain, the miner can search for another block and append it to the previously added block. After a period of 10 minutes, the miner with the longest chain of confirmed blocks wins the competition, and those blocks are added to the blockchain. Since miners are looking for the right nounce at random, e.g. by trial and error, PoW is probabilistic; the consensus confidence grows towards 100% along with every added block, although it never reaches exactly 100%.

Once we have a working consensus mechanism for exchanging data between users, one can share any goods in the network. The most natural application for this mechanism is a monetary exchange: PoW not only guarantees safe and relatively fast transactions anywhere in the world but also allows for controlling the total amount of the assets and therefore prevents injecting digitally printed money into the ecosystem. Since Bitcoin’s creation, literally, thousands of such blockchain-based currencies also referred to as cryptocurrencies, were created.

Today, Bitcoin is no longer the only cryptocurrency using PoW. Among its forks, Bitcoin Cash and Litecoin are among the most well-known. Therefore, in this sense, BTC is not unique. However, it came to the market first, and it definitely has a first-mover advantage.

Even though the identity of its founder(s), Satoshi Nakamoto, is still officially unknown, the project attracted a number of very strong programmers ever since its creation (including Nick Szabo, Adam Back, Wladimir van der Laan, Pieter Wuille or Gavin Andresen), and a vivid, inclusive online Bitcoin Core community grew around Bitcoin. Therefore, the project has a strong technological backup and is in the process of constant development.

Also, Proof of Work was the first consensus algorithm used to develop a cryptocurrency, however in the last decade, the number of options has grown considerably, and there are mixed opinions on whether or not PoW is an optimal approach to confirming transactions in distributed networks.

On one hand, PoW guarantees a high level of security. On the other hand, though, the probabilistic nature of PoW also implies that PoW is not energy-efficient, this is why it can bring a lot of controversies; according to current estimates, maintaining the Bitcoin network requires energy expenditure of a country comparable with Austria. However, arguably, the practical benefits of using PoW for improving the global financial ecosystem can easily overcome the costs.

IS BITCOIN IN A BUBBLE?

According to Investopedia.com, a bubble is ‘an economic cycle characterized by the rapid escalation of asset prices followed by a contraction. It is created by a surge in asset prices unwarranted by the fundamentals of the asset and driven by exuberant market behaviour. When no more investors are willing to buy at the elevated price, a massive selloff occurs, causing the bubble to deflate.’ According to this definition, Bitcoin actually was in a bubble at the beginning of 2018 – as indeed, the price surged exponentially in December 2018, and then slowly decayed to an equilibrium where it fluctuates since April. In other words, we just experienced a bubble, therefore Bitcoin is not in a bubble anymore.

However, it is not that simple. This definition of a bubble only touches the surface, as it does not take into account the relation between the current market value of an asset and its real value. When we look at Bitcoin’s history, such explosions in the price, followed by slow deflation, were happening with great regularity. However, does this mean that the price will continue growing in worm motion just as before? What is the real value of one Bitcoin?

The answer to this question relies on faith in the future of Bitcoin. What is the dream scenario? The primary goal of Bitcoin as a project is to provide a global monetary system alternative to traditional, government-issued currencies (and under the assumption that Bitcoin will not be replaced by another, better currency in the meantime). In case the Bitcoin venture becomes globally successful, Bitcoin could technically replace all the government-issued cash and digital currencies circulating in the world. 

How much is this? According to Business Insider, the total amount of money in checking accounts, savings accounts, and money-market accounts can be anything between 5 and 80 trillion USD. Pessimistically assuming the lower band of 5 trillion USD, and the full 21 mln BTC in circulation (which is not the case), it yields 238,000 USD per BTC. Optimistically, taking an upper band of 80 trillion USD, it yields 3.8 mln USD per 1BTC. How probable is this scenario though?

Most probably, Bitcoin will never become the only digital currency but will need to share the market with other currencies developed for more specific purposes – such as, example, native tokens developed by online video game platforms. Furthermore, there are three possible scenarios for today’s cryptocurrencies, including Bitcoin:

• cryptocurrencies becoming the mainstream payment method

• cryptocurrencies are forbidden by most of central banks and marginalized

• Bitcoin and other current top cryptocurrencies replaced by new, more technologically advanced solutions

The probability of each of these scenarios is hard to estimate. Many analytics compare the current situation to the dot.com bubble in 2000-2002 when the speculatory market around young internet companies has crushed. Most of today’s giants, including Google, Facebook, and Amazon, were listed on the stock exchange only after the crash. By analogy, it is a possibility that after the current crisis comes to the end, a handier and more technologically advanced successor of Bitcoin will replace the leader.

What do you believe is the most probable scenario?

WHAT DETERMINES THE VALUE OF CRYPTOCURRENCIES?

FIRST TO SAY, THERE IS A DIFFERENCE BETWEEN A UNIT OF ACCOUNT AND A STORE OF VALUE. A PROPER UNIT OF ACCOUNT CAN BE CHARACTERIZED BY A FEW KEY FEATURES:

1. Durability:

The unit can be exchanged between parties without the danger of damage

2. Transportability:

the unit can be transported easily

3. Divisibility:

The unit can be divided into smaller subunits (e.g. Euro can be divided into cents)

4. Fungibility:

The unit can be interchanged for another unit (e.g. you can replace one 10 Eur bill by another 10 Eur bill, and this does not change anything to the transaction status)

5. non-counterfeit ability:

It is hard to provide a fake copy of a unit

Most government-issued currencies fulfil these conditions. Bitcoin also fulfils these conditions. In some aspects, it even outperforms government-issued currencies, e.g. it is strictly non-counterfeit able by design (due to PoW) and maximally durable as it does not have a physical, paper form (unless you print your private keys on paper, and then wash them together with your laundry). For these reasons, Bitcoin is a strong unit of account, which can potentially replace government-issued currencies in the future.

However, is this the value we consider when buying Bitcoin and other cryptocurrencies in high amounts, which cannot be spent on our daily needs? Of course not; what we are really interested in when buying Bitcoin, is whether Bitcoin is valuable, either as a speculative investment or as a store of value. Some words about the current Bitcoin price in relation to its true value were given in the previous article Is Bitcoin in a bubble? Let us now consider whether Bitcoin is a good store of value.

A store of value is a mechanism for preserving wealth. A store of value can be saved and redeemed in the future with a reasonable prediction about its future value. At the same time, a store of value in a community refers to the price the members of the community are willing to pay for it and not to the value of its practical applications. For example, the current price of gold as of January 10th, 2019, is equal to 1,296 USD per ounce, but the value of jewellery produced with this amount of gold would most likely be lower.

Assets are meant to be a store of value in general: real estate, stocks, bonds, gold, diamonds, and art. Obviously, all asset prices are burdened with some degree of unpredictability, and there is no perfect store of value. According to the common viewpoint, Bitcoin should not be classified as a store of value because there is high volatility in its price. 

However, as Matt Hougan points out in his Forbes essay, volatility is what you expect from every new store of value. Virtually any asset can become bubbly, including art, the housing market, oil, commodity (e.g. uranium) or the whole sector of the economy (e.g. railway mania or dot.com bubble). Even gold – today considered to be the best store of value – had a period of large volatility after the abolishment of the USD gold standard by Richard Nixon in 1971.

Therefore, one should not feel discouraged by the price volatility in major cryptocurrencies when assessing their chances of becoming a new store of value: this will depend on the quality of underlying technology, and on whether the currently leading projects will strengthen their position and stay ahead of the competition.

BESIDES ETHEREUM AND BITCOIN IN WHICH OTHER CRYPTOCURRENCIES SHOULD WE INVEST? WHAT ARE THE MOST PROMISING ONES?

The individual investment strategy should always depend on the individual’s ability to bear both risk and loss – which is also what investors are learning about themselves in the process. Obviously, the new and small cryptocurrencies can potentially give higher rewards in the long run, but they are also likely to completely disappear from the market, which, in economic sciences, is referred to as the risk-return trade-off. There are multiple strategies one can follow in this market, and the answer to the question in the title much depends on the chosen strategy.

As the cryptocurrency market is highly speculative, many investors in this field are agnostic with respect to the choice of projects to invest in. There are two main types of agnostic strategies. Firstly, one may follow the advice of authorities, e.g. people who invest in crypto assets professionally. Most investment funds in the crypto space reveal their main bets to the public. For instance, Amsterdam-based Cyber Capital reveals the basics of its investment strategy on its website.

Another example: in April 2018, Dan Morehead, the CEO of Pantera Capital, the biggest cryptocurrency investment fund, revealed that the biggest open position in Pantera’s portfolio was ICON at that point (ICON is a Korean project designed for connecting institutions across the country, from banks, through schools to hospitals). The full list of coins in Pantera’s portfolio is presented on its website.

The second popular agnostic strategy is to “buy the market”: allocate funds to a few biggest cryptocurrencies proportionally to their market capitalization. Of course, this strategy will only pay off with respect to the alternative – which is Bitcoin maximalism – if the Bitcoin market share will eventually drops. Some investors additionally weigh current market capitalization by the current volume – as typically, the price follows the volume.

Other investment strategies typically require more in-depth knowledge about the projects. In general, there are multiple distinct sectors of the cryptocurrency market. There are multiple distinct groups of blockchain-based projects:

• New blockchain protocols (platforms such as EOS, LISK, NEM, ICON, NEO or ADA) and alternatives to the blockchain (e.g. a tangle architecture represented by IOTA or a hashgraph represented by Hedera) aim to establish new standards in the architecture of decentralized networks,

• Blockchain-based supply chains (e.g., Vechain) aim to prevent counterfeiting in the retail market,

• Exchange platforms (e.g. Binance, Huobi or Bithumb) aim to create an environment for the fast, reliable and low-cost exchange of crypto-assets,

• Internet of Things solutions (e.g. IOTA) aims to create an ecosystem which will enable to remotely control electronic equipment and allow machines to manage each other,

• Projects focused on creating decentralized media (represented by e.g. TRON, Steemit) aim to decentralize the internet and other media.

and many others.

As Warren Buffett famously said, “Risk comes from not knowing what you’re doing“. As the cryptocurrency market is especially volatile, it is particularly important to find a niche in which you can build some confidence. It is, therefore, a good start to get familiar with some particular sector of the market and invest time in reading white papers and getting to know the teams behind the projects in that particular sector.

Investing in this space requires both knowledge and intuition, therefore it is a good idea to take your personal strengths into account. For instance, if you have a good command of programming and/or cryptography, you might become good at recognizing the value of new blockchain protocols. If you were working in marketing at some point, you might become good at predicting the growth in the market value of a project solely on the basis of its public image: the quality of its website, the white paper, PR, or promotional moves.

If you were working in human resources, you might be good at assessing the quality of the team behind the project. If you have a passion for constructing electronic equipment, you could become specialized in Internet of Things solutions. There are multiple angles from which you can look at this market, and you need to find the angle which suits you best.