Cryptocurrencies: Don’t throw the baby out with the bathwater

2021 has been a yoyo year for cryptocurrencies.

In March, the world’s leading and oldest cryptocurrency, Bitcoin, had just come off an all-time high price of $63,000 (all values in USD) per coin and was hovering in the $54,000 range. Bitcoin’s market capitalization was over $1T, double the value of its closest competitor, Ethereum (Ether) and ten times that of other popular currencies, such as Dogecoin and Cardano.

You could purchase an automobile from Tesla using Bitcoin, one of the few companies to accept Bitcoin as legal tender. In February, Tesla created a stir in the capital markets and made CFOs worldwide sit up and take notice when it acquired $1.5B in Bitcoin. Shortly after that, the payment company Square also added Bitcoin to its balance sheet.

Purpose Investment launched the world’s first Bitcoin EFT, reaching over $1B in assets within the first 30 days. “Ether is emerging as the foundational base layer for decentralized finance and crypto innovations, and its price is soaring accordingly,” Greg Magadini, CEO of Genesis Volatility, declared. Magadini predicted Ether would achieve “a trillion-dollar market cap” by year-end.

After ten years of being viewed as the Wild West of finance, cryptocurrencies were beginning to gains some legitimacy and garnering interest by institutional and individual investors of all ilks.

As Dinah Washington crooned, “What a difference a day makes, 24 little hours.” On May 19, investors watched as the value of cryptocurrencies began to free fall. By mid-day, the crypto-markets experienced the most significant sell-off in 14 months, with the value of a Bitcoin dropping to below $30,000 for a brief time.

Many analysts and pundits point to the actions of Tesla’s CEO Elon Musk as the spark that ignited the sell-off. First, by his May 8 volte-face on Saturday Night Live, wherein one breath he praised Dogecoin as “It’s the future of currency. It’s an unstoppable financial vehicle that’s going to take over the world.” Moments later Musk referred to Dogecoin as “a hustle.” The value of Dogecoin dropped by 35% within minutes of Musk’s denunciation. (Unlike stocks and bonds, cryptocurrencies trade 24/7.)

Then on May 12, Musk did another about-face, tweeting, “Tesla has suspended vehicle purchases using Bitcoin. We are concerned about the rapidly increasing use of fossil fuels for Bitcoin mining and transactions, especially coal, which has the worst emission of any fuel”. Musk tried to take the sting out of his announcement by saying, “ Cryptocurrency is a good idea on many levels, and we believe it has a promising future, but this cannot come at great cost to the environment.”

While Musk is a convenient scapegoat for the sell-off, many analysts point to China as the main instigator of the sell-off. On May 18, China banned the country’s financial services and payments companies from providing services related to cryptocurrencies. The ban should have come as no surprise. Since April, the government has openly expressed concerns about the use of the currency for money laundering, drug trafficking, and smuggling. As part of the ban, China also prohibited the mining of Bitcoin, parroting the environmental concerns expressed by Musk.

Cryptocurrency proponents point to the sell-off as just part of regular market activities, the March 2020 capital market sell-off as a case in point. Of late, many retail investors have been buying into cryptocurrencies in the hope of becoming the next crypto-millionaire. Retail investors are easily spooked by tweets and proclamations, especially if they are highly leveraged, so sell-offs are a normal part of any investment cycle.

Legendary investment sage Warren Buffet believes cryptocurrencies are our generations’ tulip mania, “It’s been a very speculative kind of Buck Rogers-type thing, and people buy and sell them because they hope they go up or down just like they did with tulip bulbs a long time ago.”

It would be easy to dismiss cryptocurrency as a “mania” or “hustle.” Too complex and unruly for all but the bravest, or dumbest, of investors. But, the impetus for creating cryptocurrencies remains sound.

“A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution” is how the founder, Satoshi Nakamoto (a pseudonym), described the need for a cryptocurrency. His underlying object was to remove the need and cost of having multiple parties involved in the transfer of value between individuals and entities.

A few years ago, I wired money to the Isle of Man and quickly gained an appreciation for the number of parties involved and the high cost of sending funds aboard. Completing this transaction using cryptocurrency and blockchain technology would have removed the need for third-party involvement and the associated costs.

“Bitcoin has no uses. That could be its downfall,” declared Fortune Magazine in a recent article on the drawbacks associated with the currency.

The April 25, 2021 article points out the many flaws associated with the currency, including limited transaction capability, high processing cost, $20 to $60 per transaction depending on demand, and massive carbon footprint. The University of Cambridge estimates the consumption of electricity used annually to mine Bitcoins is on par with Sweden and Ukraine. Bitcoin can process about five transactions per second worldwide. In comparison, Visa can process about 65,000 transactions per second, with negligible environmental impact.

Supporters see Bitcoin as digital gold and a hedge against rising inflation and economic crisis. To protect the value of bitcoins, Nakamoto set a limit on the number of coins that could be mine at twenty-one million. The finite number of coins ensuring their value is not undermined through the product of additional coins. This approach contrasts fiat currencies, where governments are at liberty to print money, potentially damaging the currency’s value.

While Bitcoin has become the poster child for cryptocurrencies, many commentators point to Ethereum as laying the groundwork for new financial transactions.

Like Bitcoin, Ethereum uses distributed ledger technology (blockchain) to provide a decentralized public ledger to manage the network, so it’s not under the control of just one entity. While Bitcoin is used primarily as a store of value, Ether supports decentralized applications and services, from social media networks to more complex financial agreements. Today, apps rely on intermediates to execute their function and, therefore, must share data across multiple platforms and applications. In contrast, Ether apps, called dapps (decentralized apps), use smart contacts to execute their function.

In her 2018 TEDx talk, Olga Mack, lawyer and blockchain enthusiast, explains how smart contacts work. ‘Smart contracts work like vending machines. You select what you wish to purchase, insert your payment, and the machine dispenses the item. There is no need for an intermediary between the buyer and seller.’

Using this same principle, a person could use a smart contract to borrow money. A DeFi app brings lenders and borrows together without the need or added cost of intermediaries. The associated blockchain record providing an indisputable record of the terms and conditions of the loan and repayment agreement.

Despite $79B in outstanding loans, DeFi is still in its infancy and faces several operational hurdles to achieve the scale and security necessary for largescale lending and a broader appeal.

Like Bitcoin, Ether has capacity problems that restrict its growth. Security is also an issue, with an estimated $300M in losses this year due to hacking. Ethereum is working to address both its capacity and security issues, with an upgrade (Ether 2.0) planned later this summer.

Trying to bring law-and-order to the Wild West of cryptocurrency are stablecoins. Stablecoins are cryptocurrencies backed by a hard asset, such as a fiat currency. Unlike traditional cryptocurrencies, the value of a stablecoin is pegged to the underlying asset on a one-to-one basis. For example, Tether is a stablecoin backed by US dollars held in reserve. Each Tether coin is worth the value of one USD.

The drawback with stablecoins is their creditability is dependent on a trusted third party, like an audit firm, to validate the existence and value of the underlying assets. The need for a third-party arbiter goes against the ethos of cryptocurrencies to be self-regulated. Today, stablecoins are used primarily to convert cryptocurrencies into fiat currencies, for the most part.

The controversy over the purposefulness of cryptocurrencies reminds me of the early days of the internet. In its infancy the internet was viewed as the Wild West of technology and communications. I recall analysts and colleagues opining about how the internet would never be used to handle financial transactions.

In a 1995 Newsweek article on the internet, astronomer and computer expert Clifford Stoll wrote, “I’m uneasy about this most trendy and oversold community. Visionaries see a future of telecommuting workers, interactive libraries, and multimedia classrooms. They speak of electronic town meetings and virtual communities. Commerce and business will shift from offices and malls to networks and modems. And the freedom of digital networks will make the government more democratic. Baloney. Do our computer pundits lack all common sense? What’s missing from this electronic wonderland? Human contact. Discount the fawning techno-burble about virtual communities. Computers and networks isolate us from one another. A network chat line is a limp substitute for meeting friends over coffee.”

Stoll’s assessment demonstrates just how wrong we can be about emerging technology. Can you imagine surviving the past year without today’s internet-based technologies?

Few of the pioneers and founders of today’s internet ecosystem survive today. Companies and applications like Napster, Ask Jeeves, MySpace, and Netscape have all but disappeared.

Yet, as American activist James Haywood reminds us, “If you look at the first commercial transactions on the internet, few of the early companies necessarily survived intact, but the ideas they invented became the industry.”

Similarly, many technologists predicted the iPhone would be a total failure, including legendary Microsoft co-founder Steve Ballmer who wrote, “There’s no chance that the iPhone is going to get any significant market share. No chance. It’s a $500 subsidized item. They may make a lot of money. But if you actually take a look at the 1.3 billion phones that get sold, I’d prefer to have our software in 60% or 70% or 80% of them than I would the 2% or 3%, which is what Apple might get.” (Poignantly, in 2011, Microsoft partnered with Nokia to bring a smartphone to market and, in 2013, purchased Nokia for $7.8B. Two years later, Microsoft took a write-down on the Nokia purchase, and in 2017 exited the mobile market.)

Similar to the early day of the web and mobile, it is hard to predict the winners and losers in the world of cryptocurrencies, blockchain, dapps, and DeFi. For these reasons and more, I believe that businesses that ignore cryptocurrencies and blockchain technologies do so at their peril.

As Bill Gates opined in the early days of the internet, “We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next 10. Don’t let yourself be lulled into inaction.” Therefore, diligence, curiosity, and an open mind remain the best method of surviving and thriving in today’s Wild West of technology and innovation.