Cryptocurrency has many attractive features as a direct form of charitable giving, however successfully claiming tax benefits for cryptocurrency donations can be difficult.  Under current Department of Treasury regulations, you'll need to secure a letter of appraisal from an independent, qualified, entity.

There are several great reasons to give cryptocurrency directly to charitable organizations.  Cryptocurrency donation projects, like The Pineapple Fund (since closed) and The Giving Block, can articulate the crypto-giving philosophy in greater detail, but the key benefits of donating cryptoassets are:

• By donating cryptocurrency directly, the donor does not incur a taxable event by converting to USD.  Likewise, the value of the donation is maximized for the charity, which receives the entire present market value instead of the after-tax value of the asset.  Depending on how long you've held the cryptocurrency, your tax bracket and jurisdiction, this could increase the value of the donation by over 50%.
• Cryptocurrency, by design, is dazzlingly easy to transfer ownership of (compare this to the donation of a classic car or farmland).  This minimizes the hassle and overhead for your charity.
• Offering a donation in the form of cryptocurrency may even motivate your favorite charitable organization to onboard these modern payment technologies and, therefore, attract more donors.

The tax considerations mentioned above are due to the fact that the IRS classifies cryptocurrency as "property."   This is, therefore, a generic consideration - donating any property directly allows the donor to avoid capital gains tax on the appreciated value of the assets - and the tax code has clearly-articulated rules for so-called "Noncash Charitable Contributions."  

Due to the ease with which one can transfer and determine the value of cryptocurrency, however, the "property" designation can result in donors failing to report the gift correctly, therefore, not be awarded the deduction.

How do you report charitable giving for the purposes of taking a tax deduction?  This starts with IRS form 8283.  The 8283 is a short form that looks like one could fill out in about a minute, however a note on Part I of the form sends the tax preparer down a cryptocurrency rabbithole:

Note: In certain cases, you must attach a qualified appraisal of the property.  See Instructions.

Until there is some updated guidance in the tax code, cyrptocurrency is currently lumped in as a miscellaneous, or "other" property type.  Because of this, the 8283 requires a very specifically-formatted letter of appraisal to claim cryptocurrency donations.  

In short, the IRS requires the same appraisal process for a donation of bitcoin - the most liquid and transparently-valued cryptocurrency - as it would for a thoroughbred racehorse or the patent for your process for decaffeinating hot chocolate.  Failure to submit the right type of letter, written by the right person, can result in the gift deduction being declared ineligible.

How does one generate a cryptocurrency appraisal letter that the Deptartment of the Treasury deems to be acceptable?  Enter Treasury regulations Section 1.170 which details the requirements of an appraisal letter (subsec. 1.170A-17(a)) and the qualification criteria for a qualified appraiser (subsec. 1.170A-17(b)).

There are appraiser professional organizations who publish best practices and guidelines, but thus far none have published and guidance on cryptoasset appraisals.  The Treasury regulations' language indicates that any independent party who does appraisals on a regular basis can write a qualified appraisal, but this is unfortunately a bit of a chicken-and-egg problem for a young asset class.  

Alternatively, anyone with relevant educational credentials - presumably anyone with at least a Bachelor's degree in a field that teaches a standalone cryptocurrency or blockchain course, like math or computer science - can be a qualified appraiser.  As a practical matter, if you're reading this blog, you have found a qualified cryptocurrency appraiser.

While it may be a bit frustrating to find and retain the services of a qualified independent party to prepare a correctly-formatted appraisal letter, this is vitally important for taking the tax deduction successfully.  

While mistakes or discrepancies on other sections of a tax return can be resolved through refiles, appeals, or by providing additional documents, decisions about noncash charitable contributions can not be appealed.  That is to say, the tax preparer has one chance to get it right and the IRS gets a high return on the time they invest in carefully examining 8283 forms and their supporting documents.

As a last reminder/final caveat, the IRS and appraisal professional organizations have not written formal guidance specific to non-security cryptoassets (e.g Bitcoin), but crypto industry, tax, and private wealth professionals have worked out what are clear best practices to ensure anyone who makes a charitable donation of cryptocurrency is able to claim the deductions that they are entitled to.

Can you ever recover lost keys or can your private keys be hacked through some amazing and secretive advance in computing power?  If you’ve been learning about cryptocurrencies for a while, you’ve probably ended up somewhere in the blast radius of such a discussion.  Unfortunately, the talk of key security was probably an incomprehensible spray of the expert and esoteric language of things like elliptic curve cryptography, lost private keys, the Satoshi wallet, and - weirdest of all - quantum computing.  Compounding this is the fact that it's seldom the case that expert language is being used by experts.  I would like to explain some of the salient parts of these issues, especially the question of whether and when you should be worried about your own keys being hacked or whether you should invest in a quantum computer designed to recover Satoshi’s wallet, or maybe even invest in a quantum-resistant cryptocurrency.  First, I will start with a parable about an actual historical shipwreck that turns out to be much more relevant than it might initially seem.

On September 9th, 1857 the S. S. Central America, an 85 meter long steamship bound for New York City was caught in a hurricane off the coast of the Carolinas.  As the ship was battered by wind and waves, the boilers and bilge pumps that kept the vessel afloat and pointed safely into the swells failed.  In the heaving seas, the crew and passengers formed bucket-brigades in an attempt to bail out the floundering ship but their efforts were ultimately unsuccessful.  At about 8pm on September 12th the Central America sank.  Of the 578 passengers and crew only 153, mostly women and children, survived.  

At the time, the sinking of the S. S. Central America was the largest and most sensational maritime disaster in American history.  This was in large part because of another one of the ship’s occupants that was also lost to the deep ocean.  The steamer carried a huge cargo, 14,000 kilograms, of gold that was being transported from the gold fields of California.  The impact of this loss - what would be hundreds of millions of dollars in today's prices - was so great that a financial panic ensued when news of the sinking made it to land.

In the middle of the 19th century, the idea of finding, let alone recovering, the treasure of the Central America would have sounded like the plot of a Jules Verne novel, not a serious discussion.  As well as the vastness and treachery of the North Atlantic Ocean, there was the size and weight of the gold (some of it in large bars, some in sacks of gold dust).  In addition, the wreck occurred out beyond the continental shelf, where the seafloor plummets to depths of thousands of meters below the surface.  For reference, recreational scuba divers usually stay above depths of 20 meters and the deepest scuba dive ever successfully performed was 332 meters.  Setting this record required modern equipment and medicine as well as years of training and dozens of support personnel.  Many such attempts to reach record depths result in death.  Despite all this, however, coins and gold bars recovered from the wreckage of the Central America have been found and pulled up starting in 1988 and can now even be found in high-end coin shops, expos, and exhibits open to the public.  

You can probably fill in a lot of the story about this remarkable recovery yourself; the technological advances in robotics and deep-sea submersibles provided the eyes and arms capable of surviving the crushing weight of over 2,000 meters of seawater.  There are, however, a few more interesting aspects to the search and recovery.  The search for the wreck was enabled by modern statistical methods that drastically increased the odds of finding the wreck in the swirling vastness of the ocean.  The $13 million funding for the search was made through the formation of a company whose (fortunate) investors were sufficiently convinced by the plausibility of the fund-raising pitch.  Finally, the recovery was punctuated by a legal battle in which the discoverer, Tommy Gregory Thompson, had to defend his and his investors’ claim to the gold from dozens of insurance companies who had made payouts to policy-holders back in 1857 and therefore staked a claim to the treasure over 120 years later.  In short, finding sunken treasure ain’t easy, but one generation’s science fiction might be a later generation’s lived reality.

While the near-million bitcoins mined and untouched by Satoshi Nakamoto are the most famous example of a “dead” wallet, it’s estimated that over three million of the total 21 million supply of bitcoin are frozen and unreachable by virtue of the wallet's private keys being lost.  Everyone has probably heard or read stories of hapless unfortunates who threw out old hard drives or lost paper wallets.  Part of the thing that makes these stories so captivating is just how lost a lost private key truly is.  Just like the gold resting in the vast, deep, and dark ocean floor must have seemed unreachable to a prospective treasure hunter in the 19th century, the idea of searching for a private key in the elliptic curve used by the Bitcoin protocol is squarely in the realm of science fiction.  In order to even just describe the amount of possible values for a private key, one resorts to the same sort of bizarre analogies that astrophysicists use to describe things like the density of a neutron star or the number of planets in the visible universe.  In the case of Bitcoin’s secp256k1 elliptic curve, imagine all the grains of sand on Earth.  Now imagine that each one of those grains of sand is an entire Earth.  Now imagine all the grains of sand on all of those Earths collectively.  That number, the number of grains of sand on all the copies of Earth, is about the number of guesses that you have to have to try out before you’re assured of finding the private key associated with a public address.

Despite this, you will occasionally hear people talking about how quantum computing will be able to crack this and other computation problems, rendering Bitcoin insecure.  Some cryptocurrency projects even tout their “quantum computing resistant” protocol.  It’s worth looking into even if only to defuse the FUD.

There’s no shortage of good primers on quantum computing out there, so here’s the short, short, short version.  Quantum computing differs at the fundamental level from classical computing because of its probabilistic nature.  While a classical bit is in one of two states, it is either in the state 0 or the state 1, a quantum bit, or “qubit” can be in what’s called a superposition of 0 and 1.  Don’t worry about the weird bracket notation, it really just means “this is a quantum thingie.”

|qubit> = a|0> + b|1>

Here, a and b are numbers that tell you how likely you would be to measure the qubit in state 0 and how likely it would be for you to measure it in state 1.  The main point being that, just like Schrodinger’s simultaneously-dead-and-alive cat (|cat> =  c|dead> + d|alive>), the qubit is both 0 and 1 simultaneously.  Now, say we do a simple operation that flips the bits.  The flipped qubit would look like this, notice that the 1 and 0 changed place:

flip(|qubit>) = a|1> + b|0>.

So what?  Well, notice that we needed to just do this once to see what happens when we bit-flip both a 1 and a 0, whereas we’d need to do twice as much work on the classical bits - flipping first the 0, recording the answer then flipping the 1 separately.  

This is the magic of the quantum computer, instead of slowly working through individual inputs one after the other as you would on a classical computer, you can use this “Principle of Superposition” to load all the possible input states in a single register and do computations on them all at once.  Likewise if you want to test the properties of dead and live cats in your lab, you need two classical cats, one dead and one alive, but you only need one Schrodinger’s cat.

Specifically, for the relevant math of Bitcoin addresses, instead of guessing each of the possible 2^256 (crazy grains of sand number) ways to connect a public and private key one after the other which would take way longer than the age of the universe itself, a fancy quantum computer could load all of the guesses at once in a superposition state and do it in a single computation.  Scared?  Don’t be.

Just as the recovery of the S. S. Central America’s treasure took over a century of theoretical and technological advances to come to fruition, quantum computing is about as far along in its development as robotic submersible technology was in 1857.  Further, just as the robotic sub wasn’t the only thing required to find the sunken gold, a successful attempt at cracking Bitcoin’s key system will require a number of elements beyond just the quantum hardware.

First, there’s the theory.  You need a method, or algorithm, which can actually do the quantum computation.  Don’t let the fancy word bother you, you know what algorithms are and you know plenty of them.  In elementary school you were taught algorithms for things like multiplying large numbers and doing long division.  You might have been taught the Sieve of Eratosthenes, an algorithm for finding prime numbers by first crossing out all the multiples of two, then the multiples of three, and so on.  

If you do some programming, you might think this isn’t really a problem.  Algorithms can be efficient or inefficient, but there always seems to be a way to do something.  In fact, one of the joys of programming is that there are many, many ways of writing code to accomplish a given task.  However, if you know some computer science, you might remember that Turing’s theorem on the Halting Problem provides at least one example of something that’s uncomputable.  That is to say, Alan Turing provided us a proof that, for at least one particular problem, no algorithm can possibly exist.  It’s unsettling, but true: Certain things are uncomputable.  In fact, it’s even a bit trickier for quantum algorithms because of something we just glossed over, the fact that quantum mechanical objects are probabilistic.  Probabilistic means that when you measure your qubit, a|0> + b|1>,  to see what the output of the calculation is, you don’t get 1 and 0, you randomly get either 1 or 0 with probabilities based on the size of the numbers represented by a and b. Likewise, when you peek into the chamber you don’t see a dead-and-alive cat, your observation chooses, and measures, the state and you see just one of those two possibilities.

There are a few known algorithms for quantum computers.  The most important was published in 1994 by the American mathematician Peter Schor.  Schor devised an algorithm which can efficiently factor large numbers with a quantum computer.  Since the difficulty of factoring large numbers is the basis of the RSA encryption scheme, this was and is considered quite a triumph for theoretical progress in quantum computing.

At present, no one has actually implemented a quantum algorithm for finding private keys from public keys in an elliptic curve algorithm.  However, there seems to be good progress in extending Shor's algorithm to elliptic curves and every indication that it should be possible.

An additional complication exists in the fact that the public address is not the public key itself.  In fact, the public address is made from the elliptic curve’s public key by passing the latter through two different hashing algorithms; the ubiquitous SHA-256 and another one, called RIPEMD-160.  These steps weren’t intended for adding quantum resistance, rather they help make the public addresses more user-friendly.  As an unintended consequence, however, their use does mean that if all you know is a public address, you would also need to reverse-engineer the public key from the public address before even starting to look for the private key.  Getting the input of each of these hashing functions given their output is not easy.  In fact, finding the pre-image of a hashing function is an even more difficult calculation than finding the private key from a public key.  No classical computer could ever hope to do it efficiently and quantum computers using what's known as "Grover's Algorithm" aren't tremendously more efficient than their classical counterparts.  All told then, you need quantum algorithms to find the SHA-256 input given its output, another one to find the RIPEMD-160 input, and the quantum algorithm to reverse the secp256k1 elliptic curve calculation itself.  It should be noted that if you send a transaction, you do disclose the public key (not just the address), so once you send bitcoin from an address your private key loses two layers of its quantum resistance.  Spoiler alert: Do not lose sleep over this.

That’s the theory, or lack thereof.  Next we need to ask how the technology is progressing, or how are actual quantum computers in actual labs doing right now?  At present, quantum computers are performing their ghostly computations in rooms at all of the incumbent tech giants (IBM, Google, Intel, Microsoft) and a variety of startups too numerous to name here.  The number of qubits these machines have is measured in dozens compared to the trillions of bits that the RAM of an off-the-shelf personal computer might come standard with.  As a practical meter stick for their performance, the best quantum computers that can execute Shor’s algorithm might be able to compete with a clever middle-schooler in factoring integers.

Further, the stability of these machines and preparation of the initial states are plagued by interaction with the environment in a constant battle against entanglement (introduction of correlations you don’t want) and decoherence (loss of correlations and superpositions you do want) of the qubits.  These effects are really the boogeyman of the entire quantum computing enterprise and threaten to undermine the entire industry.  Quantum physicists do not fully understand the mechanisms of entanglement and decoherence which set the ultimate limits of how stable these systems are and determine when the environment destroys your carefully-prepared superposition or warps it in unknown ways to throw off your calculations.   Decoherence (as well as the humane society) is why there has never actually been a real Schrodinger’s cat.  The universe, in the form of the air and thermal photons and walls and cosmic rays, are constantly interacting with the cat, softly measuring it, and never allow it to cleanly split into the alive and dead branches of the superposition.  Very simple systems of tens of thousands of atoms, called “quantum-condensed gasses,” have been kept in quantum superpositions for about a second, but the information encoded and retrieved from them is very crude, certainly not a 256-bit number.  Maybe we’ll discover that it’s impossible to make quantum computer with the number of qubits and number of manipulations possible to do “real size” cryptographic calculations.

Finally, lets take a moment to consider the weird questions of the legal and social ramifications of cracking Satoshi’s (or any other “dead” wallet’s) keys.  Imagine, for a moment, that you are the one to do this.  The quantum computer you built in your lab, a jungle canopy of wires and piping, billowing heavy white clouds from the liquid nitrogen coolant, reports a 256-bit number.  You probably don’t believe it even after you check on a laptop that this private key does in fact get you to Satoshi’s public address.  Imagine the uproar.  Would a financial panic and crash ensue when it’s feared that the circulating supply of bitcoin might increase more than any time in its history, an unintentional Goldfinger attack?  Would the exchanges, or anyone really, accept any of the Satoshi coins for fiat or goods, fearing that they’re marked?  Just like the team that recovered the treasure of the S. S. Central America was blindsided by the legal claims on their find, from parties undeterred by the fact that over a century had passed, what lies in store for you?  Will an insolvent Japanese government claim that they nationalized the Satoshi treasure?  Does the cybernetic head of a 20th century Australian grifter floating in a jar of Cabernet sue you for the hoarde claiming it’s his?  Do you have the resources to defend your claim?  Does controlling a stupefying amount of wealth with a number sitting on your computer make you feel comfortable?  Or safe?

First, no matter how fast the techology progresses, it's unlikely is that anything but the abandoned wallets will be affected.  If the power of any sort of computing, quantum or other, starts to come near the threshold of breaking 256-bit elliptic curve cryptography, the Bitcoin protocol is not doomed.  Just as SegWit addresses were added to the protocol, and Schnorr signatures are being considered, Bitcoin can change to a new digital signature scheme that isn’t threatened.  The simplest way to do this would just be to increase the number of bits in the current signature scheme.  That having been said, every time this happens, users need to move their bitcoins to the new address format, so the stuck funds in these old abandoned wallets will remain vulnerable.

When might any of this happen?  I don’t know.  There’s no “Moore’s Law” heuristic for how fast quantum computing resources advance.  Further, there’s no guarantee that getting private keys from public addresses can even be done efficiently on quantum computers.  Finally, the only consistently-correct prediction about codebreaking is that every prediction is wrong (including my own).  A famous example comes from a 1977 issue of Scientific American magazine, which proposed an integer-factoring puzzle (essentially the puzzle was to decode an RSA-encrypted note).   At the time, it was believed that the puzzle would take “40 quadrillion years” to solve.  Somewhat ahead of schedule, it was solved 17 years later, in 1994, due to the widespread adoption of personal computers.  Back in 1977, the idea that hundreds of people could have thousands of processors each capable of millions of computations per second, and available so cheaply that they were willing to throw processor power to the factoring problem for fun was basically inconceivable. (Note: there was a prize of $100, about 15 cents per person, awarded for this amazing codebreaking accomplishment).  Who knows, maybe in a few years we’ll all have quantum chips in our computers designed to generate secure passwords and make the non-player characters in our video games act extra-unpredictable.  Maybe these chips can be leveraged to blow away all of our currently-secure technology.

In summary, Bitcoin wallets with lost private keys are unrecoverable for now and probably for decades to come.  For the same reasons, you shouldn’t fear “quantum computers” revealing your private keys any time soon.  Anyone going on about their quantum resistant blockchain is almost certainly a fool or scammer.  That having been said, just as Jules Verne’s fantastic vision of man prowling the uncharted depths ocean depths described in “Twenty Thousand Leagues Under the Sea” slowly came to life over the course of a century, there is a roadmap for both the theory and the technology of how one might use quantum computers to break into the millions of “stranded” bitcoin that exist even today.  While it won’t happen soon, if Bitcoin, or other cryptocurrencies continue their current pathway to widespread adoption, these lost wallets will become our treasure ships, incentivizing technological innovation and stoking the imaginations of the explorers of a virtual world of quantum bits and elliptic curves.

If you entered the space of cryptoassets in 2017, the year where investors could basically do no wrong, 2018 must seem like a nightmare.  Specifically, this nightmare might be something like a roller-coaster ride through an abattoir.  Regardless of how you’re positioned right now, however, everyone wants an answer to the trillion-dollar question.  When will it end?  I will discuss some good and bad ways of diagnosing a market turnaround and make the case for Ethereum markets as a bellwether for the end of the bear market.

What absolutely won’t help in alerting you to the bottom of the market is the news cycle.  During bull markets, even the most astonishingly bad news – like China banning cryptocurrency exchanges – won’t stop the trend.  Likewise, bear markets are completely impervious to good news, everything from talk about billion dollar investments to crypto-friendly regulation.  People have written extensively on the epistemology of capital markets and the news cycle, but it’s all basically encapsulated in this absolute gem of a story recently unearthed by Jason Zweig.

Put bluntly, if you’re a trader using news to predict price action, you’re probably just justifying your pre-existing biases.  If you’re a journalist writing news to interpret price action, you’re probably just making post hoc rationalizations.  Honestly, most of the news-traders should just flip a coin since that would probably make their risk management tighten up appropriately.

There have been a few attempts to do fundamental valuation of cryptocurencies.  The three most promising ideas are Metcalfe’s law, the equation of exchange (PQ=MV), and the network value to transactions ratio (or NVT ratio).

Metcalfe’s law is a broad scaling argument with little quantitative use – the number of protocol users increase in bear markets and bull markets alike.  It gives no help with market timing at all.  The equation of exchange is a useful idea that can give some guidance in finding a price floor, however any final numbers depend strongly on assumptions or poorly-known empirical parameters.  See this article for the relevant background and some cryptoasset specific examples.

The NVT ratio, sometimes referred to as “Bitcoin’s P/E ratio” can give some guidance similar to “overbought” and “oversold” conditions over long time scales.   At only a few years old, however, NVT is hardly a battle-tested indicator.  Willy Woo keeps track of an NVT chart and signal with some ranges and carefully details his methodology elsewhere on the site.

Fundamentals, as much as cryptocurrencies have them, are good to keep track of and measure network health, but markets can still make large moves down in “healthy” protocol tokens.

Hopefully, you’re convinced that the only truth-speaking being done here is in the tale of the tape – the price action itself.  Much like the cryptic utterances of the Delphic oracle, however, your interpretation of the sly and head-faking movements of price action might not be unique …or correct.  While swing and day-traders deal with edges and uncertainty as a matter of routine, an investor with a multi-year time horizon can wait for a clear signal for market bottom, even if they miss 10% of the move for the certainty that the carnage is over.

The most general advice is that a bear market ends when higher highs and higher lows are established.  At the time of writing, this would mean that bitcoin, for example, would need to get above $8500 after putting in a bottom above $6000.  Presumably a large buyer would look for the first dip after that to take a position.  Given the volatility of cryptocurrency markets and the high stakes in both money (30% swings between highs and lows are typical) and time (opportunity cost of six months waiting for a low after a higher high), it’s worth exploring more precise signals.  Further, we’ll look at an example where a clear higher high gave a painfully-false signal.

This is what a textbook trend reversal might look like with a higher high followed by a higher low. Not a prediction. This is close to the most optimistic possible scenario.

While the bets on markets are binary – bulls and bears – most broad theories of market phases consider four epochs.  There are variants, but market cycle traders are probably most familiar with Wyckoff theory.  Wyckoff logic gets much more technical with precise labels for particular landmarks and Richard Demille Wyckoff (1873–1934) himself is generally considered one of the great pioneers of technical analysis along with Dow and Elliott, but I’ll sweep aside the rich nuances of his work.  You can read a good synopsis here.  Essentially, Wyckoff separated the market cycle into four phases:

• During the “Accumulation” phase the security trades in a range while strong hands slowly dry up liquidity.
• In the “Markup” phase the range is broken and an upward trend is established, attracting new buyers.
• The “Distribution” phase sees trading sideways in a range while those who previously accumulated take profits.
• In the “Markdown” or “Liquidation” phase the range is broken and a downward trend is established as sellers are willing to take more and more of a loss to exit the market.

The more colorful language of Winter (accumulation), Spring (markup), Summer (distribution), and Fall (markdown/liquidation) is also frequently used.  Sometimes these aren’t very clean designations.  For example, there are reversions, almost like an “indian summer” of re-distribution when stronger hands who held during the first distribution get shaken out.  Many other times, it seems grandiose to even call them full seasons, like a Summer in Siberia.  In fact, an example of this would be our last distribution event in cryptocurrency markets.

2018 bitcoin top: only about a week of “distribution”

While there is a long and clear uptrend of Spring and a long and clear downtrend of Fall, the actual top is not a protracted sideways selling into weaker hands, but rather a quick, “blow off” top of a sharp transition from Spring to Fall.  Similarly, the Winter accumulation can be quite sharp as well.  This brings us to the idea of “capitulation.”

Capitulation is usually defined by investor sentiment: holders (fallen, apostate hodlers) of the securities will sell at any price to get out of the market, a stampede of panic selling causes the price to crash.  This event marks the bottom as all the buyers on the opposite side of this tsunami of motivated selling have a fresh attitude towards the security.  New buyers who missed the capitulation are met with stronger hands and the price moves up rapidly to find liquidity.  These charts typically form distinct V-shaped bottoms accompanied by a large volume of trades and they usher in a new accumulation of sideways or slowly-rising price action.  Capitulation is the mirror image of a blow-off top, where the price violently smashes through all of the trend lines, support or resistance levels then retraces in a high-volume crescendo.  Similarly, trading targets that made sense a few days ago are also smashed – for better or worse.

Sounds pretty obvious, like waiting for a kernel of popcorn to pop, but real capitulation events are seldom textbook.  Sometimes the volume peak precedes or lags the price low.  Gaps can miss stop loss and limit orders.  Below is a recent stock capitulation, which is about as good as it gets.  Notice that the fools who rushed in as buyers at the bottom were rewarded with 100% gains in a few weeks for their recklessness.

Weekly chart of a capitulation marking the end of a downtrend in a pharmaceutical stock.

So a capitulation would be nice (if you’re not a panic-seller), but they aren’t required at a market bottom.  Will it happen in this market and at what price(s)?  The best answer to this question we can get is to just note that it’s happened before.  Bitcoin has had at least twelve (yes, twelve) drops of more than 30% in price.   It makes the most sense to look at just one though, the crash starting in late November 2013.  The late 2013 crash took months to finally resolve, wiped out over 80% of bitcoin’s peak value and happened at bitcoin’s largest market cap, excluding the current crash of course.

The idea of forecasting by comparing one chart to another chart that has completed a similar set of moves in price action is referred to as trading “fractals.”  From purely scientific point of view, of course, this is a horrible idea, since even one neuron in one trader that fires differently can produce the butterfly effect, sending the chart on a wildly divergent path.  However, as long as you don’t get too literal, the past is as good a guide as any to the future.  If you think about it, the generalization of repeated patterns into Wyckoff logic is itself a very muted form of fractal trading.  So what might the bitcoin crash fractal tell us?

Comparison of the 2014 and 2018 bear markets including a general time and price range for a bottom. Note the very clear capitulation event, with price marker, in early 2015 on the top panel. Also note the summer 2014 higher high and low that did NOT indicate a broader market turnaround.

There are reasons that you shouldn’t take this too literally.  This is obviously not the same situation and what could be better than a bulletpointed list to explain why.

• The bitcoin network value (market cap) is much higher.
• Bitcoin’s use in international remittance payments puts a floor on the price that didn’t exist in 2014/5.
• There are publicly-acknowledged allocations of institutional money on the sidelines in an investment space whose financial lingua franca is bitcoin.
• Most importantly, bitcoin dominance is much lower.

Let me expand on that last point because I think the cause is not obvious, but the effect is quite noticeable.  About half of all cryptoasset network value is bitcoin and when traders cash out of altcoins, they usually do so into bitcoin.  In fact, sometimes Altcoin/Bitcoin is the only trading pair available, putting buying pressure on bitcoin, even in a crash.  Again, because bitcoin is the financial lingua franca of the space.

Conversely, there is a good argument that bitcoin will have a clear capitulation.  Namely, bitcoin had a blow-off top to end the bull run less than a year ago while all of those above bulletpoints were still true.  Remember, the blow-off top is the photo negative of capitulation, panic buying instead of panic selling.   So it’s hardly out of the question that bitcoin could have a capitulation-like event, but maybe over a few days (like the top) rather than over a long lunch-break like it did in 2015.

There is, however, a more promising candidate for a violent and obvious market capitulation.  One that should be a good indicator of overall cryptocurrency market bottoming.

In the author’s opinion, Ethereum should show a very distinct capitulation event in this market.  I will really quickly enumerate the reasons why in another bulletpointed list.

• The market cap of Ethereum is close to 2014 Bitcoin
• Ethereum markets have lower liquidity than Bitcoin
• Original Ethereum investors have huge blocks, many tens of thousands each, of Ether to dump
• The ICO fundraising for ERC-20 tokens was in Ether

Specifically, the last point is what makes me think that Ether will have the biggest panic sell.  The 2017 ICO mania was mostly through ERC-20 contracts which, therefore, did their fundraising denominated in ETH.  These projects have actual liabilities and expenses and they can meet fewer and fewer of them as the ETH price drops in local currencies.  Whatever we might think about the future, we still need to pay our bills in sovereign currency.  If Sirin labs, for example, had kept their entire $150 million fundraise in Ether, it would have lost over $100 million of value.  Their goal is to create a crypto-native piece of phone hardware and this will cost a lot of money.  Overall, there has been billions and billions of dollars raised in ETH.  It’s going to get ugly.

If you take the 2014 bitcoin fractal as some guidance, the ETH low price should be in the mid-hundreds, if not lower.

No doubt that the incentives is there; brag about picking the bottom, easy 5-10% or more in the first hours of your trade.  The threadbare phrase about picking bottoms is that you’re trying to “catch a falling knife.”  I think a more clumsy, but appropriate analogy is that you’re trying to bungee jump and bite the cherry off the top of a cupcake that’s sitting on a rock.  If you’re too tight, you get nothing.  If you’re too loose, you go to the hospital.  Even attempting this trade requires a lot of risk management and tying up a lot of capital with layered buy orders and stop-losses with no guarantee of manual oversight since capitulation might happen while you sleep in the 24/7 crypto markets.  As the liquidity dries up, limit and stop orders may not get executed even close to their nominal prices.  Most importantly, trading is as much emotional as it is intellectual and one of the more common mistakes traders make is irrationally “revenge trading” a market that’s been beating them up.   Selling capitulation isn’t the worst thing you can do, although it is heartbreaking.  Messing up a trade with leverage is the worst thing you can do.

Perhaps surprisingly, therefore, here is a thread of tweets that shows a good example (not an endorsement of the trade or targets!) of the meticulous thinking that goes into researching targets and making a plan for a capitulation trade.

It might seem a bit weird to issue grim and severe warnings about trading such an event and then offer some best practices, but my friend once got the following advice from his father: “Don’t get a motorcycle, but if you do – wear a helmet.”  This is basically what I’m saying here.

I would like to end with two more cartoonish charts to hopefully put some iron back in the blood of anyone left particularly anemic by the protracted savagery of 2018.  Keep your chin up and remember that this is the most important chart for investors in new technology: the S-curve of adoption.

The S-curve, in yellow, of adoption of new technology. The bell curve, in blue, showing the density of people entering the markets at any point.

In textbook pictures like this, it looks like you should be joyfully riding up a playground slide pulled aloft by a giant Helium balloon.  Certainly that does not accurately describe the crypto-investing experience at this point.  The reason for that is that while the percentage of people using a commodity affects its price, obviously the relationship between the two is complicated.  More so for a publicly-traded good, which goes through wild swings of disillusionment and euphoria.

The next image shows Gartner’s hype cycle for a new technology which, in a sense, can template market prices.  See the correspondence to AMZN stock price during the years bracketing the dot-com bubble.

The Gartner hype cycle was coined by a technology firm and it is hard to imagine that they didn’t have tech stock prices in mind. Adoption of new technologies always suffers from wild swings of over and under pricing.

Draw some Gartner hype bubbles on the S-curve of adoption and you should have the price curve of a successfully-adopted cyrptocurrency.  It’s not a smooth ride, but the reward is profound.  Cryptoassets have already proven themselves to be a generational investment opportunity.

The last year has seen a lot of discussion and effort put towards the goal of scaling cryptocurrency protocols.  I will review the reason and difficulties in scaling a crypto protocol and do a quick round-up of these efforts to date.

The term “blockchain” can be thrown around in the non-technical press with a cachet as if it’s some sort of rocket science brain surgery non-linear quantum cryptographical artifact from hyperspace bequeathed to us by the glacial intellect of a benevolent demi-god.  There are, however, two undeniable truths that any serious student of cryptoassets will eventually come to understand:

Financial journalists investigate the Bitcoin genesis block. Footage from MGM studios.

1) Blockchains are incredibly simple.  I spend a breezy ten minutes in talks to finance professionals explaining what blockchains are, but that’s just because it’s out of their domain of expertise, not because it’s difficult.  If the audience was a bunch of folks with some training in computer science, it would take seven words: “blockchains are linked lists with hash pointers.”

2) The distributed-ledger blockchains used in cryptocurrencies are very inefficient.  Firstly, they are somewhat inefficient in terms of the time it takes to update them. This is due to the large number of network participants (nodes) located all over the world who maintain copies of the ledger.  Secondly, cryptocurrency blockchains are incredibly inefficient in terms of file storage. Imagine that each of the 10,000 employees in some hypothetical company had to store and update the same copy of a giant Excel spreadsheet.  Further, the spreadsheet cannot have any entries deleted, only added. Now imagine that this spreadsheet holds every official document generated by anyone in the company. This is the paranoiac redundancy that allows cryptocurrencies to function without any (on-chain) fraud or any centralized control.

In fact, you eventually suspect that that there is a fundamental tradeoff between efficiency and security in digital assets.  The Bitcoin protocol, as currently implemented, maxes out at about 10 transactions per second. The Byzantine consensus protocol used by Stellar and Ripple claims a hundred-fold greater transaction rate.  Using the “Excel spreadsheet” analogy described above to explain how Ripple manages to do this, suppose that only the employees in the accounting department, instead of all 10,000 employees of our fictitious company, needed to keep and maintain the super-spreadsheet.  Obviously, the updating is now easier, however the probability that this, smaller, number of people make a mistake, forget to include an important document, or “defect” en masse increases.

Even if you try to scale a public blockchain using some other parameter, it seems like security is affected.  Increase the blocksize? Sorry, you lose nodes (spreadsheet custodians) because bigger blocks require better computer hardware.  Keep the blocksize, but have more frequent blocks? Sorry, you have an increased risk of timing attacks from miners and stakers and you still effectively lose nodes due to latency issues.  It’s hard to quantify these tradeoffs precisely since they are tradeoffs between different types of failure, but it really seems like the tradeoff is a fundamental one. Perhaps there is an unproven law of information theory, the Nakamoto Uncertainty Principle, if you will, that looks something like this:

That is more transactions, less security and the converse.  This idea or suspicion lurks ominously in the background of the scaling discussion.  

Why is scaling so important?  People compare cryptocurrencies and credit card payment networks all too frequently and it’s not a sensible comparison in the sense that Bitcoin is not intended to replace Visa.  However, the following is a fair statement: if a cryptocurrency is going to be a globally-adopted payment network it should be able to handle a transaction volume on par with something like Visa which, at peak, can clear over 50,000 transactions per second.  

This rather grim metric, therefore, indicates the Bitcoin protocol, with its current parameters, handles approximately 0.025% of the transaction rate it would need as a true global payment network.  The developer community understands this and the implications for scaling colors every decision they make. Ramping up transaction volume has been discussed since the inception of the Bitcoin protocol and these are well-known problems.  In fact, one of the precursors to Bitcoin, DigiCash, was essentially brought down by a scaling problem since the DigiCash protocol required a central authority (namely, the DigiCash company) to verify every single transaction on the network.  

While there is no overwhelming consensus about how to scale Bitcoin, in the last year a lot of progress has been made and some solutions have been tried out, so it is worth doing a scaling roundup.

For the reasons outlined in the previous section, scaling Bitcoin (or any other cryptocurrency) by squeezing factors of two out of block sizes and block rates would not get you the overall factor of 1000 you need, nor would it leave Bitcoin’s security uncompromised.  The Summer 2017 fork which spawned Bitcoin Cash, which is an attempt to scale the protocol through blocksize increases is increasingly looking like a failure from both a technical and a user adoption standpoint.

Additionally, changing the consensus rules or introducing “trusted” nodes to scale Bitcoin is out of the question for philosophical reasons, although niche crypto projects which aren’t trying to be an apolitical global currency may do so.  Therefore, the set of options for scaling solutions involves only “second layer” solutions in which a high volume of transactions can occur off of the primary blockchain and then settle up on the primary or “root” blockchain as needed to ensure that all the currency is properly accounted for.  

Off-chain scaling is necessary as a solution in large part because that’s simply how networks scale.  When you send a packet of information through your router at home to the internet, you don’t send it to every other router on earth, you send it where it needs to go.  This is obviously because if you’re interacting with two different websites, the information you exchange with one is irrelevant to your interaction with another. However, things are more difficult in a cryptocurrency network since each transaction you make needs to be resolved in full knowledge of the others.  That is, each party needs to know that their counterparty is solved and not double-spending funds. The basic technical challenge, therefore, of off-chain scaling is to keep people from double-spends without settling everything on-chain. That is, to break the Nakomoto Uncertainty Principle.

Presently, there are three major proposals for off-chain scaling.  I will review their essential features and give an update on how the technology and/or adoption is progressing for each.  Before we begin, however, let’s set the rules of the scaling game. In order to keep the essential properties of a blockchain-based cryptoasset, the scaling protocol must have these three properties:

1. Trustless – there is no special party or group required to make the system work
2. Decentralized – anyone can participate in making and verifying transactions
3. Immutable – valid transactions cannot be “rolled back” by anyone

For example, cryptocurrency exchanges facilitate huge amounts of crypto changing hands and some even allow fee-free transactions between two users of the exchange. Further, all of this transaction volume is off the blockchains, settled up only when a user makes a withdrawal.  We won’t, however, consider this as true scaling because there is a trusted third party (the exchange) which could roll back trades and transactions, violating all three of the criteria above.

Atomic swapping allows users to trustlessly exchange cryptocurrencies from two different blockchains.  As an example, imagine that Alice has litecoin and wants bitcoin, so Bob agrees to trade her 1 bitcoin for 100 litecoin.  The usual way to make this happen is through a cryptocurrency exchange which has a LTCBTC market, but that violates our trustless scaling rule.  

Atomic swap protocols allow Alice and Bob to make the exchange remotely and trustlessly though a password-exchange trick where essentially, in order for Alice to claim her bitcoin, she needs to reveal the key phrase that allows Bob and only Bob to claim the litecoin that Alice had to cryptographically escrow.  More technical details can be found in this article and this video.

What do atomic swaps have to with scaling?  Well, simply, by allowing trustless interoperability between different cryptos, you can transact on a lower-fee blockchain if one of the blockchains has a transaction backlog.  Think about it like changing lanes while driving if one gets too slow. Alternately, you can think about atomic swapping like exchanges between the currencies of virtual nations and realize that in between the US dollar, yen, yuan, and euro you’d have a large enough monetary base to cover all global commerce.  Similarly, between Litecoin and Bitcoin, you now have a combined transaction rate of about 80 transactions per second.

Atomic swaps are not a research project, they have been performed in between the Litecoin and Bitcoin protocols.  However, this is not necessarily a convenient or total solution by itself – remember we need tens of thousands of transactions per second, however it is progress.  Atomic swaps are also worth mentioning because they are progress towards another really important technical project, decentralized exchanges, and also offer the cryptocurrency holders some degree of safety against one particular protocol becoming compromised.

It’s also worthwhile to note that the Lightning Protocol, discussed below, can support atomic swaps between crypto protocols with similar enough consensus rules.  

Plasma is a protocol to link “daughter” blockchains to a parent blockchain.  At the risk of straining the analogy, these daughter blockchains are college-age daughters which don’t require 100% supervision, only periodic infusions of currency and intervention in times of crisis.  The participants in these daughter chains mint and use internal “tokens” which can be used for transactions in the daughter chain. The main blockchain or “root” chain does not have to, therefore, verify every transaction.  In the extreme case, the daughter blockchains may be permissioned allowing the burden of proof or work or stake on that chain to be very minimal. At some agreed upon time or in the case of suspected fraud or attack, participants can cash out their side-chain tokens for the native currency of the root chain.  A reasonable analogy is exchanging money for chips to have a night in the casino. You have two sovereign currency transactions as you enter and leave, but an arbitrary number of chip transactions governed by internal rules of the games that you play.

The Ethereum protocol and similar projects are particularly well suited to scale through a Plasma daughter-chain schemes since Ethereum has the native and robust smart-contract functionality that Plasma requires.  It’s possible Bitcoin can use daughter chains, but the support is not as native to the protocol.

The main criticism of this is that it doesn’t really exist yet outside of proof of concepts and testnets.  Even if the technology shows up, there is a serious economic issue. Since each daughter blockchain is its own isolated ecosystem, then while it could greatly increase the number of transactions in theory, in practice it reduces the number of people with whom you can interact by pushing activity into little side-chains.  Again, using the casino analogy, you can’t use the chips outside of the casino, which seriously limits their economic utility. Finally, Plasma implementations are a bit complicated which means more modes of failure or, as the security nerds say, a “larger attack surface.”

The Lightning Network (LN) is a collection of linked payment channels. The basic unit of the LN is a contract that two users open with each other though a special, but straight-forward, script which is posted on-chain.  To be more concrete, let’s say that Alice and Bob are planning on doing a lot of bitcoin-denominated business with each other. Instead of making an on-chain transaction of Alice to Bob or Bob to Alice for each and every one of these manifold transactions, the two simply keep a tab with each other and close it out at some predetermined time.  In order for this to happen according to our three rules, Alice and Bob need to escrow funds upfront. For example, imagine that Alice and Bob put 4BTC each into a contract. Each transaction updates the contract until one of them closes it or it “times out” at a point specified when it was opened. If for instance, Bob spent 1.5BTC more than Alice did in their set of transactions, the final contract will close and return 5.5BTC to Alice and 3.5BTC to Bob.  

Even though the funds in these payment channels are denominated in bitcoin instead of a token, like those of Plasma networks, you may have noticed that this seems to suffer from a much much more extreme version of Plasma’s economic insulation problem, where the contract only lets two people transact.  For instance, maybe it would make sense for me to open a contract with Amazon to handle holiday shopping, but I really don’t do too much repeated business with other parties. Why would I open a payment channel with some party I’m only going to transact with once? Instead of paying miners once for the single transaction, opening and closing a payment channel would incur at least twice the amount of mining fees.  Here’s the clever part of the LN solution, and the reason it’s called a network: Alice can not only transact with Bob, but also with anyone who Bob has an open payment channel with …and anyone that those people have payment channels with themselves, and anyone who those people have open channels with, and so on, and so on…. This happens by Alice sending a payment to Bob, who then routes it on to one of his other channels who can keep routing the payment to any destination in the network.  

Simplified LN payment network

Specifically, imagine that Alice wants to pay Charlie 0.25BTC.  Alice doesn’t have a lightning payment channel open with Charlie, but Bob does.  Alice pays Bob 0.250001BTC for the service of sending a lightning payment of 0.25BTC to Charlie.  Voila! Through the miracle of network effects, in a network that mimics real social networks, there should be an efficient path between any two participants.

If you’re just getting used to the implications of pseudonymity and how open your financial life can be on the Bitcoin network, this might seem like it’s way too public and open – for instance, who would want to call a stranger and tell them the details of their purchase every time they used a credit card?  However, the transactions themselves can be shielded at each hop by the onion routing like that used in the Tor network so that all the entities who route the transaction know is the fee they get for passing along the transaction.

Overall, the idea of a lightning network is pretty slick and the interest from the development community is really high.  There was a Lightning test network in place in late 2017 and there are already stores and services on the main network with new services and payment channels popping up constantly.  The growth is fairly exponential and in a nod to history, Lazlo Hanyecz used lightning to order two pizzas with bitcoin (this time paying 0.00649BTC instead of 10,000BTC).  Lightning apps are being written and the open source community ethos behind it means that progress will .  For example, a coder wrote a LN-powered gumball machine where users can remotely dispense candy for him and another person could fork and change his code to something more useful.  Events called “hackathons” are regularly held for LN coders to work and collaborate on tasks like this.  Currently the most popular LN-powered application is (the possibly NSFW!  https://satoshis.place/) an online graffiti board where users pay per pixel to doodle on a million-pixel space.

Your future checkbook, bank branch office and credit card terminal?
https://magazine.odroid.com/article/thundroid-perfect-bitcoin-lightning-node/

What are the issues with the lightning network?  There are a few. Firstly, one is – as always – tempted to use the analogy of a credit card.  In this case LN is like a credit card insofar as you use your credit card all you want with whomever and then settle up at the end of the month.  Likewise, you can open a payment channel with a well-situated node and then spend (or *receive* something credit cards don’t let users do) all you want until you’re spent out or the channels close.  However, the analogy doesn’t work in the sense that a credit card is, as the name suggests, a credit or debt-based instrument. Lightning network payment channels, however, need you to escrow funds up front in order to open connections.  In that sense, lightning is more like a pre-paid debit card that other users can refill. As a matter of consumer preference, pre-paid anythings are decidedly less popular since you need to know what your fiscal needs and preferences are ahead of time when you get the card.  In this case, the choice is how much bitcoin are you going to put into the payment channel and will you know in time to refill the channel if needed.

The next, and rather more serious objection is the fact that the lightning payment channel must be online to send and receive payment.  In the parlance of cryptocurrencies, lightning payments are routed through nodes which contain queryable hot wallets. Queryable hot wallets have a much different security profile than what most people prefer for keeping large amount of funds safe.  To un-euphemism that last statement: hot wallets are less secure. In fact, most of the famous exchange hacks in the history of cryptocurrency have been due to the fact that the exchange was keeping large quantities of crypto in a hot wallet. As such, people tend to store small amounts in hot wallets and only connect to transact.  The highly security conscious only use hardware wallets, again, only connected in order to transact. I suspect that someone will come up with a solution that allows the lightning node to spend non-routing transactions (i.e. ones which diminish the balance) only with some additional two-factor or hardware verification similar to how Yubikey works.  Even with robust security on the LN nodes, since the ability to route a payment of some particular size depends on each node having that amount in their channel, albeit for only a microsecond, the amount of bitcoin which you can transact will be limited by the amounts your connections have decided to stake in their LN hot wallets.

Finally, there is a really interesting legal ramification for the role of payment router that each lightning node must play in order for the who scheme to work.  The is no case law specifically in the context of crypto here, but the structure of the payment passing LN uses does raise of issues. Because each node routes transactions, someone could make the case that they are subject to any money transmitting, know your client or anti-money laundering regulations which are relevant in that jurisdiction.  Let me just offer a wild example to give a sense of how the non-physical network connections of the LN is at odds with the rules of “meat-space.”

Going back to our little network, imagine that Bob lives in Seattle, in the United States.  Bob happily transacts through the Lightning Network with Alice, taking payments to send merchandise and routing her payments to Charlie.  It turns out that Alice lives in Canada, so suddenly Bob needs to make sure that he’s in full compliance with all the rules governing international commerce.  No real problem there because he gets a shipping address from Alice and is therefore made aware of his obligations and Alice presumably knows enough about the goods and services Bob offers to know whether she’s eligible to purchase them.  The problem arises if, for example, Charlie lives in North Korea. There is no way that Bob knows this because he’s simply routing encrypted payments from Alice to Charlie and earning some small fees for doing so. There is no information in that about the size and purpose of the payments, let alone what the geographical location of the node is.  Do you know the physical location of the server which just sent your email inbox updates? If we translate this situation into meat-space from cyber-space, you can obviously see how this can be an issue. Bob is paid $1000 to deliver a package of currency from Vancouver to Pyongyang.

Who knows whether this is an issue, or how it might resolve, but there is a legitimate concern.  In practice, payment networks are uncensorable and Bob should have as much criminal liability as a UPS driver does if there’s a package full of illegal goods in her van, but legislators have a spotty history of clearly understanding this technology.

This was pretty whirlwind, but that’s where scaling stands at the moment.  In particular, Bitcoin’s lightning network, which – given a properly-funded topology – could handle more transactions than the global economy needs, has been attracting a lot of attention from the community.

Growth of the Lightning Network mainnet, screenshots from: https://rompert.com/recksplorer/

Finally, what if it all fails?  I interpret that question as “how much of the energy and money invested in cryptocurrency right now is based on the promise of a true global (~50,000 transaction per second) network?”  Or, “how much valuation will vanish if global-network-quality scaling is proven to be impossible?” I don’t know. Bitcoin won’t go to zero anytime soon since it’s still much more efficient than the current system to send international remittances and at any given time, a country somewhere on earth is experiencing high to hyperinflation.   With a combined network value close to Microsoft’s market cap during the peak of the tech bubble, however, there is definitely some hope of global transformation priced into the cryptocurrency market.  While one or none of these solutions might not be the answer, what is obvious is there is no shortage of substantive work being done to fulfill this promise.

Proof of Stake is hardly a battle-tested concept, few successful cryptoassets are native Proof of Stake.  Most notably, Ethereum’s impending hard fork to the Casper Protocol is the first time a large network-value asset will change from Proof of Work to a staking consensus mechanism.  However, instead of pricing in any risk associated with this, the impending hard fork seems to have triggered a vertigo-inducing price rally – as if investors and speculators are fighting for the sidecar seat on Evel Knievel’s motorcycle.  I argue that this is a general phenomenon for assets with masternodes, a “virtuous cycle” of price action and liquidity.

Proof of Work can be generalized a bit more readily than Proof of Stake (PoS), but we can say that most Proof of Stake schemes bundle some requisite number of the coins in “masternodes.”  The masternodes then earn more coin if they propose good blocks and have their stake slashed if they propose bad blocks to the blockchain.  Alternatively, masternodes can route transactions, handle blockchain governance, or provide anonymization services.  More on that later.  In the case of Ethereum, the masternode bundle will consist of 1000 ether which cannot be moved from the ETH address while the staking node is functional.  Operationally, therefore PoS schemes turn the currency into a dividend-paying asset – for those with the requisite number of coins to make a masternode.
 

There are many important details and technical considerations here as well.  We can suffice it to say that running a masternode may carry risks beyond the usual cryptocurrency risks and you should learn what you’re doing before broadcasting to the internet that you have a high-value bundle of cryptocurrency, even if the broadcasting is through the node topology.

As to the point of this post, since masternodes require the cryptocurrency to be taken out of active circulation, a cycle begins:

1. Masternodes take coins out of circulation, increasing scarcity
2. Increasing scarcity drives prices up
3. Increasing price makes masternodes and their stake rewards worth more
4. Greater stake rewards incentivize more masternodes

              …GOTO 1.

Since masternodes are not unique only to PoS assets, this gives us an opportunity to see if there’s evidence that this is, in fact, a significant price action effect.  The Dash cryptocurrency has blocks which are verified by a PoW algorithm, however, the protocol allows for masternodes which perform additional services of “tumbling” coins to provide anonymity and allowing nearly-instantaneous transactions through the masternode network (similar to the federated nodes idea of Stellar or Ripple).  At the beginning of the 2017 cryptocurrency bull market, Dash experienced a sharp upswing.  It’s only really sensible to make the apples-to-apples comparison to bitcoin’s price, so we include the Dash vs. bitcoin chart to see the price appreciation.

Chart of Dash, denominated in BTC. from coinmarketcap.com
 

We also can look at the two next-largest masternode utilizing currencies, PIVX and Zerocoin to see if there’s a similar appreciation, possibly due to the masternode liquidity effect.

Chart of PIVX, denominated in BTC. from coinmarketcap.com

Chart of ZCoin, denominated in BTC. from coinmarketcap.com
 
The natural next question is whether the virtuous cycle on an upswing will become a vicious cycle upon price depreciation.  The good news is that there may also be negative feedback mechanism that works against a “masternode liquidation run,” depending on the exact payout structure of the protocol.  Imagine the cycle starting to run in reverse, perhaps kicked off by lowering value of the underlying coin.  People choose to liquidate their masternodes, increasing the circulating coins and adding more selling pressure, causing more masternode operators to liquidate their nodes.  If the masternodes are paid by overall share of block rewards (as opposed to the share of transactions the node itself has verified), the runaway liquidation should have pressure to stop since the remaining nodes are getting an increasing supply of the block rewards – and incentive to remain.
 

The other good news here is that you’re not left out of price appreciation if you either don’t have enough coins to make a masternode or are, for whatever reason, squeamish about staking. The masternode price appreciation will carry even the unstaked coins with it.
 

The usual suite of due diligence questions about a cryptocurrency protocol still needs to be asked and answered, regardless of whether it has the sweetener of a masternode or staking reward, however understanding the masternode/liquidity connection can be another useful tool in your crytpoasset analysis toolkit.

Several lecturers and writers in the cryptocurrency space advise doing months and months of research before acquiring any cryptocurrency.  We present this under a different philosophy, that the best way to learn is by doing.  Also, we acknowledge human nature makes months of monk-like research while the price climbs higher somewhat unrealistic.  As such, here’s a bare-bones tutorial explaining how to get cryptocurrency by the safest and easiest path.  If you are a true beginner to the space, welcome, and take your first position with only as much money as you are willing to lose.  As you learn more, you will be able to safely invest more.

Let’s start with the disclaimers: 1) The space evolves very rapidly, better practices, hardware, and exchanges are constantly emerging. 2) This is written to orient you to the tools and resources to trade and invest, not the underlying technology or investing thesis. 3) These are not explicit recommendations to trade and invest in or through anything.  As always, you are responsible for your own financial decisions and due diligence.  Specifically, all of the services and vendors mentioned are third parties.

Whew. With that out of the way, let’s get started.

First we need to know what it means to “own” some cryptocurrency. Cryptocurrencies are based on the idea of a blockchain, which is a public, decentralized, ledger. The blockchain ledger keeps the accounting of how much cryptocurrency each address controls. If you want cryptocurrency, therefore, you need an address and then you need someone else to send cryptocurrency to that address. As the blockchain grows with linked blocks of new transactions, the credit to your address becomes sealed by an increasingly-difficult-to-fake set of computations, like a fly in amber. When you spend your cryptocurrency, you need to inform the blockchain of the transaction – specifically, the address you want to send it to and the amount that you want to send.

Simplified blockchain diagram from: Preethi Kasireddy’s tutorial http://bit.ly/2tKMeIu

Because the blockchain is a public ledger, there needs to be a mechanism to ensure that you are the only one who can transact on your behalf. This works through some amazing mathematical ideas worked out in the 1970’s called “public key cryptography.” Public key cryptography creates an un-forge-able digital signature of sorts by having a pair of keys; a public key that is distributed to anyone who needs to verify your authorized transactions, and a private key that you use to digitally sign the transactions. Think of them like two puzzle pieces, you can distribute one of the puzzle pieces (public key) and you can demonstrate that the two pieces fit together, but you don’t have to show the private puzzle piece. The basic security consideration of cryptocurrencies, therefore, is that if someone knows your private key, they can make transactions on your behalf.

In summary, to get cryptocurrency you need an address and you need to have someone send cryptocurrency to that address. In order to make transactions, you need to have your private keys. In order to make sure you’re the only making these transactions, you need to keep your private keys secure.

There are a few possibilities. The traditional way to do this is to download and install a software wallet. The new software wallet syncs up to the blockchain and verifies the amount of cryptocurrency in that address. As new blocks are added to the blockchain, the amount is updated to reflect any transactions to or from your new address. Making transactions through a software wallet is much easier than currency transfers through the traditional banking system, which is a great part of the appeal of cryptocurrencies.

Security note: The best idea is to download a cryptocurrency’s “official” software wallet from their official website.  In any case, you must do due diligence on the wallet itself.  Is it open source?  How long has it been used?  Has the software team ever released anything with an exploit?

For instance, official bitcoin wallets and a good discussion of wallet security can be found on their website:

https://bitcoin.org/en/choose-your-wallet

You can purchase a hardware wallet, which is a specialized device (basically, a glorified USB drive) that functions like a software wallet, but is secure against the computer with the software wallet getting compromised.

Security note: Saving a few dollars is absolutely not worth the risk of buying a used hardware wallet. Hardware wallets should be purchased directly through the manufacturer, licensed dealers, or a major retailer.  If you’re buying one through Amazon, are you buying it from Amazon, or a third-party seller?  The wallet should come with intact security seals on the box.

The two most popular hardware wallets are linked below.  Make sure they support the cryptocurrency you wish to store on them.

Trezor: https://trezor.io/

Ledger Nano S: https://www.ledgerwallet.com/products/ledger-nano-s

You can also create a paper wallet, which essentially is a piece of paper that has your address, private, and public keys (usually the address and public keys are the same, but this doesn’t need to be true). The upside here is that you are concealing your private keys the same way you conceal any physical object.

https://www.coindesk.com/information/paper-wallet-tutorial/

More common these days is to use a custodial service, usually an exchange, that maintains your address and holds your private keys for you. This makes it easy to trade, but again, you’re trusting someone to perform the most essential security function of cryptocurrency for you (that is, keeping the private keys safe). Some exchanges offer “cold storage” for certain cryptocurrencies. Cryptocurrency cold storage is the practice of keeping private keys off-line, for example on a computer that is not connected to the internet so that it cannot be attacked remotely. If you do chose to keep funds on exchanges, cold storage is the safest method.

You should choose among these based on your philosophy of use. If you’re an active trader, you’d keep funds on the exchange, giving a lot of security in order to move in between currencies quickly. If you want to invest in a particular currency and hodl over a long time horizon while sleeping soundly, the best solution is a hardware wallet or your own cold-storage solution.

You have picked a wallet based on your investing/trading style,  great.  Now you need to get cryptocurrency assigned to it.  Again, there are a multiplicity of ways to do this, you could accept payments for goods or services in cryptocurrency, buy it for fiat currency directly on an exchange, or try mining.  We’ll skip mining because, if you’re prepared to acquire a significant amount of crypto through a mining operation, hopefully you know all this.

If you want to accept payments in cryptocurrency, you simply have to give the other party your address and wait for the funds to show up in your wallet. Reminder that you should be 100% certain that you’re distributing your address and never your private key. Several exchanges, like Coinbase, even have widgets for putting a bitcoin payment option in your website. If you do this, of course, you’ll need to be mindful of the volatility in the local currency/cryptocurrency exchange rate.

This is a good small business FAQ on merchant payments:
https://en.bitcoin.it/wiki/How_to_accept_Bitcoin,_for_small_businesses

Most commonly, cryptocurrencies are purchased with fiat (sovereign) currency on exchanges which are made expressly for this purpose. In order to do this, you need to make an account on the exchange. Typically, this is about as complex as opening a new bank account. The process should comply with any applicable local laws for money transmitters, so they’ll need to know information about your residency status and might require forms of government ID. Once you have an exchange account, you’ll need to fund it with fiat currency. As a reminder of one of the reasons cryptocurrencies exist in the first place, this usually will be through an ACH transfer from your bank and will take days. The entire process might take over a week as this is where the slow bumpy onramp of the traditional banking system merges with the superhighway of digital currencies.

Once the ACH handshake has completed, you can now purchase cryptocurrency. Exchanges will let you buy cryptocurrency directly, usually taking 1% or more commission. A good exchange will lock in the fiat/crypto exchange rate at the time of purchase even if the crypto isn’t credited to your account until the bank transfer completes (possibly a week or more).

Alternatively, you can simply transfer funds to your exchange account and use the associated exchange directly. The exchanges have the same sort of order types as a stock brokerage account; market buy and sell, limit orders, and stops. Some exchanges have commissions on all trades, but usually the fees are lower or even waived for orders which are not instantly filled. This “maker/taker” fee structure promotes liquidity in the exchange. More on this later. Each exchange is different, but if you can use a Charles Schwab account, you can navigate the exchange’s order book and types. By doing this, you’ll not only dodge some fees, but see some of the important mechanics of how exchanges function.  The possible downside is that if you transfer funds to buy cryptocurrencies on the exchange directly, you will not be locked into a price at the time of transferring funds.

Here we’ll walk through the entire procedure which will cover the most common use case. Let’s say you’re curious about bitcoin and want to tuck away $1500 worth of it to see what happens in the next few years.

We’ll use Coinbase/GDAX as the exchange since their insurance policy is the most robust and they have gone through the compliance to operate in all 50 US states.  Coinbase/GDAX only supports the cryptocurrencies Bitcoin, Litecoin, and Ethereum.  If you want something else, you generally need to buy bitcoin and exchange the bitcoin for the other cryptocurrency on a different exchange that does support it.

Investing note: The exchanges aren’t doing research for you, they list coins based on transaction volume (therefore exchange fees), not because the coin is a good investment.  Some large exchanges list coins which are obvious scams but trade heavily.

First make sure you’re comfortable with Coinbase’s privacy and insurance policies. Your due diligence should match your level of investment.  For any exchange or cryptocurrency business, some key questions to look into are:

• Has the exchange ever been hacked?
• How is the exchange insured?
• Is the exchange under any legal investigations?
• Where is the exchange domiciled?
• Does the exchange regularly undergo “proof of reserves” audits?

Security note: There have been some extremely insidious phishing attempts using urls that look very close to reputable cryptocurrency services. They have even purchased Google ad banners, make 100% sure you’re navigating to the website you actually want.

As such, here’s a referral link to Coinbase that should have my name in it:  https://www.coinbase.com/join/5754a6c66586f2007b00065c

The exchange run by Coinbase is called GDAX. As of the time of writing this, you’ll need to provide government ID to use GDAX and the facial recognition software is rather conservative and finicky (a good thing). I’ve known people who have tried for an hour to get it to work w/o success. The Coinbase app seems to work better for that specific purpose.

Once you’re set up and have a linked bank account, you can choose to buy cryptocurrencies directly through Coinbase, or to transfer the money to Coinbase and then (instantly) move it to the GDAX exchange to trade directly. If you do the former, you could average in by buying a few $300 lots if you wanted to spread out the risk of being the last purchaser before a sharp correction.

If you use the GDAX exchange directly, you must log in, transfer the money from Coinbase and then enter the order. In the screenshot below, there’s an example of how to set a limit order which will incur no fees and most likely be filled very quickly. There is the possibility that the price will walk away from your order, but the intraday volatility of most markets make it highly likely to be filled if it’s within 0.1% of the market price.  Make sure your order is filled, of course.

An example GDAX limit order. “Look ma, no fees!”

One way or another you have some cryptocurrency, congratulations! Now you need to store it in the way that’s most in line with your philosophy of use. In this example, we’re assuming you’re a long term hodler (“holder,” you’ll figure it out…). You can use Coinbase’s cold-storage. In this case, you might have to transfer funds from GDAX to Coinbase. Alternatively, you can take the cryptocurrency entirely off of the exchange by sending it from your Coinbase account to either a hardware wallet which has its own address. This transaction will update the blockchain and require fees, paid to the computers that validate and cryptographically seal the blocks of transactions into the ledger.

You’ll need to refer to the specific setup steps for whatever hardware wallet you purchase before the transfer.

Security note: Pay careful attention to your hardware wallet’s recovery seed – what it is and how important keeping it safe is.

The security and immutability of the blockchain cuts both ways. If you mess up a transaction, there is no going back. Probably the most common mistake, especially with the huge proliferation of currencies, is to send things to the wrong address. Because of the huge target space of addresses, doing this is effectively like putting a stack of bills into a fireplace – they’re lost to everyone …forever.

1. Verify that the cryptocurrencies match. Seems obvious, but it’s more and more difficult with the misleading names and the exchanges that host dozens of cryptocurrencies. You cannot send Ethereum to an Ethereum Classic address. You cannot send Bitcoin to a Bitcoin Cash address. Barring a statistical miracle, effect is to “burn” the cryptocurrency.
2. Triple-check the address you’re sending cryptocurrencies to. Verify that the first and last few digits match after you enter the recipient address, so that you’re sure nothing was cut off or changed.
3. For large transfers, do it in lots. Send a small amount to the address. Wait for the transaction to go through, then make a bigger transaction once you’ve verified that it worked.

 
At the end of this, you should have a hardware wallet which can be tucked in a firesafe while you peek at the price of your cryptocurrency, or even verify the amount in your addresses on the blockchains itself without ever touching the wallet.  You will have also successfully used all of the parts of the cryptocurrency ecosystem and are well on your way to being able to invest successfully.

Writing about Bitcoin Cash even as recently as two weeks ago would have been more akin to giving play-by-play for a heavyweight prizefight than a sober and considered blog post about decentralized payment systems.  Now that the dust has settled a bit, however, we can evaluate the situation with some degree of clarity.

Bitcoin Cash (BCH), henceforth “BCash,” is the cryptocurrency resulting from the August 1, 2017 hardfork of the Bitcoin blockchain.  BCash is not a “legacy” chain resulting when a group of users, nodes, and miners prefer to use an old protocol over an implemented upgrade.  Instead, BCash was a proposed upgrade – hoping to address scaling issues – that was only accepted by a subset of the community.

Bitcoin will need a scaling solution of some type.  The most popular cryptocurrency has seen its usage explode to the point that the 1MB maximum blocksize is hit on every block.  Transaction fees have increased commensurately, from about $0.25 in December 2016 to over $4 for a standard transaction at the present time.  Since an important part of the (practical) appeal of blockchain-based currencies is that their transaction cost is lower than, for example, wire transfers and the SWIFT network, this is a serious issue.  

To give a sense of how much work needs to be done at the moment, BTC can handle 7 transactions/second while the VISA network handles – on average – 2,000 and has a claimed maximum capacity of 56,000 transactions/second.  The Bitcoin core development team has been accused of deliberately allowing the Bitcoin protocol to veer into the full-block, high-fee territory as part of a deliberate strategy to make Bitcoin more of a store of value (money) than an efficient transaction protocol (currency).  

BCash introduced two new innovations to boost the overall number of transactions/second; a larger maximum block size, and an “Emergency Difficulty Adjustment” to allow more blocks to be processed during times of high use.  The latter innovation was essentially a failure, but the BCash developers recognized that, hardforked again and basically de-clawed the procedure.  Okay, there was a bumpy patch, but BCash now has a higher maximum transaction rate and anyone who had Bitcoin can now use BCash since their public keys were kept in the forked blockchain.  What’s the problem?

First, the technical claims about blocksize are not universally accepted.  While scaling Bitcoin is a real challenge, simply increasing blocksize is – at best – a temporary solution.  Let’s accept the premise that Bitcoin is going to be the world’s reserve currency for one euphoric moment; the world’s reserve currency must process more than 7 transactions per second and it must be essentially free.  The Segregated Witness upgrade has the same goal and makes an effective 4MB blocksize, To scale to an actual share of global commerce, off-chain or side-chain transactions will be absolutely required. However, these are more difficult for the lay-Bitcoin-user to understand and the sheer ease of comprehensibility seems to leave the public fixation on blocksize.  One important person in the space, computer scientist and cryptographer Nick Szabo, compared letting user sentiment to dictate blocksize to allowing people who get their residential power from nuclear energy to vote on how thick the reactor shielding is.  As one of the few people on Earth who is qualified to comment on both sides of the analogy, I’d say it’s somewhat hyperbolic but gets the point across. (n.b. This also highlights how active and socially invested the Bitcoin user community is.)

Secondly, the Rube-Goldberg “Emergency Difficulty Adjustment” algorithm that BCash used turned out to be a failed innovation.  The mining pools quickly figured out how to game the code to be able to mine tens of empty blocks in the time a single Bitcoin block was dutifully filled and added to the BTC blockchain.  Having your solution require a hard fork within four months of unveiling it is not a sign that your development team did a good job of systems engineering.  

BTC vs. BCH blocks mined per hour: https://fork.lol/blocks/time
Finally, the fees for BCH transactions are so low, not because they have the scaling solution, but rather because there are so few BCH transactions compared to Bitcoin.  In this case, the BCH promoters are passing off failure to adopt as a triumph of engineering.  Code can be ugly, but it will never compare to human behavior.  

BTC vs. BCH transactions chart source: https://fork.lol/tx/txs

By any measure, the group promoting BCash as “the new Bitcoin” is not acting ethically.  The “Bitcoin Cash” name and the BCash logo seems like it’s designed deliberately to confuse new cryptocurrency users.  The real intention is to co-opt the brand, which is why the BCash promoters are so adamant about its use. (Obviously, we – like many others – use the more sensible “BCash” over “Bitcoin Cash.”)  While personal character should not be an issue in the world of trustless, decentralized, payments, it is worth mentioning that two of the most prominent BCH promoters are are surrounded with a cloud of controversy.  Craig S. Wright is most famous for his fraudulent claim that he is Satoshi Nakomoto and Roger Ver is still shadowed by his defense of the solvency of the Mt. Gox exchange months before its collapse.  Ver was revealed as the owner of Bitcoin.com (not to be, but obviously will be, confused with Bitcoin.org) which pushes the BCash adoption agenda.  The internet is dripping with stories of users who confused the two even to the point of permanently losing funds by accidentally sending BTC to their BCH address.  

Worse than passively-confusing branding, the BCash promoters have been accused of astroturfing (fake grassroots) social media campaigns and even attacking the Bitcoin blockchain by spamming transactions from an armada of new nodes in order to drive up BTC transaction fees.  These two activities explain the weird price action and transaction backlog between November 10th and 12th, 2017.  This corresponded with a large social media presence of BCash “enthusiasts” with a coherent narrative about “the flippening.”  The market cap of BCH biefly hit the #2 cryptoasset spot, surpassing Ethereum before tumbling back down and the stories of new cryptocurrency investors who sold BTC for BCH at the high and were wiped out by the trade echoed through the same social media platforms.  

Why does ugly matter?  Well, in the brave new world of voluntary currency, brand loyalty matters.  Consider, for example, the outlandish undervaluation of Ripple, the much-despised “banker coin” until the pressure of market forces finally blew the lid off of it with a 50x price increase.  Users, merchants, and exchanges may now be scared to touch the stigmatized BCash project.  Even after they doubled their own blocksize, Twitter barely has enough characters to allow someone to defuse and qualify a post that isn’t explicitly anti-BCash.   In addition, the number of BCH core developers is already small and the path of destruction and disinformation the BCash project left behind it last month couldn’t possibly incentivize new developer talent to join the team.

The large US-based exchange Coinbase had a controversial take on the August split.  Initially, Coinbase said they would not support the fork and any user who wanted to control their BCash would have to move their Bitcoin off of the exchange to a wallet or supporting exchange in order to do so.  Their announcement gave fairly short notice and the user reaction was swift and vociferous.  In response, Coinbase relented and promised to allow users to access their “rightful” BCash as soon as they were able to engineer a solution.  The currently-projected timeline for that is the 1st of January, 2018.  So on New Year’s Day, millions of users (the exact number is unclear, but probably between 5 and 8 million) will have access to BCash equivalent to what they held in their accounts at the time of the fork.  Given the currently-implied number of active BCash users, the influx could be the day of reckoning for BCash, one way or another.

Where do we stand now?  Well, three weeks (half an eternity in crypto-time) after the November “attack,” BCH is still firmly trading in the $1000+ USD range.  The BCH/BTC chart, slinking off to the bottom right, suggests that “if you come at the king, you’d best not miss” might be the story.  If the trend holds, BCH might take its place as a solid alt-coin with huge blocks and low demand, great for online purchases at an airport’s duty-free shop.

In general, any fork of the most successful cryptocurrency with a new protocol must be considered seriously.  It seems, promotion aside, BCash is aiming at a ledger with lower transaction fees which is appealing for more day-to-day retail purchases in the developed world or more general currency in the rest of the world.  The most likely scenario is that the Bitcoin core adopts whichever BCash innovations prove successful and it’s not an either-or proposition.  They should understand the warning shot that was fired: Innovate and solve scaling problems or you’re forked.

The principals at SoundCrypto all have the BCH we received at the time of the August 2017 fork and plan on letting the price action tell us what the world decides.  However, we have been very active traders at times and are very tuned in to the space.  If you are starting to average into your first cryptocurrency position, it should be in Bitcoin and not be dissuaded by the marketing confusion and hype.

Cryptocurrencies are a new asset class.  The last major new asset class, common stock in companies, existed for hundreds of years before Benjamin Graham fully elucidated metrics for their valuation. Likewise cryptos exist and have market prices established through very liquid markets, but one of the first questions on any newly interested party’s lips is “well, what should a Bitcoin be worth though?”  

It’s an important and incompletely-answered question.  In fact, as I write this, I can think of maybe only three people who I could call “buy-side analysts” in the crypto space and each one is more interested in the abstract notion of valuation more than churning out BUY/HOLD/SELL ratings for the rafts of new coins and tokens entering the space.  In this series of posts, I’ll try to acquaint readers with some of the terminology and ideas behind cryptoasset valuation.  While this entire introductory paragraph is a long-form warning that this is an incomplete theory, it will involve many fundamental ideas of the space and some light is better than none.

Possibly the most natural idea is to note that the name is not just branding: cryptocurrencies satisfy all of the economic criteria to be labeled as a currency.  As such, we can apply any valuation models people have developed for currencies or money supplies.  The most successful valuation model is the “Quantity Theory of Money” which traces roots at least back to Nicholas Copernicus who took a break from revolutionizing cosmology to write down a quantitative theory of how people value multiple currencies and the effects of circulating new, debased, coinage.  The contemporary form of the quantity theory of money is expressed in the nearly-Newtonian simplicity of Irving Fischer’s Equation of Exchange: MV = PQ.

          M is the money supply in active circulation
          V is the “velocity of money”
          P is the price level of the currency
          Q is the output level of economic activity transacted in said currency

This equation is not controversial at all, in fact, it’s an identity.  The left hand, or supply, side is simply a measures the total amount of currency changing hands during some time period.  The right hand or, or demand, side measures the total amount of goods being exchanged over the same time period.  These two quantities must be equal.  Any contentiousness arises from the estimation of the individual parameters.  

Here’s an example use in valuation of Bitcoin that should illustrate how it works, using not-unreasonable estimates of the values.  First, the left-hand side, or supply side of the equation.  Let’s assume that 20% of Bitcoin is in active circulation, the rest being in wallets with lost private keys or held as an investment.  This makes M = 3.3 million Bitcoins.  Since the blockchain is public, we can see that there’s a bit more than 250,000 BTC of daily on-chain transactions.  That makes about 100 million BTC worth of transactions per year.  The yearly velocity of money, therefore, can be estimated at V = 30.  That is, each Bitcoin in circulation is spent about 30 times a year.

On the demand side, we need to understand the economy that Bitcoin is being used as a transactional basis for.  In the case of national currencies, PQ is the GDP of the nation using that currency.  However, since cryptoassets are trans-national, the question becomes “who is using Bitcoin and for what?”  Instead of explicitly breaking this down in terms of the price level of goods or services (P) times their amount (Q), we can just – again – note that PQ is the total amount of services transacted during the same amount of time used on the MV side.

Let’s say, for example, that 25% of the half-trillion dollar/year remittance market is transacted in Bitcoin and that’s the only thing Bitcoin is used for. This means the total yearly transactional demand is for $125 billion of currency.  This quantity is the entire right-hand side of the equation: price per average remittance (P) times number of remittance payments (Q).   So, we have PQ, however it’s denominated in USD instead of Bitcoin.  This is what lets us establish an exchange rate (R) between USD and BTC.  

3,300,000 Bitcoin x 30 yearly tx = $125,000,000,000 yearly tx / R

Solving for the exchange rate, R, in this estimate, we get a price of $1300/BTC.  Again, the numbers are representative, I am not saying this is a fair value.  In this context, the equation can be used to get some general trends and estimates of the markets Bitcoin is supporting.  

Let’s say, for example, that the 3.3 million active circulation and 250k BTC/day numbers hold, but Bitcoin use expands to support transactions of $1 Trillion per year.  The price of Bitcoin would find a natural level of $10,000.

Now, let’s say for example that the that the $125 billion yearly transaction and 250k BTC/day numbers hold, but investors and speculators cash out and release another 5 million Bitcoin into active circulation (for a total of 8.3 million).  The price of Bitcoin would find a natural level of $500.

You can see some of the slipperiness in these examples.  The barrier to entry for a cryptocurrency user is low and dropping all the time.  You could send a remittance in Bitcoin this month and Ether next month if the difference in fees justifies it.  Further, the price volatility could also lead to sharp swings in the number of circulated coins.

Here’s an example use in valuation of Bitcoin that should illustrate how it works, using not-unreasonable estimates of the values.  First, the left-hand side, or supply side of the equation.  Let’s assume that 20% of Bitcoin is in active circulation, the rest being in wallets with lost private keys or held as an investment.  This makes M = 3.3 million Bitcoins.  Since the blockchain is public, we can see that there’s a bit more than 250,000 BTC of daily on-chain transactions.  That makes about 100 million BTC worth of transactions per year.  The yearly velocity of money, therefore, can be estimated at V = 30.  That is, each Bitcoin in circulation is spent about 30 times a year.

On the demand side, we need to understand the economy that Bitcoin is being used as a transactional basis for.  In the case of national currencies, PQ is the GDP of the nation using that currency.  However, since cryptoassets are trans-national, the question becomes “who is using Bitcoin and for what?”  Instead of explicitly breaking this down in terms of the price level of goods or services (P) times their amount (Q), we can just – again – note that PQ is the total amount of services transacted during the same amount of time used on the MV side.

Let’s say, for example, that 25% of the half-trillion dollar/year remittance market is transacted in Bitcoin and that’s the only thing Bitcoin is used for. This means the total yearly transactional demand is for $125 billion of currency.  This quantity is the entire right-hand side of the equation: price per average remittance (P) times number of remittance payments (Q).   So, we have PQ, however it’s denominated in USD instead of Bitcoin.  This is what lets us establish an exchange rate (R) between USD and BTC.  

3,300,000 Bitcoin x 30 yearly tx = $125,000,000,000 yearly tx / R

Solving for the exchange rate, R, in this estimate, we get a price of $1300/BTC.  Again, the numbers are representative, I am not saying this is a fair value.  In this context, the equation can be used to get some general trends and estimates of the markets Bitcoin is supporting.  

Let’s say, for example, that the 3.3 million active circulation and 250k BTC/day numbers hold, but Bitcoin use expands to support transactions of $1 Trillion per year.  The price of Bitcoin would find a natural level of $10,000.

Now, let’s say for example that the that the $125 billion yearly transaction and 250k BTC/day numbers hold, but investors and speculators cash out and release another 5 million Bitcoin into active circulation (for a total of 8.3 million).  The price of Bitcoin would find a natural level of $500.

You can see some of the slipperiness in these examples.  The barrier to entry for a cryptocurrency user is low and dropping all the time.  You could send a remittance in Bitcoin this month and Ether next month if the difference in fees justifies it.  Further, the price volatility could also lead to sharp swings in the number of circulated coins.

In a sense, the valuation example above is somewhat post-priori since it’s easy to estimate M and V from the blockchain itself, but (for probably obvious reasons) the PQ side is harder to determine precisely.  This analysis can, however, be used in a predictive way for what some are calling “cryptocommodities.”  Imagine there is a services market worth some amount of money.   This could be cloud computing, or file storage services, power from a decentralized electrical grid – anything that can be accounted for accurately on a blockchain. A cryptocommodity is a coin or token that gives you the right to use those services, secured by the blockchain, provided by a network of users paid in said tokens or coins.  We can now do a quantitative analysis of what those coins should be worth by simply comparing the market cap of the coins or tokens to the market share of the services network controlled by the blockchain.  

Here’s an example with numbers which, again, are just ballpark estimates, not careful analysis.  Imagine there’s a token which is created to control access to solar energy on a power grid that spans a few countries across the European Union.  The project’s pitch is that it will reduce payment friction by avoiding international bank settlements and that using a blockchain with a dedicated token will get sellers and buyers paired quickly and without a multiplicity of claims on the same output.  

The analysis would proceed like this; the entire solar energy market in the EU is about €3 billion.  If you think this company might get a 10% market share, you can value the PQ side of the exchange equation as €300 million.  Now, for the MV side, you need to get into the weeds a bit.  You’ll need some domain-specific knowledge to model the user behavior.  Specifically, an estimate of how frequently people transact across the grid to purchase power and what their average purchase might be.  Further, you’ll need to model investor behavior and know any token inflation or pre-mine policy in order to estimate M. It’s not a science, but it can let you know if things are outrageously over or under-valued.

Even though the regulatory status of initial coin offerings (ICOs) is still up in the air in many jurisdictions, the ICO fundraising genie is out of the bottle.  In the next few years, this will be the sort of analysis going on at investment research firms.

In the next article, I’ll discuss valuations derived from the decentralized networks themselves.

Tether is a unique blockchain token that aims to maintain a peg to the United States Dollar.  That is, 1USDT (one Tether) is 1USD.  The claim is that they’re striving to bridge the world of fiat and crypto currencies by mapping the dollar onto a blockchain-based token.  In practice, the basic appeal to users is that you can use Tether as a haven of stability during (extra) volatile market periods or possibly try to avoid the taxable event of converting cryptocurrency to government fiat currency.  For the record, we’ve never recommended trying to do either of these things.

First, regardless of other issues, basic economics says this is difficult. Any currency peg requires the institution that maintains the fixed exchange rate to satisfy all buyers above the peg price and take any sales below it.  That is, they have to step in and fill the order book any time market forces push the price from the pegged rate.  Famously, George Soros made a fortune betting that the government of the UK would abandon their peg to the Deutschmark and the Swiss central bank gave up on a short-lived currency peg to the Euro in 2015 after taking savage losses.

Tether avoids this problem entirely by not supporting free USD/USDT exchanges, rather they simply assert that 1USDT = 1USD because there is a full reserve of USD.  It’s also important to note that there’s no withdrawal mechanism; Tether will not redeem Tether tokens for dollars.  When the Kraken exchange opened a true USD/USDT exchange all Tether did was sell them lots of the token, they did not actively intervene to guarantee price parity, so as of April of this year, you can track the risk and utility premium on the Tokens.  

Unlike a truly decentralized blockchain-based coin or token, Tether must have special relationships with the reserve bank holding the USD and the Tether-issuing exchanges.  Until March of 2017 Tether’s reserve bank was Wells Fargo and Tether’s sister company Bitfinex was the exchange on which new Tethers entered the market.

In March of 2017 the scheme started to unravel.  To begin with, huge capital inflows into the cryptocurrency space stressed all of the exchanges.  Then Wells Fargo stopped taking incoming transfers from the Taiwanese banks which were loaning money to Tether/Bitfinex.  A lawsuit and notice of voluntary dismissal followed shortly.  Tether initially claimed that it would not issue new tokens until a new banking partner could be found.  Within a few months, however, new Tether tokens were being released on Bitfinex.

Timeline of Tether’s price action and issuance (market cap)

Throughout the summer, many people active in the cryptocurrency space pointed out that without audits or announcements containing verifiable specifics, there was no way of knowing if or how Tether was maintaining the 1-1 USD reserve.  Regardless, new Tether tokens started entering the market in multi-million dollar lots, taking the total number from around $50 million to over $650 million at the time of writing this.  If there is no backing on the new Tethers, why commit such open and gluttonous fraud?  The simplest answer is that they’re being exchanged for actual crypto and real currencies on the Bitfinex exchange.  Further, the raging bull market in cryptocurrencies over this time means they’re exchanging the tokens they fabricate out of thin air for appreciating assets.  Pretty good scam as long as, (1) they’re solvent, (2) haven’t violated any banking or securities regulations, and (3) don’t face any litigation from users when the music stops.  

In parallel, a few anonymous, dedicated twitter and medium handles started making the case that the hundreds of millions of dollars of new Tethers were not simply being exchanged for Bitcoin and held as the price climbed.  Their contention is that exchange manipulation via wash trading and spoofing large orders was taking place.  In general, the claim is that this market manipulation is used to raise the price of Bitcoin, the main asset acquired for the now unbacked fiat-Tether tokens.  The chief self-appointed Tether watchdog writes and gives interviews under the pseudonym “Bitfinex’ed” and whoever operates the Bitfinex’ed handle has a deep enough knowledge of the mechanics of the corporate and exchange structure, that it’s conceivable that they’re a whistleblower instead of an outside party.

This week, the Tether exchange wallet was hacked for $31 million USDT.  In a sense, it’s incredibly irrelevant since Tether can simply freeze out those tokens and the only place where you can truly exchange USDT for USD is on Kraken.  Further, the market (non-)reaction recent Ethereum Parity wallet bug that blackholed around $300 million means that crypto users understand the difference in between third-party wallet software being insecure and the blockchain itself being sound.  …Or that the market is in such a solid upward trend that it shrugs off bad news like warm summer raindrops.  What the Tether wallet hack does do, however, is bring a lot of bright light into a situation that has been festering in darkness for half a year.  Yesterday’s NYT article not only saw a large mainstream publication pick up the story, but correctly conclude that the exchange was at risk.

What does this all mean?  The two issues are the exchange itself or entire Tether project being exposed as insolvent or fraudulent.  It’s hard to see how Bitfinex could lose money since turning unbacked tokens into Bitcoin is hardly malinvestment, but it’s also hard to underestimate the power of greed in making bad decisions.  If Bitfinex goes down, taking a majority of user funds with it, it would definitely be a step backwards in courting public opinion, as was Silk Road and Mt. Gox.  From an institutional financial perspective, the overall health of the cryptocurrency ecosystem is much better than during the Mt. Gox days –  there are over 15 reasonably liquid Bitcoin exchanges in the world.  As far as the Tether project blowing up, the notional value of Tether tokens at the moment is about $650 million, about 7% of the daily volume of Bitcoin transactions, so also not much.  If there’s a systemic risk from loss of confidence in Tether it’s the fact that Tether is frequently used to facilitate transfers between exchanges, but that’s the basic function of any cryptocurrency, so you don’t need Tether to do that.

The Kraken USD/USDT market should be something of a canary in the coal mine, but preparing for the worst really just means not using Bitfinex or double-checking your portfolio against best practices.

With that, it’s broken record time.  The best security is to trust the blockchain; hold your own keys, use cold-storage, use a hardware or other physical wallet.  If you do trade or rebalance actively, know your exchange.  Proof of reserves is one of the simplest blockchain transactions possible, good exchanges do it regularly.  More philosophically, if the Bitfinex allegations turn out to be correct, it is worth noting that the private citizens using public data were able to sound the alarm over six months ago.

Bitcoin is growing up.  Don’t cheer yet; what I mean is that the markets’ enfant terrible just got the financial equivalent of a Driver’s License …and, to push the metaphor, is also of legal drinking age.  Cryptocurrency derivatives have arrived.  

LedgerX, a Bitcoin swap and options clearinghouse with CFTC approval, went live in what they’re terming a “soft launch” in which a few invited participants essentially beta-test-for-keepsies their platform.  Their soft launch exceeded volume expectations and millions of USD in notional value has already been transacted.  Further, according to the Wall Street Journal the CME is considering launching BTC futures contracts.  

This could mean a lot.  The ability to create portfolio insurance products for crypto assets could finally convince more conservative players to enter the space.  Hedging through very liquid exchanges could facilitate transactional use (y’know, the thing cryptos were invented for in the first place….)  There will be no shortage of speculation on the bullish side of ramifications of crypto derivatives, so I will leave that alone.  Conversely, however, the new options market could incentivize blockchain attacks which the game theory of decentralized payment systems has generally precluded up until now.  

In a market environment where shorting is difficult, “51%” attacks on the blockchain are generally a bad strategy since the miner is also attacking the value of the asset he’s trying to acquire or double-spend.  It’s more profitable to be a good actor and simply race to verify blocks.  This alignment of incentives for miners, holders [sic], and spenders is one of the things that makes Bitcoin work better in practice than it does in theory.  With the derivatives and futures market, you can now take a position that rewards you for attacking the blockchain.  This is the so-called “Goldfinger” attack (If you don’t get the reference, you have an excuse to rewatch a classic Bond film).

Here’s a Bitcoin Goldfinger attack scenario.  You are one of the largest Bitcoin mining farms.  Minin’ ain’t easy; in addition to your hard-working depreciating ASICs, you have Moore’s Law as a headwind, new players are entering the space, your relationship with your government may be tenuous, ever-shifting, unclear (looking at you, China).  Finally, the BTC/local currency price starts softening.  There goes your margin in a blaze of red candlesticks.  Alluringly, there is a highly liquid, deep, derivatives market for BTC.  Why not load up on cheap, out of the money puts and short futures contracts then double-spend transactions, spam nodes, move your hashing power to another SHA-256 protocol.  If you have some political clout in the community propose a frivolous fork with some complicit developers to undermine trust.  Basically, the a laundry list of attacks that the trustless payment systems are subject to.  

This is admittedly an extreme depiction, but miners, cabals of nodes, rogue developers can do a subset of these attacks.  Even a well-heeled investment bank trading desk could buy hash power to supplement some old-fashioned market manipulation.

What can you do about this?  You should stay away from margin accounts of all types and don’t use stop loss orders even in liquid exchanges.  Honestly, BTCUSD is so volatile that those are good practices anyways.  You can keep an eye on the futures and options markets or a service that does so for you.  Most importantly, realize that this is a required step in the growth of cryptocurrencies.  Stocks, bonds, and traded currencies all are subject to coordinated selling campaigns, activist investor litigation, public sentiment and market manipulation.  This has been going on since at least the 17th century in the Netherlands.  Bitcoin must also survive bear raids as it becomes more ubiquitous, it’s simply that the tools at the bears’ disposal are different because the asset class is different as well.

Admittedly, cryptocurrency ownership has some enervating aspects.  Depending on how much you like rollercoasters, one of those aspects might be the volatility. However, the irreversibility and the overall Code Is Law ethic of blockchain should inspire caution and respect.

This is especially true if you’ve gotten complacent about centralized commercial services like credit cards giving almost painless mulligans on fraudulent transactions.  Not only is there no such process for “fraudulent” crypto transactions, even the FDIC insurance on exchanges protects you only against solvency events at the exchanges, not against your account being hacked or even making a fat-finger transaction.  Between this and the swelling value of the crypto space, interest from hackers has surged, but the dry irony here is that the essential technology some hackers use to crack your two-factor-authenticated crypto-wallet is their vocal chords.

While the image of the popular image of a hacker is someone whose absent social skills are compensated for by the ability to seduce computer networks, the majority of hacks actually occur through what’s called “social engineering.”  A dramatic example of social engineering would be someone dressing up as an employee of a company they don’t work for and fast-talking their way into a secure area to get direct physical access to computing equipment or records.  More prosaically, phishing is a social engineering attack since the victim is tricked into simply offering their sensitive private information under false pretenses.

Here are a couple of narratives from people who have recently been crypto-hacked through the social engineering of their phone service providers.  They are brief reads and highly worthwhile because many online financial products share the same vulnerability.

How to lose 8k worth of Bitcoin in 15 minutes with Verizon and Coinbase.com
Hackers have stolen millions of dollars in Bitcoin using only phone numbers

The bad news here is that your financial security could suddenly be thrust into the hands of a minimum wage employee at a T-Mobile storefront in a stripmall.  The good news is that we can see a pattern for the attacks and we can distill some best practices from these stories.

As the increasingly anachronistic saying goes, it’s unlucky to light three cigarettes on one match.  Supposedly, this originated in the trenches of the first World War.  The rationale is that the first glow of light would alert the sharpshooter to your presence.  The second flare of light would let him get the range, and with the third, he would get the windage and fire.  Likewise, a social engineer operates this scheme by first becoming aware that you own crypto holdings that are worth hacking.  Next, they scrape your two-factor info (e.g. phone number) from the same place or maybe a personal webpage or Facebook.  Finally, your email address and – bang – they’re ready to hijack your life.  To see just how innocuous-seeming the information that a good social engineer could use to roll a bad Verizon employee, we present a vignette of bad security practices in the following seemingly-unrelated fake tweets.  (Note: No political subtext here, faketrumptweet.com is just fun to use)

For a normal private citizen, this might seem like a fairly sloppy, but not really outrageous, husbandry of information – after all Facebook default settings let “friends” see the phone number they constantly beg you to link to your account.  However, this is absolutely enough information for a social engineer to go to work trying to find and transfer control of the phone number, reset the email password and get access to anything linked to that email.   Even worse, if one of your contact’s phones or emails is compromised by a crypto-savvy hacker, they could get all the requisite information for a social engineering attack through a single message you sent that contact, bragging about how much your crypto-portfolio went up that week.  This bears repeating: not only do you need to trust anyone who has the contact info linked to your financial accounts not to try to hack you, but you also have to trust them not to get hacked themselves.

What can we take from this?   Well, maybe the first rule of crypto-club is don’t talk about crypto-club.  Admittedly, this statement is an absolute and part of the joy and part of the ability to succeed in the space is sharing information.  So we can put some shades of grey on this slogan and say that you shouldn’t advertise on open public forums like Twitter that you have a big stake in crypto.  This is not a new security maxim, flaunting wealth always increases attention and risk.  The only difference here is that you can get “mugged” remotely.

Next, protect the contact information that you have associated with your crypto-currency holdings.  If you are a public-facing person; separate the email addresses associated with your financial life from the ones you distribute widely.  Think about using VoIP or a business line to protect your personal number.  Most importantly, if your banks and exchanges allow it, you should use a 2FA service (like Google Authenticate, Duo, or Authy) that is not SMS through a large cell service provider.  As always, if you are not actively trading, use cold storage and hardware wallets.

What could financial service providers (from Coinbase to Wells Fargo) do to help?  Non-SMS 2FA is stronger and users should push for the option where it doesn’t exist.  Exchanges could allow users to opt for transaction freezes for some amount of time after their password is reset, at least giving them some time to regain control of their identity before hackers can move funds.  Needless to say, for this particular attack, the cell providers are the weak link and should make and carefully enforce rules like no replacement SIM cards without government photo ID.

It’s unclear how common the scam is, but it’s absolutely a growth industry.  We noticed that our corporate twitter page was almost instantly followed by what seemed to be sock-puppet accounts, a few of which were shut down within a day.  They were probably just garden-variety spammers, but more insidiously, they could have been scraping the feed for any of the bits of contact information.  …Bad hombres?  Scary!

“Bitcoin isn’t real!”  I’ve seen this objection in variants with up to three exclamation points, so it really must be self-evident.  Perhaps it’s only the crypto-zealots and those poor people who they momentarily beguile with mathematical proofs who are so lumpen as to not understand.
Maybe if one just repeats “it’s not real” three times while clicking the heels of their loafers, they will be transported away from the phantasmagorical world where Bloomberg talks about blockchain and back to the rational sanity of Collateralized Debt Obligations.  Maybe that’s too much, but certainly “it’s not real” is the slogan for those who believe the future holds some Emperor’s New Clothes moment for this silly computer money and in a few years we’ll all laugh about the people who paid $6,000 for some 1s and 0s.  I’m not going to weigh in on whether it’s currently over or under-valued here, but Bitcoin is as real as the United States Dollar.

First, we do need to get a little metaphysical and define what “reality” is in this particular context (beyond that, you’re on your own).  I’ll break this into two aspects, tangibility and intrinsic value. Tangibility means that the realness of currency is manifested by the fact that it could be in the sole physical possession of the owner, secured from corruption to the best of the owner’s abilities. Additionally, a currency (technically, at that point it’s more properly referred to as “money”) is real if it represents a unique claim on something that has value beyond fad or convention.  If this seems a bit abstract, that’s the nature of modern fiat currencies rather than an attempt to move the goalposts for crypto.   In short, it’s real if you can throw it in a safe and estimate what it’s worth without mark-to-market data relative to another currency.  Sound fair?

From here on, I’ll be casual about “currency” versus “money” because it’s not important, and if you’re well-versed on those semantics, you probably already own crypto.  It is definitely worth reminding yourself about the components of the money supply (M0, M1, M2, M3) to follow along.  Finally, I will typically refer to Bitcoin, but all cryptocurrencies have the network effect and physical wallet features, so the argument is generic.

Cryptocurrency is not required to be in physical existence.  That’s kind of the whole point.  We know, of course, that the money in our checking accounts isn’t tangible either so a precise statement of why this bugs people might sound something like “I could convert to cash and take possession of the money in my bank account, and that gives me some peace of mind about the whole wacky scheme.” Perhaps surprisingly, not only could you take possession of and physically transact your crypto-currency if you wanted, you could do it more easily and in a more robust way.

If you are not familiar with the concept of a paper wallet, the idea is that crypto users can create and print or load the all the information (address and private key) required to control some amount of Bitcoin on paper or a thumb drive.  As a practical example of why you might do this, let’s say that you have some Bitcoin and you suspect the security of your exchange or computer or maybe you want to show some serious class and give your grandkids Bitcoin for the holidays, but – as we all know – giving someone something without actually physically giving someone something just isn’t the same.  No problem, you create one uniquely-addressed paper wallet or drive for each “crypto-bill,” in whatever denominations you want; 1BTC, 3.1415BTC, 0.00002BTC, whatever.  The two operations that we apply to bills and coins – authenticate and transact – work just as well with the crypto-bills, albeit differently.  Someone can verify the amount in the wallet using only its address, analogous to looking at the denomination of the currency and checking that it’s not counterfeit.  You can transfer the amount to them by handing over the private key (the recipient should transfer it to a different wallet they’ve always controlled ASAP of course).

Aside from the aesthetic plus of being able to make your own crypto-bills of arbitrary denomination, two things distinguish this physical or M0-like cryptocurrency as superior to bills and coins. First, consider the mother of all bank runs.  The danger in a bank run is that there is more value in the other components of the money supply than there is in cash, so the promise of cash convertibility cannot always be honored.  The typical nation’s fiat money supply can be 90% unphysical, so the worst case scenario bank run is a game of musical chairs with one chair and ten people.  A good exercise would be to imagine asking the people in lines around banks and ATMs which have broken out in Venezuela, Greece, or India how real their money is.  Conversely, if everyone suddenly decides to physically instantiate all 16.5 million Bitcoin as paper wallet crypto-bills in the manner described above, perhaps a few office supply stores would see a bump in printer ink sales.

Secondly, since the address and private key constitute the complete set of information required to control a paper wallet, you can (and should) make a copy of that information to guard against destruction.  Conversely, if the family dog eats a $100 bill you left on the table, having a photocopy of the lost bill won’t do you any good.  Chalk up another plus for the paper wallet crypto-bill.

Certainly, nobody is suggesting that this is how crypto should be used and a profound advantage of cash is that even paper wallets require access to the blockchain to verify and safely transact.  One will not completely supplant the other.  The issue here is more historical than anything else; in the components of money supply M0, M1, M2… we see the phylogeny of money itself where the physical evolves into the electronic, each more awkward and derivative than the last. (n.b. The Fed itself stopped tracking M3 or “broad money” with precision in 2006, presumably because it’s too “real” to quantify, I guess.)  Since cryptocurrencies are designed to be fast and electronic, the awkwardness occurs when you go the other way and impose the atavism of replicating M0.  But, again, if you want a coffee can of Bitcoin hidden in the attic, you can do that.

(Crypto mining farm. from: https://pool.bitcoin.com/index_en.html)

(Printing $50 bills. from: https://www.moneyfactory.gov/hmimlepe.html)

The second aspect of the realness objection is the claim that cryptocurrencies aren’t anchored to any asset or institution to which we can assign value.  This is an era of fiat currencies for certain, but a national monetary supply at least has the possibility, if not outright insinuation, that it could be collateralized by national assets (public lands, goods, precious metal stores, threat of force) as an ultimate backstop.  In the past, failing national currencies have been repaired or replaced by such collateralization.  Famously, the damage from Louis XIV and Weimar Germany’s monetary excesses were halted with land-bank currencies.  It’s hardly a gold standard, but isn’t that more than crypto?  After all, what are 1’s and 0’s worth?  First, the nitpick objections: there is no reason why a cryptocurrency can’t explicitly hold reserves of something with more widely accepted value.  In fact, one coin (Tether: www.tether.to) maintains a reservoir USD at parity, one USD to one Tether coin. (n.b. we are not endorsing Tether …at all. )

Even without an explicit Fort Knox, all cryptocurrencies are tied to an intrinsically-valuable service; namely inexpensive, swift, and secure transactions.  I will appeal to Adam Smith’s view on value and say that fundamental worth of something is in its productive capacity.  Saying a Bitcoin wallet is worthless because it’s a ghost on a hard drive analogous to calculating a valuation of Hong Kong real estate based on the mineral wealth of the land (none) and arability of the soil (nope).   Serious quantitative work on how to value networks of transactions through ideas like Metcalfe’s law is fairly young, but minimally all networks working to use and verify blockchain have the value that their services provide.  I’m not expecting anyone to be totally blown away by arcana about network scaling laws, but the basic fact is that the ability to have secure nearly-instant transactions from a user in Oslo to someone in Ghana does have value and Bitcoin will only “go to zero” when absolutely nobody is willing to incentivize others to perform such services.  This can happen, but it will be when the protocol in question (Bitcoin, for example) is completely supplanted by better networks that do a better job.  Specifically, this will require a long blockchain, tested protocols, lots of independent nodes and that will take time.

Other cryptocurrencies provide or represent additional specific services that hold intrinsic value as well.  Currently, the most important of these, from both a market cap and interest point of view, is the Ethereum network.  An ETH token is convertible to an amount of computing power which allows users to have code executed on the blockchain.  It’s just about as complicated as it sounds, but the point is that Ether tokens represent an amount of computing power that the network is obliged to execute.  There are also applications tied to cryptocurrencies that represent the right to use some amount of distributed file storage (Storj, Siacoin) and as with Ethereum, one could calculate the market rate for these services to assign a sort of “book value” for the cryptocurrency.  The point, again, is that there is a very non-speculative intrinsic value which is generally secured by the mathematical legislation of computer code instead of trust that political exigencies would force nation states to intercede to “restore faith in the currency.”

Just to put some crude real-life comparison to this, the world is currently valuing the Ethereum network of transactions, smart contract framework and computing power as roughly equal to the “faith and credit” inferred to exist in Ecuador’s non-physical money supply.  Which would you rather have a 1% claim on?  Regardless of your decision, if you had to think about it, you’ve admitted that we’re dealing with more than digital tulips.  A full list of the institutions that are supporting or collaborating with the Ethereum project can be found here (insert link).  In full disclosure, I picked Ecuador because of the size of their money supply compared to ETH’s market cap at the time of writing this, but I would be remiss not to  point out that the faith and credit in their currency collapsed in 2000 forcing Ecuador to abandon their currency and use the USD as legal tender.  You may change your answer to the above question, nobody will judge you.

Do an image search on “Bitcoin” and you’ll see the psychological crux of the “it’s not real” objection.  Almost invariably The Bitcoin is depicted as a circular medallion cast from some precious metal.  Even people in the crypto space themselves, those supposedly not benighted by the dogmas of tradition, seemingly can’t help but make an idol for Bitcoin.   In a sense, the realness objection is more of an alien-ness objection; because we haven’t been immersed in these ideas for our entire lives, we need to distill and carefully verify that each of the aspects that make sovereign currencies useful and trusted and “real” have an analog in the cryptocurrency space.  Can the QR code and private key replace the role of the watermark?  Can the robust computational network replace the role of nation state’s backing as legal tender?  They can, we just need to develop and use the correct tools to evaluate their health.