In this article I attempt to describe how cryptocurrencies may benefit us and the economics at their core. I also provide a vision for a future improved by cryptocurrencies and blockchain.
A couple of years ago, I wrote this post explaining cryptocurrencies to the layperson. Having done some serious thinking on the matter during the cryptocurrency craze of the last few months, I felt the need for a part 2. The original post now seems overly simplistic in merely covering trust itself as something of value. It also does not go beyond Bitcoin, but the cryptocurrency universe is much larger and more varied than just Bitcoin.
Caveats & disclosure:
- This article is not financial advice. Do not make investment decisions based on a single person’s views in a new and risky field such as cryptocurrency.
- This article is not endorsed by my employer. The views expressed within are my own.
- I own cryptocurrency.
This article will cover three areas:
- Selected use cases
- A vision of the future
Selected use cases
I have identified a limited selection of cryptocurrency use cases. For the purposes of this article, I will not draw a distinction between blockchains and tokens running on blockchains.
Many blockchains provide payment functionality that is faster and therefore more convenient than Bitcoin. If a few cryptocurrencies become popular and genuinely useful as payment mechanisms, we can imagine a future where we can quickly and instantly use our cryptocurrency wallets to make payments as part of our daily lives. Cross-border transactions are a huge advantage of cryptocurrencies in that they can take place over seconds or minutes, while the equivalent fiat currency (government currencies such as the US Dollar, Euro, etc.) transactions using traditional financial services still take days, are expensive, require users to provide various pieces of documentation and sometimes the transactions still fail for various reasons.
Non-fungible tokens (NFTs)
NFTs are unique cryptocurrency tokens that have special characteristics, which are not 1:1 exchangeable with other NFTs. Cryptokitties was a phenomenon where tokens of unique cats with various properties were released onto the Ethereum blockchain. A kitty called Dragon, was acquired by a collector for 600 ETH in 2018 (US $170,000 at the time). The kitties can “breed” other kitties, which can then be sold to other collectors, thus providing “value” beyond just the aesthetics of the kitty. Today, other digital art collectibles are also sold online, including paintings and GIF artworks. While people do buy and sell these items, this use case is mystifying. A digital painting or GIF can be easily replicated. A picture provided on the website effectively gives away the artwork. A user may right-click and save the file to their computer, without paying for it.
Tokenisation of real-world assets
Certain kinds of real-world assets may be too expensive for individual investors to buy – or traditionally may only have been available for people in a certain location or connected to the right brokers. People are now attempting to put such assets on the blockchain, allowing investors across the globe to invest, and enabling them to invest in small fractions or large chunks that are precisely what they want to invest. Having done this, they are able to trade the tokens among each other easily without having to go through a lot of bureaucracy and hassle – at least that is the idea. Sometimes these are registered as financial instruments with the respective securities regulators of applicable jurisdictions and sold as “securities token offerings” (STOs). There is a secondary market for tokenised real estate, but time will tell as to how liquid or practical it ultimately turns out to be. Obviously, real estate is not the only real-world asset that can be tokenised, but it is one of the most interesting use cases, given the utility of fractionalising something that is typically rather expensive. Could tokenisation have been done without the blockchain? Yes, it could and perhaps it has already been done. It just happens that people took up the momentum that came with cryptocurrency in the finance field and ran with it.
Utility tokens are tokens that provide access to a service. Examples of such services include cryptocurrency exchanges, cryptocurrency ATMs and others (including services that are not cryptocurrency-specific). In most cases, these services would be accessible for a fee paid in the local fiat currency, e.g. an exchange may take a fee of 0.25% for every trade performed on it. If paid in the exchange’s token, they may give you a 10-30% discount on the fee at the current value of the token. If you are a heavy user of that exchange, it would make sense for you to hold that token. In the initial coin offering (ICO) boom of 2017, hundreds of such utility tokens were created. Some of these even turned out to be scams (e.g. OneCoin, Centra, etc.) where the promoters took the money and failed to deliver the products. However, a number of utility tokens from that period are still active as of 2021, and some of these increased drastically in value as their platforms are now providing useful services.
Decentralised Finance (DeFi)
DeFi brings additional aspects of traditional finance outside the sphere of traditional financial institutions in a manner that significantly increases users’ participation in the financial sector. It enables people to ask for and get loans in minutes rather than days, without needing to fill in paperwork, without needing to pass institutional gatekeepers or a variety of hurdles. One must remember that the traditional gatekeepers do perform relevant functions such as due diligence on the borrower, whether they are using the loan for malicious activities, etc. Given that cryptocurrency began as a way to get around governments and banks, the removal of these safeguards (and consequently their benefits) is understandable. Likewise DeFi solutions enable people to trade their cryptocurrency tokens at decentralised exchanges (DEXes) – without ever needing to actually provide their information or even the tokens to the exchange, instead allowing them to directly transact with the other party. Crowdfunding is another capability that is now being enabled by DeFi. All of these come with their risks: decentralised finance reduces the likelihood that the provider of the service could be obliged to do right by their “customers”. A DEX could lose its customers money if malicious hackers attack its protocols. Hackers have previously attacked DeFi lending platforms, making money for themselves by manipulating the prices of tokens, and then leaving the remaining participants with tokens which they were unable to sell.
We now come back to the challenging effort to ascertain value of the cryptocurrency.
Bitcoin originated the model where the token would be “mined” by competing “miners” from the very first block. A pre-programmed hard limit of 21 million Bitcoins let everyone know how many Bitcoin there would ever be. This gave it scarcity while ensuring it would not succeed in its stated goal as being a peer-to-peer payment system. The scarcity causes people to believe that its value will increase, thereby making users hold on to Bitcoin rather than transact with it. The energy-intensive mining process is terrible for the environment at a time when global warming is an essential news topic. Bitcoin is now considered to be a store of value rather than a medium of exchange.
Cryptocurrencies and tokens that followed have learned some lessons from the proof of concept that is Bitcoin. Founders of various blockchain projects (e.g. Ethereum, Cardano, Binance, etc.) needed to raise money to fund their projects. They also wanted to ensure that they would be handsomely rewarded for their pioneering efforts. This resulted in the concept of “minting”, i.e. tokens would be generated in a similar way to how your central bank creates new money, i.e. by typing a number with the appropriate number of zeros at the end into a program. These would be shared with the founders and early big investors. New tokens would then continue to be created and released, with either a fixed supply or a planned rate of inflation, depending upon the exact objectives of the project. Small investors and later users would continue to get a share of the new tokens via a scheme that would bring about the right balance of appropriate reward for early stakeholders and good incentives for new users to continue to use the platform. In order to ensure that the developers and early investors do not ditch their tokens as soon as it hits the market, most tokens these days have a “vesting schedule” that, for instance, limits the number of tokens they can sell each year. “Tokenomics” is the name given for the economics of cryptocurrency tokens.
A cryptocurrency’s success depends on many factors:
- A genuine use case that goes beyond mere speculation
- The quality of the technology
- The talent of the immediate team
- An engaged user community
- The developer ecosystem
- The application ecosystem and partnerships
- An effective incentive mechanism through tokenomics
Bad tokenomics and scams are aplenty. A token that enables founders and early investors to sell early is at risk of collapse if early investors flood the market with their cryptocurrency and exit. This has also happened for a number of cases where coordinated actors artificially pumped the value of tokens before dumping (“pump and dump”) them onto the newbies who were left holding the bag with nobody to sell to. Poorly designed tokenomics may prevent users from transacting with the token or otherwise using it in a manner that benefits the ecosystem.
A vision of the future
This brings me to the key point of this article. Investing (gambling?) in cryptocurrency is risky, but some cryptocurrencies have been through the “Crypto Winter” of 2018-2019 and have emerged the better for it. Supporting a cryptocurrency project today could be likened to supporting an information technology company in the 1990s, i.e. it would be an investment in the future of technology and finance. We do not know if the project we are supporting would be tomorrow’s Amazon or Paypal on the one hand – or tomorrow’s Pets.com on the other. If you have not heard of Pets.com, that is because it shut down in the Dot Com crash of 2000, losing investors a lot of money, with its shares dropping from $11 at IPO to $0.19 when its liquidation was announced. However, we can make some educated assessments based on the success factors I mentioned previously.
I made this analogy to a colleague who advised me that he was risk averse. “I would invest in the shares of the companies that provide blockchain services”, he told me. But what if the companies of the future do not publicly offer shares at all? Capital investments in the blockchain and cryptocurrency space have really been made through investors buying up tokens during the ICO (technically they are “investors” only if it was an STO, but who really believes that people who bought utility tokens did so because they expected to use up all the tokens on the service?). In some cases (but not all), tokens even provide some level of influence over how the corresponding blockchain is to be run (if it is a blockchain project, and not merely a technology service).
We pay our cloud computing bills in fiat currency. Your Apple iCloud, Microsoft OneDrive or Google Drive bills are paid in fiat. Likewise if you or your company hosts websites or applications on the cloud. In the future, some of your technology providers may be cryptocurrency-related, with payments possible in fiat or cryptocurrency.
New blockchain companies have built upon the “decentralisation” ethos and applied it to their organisation structures. Few have entirely done away with organisational hierarchies, but there are organisations with teams spread across the globe and individuals working from within the comfort of their home or nearby cafe (or a low cost-of-living tropical location), so long as they can make themselves available for the weekly conference call and deliver their work. Could we see a future in which developers work on their own time without a contract bound by the laws of any country, but perhaps with an agreement that is visible to the public and clarified in code?
Could the blockchain and cryptocurrency experiments fail? Yes, there have already been failures and scams and there will certainly be more. But the time may come when some of these work well enough that the failures are the exceptions and we see blockchain as an obvious progression in the evolution of technology and financial businesses. We need to prepare for it today.
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If you are looking for technology advice, audit services, etc. regarding your blockchain or cryptocurrency efforts, reach out to me via the Contact Form or LinkedIn. I do not offer advice regarding cryptocurrency prices or investment. I am also not interested to invest in your cryptocurrency.