Introduction to Cryptocurrencies and Blockchains

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We have received quite a few questions about cryptocurrencies over the past several weeks, ostensibly driven by the recent parabolic appreciation of many cryptocurrencies such as bitcoin and ether. Blockchain technology and cryptocurrencies are an area that we have watched grow for the past several years, although it has received scant interest beyond the fintech (financial technology) community. However, given the recent attention, we feel it is important to publish our thinking and position.

What is blockchain?

Headlines often highlight cryptocurrencies, but blockchains are the starting point to understanding them. For the purposes of this post, a blockchain is simply a database that facilitates financial transactions. Among other things, blockchains represents a new method of facilitating transactions and transfers.

Clearly, blockchains are complex, but we will not cover the technical details or nuances of blockchain technology in this post. However, we do think that blockchain technology holds a lot of promise. To date, it has demonstrated quite a few benefits, but these come with some drawbacks and risks as well.

What is a cryptocurrency?

A cryptocurrency is a "token" that can be used within the blockchain. These tokens or "coins" act as a currency within the blockchain. For instance, a bitcoin can be used on the bitcoin blockchain and ether is the crytocurrency of the Ethereum blockchain.

What is the point blockchains and cryptocurrencies?

As mentioned above, blockchain technology holds a lot of promise and there are a lot of new participants working to develop blockchains and solve for the existing drawbacks and risks. Startups typically seek venture capital funding and/or participate in an initial public offering (IPO) to raise capital. However, blockchain entrepreneurs have begun to raise capital via initial coin offerings (ICO). That is, they create a cryptocurrency that can be used on their prospective blockchain and sell this cryptocurrency to investors. They then use the money raised for rent, payroll, overhead expenses, software development, and so on.

Let's imagine a traditional business instead of a blockchain:

  1. Imagine that when Amazon was getting started, they created a cryptocurrency that could be used in lieu of US dollars on its prospective site. In fact, all purchases on the prospective site will need to be made with this cryptocurrency. US dollars will need to be converted to cryptocurrency prior to purchase.
  2. Instead of raising money through venture capital firms and an IPO, Amazon sells the cryptocurrency that they created to raise money through an ICO.
  3. If Amazon is successful, the owners of the cryptocurrency can use it to purchase things on Amazon.

There are a few key differences, however:

  1. ICOs are unregulated, whereas IPOs require extensive disclosures to investors and regulators (such as the SEC)
  2. Tokens/coins/cryptocurrency are neither equity nor debt. They do not confer ownership or creditor rights to their holders.

What value does cryptocurrency have?

Tokens are the medium of exchange on a blockchain, which is why people refer to them as currencies. By definition, anything that is commonly accepted as a medium of exchange has some value simply because it can be exchanged for something else. For instance, paper money has no value except for the fact that it can be used to purchase things like food and drink, a car, investments, and so on.

So the incentive to purchase a cryptocurrency is that its blockchain will become a viable network that will be used to transact. If the blockchain is widely used (such as the bitcoin blockchain), then the cryptocurrency will have value because it can be exchanged for other things like traditional currencies or goods/services. This parallels traditional currencies; most countries have their own currencies and all business within that country is transacted in the official currency. If, however, the country collapses, then the currency often becomes worthless.

What drives the value of cryptocurrency?

If the underlying blockchain grows and attracts users, then the cryptocurrency will have value. If the underlying blockchain fails to launch or fails to attract a critical mass of users, then the cryptocurrency will not be very useful and demand for it will diminish. Things with no demand also have no value. So the long-term investment proposition of a cryptocurrency is that its blockchain will be widely used. 

So it is a bet on blockchains?

Although cryptocurrencies are not equity, the practical implication is that a cryptocurrency investment is a bet on its blockchain. Of course, there are some that see cryptocurrencies as short-term trading vehicles as well, in which case cryptocurrencies do not differ much from stocks or wheat futures or any other financial instrument.

Final Thoughts on Allocating:

  • The first thing to know is that this entire space is unregulated and there have been some high-profile cases of fraud and theft. 
  • For investors that want to allocate to cryptocurrencies, consider the following:
    • Cryptocurrencies have exhibited extreme volatility. Although they have appreciated lately, they have also experienced massive drawdowns. We would never recommend investing more than a very small amount in something that could easily lose 80, 90, or 100%.
    • On the flip side, an early investment in any venture can appreciate many times over.
    • Thus, we have counseled clients to only invest money that they would not mind losing.
  • Diversification is important. New technologies invite large numbers of early participants. Even when a new technology is massively successful, many of the early participants go bust. The automobile was adopted globally, yet few of the original automakers survive today. One hundred years later, social media enveloped the globe, but today nobody uses the original networks like Friendster or MySpace (despite once sky-high expectations and valuations from venture capitalists).

To date, we have advised inquiring clients to educate themselves on cryptocurrencies and invest if they are very interested, but only in amounts that they would not mind losing. Diversification is paramount.

We continue to observe the space and evaluate it for potential opportunities. To date, we have not found opportunities that we can make sizable allocations to with a favorable risk/return profiles. However, we do see some promising future opportunities and will keep you updated.