by Martin de Bruyn, CFA, CFP®

Please note that anyone can invest in cryptocurrencies, but it is unregulated and as such nothing written here should be construed as advice. It is merely meant to enlighten the reader as to the opportunities and risks in this space. SARS, SARB and the FSCA is currently working on how best to regulate cryptoassets.

In part 2, we dive into the crypto landscape.

Bitcoin is not the only cryptoasset. According to the popular data aggregator CoinMarketCap, more than 6,000 different cryptoassets exist, and many new ones are created each month. Although most of these assets are small, many are valued at more than $1 billion.  There are three critical questions that need to be answered:

– Why does more than one cryptoasset exist?

– Does the existence of thousands of cryptoassets damage the “scarcity” of an asset such as bitcoin?

– Do you need a cryptoasset to have a blockchain?

Why does more than one Cryptoasset exist?

Multiple cryptoassets exist and are thriving because their underlying blockchains are optimized for different uses.

The blockchain technology tied to each cryp­toasset is simply software. Any two block­chains are similar types of software, but they can be programmed to serve very different uses. Consider this analogy: Both Microsoft and Oracle are software companies, but their software products are designed to do different things.

The impact of these optimizations is best explored by comparing bitcoin’s blockchain with that of the next-largest cryptoassets.

Bitcoin vs. Ethereum

Bitcoin’s blockchain—the first ever launched—is in certain ways simple. As a piece of software, it allows for only a very narrow set of types of transactions: You can program it to send, receive, or hold bitcoin and to set up very sim­ple escrow- and trust-style accounts.

Ethereum, the second-largest cryptoasset by market cap, was conceived in 2013 and launched in 2015 with the idea of expand­ing that list of capabilities. In fact, Ethereum’s developers designed it to be “Turing complete,” a computer science term that means it can be programmed to do anything a general computer can do. By offering the ability to program any type of transaction, Ethereum has established itself as the platform of choice for the “pro­grammable money” use case. To date, people have replicated everything from collateralized loans to IPO-style fundraising efforts using Ethereum-based “smart contracts.” People have even built fully functional decentralised asset exchanges, which rely on software-based auto­mated-market-making programs to facilitate liquidity and have supported billions of dollars in crypto trades. One might assume that this additional flexibil­ity makes Ethereum a “better” blockchain than bitcoin, but this functionality comes at a cost. One core tenet of cybersecurity when program­ming software is to “limit the attack surface.” In practice, for the crypto/blockchain space, this means that the simpler a blockchain is, the more secure the technology is. It is common sense: Just as a book is more likely to have a typo than a single sentence, a complex computer program is more likely to have a bug or vulnerability than a simple one.

Bitcoin’s simplicity is part of what makes it extremely secure and what gives people con­fidence putting large sums of money into it—perfect for serving as “digital gold.” Ethereum’s flexibility and dynamism entail a level of techni­cal risk that would be unacceptable for bitcoin but that allows other interesting applications to flourish.

Bitcoin vs. XRP

XRP, also known as Ripple, is currently the third-largest cryptoasset. It differentiates itself from bitcoin in an entirely different way from Ethereum.

Bitcoin is a fully decentralised blockchain, with instances of the database distributed around the world and maintained by thousands upon thou­sands of computers. The fully distributed nature of bitcoin offers great advantages: For instance, for any single government to disrupt, shut down, or harm the bitcoin blockchain would be very difficult because it is maintained in virtu­ally every country around the world. Bitcoin is also truly censorship resistant and seizure resis­tant. No governmental or other entity can block bitcoin payments or seize bitcoin.

The flip side of this decentralization is that bit­coin is too slow for some use cases. The bitcoin blockchain can currently process only a hand­ful of transactions per second, compared with more than 20,000 per second for a centralized payment network such as Visa’s. Although researchers are working on ways to get around this limitation, it remains a significant restraint.

This restraint does not matter for bitcoin’s pri­mary use cases as a store of value or a tool to move large sums around the world with low fees, but it makes using bitcoin as a daily pay­ment vehicle a challenge.

XRP and its underlying blockchain are designed specifically to support the payments use case. XRP’s blockchain is maintained by a group of just 36 nodes, which work together to process transactions and maintain the blockchain’s security. A single company, Ripple, controls the majority of the supply of the asset and maintains significant oversight of the ecosystem, including controlling 6 of the 36 nodes.

The advantage of this centralization is that the XRP blockchain is extremely fast, capable of processing transactions at a pace that matches Visa’s. The downsides include that it is exposed to greater government oversight, that payments can be more easily censured or reversed, and that holdings of XRP are subject to possible seizure.

XRP would be a poor choice of blockchain for someone looking for digital gold. In contrast, XRP is a feasible blockchain if the goal is to pro­cess payments quickly, which means it might have applications in such fields as international remittances and corporate payments across borders, among others.

Other assets

The aforementioned trade-offs—between security, programmability, and speed—are the three biggest trade-offs that blockchains must consider. And the aforementioned markets—digital gold, programmable money, and payments—are the three biggest markets that crypto is tackling today.

But other points of differentiation exist between blockchains and other use cases the industry is pursuing. These include the following:

– Governance: How should a blockchain han­dle software upgrades and settle disputes?

– Development funding: Should a centralized entity—such as a foundation—that is granted a large initial or ongoing share of a given cryp­toasset be in place so that it can help develop the ecosystem surrounding that asset?

– Privacy: Should transactions on a block­chain be public, pseudonymous, or truly anonymous?

– Consensus mechanism: What is the best technical and incentive architecture to maintain a blockchain? And how should concerns about high energy use, database bloat, and similar issues be handled?

– Specific use cases: Should blockchains pro­vide general capabilities, or they focus on specific use cases?

Whatever the right priorities are, the natural tendency in the cryptoasset market is for the winners in each market to get bigger, because cryptoasset-powered blockchains are network effects systems. The larger the asset, the more liquid it is, the more development activity sur­rounds it, the more robust its regulatory frame­work will be, the more support it has from institutional custody and trading firms, the more feasible it is to use, and so on.

Despite this fact, however, the likelihood that a single cryptoasset will come to serve every market need seems low. Some degree of special­ization typically exists even in network-effect businesses. For instance, in the realm of social networks, Facebook is used extensively for social connections, LinkedIn for work, WhatsApp for chatting, and so on. Something similar seems likely to emerge in the crypto space.

Does the Existence of Thousands of Cryptoassets Damage the “Scarcity” of an Asset Such as Bitcoin?

The other question people ask when learning about the great number of existing cryptoassets is whether their existence (and the potential future existence of an unlimited number of additional cryptoassets) threatens the scarcity value of a cryptoasset, such as bitcoin.

The answer is no. Just as a foreign country creat­ing a currency does not affect the scarcity of the US dollar, given that the two currencies would not be fungible, a new cryptoasset is not fun­gible with existing ones simply because it is also a cryptoasset.

Consider that thousands of cryptoassets have launched since bitcoin’s inception, but bitcoin’s value has only increased. Dozens of “forks” of bitcoin have even been released—cryptoasset projects that copy and paste the original bit­coin code, change a relatively trivial feature, and issue a new version of the coin. These forks have such names as Bitcoin Cash, Bitcoin SV, Bitcoin 2, Bitcoin Nano, World Bitcoin, and Quantum Bitcoin. Although one or two forks have accrued meaningful value and seem to have staying power due to community interest and/or unique technical optimizations, most have amounted to virtually nothing.

What is important to understand is that the value of each cryptoasset-powered block­chain is less a patent-worthy secret technology and more the network that emerges around each one.

Bitcoin, for instance, is a well-known global brand that trades on exchanges in countries around the world. It is supported by a robust network of custodians, liquidity providers, and developers; is integrated with dozens of apps; and is coveted by millions of investors. The bitcoin blockchain is secured by the largest network of computing power in the world, a network that is many times more powerful than the world’s largest supercomputer. This network is supported by an industry of “bitcoin mining companies” and chip manufacturers that exist specifically to maintain and strengthen the net­work. There are bitcoin funds, efforts to launch bitcoin exchange-traded funds (ETFs), payment tools that focus on bitcoin, and so on.

In comparison, any new cryptoasset or block­chain has none of that: no liquidity, no comput­ers securing the blockchain, no clear regulatory structure, and no global brand.

As an analogy, duplicating the software code that powers Facebook would be relatively easy, but recreating the network that makes it one of the most valuable companies in the world would be extremely difficult. Similarly, cryptoasset-powered blockchains are proprietary networks that form around nonproprietary software.

Do You Need a Cryptoasset to Have a Blockchain?

A final common question that arises when studying blockchains is, why not just create a blockchain without a cryptoasset?

Many people understand the value that block­chains bring to the world, but they are uncom­fortable with the idea of an independent cryptoasset, such as bitcoin, and its accompany­ing high levels of volatility or with the concept of a decentralized network that might be diffi­cult to regulate or control.

Can you get the advantages of a blockchain without the cryptoasset?

At the heart of the question about blockchains versus cryptoassets is the issue of “public, decentralized blockchains” versus “private, cen­tralized blockchains.”

Public, decentralized blockchains, such as bitcoin, require a cryptoasset to function, in part because the issuance of that cryptoasset provides the economic incentive for miners to maintain the network.

You can, however, have a “private blockchain” that uses much of the same distributed database architecture components as bitcoin but that has a company that sets up, maintains, and controls the network and provides the economic incen­tives for it to function. In a private blockchain, the company or entity in charge decides who gets to participate in the database, can block or reverse transactions, can determine what privi­leges different members get, can rewrite the rules, can shut the blockchain down, and so on.

In between these two extremes, you have shades of gray. For instance, some cryptoasset-driven networks are relatively centralized, such as Ripple, where transactions are processed by a limited set of entities, and most of the asset is owned by one company. Similarly, other block­chain networks are somewhat decentralized but still privately guided, such as the Facebook-associated Libra blockchain, which is managed by a consortium of dozens of members.

The variation in the level of centralization—from decentralized to more centralized to pri­vately operated—is in many ways similar to the internet.

The internet we typically use today is an open, decentralized internet: No one owns it, and virtually anyone can create a website and inter­act with it. In this sense, the internet is like bit­coin or any other cryptoasset-driven blockchain database.

But privately run, corporate “intranets” that can be accessed only by certain people also exist. Your employer, for instance, might have an intranet whose content can be updated only by the firm’s human resources department and viewed only by the company’s employees.

In between are shades of gray: The Chinese internet, for instance, is one such system, with censorship and central control but a fair degree of discretion within those constraints.

So which system will win?

To date, by far the most exciting advances and new capabilities—such as digital gold and programmable money—have emerged from public blockchains powered by cryptoassets. Cryptoasset-powered blockchains, such as the bitcoin network, are the blockchains that have advanced such entirely new concepts as “digital scarcity” into the world and have garnered the attention of thousands of leading technologists, entrepreneurs, investors, and even innovative corporates. These cryptoasset-powered block­chains have grown from a proof of concept to an asset class valued at more than $1 trillion in little more than a decade.

Surely, opportunities will arise for companies to create private blockchain-style databases to reduce back-office costs by a few percentage points or to increase transparency in supply chains, and significant ongoing efforts are being made by governments to iterate on fiat money by leveraging blockchain’s advances to develop “central bank digital currencies.” But these advances are incremental, rather than funda­mental. They do not introduce entirely new capabilities into the world; rather, they enhance the functionality of existing systems in certain ways, while degrading them in others.

As in the early days of the internet, the public blockchain space can feel bizarre and even haz­ardous for the unversed. And again similar to the internet, the disruptive possibilities created by public blockchains have opened up windows for fraud and bad actors in its early years. But only public blockchains advance fundamen­tal breakthroughs, such as digital scarcity, and in our opinion, this is likely the area where the largest leaps forward will happen.

If you would like to receive the source document that the above is based on or have any other crypto related questions, please feel free to reach out to us.

Sources:

Cryptoassets: The guide to bitcoin, blockchain and cryptocurrency for professionals. CFA Institute Research Foundation.