“What ARE cryptocurrencies, really?”

last Update: Dec 5, 2023

A neighbor asked: “What ARE cryptocurrencies, really?” at a recent cul-de-sac gathering. My comprehensive answer (obviously limited by my knowledge) starts with what I wrote in 2021 on FinTech, and ends with what follows.

To me, a cryptocurrency is at once:

• A store of value: People invest in objects of perceived value (especially if the objects are scarce). As proven by NFT (Non-Fungible Token)s, such objects need not be tangible/physical. They are, nonetheless, verifiable (via on-chain tokenization) assets (whereas nobody knows if Fort Knox is actually empty). The poster boy of this attribute is, of course, Bitcoin. By Dec 2023, Bitcoin has become recognized as “digital gold” (i.e. an arbitrator of fiat currency). This is an implicit acceptance of digital currency to (eventually) replace paper fiat currency. Viewed in that light, valuation of Bitcoin becomes obvious and logical. The implication is that digital gold, just like gold (and bond vigilantes), will wind up being a check on government deficit spending.
• A collateral that can be lent or borrowed against, just like any other asset. Stablecoin lending and DeFi lending are ways to generate interest income from crypto ownership. Currently, USDC is the most popular stablecoin and Etherium is the go-to platform for DeFi (based on the native cryptocurrency by the same name).
• A medium of exchange, — i.e. a digital currency with which to acquire/ exchange goods or services which are increasingly created in a digital, networked economy. It will disintermediate first-gen social network platforms like Youtube which own the content but compensate the creator with a mere cut of ad revenue. It will facilitate a direct relationship between content creator and content consumer via Web 3.0. Bitcoin is the most used for such transactions.
• The mechanism for peer-to-peer smart contracts between any principals for any purpose, without permission from intermediaries like banks, brokerages, law firms or realtors. Etherium is the best (layer 1) platform for that. (Other layer 1 platforms are Solana, Cardano et al.)
• A mechanism for transmitting payments over networks, — especially in the trans-border context. Obviously, this can be used to circumvent capital control by countries like China and Russia, thus either of concern to, or outright banned by, such countries. Bitcoin is the most used for such a purpose.
• The building block for a parallel anonymous and “permission-less” universe to the current financial industry. A stablecoin pegged to the U.S. dollar is an anonymous “representation” of the U.S. dollar unrecognized by the banking cartel (which grants “permission” per its rules and regulations). Yet it is a tradeable and redeemable asset within its own universe, unbeknownst to the banking cartel.
• The token/agent for the infrastructure of Web 3.0, such as applications like DApp’s for specific use cases.
• A network whose intrinsic value increases with its size (just like a social network) per Metcalf’s Law. Bitcoin has enjoyed exponential value appreciation from the “network effect” more than any other “coin” to date.
• An asset class competing with gold, cash, stock and bonds when considering macro shifts in real rates, inflation, and growth (the upcoming Blackrock Bitcoin ETF launch in 2024 will be the primary retail instrument for this aspect). This goes beyond the first “store of value” attribute because all the layers of cryptocurrencies,— including the infrastructure layer (the equivalence of TCP/IP)— has value and can be own.
• A catalyst for redefining finance as we know it (they wouldn’t be able to rewrite textbooks fast enough). By changing the format and duration of “store of value”, creating smart contracts between any parties for any reason, and instantly creating and transmitting value and ownership, the crypto movement will inevitably redefine the capital structure (how much equity and how much debt from which “markets”) of an enterprise. The exact business models (who plays what roles for what rewards) in an ever expansive digital, networked economy will most likely be simulated in Metaverse (i.e. virtual reality) before launch. When launched, this will replace the current financial industry in whole.
• A catalyst for social equality. By disintermediating the financial industry and redefining money, the crypto movement will reverse the decades-long wealth-divide trend, and allow wealth building by the bottom rung. McDonald’s can use tokens to reward its customers with equity ownership of the company and make them even more loyal evangelists, much like the Apple and Tesla model. As well, “tokenized” crowd-funding will turn the “vulture capital” model on its head.
• A catalyst for ushering in a new currency regime and thus, a new world order. This time, unlike centuries past, it won’t be on the heel of a global war, hopefully.

The important takeaway is that all of these attributes add to the valuation of cryptocurrencies. Most of these attributes are already in-play at existing crypto exchanges like Coinbase and Abra (recently raised series-C with American Express as an investor), which handle the many involved tokens and protocols, and manage attendant conversion and liquidity risks at “contract exits”. The crypto space is already a burgeoning industry rapidly gathering momentum and more importantly, building critical mass everyday. It is important to recognize the crypto space as a network — not a monolithic enterprise. Networks grow exponentially (think of the revenue growth experienced by Facebook and Amazon). So the runway may be long, but the takeoff will be vertical! (Indeed, the takeoff started in Dec, 2023.)

This brings us back to DeFi. As I opined in what I wrote in 2021 on FinTech, Decentralized Finance is a misleading label. The decentralization aspect of the crypto movement has to do with the networking nature of proof of work, which will have the unintended consequence of building a networked economy that obviates the current financial industry. So DeFi is a much bigger story than decentralization. It is one of disintermediation, specifically of the financial industry. What is financialization in the first place? It is the requirement of every financial transaction be intermediated by the financial industry. The foundation of this industry is a credit system dating back to the Renaissance, — by now 6 centuries old! It is not only oligopolistic, predatory, and a facilitator of the 1%-99% divide, but also archaic (automating its accounting is not the same as digitizing it). This system needs demolishment, not decentralization. And a genius barely out of high school figured out how. So what does a panicky financial industry do? Try to co-opt the movement (e.g. Amex’ investment in Abra) and fit the crypto movement into the existing financial regulatory framework. That ain’t happening because Samson is here to tear down the Temple of Dagon, not to be its enslaved errand boy. And anybody with half a brain can see through, and reject CBDC (Central Bank Digital Currency) for what it is: The same centralized monetary system in digital form except with much greater control by the monetary authority (i.e. central bank) over the populace. As well, a central bank doesn’t want to supplant its own commercial and investment banking system by having a direct relationship with the populace. Ergo, it is wishful thinking on the part of global central banks that China’s CBDC rollout will wind up being a blueprint for democratic countries. If nothing else, the Canadian government’s overreach in freezing the accounts of supporters who donated to protesting truckers was a wakeup call to CBDC’s power to create “digital concentration camps” (whereby the government knows every cent you own and directs you to spend it on what, where, and when).

DeFi actually threatens not only the financial industry of a sovereignty, but also its monetary authority which creates and controls its fiat currency. No sovereignty is more threatened than the U.S. because its currency is the world’s dominant reserve currency, — an “exorbitant privilege” as coined by the French Finance Minister Valéry Giscard d’Estaing in the 1960’s. For 80 years now, countries closer to the top of the pyramid (the U.S. being the top) of the U.S. Dollar regime get cheaper financing and better access to capital markets, through globalized financialization. The further down the pyramid, the higher costs of capital and the less access to capital markets (they have to go through intermediaries like the World Bank or the IMF). Worse, these countries are the most vulnerable to being shut out for “misbehavior”. (Global) DeFi offers these underprivileged countries the opportunity to exit and end-run that pyramid. Is it any wonder that crypto adoption rate (level of penetration into the populace) is the highest in third world (Asian, African, Middle Eastern and Latin American) countries? They have the strongest incentive to adopt! As well, precisely because they don’t have a sophisticated financial industry as legacy, they are in the best position to leapfrog and lead the effort toward a new global financial system. A sign post for that is the official recognition of cryptos as legal tender, and the subsequent fashioning of a regulatory framework for it. El Salvador was the first on the list. It’ll be interesting to watch how that list grows this year.

Meanwhile in the U.S., various states are crafting their own regulations to treat cryptos, presumably in part to best serve the millions of “under-banked” customers in their states (banks don’t want them as customers because they lose money on the measly cash balances these customers keep). If now served by the crypto movement, these constituents will add to the critical mass of the crypto movement per Metcalf’s Law (because of the network effect).

There is a trilemma facing the cypto movement: Maximum proliferation, scalability, and security/reliability/stability cannot all be had at once. A platform optimized for one sacrifices the others. Hence, the proper choice of platform for application is key. Of the trilemma, security/reliability/stability is the biggest challenge in the immediacy. Most developers in the crypto movement are from the game industry ingrained with the “hurry up and launch version 1.0 and break something before version 2.0” culture. This has to change because real world industries like healthcare (with risk of losing lives) and finance (with risk of losing money) do not tolerate bugs (and then fixes). Longer term, scaling a global payment system for 8B people will be the next biggest challenge. Lightening is the current idea of a blockchain highway system (layer 2 platform) with “car pool lanes”. Obviously, the technology has yet to be “field tested” and business models (who plays what role for what incentive) have yet to be solidified. A major headwind for maximum proliferation is regulators (such as the SEC) hamstrung by outdated legal frameworks that only Congress can revise. Sadly, the current Congress is arguably the most incompetent one, ever. If that situation doesn’t change quickly, we will lose our global reserve currency to another country which figures out how to seamlessly transition from TradFi to DeFi. Caitlin Long is one of the top trailblazers in that journey.

Since no one platform can displace all others, cross-platform communication is necessary. This is complicated stuff that requires careful design, implementation, and testing of foundational layers. Unfortunately, rapid monetization of digital assets incents rapid deployment of platforms and precludes sufficient testing (I referred to this in my previous article as the Silicon Valley “break things fast” way). So flaws and hacks abound, particularly in DeFi. One can liken the crypto movement to railroad building in the Wild West. There were mishaps, but there was no going back to horse and buggies (just because a protocol can be hacked doesn’t mean the cryptocurrency itself is invalid; just because a bank can be robbed doesn’t mean the currency itself is invalid).

There will surely be many road-kills from the crypto movement in the coming years. I bet the finance industry and monetary authorities are just licking their chops for more mishaps like this to happen. They will then be able to discredit the crypto movement as some Millennial pipedream and regulate it out of meaningful existence. So the crypto movement is in a race against time to lay down enough tracks so the railroad cannot be denied. The original trans-continental railroad was funded by private, state, and federal bonds. It’d be interesting to see who all will step up and sustain funding of the crypto infrastructure buildout.

Jul, 2023 update: On the heel of the FTX debacle, SEC has swooped in and sued centralized crypto exchanges like Binance and Coinbase. CeFi — the bridge between DeFi and TradFi (i.e. on and off ramp for exchanging crypto for fiat) — seems to be where all the action is at. DeFi hasn’t really taken off. Thus far, cryptos have not been transacted “on chain” (as smart contracts) but on centralized crypto exchanges (as stores of value). This will likely change when AI takes off (“on chain” crypto funding of AI services via smart contracts is a “natural”).

Dec, 2023 update: Bitcoin rallies past $40,000 and is en fuego!