Cryptoassets: The Innovative Investor's Guide to Bitcoin and Beyond

by Chris Burniske

One of the keys to Graham’s book was always reminding the investor to focus on the inherent value of an investment without getting caught in the irrational behavior of the markets.

Bitcoin with an uppercase B refers to the software that facilitates the transfer and custody of bitcoin the currency, which starts with a lowercase b. • Bitcoin equals software. • bitcoin equals currency.

The Code Book: The Science of Secrecy from Ancient Egypt to Quantum Cryptography by Simon Singh.

The combination of globally distributed computers that can cryptographically verify transactions and the building of Bitcoin’s blockchain leads to an immutable database, meaning the computers building Bitcoin’s blockchain can only do so in an append only fashion.

Competition for a financial reward is also what keeps Bitcoin’s blockchain secure. If any ill-motivated actors wanted to change Bitcoin’s blockchain, they would need to compete with all the other miners distributed globally who have in total invested hundreds of millions of dollars into the machinery necessary to perform PoW. The miners compete by searching for the solution to a cryptographic puzzle that will allow them to add a block of transactions to Bitcoin’s blockchain. The solution to this cryptographic puzzle involves combining four variables: the time, a summary of the proposed transactions, the identity of the previous block, and a variable called the nonce.

pursuit of clarity, we will always use “Bitcoin’s blockchain” instead of “the blockchain.”

The term blockchain, independent of Bitcoin, began to be used more widely in North America in the fall of 2015 when two prominent financial magazines catalyzed awareness of the concept. First, Bloomberg Markets published an article titled “Blythe Masters Tells Banks the Blockchain Changes Everything: The banker who helped give the world credit-default swaps wants to upend finance again—this time with the code that powers bitcoin.”13 In emphasizing “the code that powers bitcoin,” this article quietly questioned the need for the native asset, instead emphasizing the underlying technology. Masters was a well-known and respected figure in financial services, one that people associated with financial innovation. Her choice to join a little-known firm at the time called Digital Asset Holdings, after having been the head of global commodities at JPMorgan Chase, was reason to believe that blockchain technology was no longer on the fringe of the business world. In the article, a quote from Masters brought everyone to attention: “You should be taking this technology as seriously as you should have been taking the development of the Internet in the early 1990s. It’s analogous to email for money.”

On the other hand, for Bitcoin to incentivize a self-selecting group of global volunteers, known as miners, to deploy capital into the mining machines that validate and secure bitcoin transactions, there needs to be a native asset that can be paid out to the miners for their work. The native asset builds out support for the service from the bottom up in a truly decentralized manner. Public blockchains are not so much databases as they are system architectures spawned from the bottom up to orchestrate the creation of globally decentralized digital services. Over time, miner compensation will shift from the issuance of new bitcoin to transaction fees, and if global adoption is great enough, then transaction fees will be sufficient to sustain miners.

The progression of a new technology, and the way it evolves as it gains mental mindshare, is at the core of Gartner’s Hype Cycle for Emerging Technologies (Gartner is a leading technology research and advisory firm),17 which displays five common stages of technology.18 • Innovation Trigger • Peak of Inflated Expectations • Trough of Disillusionment • Slope of Enlightenment • Plateau of Productivity

Historically, cryptoassets have most commonly been referred to as cryptocurrencies, which we think confuses new users and constrains the conversation on the future of these assets. We would not classify the majority of cryptoassets as currencies, but rather most are either digital commodities (cryptocommodities), provisioning raw digital resources, or digital tokens (cryptotokens), provisioning finished digital goods and services.

A currency fulfills three well-defined purposes: to serve as a means of exchange, store of value, and unit of account. However, the form of currency itself often has little inherent value. For example, the paper bills in people’s wallets have about as little value as the paper in their printer. Instead, they have the illusion of value, which if shared widely enough by society and endorsed by the government, allows these monetary bills to be used to buy goods and services, to store value for later purchases, and to serve as a metric to price the value of other things.

In an increasingly digital world, it only makes sense that we have digital commodities, such as compute power, storage capacity, and network bandwidth.

Paper currency has value because it is mutually agreed upon by members of society that it has value. It’s much easier for society to agree to this with a government involved. Getting a global society to agree that something has value and can be used as a currency without government support and without a physical form is one of the most significant accomplishments in monetary history.

Smart contracts are critical to understand but have a misleading name. The first thing people think of when they hear smart contracts is legal documents that think for themselves, which misses the mark by a wide margin. We believe smart contracts are better thought of as conditional transactions because they refer to logic written in code that has “IF this, THEN that” conditions. For example, it can easily be programmed in a smart contract that “IF Jack misses his flight and IF it was the airline’s fault, THEN the airline pays him the cost of the flight.” A vending machine is another commonly used example of a smart contract: “IF the user puts in enough money and IF the user types in the right code, THEN the user gets Doritos.” These conditions can become much more complex, creating conditional waterfalls depending on the process being programmed and the variables that need to be met.

Venture capital investors (VCs) often invest in ideas and development teams, having faith they will work their way toward success. Ethereum democratized that process beyond VCs. For perspective on the price of ether in this crowdsale, consider that at the start of April 2017, ether was worth $50 per unit, implying returns over 160x in under three years.19 Just over 9,000 people bought ether during the presale, placing the average initial investment at $2,000, which has since grown to over $320,000.20

A full list of Ethereum dApps can be seen and explored here: http://dapps .ethercasts.com/. The code of many can be investigated in full here: https://live.ether.camp/contracts. We will look at the most (in)famous of the dApps thus far, as it will inform the innovative investor on all future dApps and potential cryptotoken investments. We should note that dApp development and the associated native units has been one of the fastest moving areas in the cryptoasset space, as we watched new ones come out each week during the writing of this book. Thus, the curious reader should take time after this chapter to further explore them as we are only scratching the tip of the iceberg in this section.

The crash of 2008 shook these investors from their “economic lullaby.”6 In an increasingly globalized world where capital market assets are more closely intertwined, it was becoming clear that twentieth- century diversification models wouldn’t cut it for twenty-first-century investing.

The thinness of the order book is also referred to as the liquidity of the market. If the market is highly liquid, then there are lots of orders and many of them are likely large. In this case, value can be traded easily. If the market is illiquid, or thin, then sizeable price swings with low volume will occur because someone trying to buy (or sell) a lot of the asset will fill all the available sell (or buy) orders, which drives the price up (or down). As a result, in thin or illiquid markets, when investors are bullish they can drive massive swings to the upside, just as when investors turn bearish, strong selling volume can quickly drive the price down.

Absolute returns and volatility are important in their own right, but when they’re put together they yield the Sharpe ratio, which is an equally important metric for investors to consider. Remember that by dividing the absolute returns9 by the volatility, we can calibrate the returns for the risk taken. The higher the Sharpe ratio, the more the asset is compensating investors for the risk. This is an extremely important metric in the context of modern portfolio theory, because while an aggressive investor may salivate over sexy returns, the innovative investor is equally aware of the risk necessary to achieve those returns.

Inarguably, the liquidity and trading volume profiles along with the marketplace behavior of an asset class—and individual examples within an asset class—mature considerably over time. For example, in 1602 when the United Dutch Chartered East India Company (Dutch East India Company, for short) became the first company to issue stock,1 the shares were extremely illiquid. When first issued, no stock market even existed, and purchasers were expected to hold on to the shares for 21 years, the length of time granted to the company by the Netherlands’ charter over trade in Asia. However, some investors wanted to sell their shares, perhaps to pay down debts, and so an informal market for the stock (the very first stock market) developed in the Amsterdam East India House. As more joint-stock equity companies were founded, this informal location grew, and was later formalized as the Amsterdam Stock Exchange, the oldest “modern” securities exchange in the world.2 Despite the structure of the shares of the Dutch East India Company not changing much, their market liquidity and trading volumes changed considerably.

On January 6, 2017, the day after bitcoin hit an all-time high trading volume of $11 billion in one day and crossed the $1000-a-coin mark for the second time in its life, the People’s Bank of China (PBoC) announced it was investigating bitcoin trading on Chinese exchanges.9 Shortly after, the PBoC issued new regulations for the trading of bitcoin on exchanges within the country, including curtailing margin trading, requiring trading fees, and demanding stronger anti–money laundering and know-your-customer protocols. All of these requirements were understandable and have helped to legitimize bitcoin, but they did lead to a noticeable decline in Chinese trading volume, which for much of 2016 was still greater than 90 percent of trading volumes worldwide in bitcoin.

Throughout this book, we’ve tried to stay on message that the innovative investor may be a new class of investor, just as cryptoassets are a new asset class. However, we’ve also been reminding readers of lessons to be learned from the past and time-tested tools of portfolio and asset analysis. Ignoring these important lessons will lead people into the trap of thinking that not only are things different this time, but that they are different from other investors as well.

Criticisms of bitcoin and cryptoassets being Ponzi schemes have been circulating since bitcoin first hit investors’ radar screens.10 However, this criticism is deeply misinformed, and the World Bank has joined us in this opinion. In a 2014 report it states: Contrary to a widely-held opinion, Bitcoin is not a deliberate Ponzi. And there is little to learn by treating it as such. The main value of Bitcoin may, in retrospect, turn out to be the lessons it offers to central banks on the prospects of electronic currency, and on how to enhance efficiency and cut transactions cost.

A new cryptoasset called OneCoin was met with much interest due to its promise of providing a guaranteed return to investors. When the words “guaranteed return” appear, the innovative investor should always see an instant red flag. All investors should always be deterred by an investment that purports a guarantee (although annuities or other insurance-backed investments may qualify).

Many miners, and large investors, choose OTC services like those provided by Cumberland Mining, Genesis Trading, or itBit. OTC is not quite an exchange because the buy and sell orders are not out in the open. Instead, an entity like the aforementioned services matches large buys with large sells, which allows big trades to be made without moving the order books within an exchange. OTC is a potential path for accredited innovative investors that want to deploy large amounts of capital.

The first exchange on record was seeded with a transfer of 5,050 bitcoin for $5.02, and actually ended up shutting down a few months later due to a lack of interest.16 Mt. Gox was the first mainstream exchange, but it took two weeks for a customer’s account to be cleared, and initially fiat currency had to be wired to Japan. However, as the assets and underlying technology have matured, so too have the means of buying and selling them. To this end, today numerous quality exchanges are available to investors looking to gain and transact the more than 800 cryptoassets that currently exist.17 Some of the most popular Western exchanges include Bitstamp, Bittrex, Global Digital Asset Exchange (GDAX), Gemini, itBit, Kraken, and Poloniex. BTCC, OKCoin, and Huobi dominate China, but also offer services in other geographic locations. There are country-specific exchanges, such as Bitso in Mexico, Unocoin in India, and BitBay in Poland.

Ben Evans, an analyst at Andreessen Horowitz—one of the most famous venture capital firms in the world—published a report in 2015 that clearly laid out the value shift toward private markets. The median time for a tech company to IPO in 1999 was four years, whereas in 2014 it was 11 years,4 meaning the average investor now has to wait nearly three times as long to get access to company shares. Although there’s less enthusiasm for IPOs than there was during the tech boom, much of the delay is due to regulatory changes as a result of that tech and telecom boom, as well as the financial crisis of 2008. In the late 1990s, companies used to IPO with $20 million in annual revenue, whereas in 2014, the median annual revenue was just shy of $100 million, which had come down from a peak of nearly $200 million during the financial crisis.5 While this trend has resulted in more stable IPOs and reduced risk for capital market investors, with less risk, there’s often less reward. As Ben Evans wrote in his report, “Almost all the returns are now private. Old world tech giants returned plenty in public markets—new ones have not.” By old world tech giants, he’s referring to companies such as Microsoft, Oracle, and even Amazon, all of which have provided much more value creation for public markets than private markets. Meanwhile, with companies like LinkedIn, Yelp, Facebook, and Twitter, the clear majority of returns have gone to private investors. For example, while Microsoft grew private...

Crowdfunding sites such as Kickstarter, Indiegogo, and others positioned themselves online as a way for connecting entrepreneurs and investors. In exchange for investors pledging money, the project or company promised to return the fruits of its labor, depending on the amount a specific investor pledged. Recognizing that this platform was a fertile ground for scams, the sites implemented policies and procedures to protect investors. For instance, Kickstarter maintains investor funds in escrow until a project is funded to a sufficiently high level. If not enough people invest, then funding stops and investors get their money back.

CROWDFUNDING PORTALS FOR ALL INVESTORS The ability of the JOBS Act to open the door to venture capital for nonaccredited investors, including crowdfunding and ICO investments, has been a great step forward in increasing the number of people who may be included in these opportunities. One of the provisions of the JOBS Act will be the implementation of portals—online platforms on which investors can find investment opportunities. These portals must be approved by both the SEC and FINRA.11 Although there aren’t currently many such portals (Wefunder is one), over time, the number will increase and provide even more opportunities for investors and entrepreneurs.12 Additionally, we expect that portals will soon be set up by broker-dealers to provide a combination of investment opportunities with advice and access.

If some cryptoassets are commodities, this could open them up to different tax treatment than if they were considered solely as property. Commodities fall under the 60/40 tax ruling, meaning 60 percent of the gains on a commodity transaction are treated as long-term capital gains and 40 percent are treated as short-term capital gains. This is different from taxing stocks where profitably selling an equity after 12 months is classified as a long-term capital gain with a current tax rate cap of 15 percent. Selling prior to 12 months would be considered a short-term gain with the tax ramification based on an investor’s income bracket. All cryptoassets are not alike. There needs to be further clarity and understanding of these assets by government agencies and potentially a new set of regulations (including tax treatments) that recognize these differences. For now, the IRS and the CFTC view these assets differently, and this will surely necessitate further clarifying rulings by the IRS to provide appropriate direction. Don’t expect this to happen quickly; it took the IRS over 15 years to provide tax guidance on derivatives.

Having come of age through market crises, millennials are surprisingly conscious of their financial well-being. A recent study conducted through Facebook found millennials are highly educated, and perhaps due to the student loans required to gain this status, their financial situation is an important consideration in their life. In fact, 86 percent of millennials put money away each month.3 Equally interesting, according to a Goldman Sachs survey, 33 percent of millennials think they won’t need a bank by 2020.4 Seeing these statistics, it’s no wonder that many financial institutions are seeking ways to engage the millennial banking and investing client. The problem is that the business models of many wealth managers are not positioned to cater to millennials. Over the last two decades, wealth management firms have encouraged their financial advisors to sign up only investors with $250,000 in assets and move away from servicing all levels of investors.5 The reasoning has been to allow advisors to provide better service to a smaller base of clients, which is also good for profit margins. However, this means that their client base is aging. Because of these business policies, they are now less able to acquire and support young investors who are perhaps most in need of their assistance.