Cryptoasset Analysis

For the last two years, we’ve been running a buy-and-hold cryptoasset hedge fund.

These assets are a new investment class with many desirable features, including extraordinary upside potential and price movements that are highly non-correlated with other asset classes (such as equities, gold and real estate).

In this post, we present our framework for valuing these assets, which we’ve used to build our portfolio.  In its two-year history, our portfolio has had roughly the same volatility as bitcoin, and produced returns far better than bitcoin alone.

Terminology

 

It’s worthwhile to spend a bit of time dissecting the term cryptoasset.  We define cryptoassets as assets for which questions of ownership are settled via blockchain-based ledgers. We distinguish between Layer-1 and Layer-2 assets.  Most blockchains have a single Layer-1 asset (often referred to as it’s native currency).  Fees associated with publishing transactions on a blockchain are denominated in its Layer-1 asset and typically this asset’s supply and distribution are mathematically controlled (e.g. via mining).  For example in the Bitcoin blockchain the Layer-1 asset is BTC; for Ethereum it’s ETC; for Ripple it’s XRP.

Many blockchains support the creation, transfer and exchange of assets other than their Layer-1 asset; we term these Layer-2 cryptoassets.  Examples include TheDAO tokens on the Ethereum blockchain, MaidSafeCoin (via OmniLayer) on the Bitcoin blockchain and Bitstamp-USD on the Ripple blockchain.  It’s worth pointing out that many (although not all) Layer-2 assets imply a level of counterparty risk vis-a-vis whatever entity that issues them.  E.g. Owning 1 Bitstamp-USD on the Ripple blockchain simply means Bitstamp owes you 1 USD.

It’s worth noting that as an investor, Layer-1 assets are usually preferable to Layer-2.  Joel Monegro eloquently captures one of the main reasons why (casting Layer 1 vs 2 in the terminology of protocol vs application) in his Fat Protocols post:

the market cap of the protocol always grows faster than the combined value of the applications built on top, since the success of the application layer drives further speculation at the protocol layer. And again, increasing value at the protocol layer attracts and incentivises competition at the application layer.

It’s worth noting that while we aim to be general, much of our framework only makes sense in the context of Layer-1 assets.  Layer-2 assets (especially those representing liabilities of specific issuers) lie outside its scope of this framework.

Questions to ask when Evaluating Cryptoassets

 

  1. Market: Is it useful?  How big (in USD) is the problem it is trying to solve?

Examples of valuable problems possibly open to blockchain-based solutions include:

  • Vanilla Person-to-Person Value Transfer
  • Store of Value (Gold 2.0)
  • Black/Gray Markets
  • Venture Fundraising
  • Prediction Markets / Information Markets
  • Computational Resource Brokering
  • Arbitrary Asset Exchange
  • Voting / Decentralized / Venueless Corporate Governance
  1. Implementation: Does/can it work?  Is the underlying technology feasible?  What is the current quality of the implementation?  What is the quality of the project’s members and its governance?  What is their level of commitment and true motivation?

We also look at the technical design decisions, and whether they are appropriate for the use case of the coin.  These include:

  • Privacy vs Transparency
  • Cost (for participants to transact)
  • Expressibility (for conditional transactions)
  • Scalability / Resource Efficiency
  • Settlement speed

One particular design decision of enormous import is the consensus mechanism / governance.  The choice of consensus / governance mechanism determines where the chain falls on the spectrum of Trustlessness/Permissionlessness/Immutability vs Centralized Control.  Events like the ETH/ETC split demonstrate that the notion of chain consensus must be analyzed at two distinct levels.  At the lowest (first-order) level one can analyze the formal rules embodied in a chain’s consensus code.  However, one must also contemplate the informal and inherently political process governing how those first-order rules can be changed and what recourse different stakeholders have when confronted with code changes contrary to their interests.  The space has attracted experimentation on both levels.  In this author’s opinion our collective understanding of both levels is still rather dim.  That said, certain things should stand out as red flags, e.g. project’s with (1) no “constitution” (2) incentive-incompatible constitutions or (3) constitutions that have been broken.

  1. Value accretion: Can it grow in value?  If it functions as advertised and is adopted by the target market what is the expected upside potential for early adopters?  

It’s worth noting:

  • The open source, permissionless and friction-free nature of most blockchains makes it challenging for those using them as application platforms to engineer sustainable mechanisms for rent-seeking (and thus profit) within their applications and/or Layer-2 issues.  E.g. If Alice builds an on-chain dice gambling smart contract with a 2% house edge paid to Alice, there’s nothing stopping Bob from creating a copy with a 1% edge.  
  • Cryptoassets can be useful without being valuable as investments.  Some are in fact intentionally structured to discourage speculative holding (e.g. via constant high inflation.)
  1. Competitive advantage: What advantages does it have vis-a-vis competitors targeting the same market or vis-a-vis outright forks?

Case Study: Monero (Verdict: Buy – Original Analysis from Late 2014)

 

Market: Anonymous payment.

Implementation: Incomplete and somewhat messy but has the most theoretical promise vis-a-vis available anonymity alternatives.  Dev team is comparatively small/slow but on the whole thoughtful and focused.

Value Accretion: The anonymous payments use-case already has a large and growing market.  The lack of anonymity provided in practice by Bitcoin is underappreciated.  A large segment of this market adopting Monero (as has happened to a certain degree recently) would translate to a large increase in demand.  Furthermore, Monero’s inflation schedule in the medium-long term would fall well below demand in such a scenario.

Competitive advantage: Monero started life as a fork of Bytecoin.  The Monero team admired Bytecoin’s anonymity tech but found its code a mess and its distribution mechanism patently unfair.  Since the split it has managed to command superior developer talent/mindshare.  

Zcash’s anonymity tech is theoretically superior but far more complex and will likely take a long time to stabilize.

Case Study: Ethereum (Verdict: Buy)

 

Market: The goal of Ethereum is to build a general platform for decentralized applications.  Is this useful?  Platforms per-se aren’t useful, the applications running on them are.  In this light some imagination is required since many potential applications would be the first of their kind.

However, even beyond its decentralized application focus, I think a strong argument could be made that Ethereum is better (or will be once/assuming it stabilizes) than Bitcoin when it comes to Bitcoin’s core use-case: p2p value transfer.  This is in large measure due to its design having benefited from learning from Bitcoin’s mistakes.

Implementation: Even at the time of its pre-sale, the team working on Ethereum was impressive and since then has managed to attract a development ecosystem rivaling Bitcoin.  The management of the project has proven exceptionally competent, focused, pragmatic and open-minded and the result has been the most technically ambitious blockchain project to date.  

Value Accretion: The native currency has similar supply characterics as Bitcoin (modulo the possibility that inflation may continue forever at some small level) and other than the genesis block carve-outs for presale buyers and development funding, distribution is via mining (currently).  This doesn’t raise any red flags and IMHO an attractive model for speculators.

Competitive advantage: With regard to its core decentralized application use-case Ethereum currently has no real peers functionality-wise other than forks.  IMHO developing a distributed application on a fork with a minority of the developer mindshare makes little sense, especially given Ethereum is still an evolving work in progress.  

In theory Bitcoin could evolve to compete but this is unlikely anytime soon given its conservative development philosophy.  

Case Study: Steemit (Verdict: Avoid)

 

Market: Steem aims to create a social media platform.  This is an admittedly huge market whose revenues traditionally flow from selling user’s data and attention.  Existing platforms like reddit rely on complex weighted user voting schemes to curate user-contributed content based on a karma-driven reward system.  Steemit has attempted to devised a blockchain-based scheme that rewards valuable contributors with both money and editorial influence as well as allows users to outright buy editorial influence.

Implementation: The core idea is cool but the implementation raises some red flags.  To name a few:

  • Steem’s design arguably tries to do too many things and is too complex.  
  • An audit of the implementation does not inspire confidence from a scalability/security standpoint.  
  • Prominent members of the team have been at the epicenter of other cryptocurrency duds.  
  • Given the protocols lack of genuinely decentralization, Steemit the company appears to be breaking US laws.
  • It’s not clear the incentive structure they’ve designed actually encourages high-quality content.

Value Accretion: There are liquidity constraints intentionally built into Steem (which actually has several different native currencies) that, in our opinion, lead to widespread misunderstanding of its overall  true valuation and make it less appropriate for passive long-term speculation.  Additionally, the disproportionate amount of it held by the company and its founders make it challenging to model future market supply.

Competitive Advantage:  Unclear.  You can earn money publishing on Steem.  However, it’s not clear it’s the optimal medium for garnering either profit or attention.  

Pitfalls

 

While cryptoassets have many attractive qualities, anyone entering this space should be aware of several challenges, such as:

  • For every project with merit, dozens exist that are scams.  Price manipulation abounds.
  • Some of the best opportunities are thinly traded, which limits the market capacity.
  • Secure custody of these assets is itself a serious undertaking.

But for those willing to put in the work, cryptoassets offer incredible upside.  And their high volatility can actually reduce the overall risk in your portfolio, given the non-correlation of their returns vis-a-viz other asset classes.

Thoughts on Sidechains

Who is blockstream and what exactly are sidechains?

Blockstream is a company that recently raised $21M and has a bunch of bitcoin core developers as founders.

Their master plan is to extend bitcoin in ways that make it more expressible and open.  The first part of this plan is to implement a proposal called sidechains, which is an idea for allowing bitcoin to interoperate with altcoin blockchains.  The scheme requires forking changes to both the bitcoin protocol as well as the addition of special logic into any altcoin wishing to act as a sidechain.

“Interoperable blockchains” means I could create a sidechain-enabled altcoin, lets call it FOO, that can be 2-way-pegged to BTC instead of mined.  This means people can buy/sell FOO at a fixed BTC rate (without exchanges) by sending special transactions to both the FOO and bitcoin blockchains.  What does this get us?  Firstly and foremost, I can incorporate almost any crazy rules I want to into FOO-coin without getting anyone’s permission or coordination (whereas rule changes to bitcoin would require miner consensus and potentially systemwide client updates) yet FOO is pegged to BTC so there is no need to worry about distribution or exchange rate issues.  In theory sidechains make ideal labs for cryptocurrency experimentation.

What if the FOO sidechain has a flaw enabling it to be counterfeited.  Wouldn’t this flaw leak into the bitcoin economy as people start selling tons of counterfeit FOO for BTC?

The sidechains proposal accounts for this.  Bitcoin will track how much BTC has been converted to FOO and this places a strict limit on how much FOO can be converted back to BTC.  A counterfeiting “leak” would only have the effect of destroying the value of FOO.

Is the sidechains proposal technically sound?

It’s worth stepping back and splitting up the question into “is the goal of what they are trying to do possible?” and “is the proposal in the paper they published workable?”  I’m enthusiastic about former and lukewarm on the latter.  However, the blockstream team is crackerjack enough that if a goal of theirs is technically possible, it’s unwise to bet against them realizing it long term even if the current proposal is ugly.

What they are trying to do is have the bitcoin blockchain be the “one PoW-based blockchain to rule them all”.  IMHO this is a good thing because (big picture) if you aren’t on the PoW blockchain that the most work is being devoted to (regardless of algorithm), you are probably asking for trouble security-wise.  Sidechains will also make it vastly easier to stage proposed changes to the bitcoin core protocol.  However, I do have concerns with the sidechains proposal related to merged-mining.

What’s merged-mining and how does it relate to sidechains?

Merged-mining is a PoW-based consensus mechanism used by some altcoins (e.g. namecoin) that allows bitcoin miners to mine that altchain simultaneously with bitcoin at zero extra cost (other than the cost of running a node for that altcoin).  Some large mining pools elect to merge mine a few other currencies because it makes them eligible for block rewards on all chains.  It’s like being able to use your lottery ticket in multiple states lotteries at the same time.  At the moment there are only 3 coins with any real level of [bitcoin] merged-mining hashpower: Namecoin (52%), Ixcoin (38%) and Devcoin (32%) [1].  Close to half of the hashpower of the latter two is due to the merged mining of a single pool operator (ghash.io).

IMHO realistically all sidechains will have to rely on merged-mining for consensus [2].   In a non-sidechain altcoin an attacker with sufficient hashpower can arbitrarily censor (or totally halt) transactions as well as double spend coins under his control.  In the sidechains scenario the situation is much worse: an attacker can not only halt transactions but steal all the bitcoins backing the sidechain (or halt transfers between the altcoin and bitcoin).   To be fair, the sidechains paper throws out several tentative ideas on how to incentivize honest behavior; however, none strike me a terribly workable.  In particular, their ideas involving miner susidies on the altchain requiring abandoning the symmetry of the 2-way-peg seem to obviate a lot of the motivation for sidechains in the first place.

If you want to create a sidechain and your only realistic consensus option is merged-mining and you don’t want to get robbed, then you need a significant percentage of the bitcoin hashpower to merge-mine your coin.  As others have pointed out, “Permissionless innovation” isn’t really “permissionless” if it requires getting a large percentage of bitcoin miners to merge-mine your coin.  There’s only one merged-mined coin that’s managed to clear 50% of the bitcoin hashpower: namecoin, which coincidentally is the first major alt to implement merged mining and has been around for over 3 years.

That said, it’s not clear even 50% would be sufficient.  One bitcoin mining pool operator, Luke Dashjr, (who also happens to be one of the co-authors of the sidechains paper, although not a blockstream founder), in early 2012 attacked (to death) a thinly merged-mined altcoin he found obnoxious.  Due to the nature of how merged mining works he was able to mount this attack without disrupting his pool’s bitcoin mining and without informing or asking the consent of pool contributors.  In his defense the altcoin attacked was arguably obnoxious; however, this incident vividly demonstrates the plausibility of merged-mining related attacks orchestrated by small groups or individuals.  Given the centralizing forces at work in the bitcoin mining ecosystem and the vastly larger incentives for attacking merged-mined sidechains (i.e. being able to steal all the bitcoins backing the sidechain), I reiterate my concern that sidechains will find it difficult to recruit sufficient hashpower to secure themselves.

Does blockstream have the technical/political clout to get sidechains adopted?

IMHO, Yes.  The politics surrounding governance of changes to the bitcoin core protocol is a book waiting to be written, but my short answer is I could see the changes they are proposing being introduced by 2016-2017.  They also have ghetto ways of demonstrating it’s feasibility before that time that do not require forking protocol changes (a scheme they refer to in their paper as a federated peg, which IMHO could happen as soon as early 2015).

What does this mean for the altcoin ecosystem and altcoin investors?

Pervasive adoption of sidechains would definitely put a damper on altcoin speculation.  In fact, the blockstream founders have explicitly stated they see sidechains as a mechanism for “innovation without speculation” (aside from bitcoin speculation of course) and a subset of the blockstream team are arguably altcoin haters.

Sidechains will makes it harder for an alt to accrue value on the merits of many categories of innovation.  Since all serious altcoins are open source anyone can create a sidechained fork of an altcoin that isn’t already a sidechain.  People are already talking about trying to do this with Ethereum and many are arguing Zerocash should be implemented this way as well (although neither of those two has announced an intention to).

However, I see three major reasons why sidechains (assuming they work) won’t spell the end of all altcoins:

  1. It’s not clear PoW-based consensus is the last and only word in cryptocurrency consensus.  It has known problems and almost all alternatives invented since are incompatible with sidechains.  Systems based on these alternative consensus mechanisms are largely immune from being sidechain-forked for this reason.  Examples include Proof-of-Stake currencies (e.g. NXT, BitsharesX) as well as mechanisms resembling more traditional Byzantine consensus protocols (e.g. Stellar, Ripple).
  2. Certain coins embody a thesis that the initial distribution of coin holders matters greatly to the probability of ultimate widespread adoption.  Altcoins attempting novel coin distribution mechanisms don’t make sense as sidechains since an altcoin that elects to sidechain no longer has explicit control over distribution (it’s coins are only created and destroyed by the 2-way-pegging mechanism).  Examples of coins with novel distribution strategies include Auroracoin (they tried to distribute half the coins to the entire population of Iceland … failed) and Stellar (they are in the process of attempting to initially give them away to everyone on the planet).
  3. Another factor to consider is that altcoin developers / early adopters are in part economically motivated and the economics favor creation of an independent currency over a sidechain.   For example, it is unlikely Ethereum would have had access to the level of crowd-funding or talent had they not decided on a independent currency approach.   A sidechain fork may be uncompetitive with an otherwise-identical independent cousin if the devs of the sidechain are merely copypasta opportunists hacks in comparison to the original team.

Where does this leave Ethereum?

If you really want to experiment with innovative cryptocurrency ideas that don’t relate to new consensus or distribution mechanisms and would rather have both of those issues abstracted away, IMHO you will be better off implementing your idea as as subcurrency (or smart contract) of Ethereum (once it launches) than as a sidechain.  Ethereum is explicitly designed as a platform for cryptocurrency innovation.  You would be spared from having to convince half the mining world to merge-mine your altchain and you can implement arbitrarily complex network-enfoced rules for convertibility to/from your new subcurrency and the network’s parent currency, ether (ETH).

One possible scenario I could see emerging is a bitcoin sidechain based on an ethereum-fork gets a large majority of bitcoin miners to merge-mine it (thus actually securing it) and then everyone could do their cryptocurrency experimentation on this sidechain.  However, in light of point 3 in my last section, it would be interesting to see how such a scenario would ultimately play out.

Notes

[1] Percentages are current as of 2014-12-18.

[2] The sidechains authors will likely disagree with me here, but I challenge them to cite a compelling alternative decentralized consensus mechanism.  Picking a different PoW algorithm, (e.g. scrypt) I view as a short-term dodge.  I can see how centralized consensus schemes would work with sidechains; however, if you are OK with centralized consensus there are likely much more efficient ways to go about your business than using sidechains.

Futher Reading

How Could an AltCoin Win?

Bitcoin is currently the dominant digital currency. What would it take for another digital currency to displace it, or at least carve out a sizable market for itself?

Some would argue that nothing will displace Bitcoin. The network effect of currencies is too strong, so value will always go to the currency with the most liquidity. And any protocol-level innovations will be integrated into Bitcoin.

These aren’t bad arguments. One year ago, I thought the same. But after many months immersed in the crypto currency world, I can see several ways for value to accrue to other currencies.

Especially if you take a long-term view (say, 10 years), a lot can happen. No one can predict the future; however, you can model various scenarios and position yourself to benefit from them.

Better Anonymity

Bitcoin is only pseudo-anonymous. Anyone who could map some portion of addresses to identities (such as a prosecutor with subpoena power) could deanonymize a large part of the blockchain. And data in the blockchain stays there forever, so your identity could be unmasked any point in the future.

There is huge demand for an anonymous payment system and store of value. An estimated 22% of the world economy is in the black market.

Several of the recent AltCoins that have done well (drk, bc, xc) tout anonymity features. However, these coins provide imperfect anonymity. They leak information that would still allow successful forensic blockchain analysis (albeit harder than with bitcoin).

There’s a protocol called Zerocash that promises perfect anonymity. However, it’s extremely complicated, and uses bleeding edge cryptography. It’s not out yet, and the first few versions will likely contain security holes.

Although Zerocash doesn’t currently exist, it’s safe to say that sometime in the next few years, a truly anonymous coin will be available. What might be the market value of such a coin? Especially after a few high-profile cases of people convicted of financial crimes based on Bitcoin blockchain analysis?

Maybe people will quickly trade their bitcoins in and out of this currency as a way to launder them, in which case it won’t be worth very much. Or maybe users will migrate en masse over to this new currency, as it has a clearly differentiated superior feature, in which case it will become the dominant digital currency.

Governments may try to ban an anonymous currency, but unless they also ban bitcoin, it will be impossible to stop. That’s because trading between fiat and digital currencies requires connecting to the banking industry, which is centralized enough for government control. But crypto-to-crypto trading is merely a sequence of data broadcasts. There’s no way to stop it.

Solve Centralized Mining

There are a couple problems with how bitcoins are mined. First of all, it’s incredibly wasteful.  It takes something like $12 in electricity to confirm each transaction.

The other problem is Bitcoin is vulnerable to a 51% attack. Any entity that controls over 50% of the network’s hashing power can decide what to put in the ledger going forward (enabling such nefarious activities as double spending).

Mining pools routinely get close to this 50% level. In fact, last month, ghash.io briefly exceeded 50% until enough of their users voluntarily left to bring the hashrate down.

Some people have made game theoretic arguments that centralized mining is inevitable. It wouldn’t even have to be nefarious — a benevolent mining monopoly could process all valid transactions, but only add blocks that it forges to the ledger.  All other miners would disappear, as they would no longer be able to mine. You’d have a functioning currency, but without the decentralization that makes Bitcoin appealing.

AltCoins are experimenting with different approaches. Some use proof-of-stake, where transactions are processed by those who already own coins (51% attacks are still possible, but much more expensive). Others use web-of-trust, which is able to verify transactions in real time.

All these approaches have their own set of problems. Nonetheless, it’s possible that over the next several years, a consensus will emerge around some algorithm that’s significantly better than Bitcoin’s SHA-256-based proof of work. And value will flow to the currency that best embodies this new approach.

A More Expressive Protocol

Bitcoin introduced to the world a distributed, unforgeable data structure called the blockchain. It didn’t take long for people to come up with lots of uses for this concept beyond payment. You could track ownership of physical assets. You could create financial derivatives, and trade them in a fully distributed fashion. You could even create a distributed organization, with transparent logic for how decisions are made, and a native currency for paying for resources.

But you can’t do most of this in Bitcoin. The protocol is just not expressive enough. Today, there’s not much demand for these features. But over the next several years, who can say? Maybe significant portions of our legal and financial industries will run on a protocol like Ethereum, giving value to its currency.

Brokering a Scarce Resource

Another AltCoin that could prove valuable is one that controls access to a scarce resource.

For instance, Storj plans to release a coin that pays people who rent out space on their hard drives. Such a coin could be worth a lot, considering the size of the storage market and how much unused space exists on everyone’s home computer.

There could exist several AltCoins in this category that all have real value, while not displacing Bitcoin as the biggest digital currency.

Bitcoin Becomes too Conservative to Improve

I often hear the argument that if any AltCoin were to produce a useful feature, Bitcoin would just add it to its protocol.

In theory, Bitcoin can keep changing. But in practice, Bitcoin is already so conservative that it’s difficult to make meaningful protocol changes. And it will only become harder as the Bitcoin ecosystem grows, and the number of stakeholders increases.

Some changes are easier than others. Like adding more expressiveness to the protocol. Others are harder. For instance, Zerocash could theoretically be integrated into Bitcoin, but it’s so complicated, so risky, and would change the image of Bitcoin so drastically that I doubt it will ever happen.

And it would be impossible to get miners to agree to change their SHA-256 proof of work, since that would require that they write off their entire investment in ASIC mining hardware.

What might happen is in a few years, some developers create a hard fork of the Bitcoin blockchain and create a new protocol with lots of desired features. Everyone who owns bitcoins at a certain point in time will also own some of this new coin. Some bitcoin holders will have low faith in this new currency, and sell it for bitcoin. And this new fork becomes an AltCoin.

So in conclusion, the future is uncertain. There are many scenarios under which some AltCoin might displace Bitcoin as the leading digital currency, or at least find a sizable niche in the digital currency economy.