Why Crypto Matters: Evolution of the Global Financial Ecosystem
Wow, crypto has been blowing up in 2021! Bitcoin and Ethereum recently hit several all-time highs with announcements that Tesla bought $1.5B worth and will accept crypto payments in the future. The US's oldest bank BNY Mellon will custody crypto and we've witnessed the launch of the first North American Bitcoin ETF (two actually). Coinbase's pre-IPO S-1 indicates more people and institutions are investing in crypto, the Bank of International Settlements say 86% of central banks are exploring digital currencies, and the US Fed said a digital dollar is now a high priority.
Recently friends and I have been diving into deeper discussions of crypto, so I decided to write a post about it. If you know a thing or two about finance and investing but still don't feel like you understand why crypto matters, here's a crash course on what it is, critiques, and resources to dive deeper. (Note: I'm not a programmer, so I like to look at the topics from a more macro business point of view.)
You can make money trading crypto, just like you can make money trading securities. But that is not the most important or fascinating aspect of crypto — it's the impact on our global financial ecosystem that is. We have a massive financial ecosystem built on operations, procedures, and people. The key advantage of crypto is that almost all parts of that ecosystem can be replaced by code that operates automatically and instantaneously. Imagine the opportunity that holds!
Crypto has the ability to:
Be the most universal and sound form of money (i.e. store-of-value)
Decrease the cost while increasing the speed and security of moving money
Increase access to capital markets and financial services to the un/underbanked
What's Unique About Crypto
Whenever you hear crypto you can think "software application". Bitcoin and Ethereum are software applications using cryptographic algorithms and blockchain technology to create cryptocurrencies.
Blockchain: In simple terms it's a type of database. In complicated terms it's a decentralized and pseudo-anonymous public ledger software using cryptographic technology.
Cryptography: The mathematical and computational practice of encoding and decoding data.
Cryptocurrency (a.k.a. coin or token): In simple terms it's a digital asset. In complicated terms it's a digital medium of exchange using strong cryptography to secure financial transactions, control the creation of additional units, and verify the transfer of assets.
Crypto's unique attributes make it a viable store-of-value (i.e. money). Over time many things have acted as a store-of-value (e.g. shells, stones, silver, etc.) but one has persisted — gold. The key attributes of a store-of-value are: it must be an accepted medium of exchange, have salability across space and time, and act as a unit of account. Beware that not all cryptocurrencies share these attributes. However there is one that set the bar — bitcoin. (Read more about crypto as a store-of-value here and here. I also highly recommend the book The Bitcoin Standard).
It All Starts with Bitcoin
Bitcoin: a peer-to-peer, decentralized, censorship-resistant store-of-value and transfer-of-value and the first software created using blockchain technology.
One thing to clarify — Bitcoin (big B) is the name of the software application and bitcoin (small b) is the name of the application's cryptocurrency (i.e. coin).
Bitcoin is the first successful real world software application that uses cryptography and blockchain technology to create a cryptocurrency. It was designed to be a form of digital money that doesn't have to go through a financial institution and was outlined in a 2008 white paper by Satoshi Nakamoto (a pseudo-name that represents an unknown person or group of people). Satoshi solved three critical problems related to money and how payments work in our current global financial ecosystem:
Solved the "Byzantine general's" problem by designing the application to run on a decentralized peer-to-peer (P2P) network in which 51% of the nodes on a network must agree in order to post something to the blockchain ledger. This means a majority of nodes would have to conspire to cheat in any way, nearly an impossible feat given the size of the network and incentive structure of the system.
Solved the "double spend" problem by requiring every node on a network to maintain a copy of the blockchain ledger and any node posting to the blockchain to provide verifiable proof-of-work (this process is called mining - learn more here). The proof-of-work is an easily verifiable answer to a cryptographic math problem someone must spend real-world assets, such as electricity on computing power which costs money, to solve the problem. If solved and the block is posted and the poster (i.e. miner) gets a reward in the form of bitcoin. Hence the incentives are aligned in the network to protect truth.
These design features of the Bitcoin blockchain facilitate the existence of new protocols (i.e. rules for what and how things can be transmitted between electronic devices) that have no central authority, are cheap, and secure. This means what Bitcoin has done is prove it's possible to automate how parts of the financial ecosystem works — and remove middlemen.
As time goes on Bitcoin has consistently proven design is resilient and reliable. That has made it more accepted thereby increasing its potential role in the financial ecosystem, which in turn has increased the demand for it. Since ultimately the price is set through supply and demand, not on underlying cashflows, that has made it volatile. Advocates argue as time goes on that will decrease. Furthermore, they say that bitcoin will become digital gold serving as a reserve store-of-value for consumers, investors, and central banks.
After more than a decade of quantitative easing (QE) in developed economies that seems likely to continue investors are concerned about inflation and bitcoin is viewed as a long-term hedge on fiat money's role in the global financial ecosystem with high upside potential. The media pays attention mostly when the price increases dramatically but what crypto advocates and venture capitalists see is the potential evolution of our global financial ecosystem. The best explanation is by Chris Dixon, General Partner at Andreesen Horowitz.
Evolving the Global Financial Ecosystem
For most of human existence financial systems were rudimentary — barter-based, coin money for payments, and small scale financing of governments and trade. Large scale industrialization changed the role of finance to mobilize assets but was beset by fraud and mismanagement. Over time we humans have evolved the global financial ecosystem to guard against these risks with more centralized actors — such as banks, stock and commodity markets, clearing houses, ratings agencies, central banks, payment networks, etc. Synthesizing these changes through time it becomes clear what we have is a financial ecosystem that is the result of compounding evolution, and that it will continue to evolve. Crypto is the next evolution of our global financial ecosystem.
Crypto will change how the global financial ecosystem provides money and investment products across payments, marketplaces, central banking, custody, lending, investing, real estate contracts, as well as legal, audit, compliance, and security services. Here are a few examples of how the ecosystem is already evolving:
BlockFi offers +7% to depositors by providing loans (debt and retail bank)
Coinbase provides access to markets to buy, sell, and trade crypto (broker)
Anchorage is the first national crypto bank (custodian bank)
Chainalysis analyzes crypto transactions on the blockchain for security (compliance)
China is launching a central bank coin (money)
And the crypto ecosystem is growing rapidly. Check out this 2018 Pitchbook market map analysis of the ecosystem by a former investment banker. You'll notice the range of services touching the global financial ecosystem — transactions, clearing and settlement, compliance, and more!
Popular Crypto Critiques
OK, so crypto sounds interesting but you've heard bad things about it as well. It's good to be skeptical and ask those questions. And it's important to distinguish between bad actors building bad crypto companies vs. the technology being bad. Bad actors exist in every industry, so let's focus on the technology. The most common, legitimate, and important critiques of crypto are:
Governments will ban it
Governments will co-opt it, taking our privacy
Sustainability — It's bad for the environment
Cyber attack — it will be hacked one day
Illicit crypto — it's for criminals
Price volatility is probably the most common critique and I had it too. My logic was something like this — if crypto is money how can I spend it like money if it's so volatile (e.g. the bitcoin pizza case)? But what I came to understand is that this is not an accurate way to think about cryptocurrencies. Cryptocurrencies can have different properties (it's a software application after all) that are designed for different use cases. That's why stable coins (e.g. USDC), cryptocurrencies pegged to something like a fiat currency, were created. Bitcoin is more similar to a commodity and other cryptocurrencies act more like stocks or bonds. Once viewed from this vantage point the same recommendations for personally investing in traditional financial assets by and large holds true for cryptocurrencies. Study it, develop a strategy that fits your risk profile, and unless you're a pro don't actively trade! I personally buy crypto and tend to hold it as a long-term position making up a fraction of my alternative asset allocation as part of a broadly diversified portfolio.
Governments Will Ban It
Some governments have tried to ban cryptocurrency (e.g. India) but this isn't really possible or practical given the decentralized nature of crypto. Think about it this way — crypto is a software application that runs on millions of decentralized computers around the world. They can't all be shut down and as long as a few machines are running the software people can buy, sell, and trade cryptocurrencies. What governments can do is restrict companies from interacting with it. But this then creates a greater incentive for other countries to support it and attract the talent and capital that wants to use crypto, which will still be accessible to people around the world. You can't stop human nature and when you try it adjusts the risk / reward structure of the incentives and others will get in the mix. (For more read Can Governments Stop Bitcoin?)
Governments Will Co-Opt It
One big aim of Bitcoin was to remove institutional and government control over people. What we've seen in China's efforts at creating a central bank digital currency (CBDC) could be used to track every transaction someone makes. And that's scary! This can be addressed by working with governments on how we design the use of crypto in our global financial ecosystem. For example, countries can issue their own cryptocurrencies for banks and others to process transactions. Then central banks can have their coin float against bitcoin. There's more to address along these lines, particularly regarding security and privacy features so this critique should not be ignored. This is why I think it's important for the US to lead the way in creating CBDCs instead of China. (For more read this piece by Electric Capital, a crypto focused venture capital firm.)
I 100% believe climate change is real and support the need for a green revolution so I agree there are legitimate concerns here. The main issue critics point to here is that crypto mining uses a lot of energy and so argue that we shouldn't do it. But comparing crypto to traditional payment processing indicates crypto isn't as bad for the environment as it seems. I also think this is just bad logic that lacks common sense; using that same logic we should immediately stop flying, driving, and using electricity all together which is just not practical. I think the real issue here is about how we generate green renewable zero carbon emission energy that powers all aspects of our life; a topic for another day.
Do you use Apple, Microsoft, or Google software? Of course you do. Because we don't not use software because it might be hacked. Almost no software system has been immune from hackers, as the 2020 SolarWinds hack of the US Government shows, except maybe Bitcoin. Bitcoin has proven resilient since inception — it's never been hacked. But let's just say Bitcoin were to be hacked. Due to the blockchain being a decentralized system with a public ledger on every node we can just go back to the last block and pickup where we left off. The most salient hacking risk is around other applications in the crypto ecosystem like wallets, exchanges, and other decentralized apps (DApps).
Yes, crypto has been used for crime. Just like every form of money! We'll never be able to eradicate the link between crime and money, that's a human problem. But you might be surprised to learn that there's a lower amount of illicit funds - both absolutely and relatively - flowing through the crypto ecosystem than the traditional financial ecosystem — <1% in crypto vs 2-5% in traditional finance.
[Get the full 2020 Chainalysis Crypto Crime report here for free]
In some ways crypto is worse for criminals because it's pseudo-anonymous, not anonymous. All transactions on the blockchain are 100% transparent and recorded forever, so if personally identifiable info can be connected to crypto wallet address on the blockchain law enforcement can trace everything! Learn more in this discussion with a DOJ strike force focused on crypto criminals.
Red Pill vs. Blue Pill
By now I hope you're see the possibilities of crypto's role in evolving our global financial ecosystem and the potential that holds for human lives around the world. According to the World Bank there are still 1.7B unbanked people in the world — approximately 20% of the global population. Imagine if they had increased access to financial markets, products, and services! Imagine if instead of international wire transfers costing $50 and taking days it would cost a few dollars and be nearly instant. Imagine if central banks couldn't print money to drive up inflation like in has happened in the USA, Zimbabwe, and Lebanon. Imagine if governments could be constrained in their ability to impose capital controls on the movement of citizens' money like in Venezuela, China, and India. Imagine if instead of payment processors charging businesses 2-4% it would be <1%. Imagine a world where money doesn't weigh us down like a (gold) brick!
If the potential of crypto sounds exciting then I highly recommend learning more about it so you can decide how you want to be involved in one of the most revolutionary changes to our global financial ecosystem. All along this article I've linked to good readings and below I've compiled a list of what I think are some of the best resources to help you go down the crypto rabbit hole. The only question is: are you open-minded enough to choose the red pill?
The Bitcoin Standard book by Saifedean Ammous
The Bullish Case for Bitcoin by Vijay Boyapati
3 Reasons to invest in Bitcoin by Lyn Alden
What I Think of Bitcoin by Ray Dalio
List of Top Essential Crypto Readings by Year by Dan Romero
The Seminal Videos by Andreas Antonopoulos
A16Z Crypto Startup School video series
An Intro to Crypto: Building Blocks by Linda Xie of Scalar Capital