The Power of Pseudonymity

Open to Interpretation

September 15, 2008 marked the height of turmoil for financial markets. The Dow plummeted 500 points. Oil dropped below $100 per barrel for the first time in a year. And Lehman Brothers, the 4th largest investment bank in the world, filed for Chapter 11 Bankruptcy Protection.

While hell broke loose on Wall Street, a shadowy character under the guise of a pseudonym posted to an internet message board. Though largely unnoticed by the mainstream at the time, this post, and the mystery of the persona behind it, would go on to become the stuff of internet legend.

I am talking about @dril. @dril (also known as ‘wint’) is the pseudonymous Twitter account that uncannily parodies everyone you’ve ever considered unfollowing on the internet. Firmly in the realm of the absurd, bordering on the unintelligible, @dril’s humor has reached cult status and has created an internet subculture unto itself: Weird Twitter.

What’s most incredible to me, however, is not the popularity of @dril (over 850,000 followers). Most astounding is that @dril has managed to remain masked.

Cursory research indicates that there has not been much serious attempt to reveal @dril’s identity. Whether consciously or not, @dril’s fans must know that the humor of their favorite Twitter account would be eroded if they knew who was behind it. So they don’t want to know. @dril’s tweets can mean anything to anyone in his (her? their?) audience. Pseudonymity allows the consumer to impose their own meaning, independent of the intent of the author or creator.

A few weeks after @dril’s initial post, another pseudonymous figure who would go on to attain cult-status emerged on a different forum.

The last day of October 2008 was a Friday. Traders, beaten from the last several sleepless weeks, went home that night hoping they would still have a job come Monday. It was the worst month on record for Wall Street. Three days earlier, the consumer confidence index had printed an all-time low.

That day, Satoshi Nakamoto posted a paper to the Cryptography Mailing List. The Bitcoin Whitepaper.

The breakthroughs of the Bitcoin Whitepaper need no retelling here. For the first time, thanks to Satoshi’s design, fully peer-to-peer electronic cash was possible.

The Bitcoin Whitepaper, without doubt, represented a technological leap forward. But, interestingly, many of the components of the protocol had been around for years by the time it was released.

The new combination of these various pieces is cited as the real differentiator and innovation of bitcoin. While (pretty much) all the pieces were there in 1998, it took ten years to assemble them correctly.

Or perhaps that was not really the hard part. Maybe Satoshi put those pieces together back in 1998 — and then spent ten years figuring out where, when, and how to successfully release the idea.

After all, in order for this new model to work, in order for this system to truly be decentralized, it could not have a long term figurehead. Trust in the technology (or lack thereof) needed to be based on objective assessment, not based on an individual or organization backing it. Trust in the asset, likewise, needed to respect the fact that value is a social construct. By publishing under a pseudonym, Satoshi Nakamoto enabled consumers to make their own judgments of the technology and determine the value of the asset independent from its creator.

Just as with @dril’s humor, pseudonymity allowed individuals to impose their own meaning on Satoshi’s creation. Incredibly, almost a decade later, Satoshi has also remained masked.

In order to pull this off, Satoshi needed to ensure that his identity would not be uncovered even when under scrutiny from the likes of journalists, security experts, and government agencies. This would have demanded consideration of not only technical problems of operational security, but would also have entailed composing his code and the language of the whitepaper such that semantics would not allow him (her? them?) to be traced. Discussing ideas related to bitcoin with family, friends, colleagues was to be scrupulously avoided, as was posting anything online that could possibly link his pseudonym to his real-world identity.

(For an example of how not to do this, one need look no further than one of the first major commercial adopters of bitcoin, Dread Pirate Roberts.)

But Satoshi was not only solving for how to keep his identity private. He was also solving for how to make sure the idea would end up in the right hands, would be implemented, and would gain adoption.

He had to craft a go-to-market strategy that would take care of itself, once set in motion. He had to figure out in what format to release the idea (whitepaper), in what forum (the Cryptography Mailing List), and at what time of day so that it would be picked up by the right people. He had to find a name to release it under, such that it would not be traced back to him or anyone else. A name that would be neutral. A name that would invoke trust.

But perhaps most of all, he had to consider the broader societal circumstances under which to release it. He must have waited patiently for a time when the world was doubting the structures that had held the global financial system in a precarious balance. Maybe he woke up that morning of September 15, when Lehman filed, and thought to himself: this is it. Maybe he spent the next six weeks getting organized.

The message Satoshi embedded in the bitcoin genesis block, the headline of the Times that day, is a pointer to this consideration. And was also a masterstroke of marketing. “Chancellor on brink of second bailout for banks.”

Banksy, the subversive, pseudonymous artist has said: “if you want to say something and have people listen then you have to wear a mask.”

It certainly seems to help with the listening. It also helps with the longevity. Only when separated from their creators can concepts, humor, inventions, and content be fully open to interpretation.

This is why bitcoin is so many different things to different people. This is why forks happen and why, with every forking debate, there is a vocal faction asking the question “What would Satoshi do?”

But this inefficiency is also one of the main value propositions of bitcoin. It does not have a leader who can answer that question, who can decide on forks, and who can steer the community or consumer. So the purpose of the network and the value of the asset remain uncorrupted by intent. Often cited as a problem, this may in fact be the feature that will ensure Bitcoin’s staying power.

A Brief History of Blockchains

In Search of Assets

If the recent run up in crypto markets is to be sustained, some of its products will need to start delivering real end-user utility. As we go into 2018, the biggest question facing blockchain technology is that of product-market fit, or more specifically, whether these products have utility beyond speculation.

Bitcoin, the original blockchain-based product, has arguably achieved this: acting as disintermediated, digital gold. But the market is currently pricing in a bet that many more products will deliver value.

In order to understand where the industry is going, and where fundamental value might lie, it is helpful to consider the short history of crypto innovation. The market has experimented with blockchain technology in three waves: altcoins, permissioned chains, and tokens.

In examining this progression, it becomes clear that the search for product-market fit in blockchain has always been about a search for assets.

Altcoins

The first trend of experimentation saw the creation of altcoins in 2013 and 2014. Most of these altcoins were technically very similar to bitcoin, with a few tweaks, maybe a new feature, and some fresh branding.

Some of these altcoin protocols have survived and thrived over the last 4 years, while others have failed. Those that have gained and retained value have found product-market fit in two ways: either the asset has met an economic need or the protocol has met a technological demand.

Like bitcoin before them, the assets that have met a real economic need have done so by enabling a form of ownership or transaction that was not previously possible. Zcash and Monero, which both implement privacy as a feature of transactions, are good examples of this.

Other altcoin projects that have endured have done so because of they meet technological demands of developers and innovators. They have served as testing grounds (Litecoin) or they have become platforms for building (Ethereum).

The altcoin boom was explicit in what it was creating: new protocols, platforms, and, most fundamentally, assets.

Permissioned Blockchains

In 2015 and 2016, as many altcoins lost momentum, the second wave of blockchain innovation took off. Rather than generating new assets, this wave focused on assets that already existed.

One lesson from the altcoin boom was that creating a new asset is hard. Not technologically, but economically. How do you endow a new asset with value? Value is a social construct. For an asset to have value, the only rule is that people must perceive the asset to have value.

In traditional finance, perception of value usually comes from the backing of institutions and legal constructs. So this second wave of blockchain innovation says, “let’s apply the blockchain innovation to the assets we already have.” Assets that already exist should not face the perception-of-value problem.

But as soon as you represent an asset in a new format, the nature of it changes — and so does the perception of its value. It is not as simple as creating a digital asset and saying it represents the US dollar. (Although, Tether seems to have achieved this, but we will leave discussion of that for another time.)

This point is intuitive but is so fundamental that it is worth spelling out. In order for an asset to represent an actual dollar, the Federal Reserve would have to be the issuer and declare that it is backed by the full faith and credit of the US government. Legal structures would have to be created around this asset to make people comfortable with the idea that the digital version was equivalent to the dollar in their pocket. Even then, there might be a spread between the value of the two, as there is between on- and off-shore versions of currencies.

This concept of porting existing assets into new formats is at the heart of what permissioned blockchain technology attempts. Operating within a closed environment helps get us part of the way there.

Let’s say there is a digital asset that is intended to represent a US dollar. Now let’s say that the only users of this digital asset — Alice, Bob, and Carol — exist within an enclosed system. If Alice, Bob, and Carol all come to consensus that this asset is equivalent to a US dollar, then they might be able to create a functioning market for transactions amongst just themselves. This is what every blockchain consortium is attempting to achieve with stocks, bonds, and syndicated loans.

The persistent problem with permissioned blockchain technology is the on- and off-ramps. How do you cash in and out of the system? A friend of minehas coined this the Porsche problem: I might have all of these cryptodollars that Alice gave me, but if I can’t go buy a Porsche with them, what good have they really done me? Maybe I can redeem them with Alice for US dollars, but then the asset is really just a claim on Alice. A claim that is redeemable for an underlying asset, as anyone who lived through 2008 can tell you, is never the same as owning the underlying asset itself.

This second wave of blockchain experimentation also tries to move physical assets onto a blockchain. This has been applied to everything from shoes, to homes, to diamonds, to pork bellies, to art. One illuminating point here is that the world has a major tracking problem. Maintaining a record of the existence and ownership and authenticity of physical goods, it turns out, is something we are very bad at.

Unfortunately, a blockchain won’t help you with this. This is a last mile problem. You can, perhaps, track digital deeds or titles on a blockchain. The real difficulty, however, lies in linking those deeds and titles to the physical good. The issue that arises in tracking provenance and ownership is not a matter of the database not being good enough. It’s a matter of having good data that actually represents the assets.

Reformatting existing assets onto a blockchain, it turns out, is just as challenging as creating new assets. Valuing digitized assets poses many of the same problems as valuing digital assets.

Tokens

Which brings us to the third wave of blockchain experimentation. The market has returned to a trend of creating new assets, this time rebranded as tokens. Tokens are new natively digital assets that creators attempt to imbue with value.

Tokens differ from altcoins in that their value attempts to be derived in more traditional ways. They might, for example, represent a claim on returns of a project or set of ventures. (In traditional finance, this would be called a share or an LP interest, but never mind that.) Blockchain Capital’s token and the Ethereum DAO are obvious examples here.

Tokens might also represent an asset to be used in an application. File storage is an intuitive example. Various applications offering a decentralized version of DropBox have come to market in the last several months. The file storing system runs as a market, where users can purchase storage from each other. App-specific tokens are the medium of exchange for these markets.

This type of design begs the question, why not use bitcoin? Or ether, the asset that is native to the platform some of these apps are built upon? Just because it is a decentralized marketplace does not mean that it needs its own peer-to-peer currency: AirBnB and Uber did not need BnBCoin or UberCoin to bootstrap their networks and become successful.

Admittedly, using in-app tokens as a medium of exchange helps to solve the token’s perception-of-value problem by making it redeemable for an actual good or service.

So the token’s problem gets solved… But the token does not solve a problem for the application or the user. Indeed, it most likely harms user experience. Are people willing to use specified assets for different goods or experiences? After all, I probably want to buy my Porsche with US dollars, not with PorscheCoin.

These examples, wherein tokens act as securities or app-specific money, are the most straightforward paradigms emerging. In fact, many tokens being pitched to the market today do not fall squarely in either category — meaning the perception of their value remains pure ideology. It has become a trend for entrepreneurs to find a way to wrap their app in a token in order to fundraise. Really, however, these entrepreneurs are encumbering their business models, corrupting their cap tables, and creating a user experience of their app rife with friction. Only the tokens that can justify their existence as independent assets will have staying power.

How to Price Hard Forks

Can Bitcoin Markets Add and Subtract?

I find it fitting that the winner of the Nobel Prize in Economics for 2017, bitcoin’s annus mirabilis, is Richard Thaler. Thaler is known for his work on irrationality and the role of psychology in determining market movements.

In 2001, as the market approached the nadir of the dot-com bubble, Thaler co-authored a paper that asked the question: Can the Market Add and Subtract? The question certainly feels applicable to cryptocurrency markets. Nowhere is this more evident than in considering the bitcoin fork that occurred in August.

In this 2001 paper, Thaler and his coauthor Owen Lamont explore inefficiencies in the pricing of technology stocks. The basic idea that they explore is that when companies are split, the broken-up units should, in aggregate, be priced on par with the company pre-split. But that does not always happen.

The example of Palm and 3Com is the most well known and is fairly intuitive. Palm (remember Palm Pilots!?) was owned by a company called 3Com. In 2000, 3Com sold some of its stake in Palm to the public in an IPO (this is called a carve-out). 3Com also announced its intention to eventually spin off the rest of Palm to 3Com shareholders at a rate of 1.5 Palm shares for every 3Com share they owned. In other words, everyone who owned 1 share of 3Com would wake up the morning of the spin off with not only 1 share of 3Com but also 1.5 shares of Palm.

Intuitively, the following inequality should therefore have been true on the day of the carve out:

Price 3Com > Price Palm x 1.5

This is assuming that there is some fundamental value to 3Com in addition to its stake in Palm. Since equity cannot be priced negatively (and really rarely trades at zero), this is reasonable.

But this is not how it went down.

In the words of Lamont and Thaler:

“The day before the Palm IPO, 3Com closed at $104.13 per share. After the first day of trading, Palm closed at $95.06 a share, implying that the price of 3Com should have jumped to at least $145 (using the precise ratio of 1.525). Instead, 3Com fell to $81.81. The stub value of 3Com (the implied value of 3Com’s non-Palm assets and businesses) was minus $63. In other words, the stock market was saying that the value of 3Com’s non-Palm business was minus 22 billion dollars!”

The IPO was widely publicized, so it’s unlikely that there was an informational inefficiency at play. Thaler and Lamont explore the possibility that the overpriced stock was merely too expensive to short for arbitrage to make economic sense — but as they note, this does not explain why there werebuyers of the overpriced stockThis mispricing lasted for weeks, despite it being publicized in the media.

What does all of this have to do with cryptocurrency and hard forks?

The closest parallel to a hard fork in existing financial markets is a stock spin off. In both cases, a pre-announced event occurs wherein the owner of a single asset ends up not only with the initial asset but also an additional asset.

Last August, the bitcoin network experienced a major fork, testing the rationality of the crypto market. The results were unsurprising (the market is irrational), but noteworthy nonetheless. This fork resulted in owners of bitcoin not only possessing the original, but also a new asset called Bitcoin Cash.

The equality that should intuitively have held true for the Bitcoin Cash fork, then, is the following:

Price BTCPreFork ≈ Price BTCPostFork + Price BCH

Just before the fork actually occurred, the price of bitcoin should have roughly reflected the price of the two resulting assets. There are some explanations for why the price might have deviated: there may be some discount in the price to reflect the risks of the impending fork or the possibility that the fork would not actually occur. But broadly, the immediate pre-fork price of bitcoin should have been about equivalent to the collective prices of post-fork bitcoin and the newly created Bitcoin Cash.

This is not about whether forks are accretive. Whether you support cash, or gold, or classic, or core — undeniably a fork results in the existence of two assets with some value. Efficient market hypothesis would say that the collective value should approximate the value of the single parent asset just prior to the event.

But this is not what happened. Bitcoin barely moved on the day of the fork. Yet Bitcoin Cash closed the day with a market cap of over $6 billion. This $6 billion in value emerged from one moment to the next… at the moment that the fork occurred. Even assuming the market viewed the event as accretive, it was foreseeable for hours, days, weeks, before it happened. Why was none of this priced in?

The only thing to do is return to Thaler:

“To explain that, one needs investors who are (in our specific case) irrational, woefully uninformed, or endowed with very strange preferences.”

 

Thanks to another UChicago affiliate, John Loeber, for providing feedback and to Shelley Pearson for bringing the Palm / 3Com example to my attention.

The Riot Act

What’s in a blockchain?

Last Friday, a stock called Riot Blockchain gained nearly 50%.

The former biotech company pivoted in October to “Blockchain.” Since then, the share price has risen from $5 to over $20. 

Upon learning this, I went to Riot’s website to see what exactly they are doing with blockchain technology. I suggest you check out their site. I mean, this place has everything: a bitcoin and ether price feed, an animation of a gold coin bearing the Ethereum logo, and a proclamation that they are disrupting the future of transactions.

The first line of their About section betrays what is, of course, really happening here: “Riot Blockchain Inc is a first mover on the NASDAQ focused on blockchain technology.”

Their main value prop is that they are a publicly traded company that has said the word blockchain. Wall Street players have to date largely been unable to invest directly in crypto. Hungry for the action, they seem to be piling into this stock as a vehicle for some of that coveted blockchain exposure.

It’s right there on the third slide of their recent investor presentation: “What’s in a name?”

I think “Riot” is not the part of your name people are paying attention to…

The importance of names in publicly traded stocks is well documented. Psychologists Adam Alter and Danny Oppenheimer studied this phenomenon in newly IPOed stocks from 1990 to 2004. They found that stocks with easy-to-pronounce names fared significantly better in early days of trading than others. If you can boost your stock price just by having a catchy ticker symbol, imagine what adding the word “blockchain” can do for you in 2017.

To be fair, Riot has put some money where its mouth is. It has acquired stakes in a handful of blockchain-oriented startups and has also entered an agreement to purchase mining hardware. This hodgepodge of “strategic” investments strikes me as a strange approach for a public company executing a pivot. It looks more like a haphazard attempt to quickly gain exposure to this whole blockchain thing. Of course, they could have just bought some bitcoin.

The company has said in its recent press releases that it “leverages its expertise and network to build and support blockchain technology companies.”

Expertise and network, eh?

Who are these people? I read their 2016 annual report so you don’t have to. That’s where this whole thing gets really weird.

The report does not even attempt to construct a coherent narrative for the meandering course that the business has charted in the years since it was founded in 2000.

The company began its life as a veterinary venture. In 2004, it acquired an exclusive license agreement for products related to cattle reproductive health and animal pregnancy testing. It has since sublicensed this IP to a French animal health company.

Around 2012, the company changed course into diagnostics. It spent several years attempting to obtain approvals from the FDA for a blood test that would be used to rule out the possibility of appendicitis in (human) patients. It failed.

In September 2016, just 14 months ago, the company made another acquisition: this time the target was a company that was building something called Enhanced Surface Plasmon Resonance technology. I don’t know what this product is, but I can tell you that working on it for a little over a year is unlikely to endow you with expertise in blockchain technology.

One theme that has been consistent for the company over the years is management’s inability to deliver results. No matter the market, industry, or product, the company’s financials have been perennially abysmal. As of December 31, 2016, the company had an accumulated deficit of almost $110 million. They achieved $9,000 in sales last year. There is no “k” missing from the end of that number. Nine thousand dollars. You don’t need to know accounting to know that this is not good.

I have to admire management’s honesty about all their misguided decisions, though. In their 2016 annual report, one of the first things they said regarding their biotech strategy was: “It will be difficult for us to establish a market position… We believe that most of our competitors have significantly greater financial, manufacturing, marketing and product development resources than we do.” Pretty self-reflective for a venture that has taken so many wrong turns. It’s unclear, however, why they think their market position “in blockchain” is any better.

There’s something about saying the word blockchain that is currently causing normally thoughtful, intelligent people to lose their heads.

FOMO is a big part of this, but it’s not the only dynamic at play. There is also a Fear Of Missing Something. What I am talking about is a form of gaslighting that has gripped the market. People right now will hear about a token or a company or a pivot and they might think to themselves, “this whole pitch doesn’t make a lot of sense to me.” But then they look at the price of bitcoin, read some jargon-filled whitepapers, and shrug and go, “well I must just be missing something here.”

To these people I say: you are not missing something. You don’t need to understand blockchain technology to be able to spot bad business models or poor management teams. Keep your wits about you in this market.

After all, would this company by any other name look like quite so cheap?

Thanks to my mom for first pointing out to me the crazy rally in this stock. And then for listening to me complain about it for the better part of Thanksgiving weekend.

Top-Down Demand

Fat Products

Yesterday, I wrote about the layers of blockchain technology.

Products, platforms, and protocols. Assets, tools, and rules.

I noted that there are all kinds of dependencies among products, platforms, and protocols, resulting in every layer of the stack being built at once. Good products rely on secure, friendly platforms. Secure platforms depend on sound, scalable protocols. Protocols hinge upon an asset that, itself, serves as a product.

The flow of dependencies among these layers is circular, but the flow of demand through these layers looks different.

Demand flows from the top-down. End users demand products. Products are built by developers. Developers demand platforms. Platforms are created by engineers. Engineers depend on protocols. 

This is significant because demand drives value.

One of the most influential pieces on valuing blockchain technology is Joel Monegro’s note on fat protocols. The idea is that, in blockchain ecosystems, value accrues at the protocol layer as opposed to the application layer.

This is a helpful framework for understanding how protocol technology can be funded and monetized, but it is important to note that protocols are not intrinsically valuable. A protocol is only as good as its products.

Sustaining the astronomic rise in the price of bitcoin this year will depend on it continuing to gain adoption as a product: as a store of value, a means of diversification, and (maybe someday) a form of payment. Maintaining the colossal increase in the price of ether will similarly hinge upon tokens, Ethereum’s products, finding genuine demand among end users.

Many interpretations of fat protocol theory also confuse infrastructure for applications. An investment in bitcoin, the reasoning goes, has fared better than an investment in, say, Coinbase. But Coinbase is not an application of the Bitcoin protocol. Coinbase is a web application that provides infrastructure for the bitcoin product. Like protocols and platforms, infrastructure is only as valuable as the products it serves.

Fat protocol theory glosses over the top-down dynamic of demand. If a protocol accrues value — and keeps it — it is only because its products are delivering value.

Products, Platforms, and Protocols

The Blockchain Technology Stack

A couple weeks ago, I mentioned the moat of jargon around crypto. Even among those who have been working on this technology for years, there is often dispute over preferred terminology. Indeed, the word “crypto” is itself a point of contention. It’s little wonder there is so much confusion.

Whether you are new to the space or deep down the rabbit hole, it’s worth having a framework for where different technologies fit into the ecosystem.

Blockchain technologies break down into three categories: products, platforms, and protocols.

  1. Products serve end users
  2. Platforms serve product developers
  3. Protocols serve platform & product developers

Products sit at the top of the stack and are what end users interact with. These are often standalone assets: cryptocurrencies and tokens. Sometimes these assets serve a function within larger products called smart contracts or decentralized applications (dapps). Tokens are generally built by developers on top of a platform.

Platforms are a kind of middleware. Platforms facilitate the creation of products (in this case, tokens) and are usually associated with things like IDEs, high level languages, compilers, and other tools. These platforms, along with the products built on top of them, abide by conventions and procedures defined in their respective protocols.

Protocols are the set of rules that govern the network. Blockchain protocols usually include rules about consensus, transaction validation, and network participation. Protocols are often dependent on economic incentives — which generally means the protocol hinges upon an asset.

Circularly, this protocol-level asset can also serve as the protocol’s native product (no platform required!)

Bitcoin is a good example of this. Bitcoin (capital B) refers to the protocol. The protocol hinges upon a native asset: bitcoin (lowercase b). This native asset is also what gets used as the end product: it is the user’s means of payment, store of value, and (let’s be honest) vehicle for speculation. Note that Bitcoin does not really offer a platform. It’s not very friendly for developers trying to build new products on top of it.

Ethereum, on the other hand, exists at all three layers. It is a protocol, providing base-level rules. It is a platform, enabling developers to build new products on the system. And, because its protocol also has a native asset, it is also a product (in the form of ether).

Bitcoin and ether are cryptocurrencies, not tokens. A cryptocurrency is an asset that serves an economic purpose at the protocol layer and exists as an end product itself. Other examples include zcash and tezzies.

Tokens, meanwhile, are assets that function solely at the product level. Tokens are built on a platform and are not a core component of the underlying blockchain protocol. They may, however, be a core component of a smart contract or a decentralized application. Examples of decentralized applications include Augur and Brave, which implement the REPutation Token and the Basic Attention Token respectively. Both examples are built on the Ethereum platform and leverage the Ethereum protocol.

There are lots of layers to blockchain technology — all of which are being built at once. There are circularities to and dependencies among these layers. Having a framework of terminology helps in reasoning about where value lies, where investment is being made, and what is left to be worked on.

Of Blockchains and Brokers

A Note on Intermediaries

A couple of days ago, I wrote that blockchains are basically only good for cutting intermediaries out of transactions.

The idea of disintermediation gets thrown around a lot in this world. But when you talk about disintermediation, you have to be specific about where you are removing a third party.

Transactions can be broken down into three levels:

  1. Execution
  2. Clearing
  3. Settlement

Execution occurs when counterparties are coordinated and agree to a transaction. This is usually done through a broker or exchange.

Clearing refers to the official recording of the transaction by each party involved, along with whatever reconciliation needs to happen amongst them. Clearing can be done through a central clearinghouse that manages all of the transactions in a market. It can also be done bilaterally, directly between the two counterparties.

Settlement happens when the trade or transaction is considered complete. This is when the funds actually show up in the account.

Blockchain technology today only provides solutions for disintermediation at the clearing and settlement layers.

This is important to recognize because oftentimes, value extraction occurs at the execution layer. Middlemen often take tolls for coordinating buyer and seller or managing market liquidity, not for updating books and records. If you want to disintermediate the execution level of a transaction, a blockchain cannot help you. At least not yet… Innovation in decentralized exchange may eventually get us there.

But until then, we will still need brokers, exchanges, and other liquidity providers. Which is why, with its explosion of new assets to be traded and moved, blockchain technology has created more intermediaries than it has destroyed.

Always Start with the Assets

Or, Can a Blockchain Solve My Problem?

People talk a lot about “blockchaining” things. People seem to be “blockchaining” everything from loyalty points, to file sharing, to diamonds, to syndicated bank loans, to the internet itself.

Firstly, let’s all stop using “blockchain” as a verb.

Secondly, here are some thoughts on how to begin when considering the technology.

In determining whether a blockchain will help you solve a problem, you need to ask yourself three questions:

  1. Am I dealing with assets?
  2. Do these assets change hands?
  3. Do transactions suffer as a result of third parties?

[Note: speculation is not, in itself, a defensible use case. It is not a problem to be solved.]

1. Am I dealing with assets?

Assets are items of value owned by a person or entity. Ownership is generally represented in one of two ways: through possession of the asset itself or through representation in the form of database records. Cash, stock certificates, deeds of title, gold bars, and other bearer assets fall in the former category. Most assets we think about day-to-day fall in the latter category. These are registered assets.

Registered assets can be great. They are easy to manage and access across distances and can sometimes provide certain comforts and protections for owners. But they create challenges as soon as the assets start to change hands.

2. Do these assets change hands?

Every time registered assets move, database records of ownership must be updated.

Updating ownership records centrally serves to address a problem specific to assets: we need to know that two different owners don’t have claims on them. With digital assets, this gets even harder: we need to know that they don’t exist in two places at once. This is called the double-spend problem.

Generally this is solved by a central authority keeping the official book of record of ownership. The Department of Motor Vehicles tracks car ownership. When you go buy that Lamborghini, you’ll have to wait in line at the DMV to get them to update the book of record. This is also the mandate of central securities depositories in capital markets. CSDs immobilize and dematerialize stock certificates so that transfers of ownership can happen through a book-entry system instead of physical delivery. Like banks and payment processors, the DMV and CSDs are examples of third parties responsible for digitally tracking ownership of certain types of assets.

3. Do transactions suffer as a result of third parties?

In my experience, there can be good reasons to have third parties involved in your transactions. When fraudulent charges appear on my credit card bill, for example, I like to be able to call the company and execute a chargeback.

But other times, third parties create problems. These third parties must know about and be involved every time an exchange or trade is done. This is why we end up with convoluted systems of clearing and settlement that are likely slow and inefficient and prone to human error.

Third parties might also create economic problems because they are rent-seeking. Intermediaries often charge a toll for doing the service of updating a book of record or executing a reconciliation process.

Finally, third parties create much bigger problems when you want to make a transaction that your bank, your government, or other authorities wants to censor. Or when you don’t trust your bank or your government not to confiscate your assets.

Blockchains are good for digital assets that need to behave as bearer instruments. This means no single, central authority registering ownership. This means removing middlemen or third parties involved in transactions.

The possibilities opened by this are hugely transformative to how we transact, understand ownership, and shape the global economy. But it always comes back to the assets.

Please Take A Number

Reasoning About Ownership

Car ownership is a funny thing.

For a lot of assets, if I am in possession of it, then I own it. If I paid money for it and I have the keys and it is sitting in my driveway, then that is all there is to it. This is true for the cash in your wallet, the treasury bonds in your safety deposit box, and the gold bars in your vault. These assets are bearer instruments. He who bears them, owns them. Not so with cars.

In addition to the car itself, I also have a title for my car. Someone can hot-wire the vehicle and drive off from my driveway, but if I have the title, I can still prove that it is mine and discredit the thief. But is the title a bearer asset? What if I left the title in the glovebox and now both car and title are in the hands of this bandit?

The title represents proof of ownership, but is not a bearer asset itself either. Rather, a car is a registered asset. The ultimate authority on whether or not you own your car is a database created and updated by your local DMV. That’s what you spend hours waiting in line for. Despite the existence of the asset itself and a title for that asset, there is no bearer instrument here.

Thinking about these layers of cars, titles, and registrations is helpful for reasoning about assets and ownership.

In considering blockchain technology and the cryptocurrencies and tokens that exist on top of these protocols, you should always start by reasoning about assets and ownership.

Bitcoin is a bearer asset. It exists as a standalone digital instrument. This is analogous to possession of the car being sufficient for ownership — and this is why, if someone makes off with your bitcoin holdings, you don’t have much in the way of recourse.

Blockchain-based instruments might also exist as claims. This would be akin to the title of a car acting as a bearer asset. This presents a last mile problem: how do you link the title or claim to the underlying good? For physical goods, it will probably take advances in IoT to solve this problem. For everything else, the solution will rest on legal frameworks with open questions of enforceability.

Finally, there are some assets that claim to be blockchain-based, but still rely on a central registry system. If a central authority (like the DMV) gets to determine ownership of the asset, that asset should not be using a blockchain. Conversely, if a token makes claims of being backed by a blockchain protocol or gets described as decentralized, but in practice seems to use a central registry, you might want to take a harder look. The system might not be as “trustless” as advertised.

Messy Markets

Lessons in Reading Fine Print

In case you missed it, Venezuela defaulted last week.

Messy is a word that a lot of people are using to describe the situation.

Whether a country is in default is a deceptively tricky question to answer. It highlights one critical question for investors: what is it that I actually own?

For Venezuela, the saga of uncertainties began when its state-owned oil company failed to make a timely payment on its bonds. Venezuela claimed that cash was on its way. Bondholders agreed that they were okay with holding their breath. Even as S&P and other agencies started to declare the country and its oil company in default, The Emerging Markets Traders Association, an organization that attempts to set standards in these markets, decided to continue to trade bonds with accrued interest. This belied an assumption, or perhaps a hope, that the bonds would continue to be paid.

Meanwhile, ISDA, another trade organization, put off a decision on whether or not to deem the country to be in “technical default”. ISDA, comprised of banks and other market players, is tasked with determining whether or not credit default swaps (those notorious insurance-like contracts) should be triggered. There is lots of fine print around how this goes down, including rules about grace periods and what assets can be implicated. After a few days of delay, ISDA’s members agreed that Venezuela’s missed (late?) payments did constitute a credit event.

Under normal circumstances (if there are such things in a sovereign default), negotiations for an orderly restructuring would now be getting underway. Restructuring is the process whereby defaulted issuers renegotiate the terms of their loans with their bondholders.

But the question of what rights and recourse bondholders have is a complicated one. While some bondholders might agree to negotiate, other bondholders might retain their right to “holdout”, hoping or scheming to get repaid in some other manner. In the case of Argentina’s default, one group of holdouts waited roughly ten years for payment, employing tactics ranging from the litigious to the absurd.

Venezuela is facing its own problems in attempts to restructure. The Trump administration’s sanctions on the country bar US-regulated banks and asset managers from agreeing to a deal. And to make matters worse, those sanctions are also making it difficult for the country to retain legal counsel to advise them on what to do. Due to a larger geopolitical game, bondholders have found themselves without some of the rights they might have otherwise expected.

The last resort option for bondholders is always seizure of assets. But it’s not even clear what assets are up for grabs here. (See the infallible Matt Levine for more on the subject.)

Sovereign debt markets are highly regulated and are known for their pitfalls and their penchant for things to go pear-shaped. But even here, you’ll find plenty of investors who didn’t quite realize what they were getting themselves into. And even with all these established processes and practices and trade organizations and seasoned market participants… well, it’s still a mess.

It all comes back to that slippery and ill-understood question for bondholders: what do I actually own? Answering this question involves lots of time spent reading through heavy bond indentures, gaining an understanding of market practices — and that’s not to mention the money spent on legal fees.

Conventional Warren Buffett wisdom tells us not to buy what we don’t understand. Most people take this as a warning to do your research on the fundamentals of an investment. But for Venezuela, having an understanding of the country’s economic situation would never have been enough. You also need to understand your rights as a bondholder. What do you actually have a claim on?

Anyone investing in tokens would do well to take heed of these lessons. When you are dealing in emerging markets, you are better off treating assets as distressed before the market forces you to. This means doing the due diligence to understand your rights (or lack thereof) as a holder. Crypto is the ultimate emerging market right now. It does not yet have expectations for disclosures. There are no covenants or indentures. It’s not even clear to me where tokens would lie in a cap structure. Market best practices don’t exist and there aren’t really trade associations to set standards.

Good investors in tokens will understand the technology behind what they are buying. Better investors will ask questions about the team and the roadmap for the project. But the investors who will have staying power will be the ones who have researched their rights as holders — and who have done so before the market starts to get messy.