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How Will the Bitcoin Mania End?

“Bitcoin is capitalism, distilled. You should love it!” – Adam Ludwin

I’ve tried to remain pretty balanced in my view on Bitcoin and cryptocurrencies in general. Back in 2013 I said Bitcoin was definitely money and that the ideological hatred of it was irrational. This monetary view is consistent with the general view I have on cryptos as a part of someone’s portfolio – as I said yesterday, no one really knows how this will play out so you need to be extremely cautious and avoid taking recklessly ideological positions in either direction. As a monetary nerd I am much more interested in the application of cryptocurrencies than I am with the unpredictable value of the corresponding coins. I think of it as trying to decipher the utility of the internet circa 1995 as opposed to trying to figure out if Netscape is overpriced or not.

That’s a good segue into this post. So I’ll get this out of the way upfront – I have no idea how any of this is actually going to play out, but I have an opinion and I think that opinion might help some people better understand what’s going on and what could go on. So let me elaborate on all of this.

First, I think it’s helpful to hash some of this out by defining some of the terms we’re using:

  • Bitcoin is a peer to peer electronic cash system.¹
  • Blockchain is a type of distributed ledger created to trace the use of a decentralized application.
  • Mining is the process of creating new coins in exchange for validating the ledgers and verifying their accuracy.
  • Cryptocurrency refers to any of the coins being created to incentivize the mining for various blockchains and their corresponding applications.

There are two elements at work here. First, there is the actual utility via an application; and second, the coin that validates the ledger that traces that utility. So, for instance, in the case of Bitcoin and the Bitcoin blockchain the coin itself is a payment processing tool. The Bitcoin blockchain itself is validated by the miners who are incentivized to mine for Bitcoin. You might use Bitcoin to process a payment with a local business and that transaction will be verified via the mining process. So it’s a decentralized payment system that is self validating and secure. At present, Bitcoin is kind of the “central coin” in a crypto world with a whole bunch of coins. It’s kind of like the reserve currency of cryptos.

The real goal of a cryptocurrency is to create a decentralized system of peer-to-peer applications. For instance, if you had a crypto wallet that traced the title of your house in your name then you could theoretically give that title to a new home buyer in exchange for some amount of crypto. You cut out all the middlemen in the process and the title is secured on the blockchain as a valid transaction. Super secure, safe and inexpensive. You could take this general framework and apply it to millions of other applications.

There’s a couple of problems with this system and I’ve touched on them in the past:

  1. The coins have no par price settlement. This is a colossal problem with any form of money. The reason we centralize money is mainly because we can create stability in its value relative to everything else. No, not the real value, the nominal value. Yes, governments sometimes do a piss poor job of this and create hyperinflation, but in general fiat currencies are extremely stable in nominal terms. You can almost always settle a payment at par even if you’re losing some marginal purchasing power over time. Cryptos currently have no par settling mechanism which makes them a pretty bad currency. I’ve described the current iterations as financial collective equity because they are more like companies than currencies. Centralized money is very good at settling at par in nominal terms because the entities that achieve this do so through massive economies of scale and, in the case of the government, no need for profit. Many Bitcoin advocates claim that Bitcoin’s decentralized nature is its strongest point, but you could also argue that the lack of a centralized market maker settling at par, is also its greatest weakness since the utility of the coin collapses when its value collapses. This is not a small flaw in Bitcoin. It is arguably a fatal flaw. The historical graveyard of monetary units is comprised of instruments that could not maintain stability in either nominal or real terms.
  2. Some crypto activities aren’t consistent with public purpose. Again, this is arguably the greatest strength and weakness of cryptocurrencies. The decentralized peer-to-peer applications are going to be extremely useful and world changing because they cut out the middleman in many transactions and transfers. But they can also be used to evade taxes which creates a big problem for society as a whole. We have taxes for specific reasons. We need firefighters, public roads, police officers, military, etc. And we need revenue to pay those people so we need to be able to tax. One of the main reasons we centralize forms of money is so we can regulate it primarily so we can tax it and create a system whereby everyone chips-in to public purpose. Yeah, I hate taxes as much as the next guy and I think we all pay too much in taxes and that governments suck at spending our tax dollars, but I also realize there’s a logical need for some level of taxes. Therefore, a currency has to be consistent with implementing public purpose. It has to be taxable.

Now, when I think of the current state of cryptocurrencies I think we’re still way in the early stages. Just like Friendster gave way to MySpace which gave way to Facebook we will likely see many iterations of these coins over time as they evolve and become more consistent with solving practical real-world needs.

That brings me to my grand conclusion and how I think this might all play out over time. Bear in mind I am just spit balling, but I think this view kind of resolves the above issues and creates a parallel crypto world where these decentralized applications blossom.

  • A stablecoin will develop over time to become the “reserve currency” of cryptocurrencies. The peer-to-peer applications will boom over time and create many seamless activities that streamline currently mundane and archaic transactions and transfers. However, the holy grail of the coin world is a stable coin. For instance, I’ve reviewed this white paper by the founders of Basecoin and find it extremely appealing.² Their goal is to create a decentralized cryptocoin that would settle at par. This coin could then serve as a reserve coin of sorts. People (even miners) want to be paid in something stable. That’s why people use the banking system. Not because they love banks, but because they don’t want to be paid in something that might drop 50% in nominal terms before they even buy their morning coffee. You have $5 in your wallet and coffee costs $5? Awesome, you can afford it. But if you have $5 in Bitcoins in your wallet you might only have $4.50 by the time you get to Starbucks. Not cool. You get the point.
  • A parallel financial system will develop. This stable coin will become a parallel monetary unit to global currencies. It will settle at par (pegged to the domestic economy) as one player obtains what is essentially a monopoly on the coin market and all applications will settle through this coin or some derivative of it. Think of it as the reserve currency of coins. This will create a system where we can seamlessly transact and process data transfers without the need for a centralized money issuer to validate every little transaction we make. Think of it as electronic cash. It’s just more convenient and impossible for anyone to censor.
  • Governments will become necessarily involved in much (but not all) of this. Let’s go back to the example I used where we transfer the title of a house in the future. I sell you my house for $500,000 Basecoins and you can instantly transfer that into USD (if you want). But the transaction gets recorded in the Basecoin ledger. Now, there’s a problem here. You haven’t just been transferred my house title. You’ve been transferred my house’s property taxes as well. I am not going to let this transaction go unnoticed by the County Recorder so the Recorder MUST be involved in the process somehow. Taxes are central to so many property transactions and transfers so there’s no getting around this reality. I suspect the government will eventually embed itself in the blockchain process by automating some form of transfer process whereby my house title is transferred to you seamlessly, but you also get recorded as the rightful owner and lovely new owner of my tax liability.

It’s a beautiful thing the more you think about it. You can cut out tons of middlemen here. Again, use my house sale and title transfer. In 10 years I’ll log-on to something like RedFin (or probably something else by then built on a decentralized application that streamlines the paperwork/legal process) and find a house I like. I might go peer-to-peer with the seller and we’ll transfer the title after a few meetings in exchange for some crypto using the decentralized application built on Basecoin. I’ll pay the seller and the app creator will get paid in Basecoin as a fee for streamlining everything. The County Recorder is instantly notified and tax records updated. My title gets properly recorded and seamlessly transferred and my crypto wallet is updated with the new house title. Who won’t be involved in all of this? The brokers, title companies, etc with all their crazy fees and paper pushing. And in the end we’ll have achieved the same basic process without incurring all these middleman steps along the way.

Of course, there are obvious limitations here that some crypto enthusiasts overlook. For instance, with my example most people don’t buy a house and transfer the title with cash. They borrow money they don’t have and they borrow that from a bank because a bank is just an entity that bears a credit risk (giving you money you don’t have) in exchange for a fee (interest). So, in the end the crypto system will likely run parallel to the existing financial system. It won’t replace it, and in fact, it will enhance it in many ways.

Anyhow, that’s a pretty general framework for how I see this all playing out over time. I think cryptocurrencies are cool inventions and I do think they’ll change the world in many ways. But I think we’re so early in the game that it’s dangerous to get too ideological in either direction about certain coins and their utility. This is all going to develop over a much longer period than anyone suspects and my theories will likely change over time. Stay tuned.

¹ – Bitcoin: A Peer-To-Peer Electronic Cash System, Satoshi Nakamoto

² – Basecoin: A Robust, Price-stable Cryptocurrency with an Algorithmic Central Bank