SD#41: Special edition on CRYPTO
October 23, 2022
Hi friends,
Today’s newsletter is different.
I’ve spoken to many of you that all say they want to get into crypto but don’t know where to start. There are loads of resources and beginner guides online and with this newsletter, I am also attempting to shed a little bit of light into the world of crypto and perhaps spark some curiosity to explore further.
After doing some initial reading, it’s becoming clear to me how this could be much bigger than a simple investment opportunity or a way to store value. There’s a reason why people in this space are talking about the end of traditional finance.
Let me know your thoughts on this single-topic newsletter version, if people like it I will do more of these.
Let’s dive into it:
1. Understanding blockchain Before we dive into cryptocurrencies, their applications and all that jazz, we need to have a quick intro to blockchains. A blockchain is a type of distributed ledger technology (DLT) that consists of growing list of records, called blocks, that are securely linked together using cryptography (from Wikipedia). For bitcoin a blockchain was created by a person (or group of people) using the name Satoshi Nakamoto in 2008 to serve as the public distributed ledger for bitcoin cryptocurrency transactions. But it also opened up a whole new way to think about the internet and what we can do with it. How does the blockchain technology affect the internet? Here’s one way to think about the differences between them: the previous generation of shared protocols (TCP/IP, HTTP, SMTP, etc.) produced immeasurable amounts of value, but most of it got captured and re-aggregated on top at the applications layer, largely in the form of data (think Google, Facebook and so on). The Internet stack, in terms of how value is distributed, is composed of “thin” protocols and “fat” applications. As the market developed, we learned that investing in applications produced high returns whereas investing directly in protocol technologies generally produced low returns. This relationship between protocols and applications is reversed in the blockchain application stack. Value concentrates at the shared protocol layer and only a fraction of that value is distributed along the applications layer. It’s a stack with “fat” protocols and “thin” applications. We see this very clearly in the two dominant blockchain networks, Bitcoin and Ethereum. The Bitcoin network has a $360B market cap yet the largest companies built on top are worth a few billion at best, and most are probably overvalued by “business fundamentals” standards. Fat protocols |
2. Bitcoin vs Ethereum Simply put, Bitcoin can be described as digital money. Bitcoin has been around for thirteen years now and is used to transfer money from one person to another. It is commonly used as a store of value and has been a critical way for the public to understand the concept of a decentralized digital currency. Ethereum is different from Bitcoin in that it allows for smart contracts which can be described as highly programmable digital money. Imagine automatically sending money from one person to another but only when a certain set of conditions are met. For example, an individual wants to purchase a home from another person. Traditionally there are multiple third parties involved in the exchange including lawyers and escrow agents which makes the process unnecessarily slow and expensive. With Ethereum, a piece of code could automatically transfer the home ownership to the buyer and the funds to the seller after a deal is agreed upon without needing a third party to execute on their behalf. The two also use different ways to keep their infrastructure secure and legitimate. Decentralized cryptocurrency networks need to make sure that nobody spends the same money twice without a central authority like Visa or PayPal in the middle. To accomplish this, networks use something called a “consensus mechanism,” which is a system that allows all the computers in a crypto network to agree on which transactions are legitimate. There are two major consensus mechanisms used by most cryptocurrencies today. Proof of work is the older of the two and is used by Bitcoin and many others. The newer consensus mechanism is called proof of stake, and it powers Ethereum 2.0, Cardano, Tezos and other (generally newer) cryptocurrencies. In simple terms, proof-of-work blockchains are secured and verified by virtual miners around the world racing to be the first to solve a math puzzle. The winner gets to update the blockchain with the latest verified transactions and is rewarded by the network with a predetermined amount of crypto. In a proof of stake system, staking serves a similar function to proof of work’s mining, in that it’s the process by which a network participant gets selected to add the latest batch of transactions to the blockchain and earn some crypto in exchange. These blockchains employ a network of “validators” who contribute — or “stake” — their own crypto in exchange for a chance of getting to validate new transactions, update the blockchain, and earn a reward. |
3. Finding your faction The world of crypto began as a small island of misfits, but in the past 13 years, it has evolved into an enormous ecosystem of different subcultures and (sometimes warring) factions. You have the Bitcoiners, Ethereans, the Solana crowd, the small coiners, and the Suits. Different cryptos seem to attract different kinds of people, almost like a Harry Potter or Game of Thrones house, which one will you plead allegiance to? The earliest bitcoiners, often regarded as the boomers of Crypto Land, weren’t in it for the money — instead, they were drawn to the cypherpunk vision of a currency free from government oversight. Unlike the bitcoin network (which can be pictured as a database of wallets), ethereum was conceived as a World Computer. It allowed users to do more than just transfer money; it was also a platform on which people could create new apps and currencies. Many of the first people to arrive were technical developers. If you’re struggling to understand what crowd likes which cryptocurrency, this normie’s guide to becoming a crypto person can give you a few pointers. |
4. Play around but do your research At this point you should have a rough understanding of how things work and what your main options are, to understand them a little further you could get a small amount and start using it. Buy a small amount of bitcoin or ether to play around with in one of the popular exchanges and try using it in a few different ways: Make a donation: Many organizations accept bitcoin donations. For example, you can follow Wikimedia’s online instructions to send bitcoin to their donation address Buy a digital collectable: CryptoKitties, where people can collect unique digital cats, is a fun way to play around with Ethereum Pay in person: Yelp has a feature where you can filter for places that accept bitcoin payments But be mindful, if others are telling you to buy or sell a coin they might have a vested interest so it’s important to always do your research. There are many scams, projects without a working product, and projects that are marketing-heavy rather than focused on building the technology. Make sure to review how the technology works by reading through the white paper, blog posts, and forums. Here’s a few more beginner tips by Linda Xie |
5.1 Theory behind cryptoasset valuations How do you actually understand the value of a cryptocurrency? The first thing to note with crypto valuations is these aren’t companies; they don’t have cash flows. Hence, using a discounted cash flow (DCF) analysis is not suitable. Instead, valuing cryptoassets requires setting up models structurally similar to what a DCF would look like, with a projection for each year, but instead of revenues, margins and profits, the equation of exchange is used to derive each year’s current utility value (CUV). Then, since markets price assets based on future expectations, one must discount a future utility value back to the present to derive a rational market price for any given year. The taxonomy of cryptoassets goes far beyond currencies. That said, within its native protocol a cryptoasset serves as a means of exchange, store of value, and unit of account. By definition, then, each cryptoasset serves as a currency in the protocol economy it supports. Since the equation of exchange is used to understand the flow of money needed to support an economy, it becomes a cornerstone to cryptoasset valuations. If we want to get technical, some bloggers tried to figure out ways to calculate a cryptoasset valuation. I couldn’t possibly cover it all here so read Chris Burineske‘s blog to dig into his way. |
5.2 Understanding cryptoeconomics Separate from the world of cryptocurrencies valuations and speculation is the world of cryptoeconomics. The term “cryptoeconomics” causes a lot of confusion. People are often unclear on what it is supposed to mean. The word itself can be misleading, as it suggests that there is a parallel “crypto” version of the whole of economics. In simple terms, cryptoeconomics is the use of incentives and cryptography to design new kinds of systems, applications, and networks. Cryptoeconomics is specifically about building things and has most in common with mechanism design — an area of mathematics and economic theory. Cryptoeconomics is not a subfield of economics, but rather an area of applied cryptography that takes economic incentives and economic theory into account. Bitcoin, ethereum, zcash and all other public blockchains are products of cryptoeconomics. Cryptoeconomics is what makes blockchains interesting, what makes them different from other technologies. Bitcoin is a product of cryptoeconomics. Bitcoin’s innovation is that it allows many entities who do not know one another to reliably reach consensus about the state of the bitcoin blockchain. This is achieved using a combination of economic incentives and basic cryptographic tools. Bitcoin’s design relies on economic incentives and penalties. Economic rewards are used to enlist miners to support the network. Miners contribute their hardware and electricity because if they produce new blocks, they are rewarded with amounts of bitcoin. In the past years, we’ve moved from thinking about this new field solely through the lens of one application (bitcoin) to thinking about it in terms of one underlying technology (blockchains). What needs to happen now is to step back once again and view this industry in terms of a unifying approach to solving problems: cryptoeconomics. Hackernoon |
6. Crypto startups and architecture Big tech companies of today (Facebook, Google) tend to expand their platforms and monopolize information by locking users into proprietary interfaces. Cryptonetworks, on the other hand, tend to provide single services, and can’t “own” the interface because they don’t control the data. Specialization helps because the more decentralized a network, the harder it is to coordinate a complete suite of services under a single interface like Google, Facebook, or Amazon do. So instead, consumer applications in crypto/Web3 are independently built on top of multiple “composable” protocols using what we could call a cryptoservices architecture (like microservices, but with sovereign components). In Decentralized Finance (DeFi) people call this “money legos”. Consider Zerion (a Placeholder investment), Instadapp and Multis. They are building similar crypto-finance apps using many of the same protocols, like Ethereum, Compound, Maker, and Uniswap. This allows them to deliver a complete suite of financial services (transactions, borrowing, lending, trading, investing, etc.) without building all that functionality, infrastructure and liquidity in-house. The protocols provide specific services across many interfaces and the apps on top share resources and data with no centralized platform risk. Sharing the infrastructure lowers the costs across the board. These same dynamics are showing up in corners of crypto like DAOs and games. A cryptoservices architecture is great for startups. Entrepreneurs can launch new applications quickly and cheaply by outsourcing a lot of the functionality to various networks. And every app is on equal footing when it comes to protocol costs and resources (unlike web infrastructure like AWS where the smaller you are, the more expensive it is). Thin applications |
7. Beyond crypto – how we are transitioning from an age of geopolitics to one of techno-politics The 21st century belongs not to China or the United States—nor to tech companies as traditionally understood. It belongs to the internet. Traditional geopolitics concerns itself with the eternal location of territorial powers. Russia and Japan might have different ideologies over time, but their geography remains constant. The internet is adding a new dimension to this. It is not merely a passive data layer that states enable and contest but a new kind of geography comparable in scope to the physical world. Basic geopolitical assumptions about citizenship, migration, power projection and the use of force need to be rethought for the digital world. Currencies will change too, we are about to enter an age of global monetary competition, where national currencies are competing against cryptocurrencies to earn their place in someone’s wallet portfolio every hour of every day, even among citizens of their own countries. Next will come online marketplaces and sharing economy services. The Federal Aviation Administration was built for Boeing and Airbus, not 1 million drone hobbyists; and the U.S. Securities and Exchange Commission was created to go after Goldman Sachs and Morgan Stanley, not 1 million Web3 developers. The people running these institutions typically have career tenure; they were not democratically elected and are not easily fired. They are thus not accountable to the public they claim to serve. Add changes in property rights, how web3 is addressing global inequality, companies, cities, communities, and countries becoming networks, and you have a movement. Great Protocol Politics |
Further resources:
- A normie’s guide to becoming a crypto person
- Linda Xie tips for crypto newcomers
- A MASSIVE list of crypto resources compiled by a16z
- Messari crypto theses for 2022
Thanks for reading! This edition is only a minor attempt at sparking your curiosity into the world of crypto. It does not attempt to cover the topic in full nor it is possible to do so within such a small space. But I hope it clears some initial confusions and fears that this world is out of your reach. Let me know if you liked this edition and I will try to create more (either on crypto or completely other subjects).
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Speak soon,
Tom