Revisiting the Case for Crypto

"A rising tide floats all boats… only when the tide goes out do you discover who’s been swimming naked." – Warren Buffett.

The famous quote by the Oracle of Omaha seems rather apt for the tumultuous shock waves that buffeted the crypto space in 2022. And while Buffett might feel that all crypto projects are bereft of swimming trunks, open-minded investors might critically reflect on how and why crypto creates value before making any decisions about selecting assets or investment vehicles.

There is arguably no better way to do so than revisiting the original case put forward by Bitcoin’s pseudonymous creator Satoshi Nakamoto in the original white paper. Bitcoin is widely considered to be the progenitor of the crypto space and the base design from which all other crypto projects have emerged.

While the paper delves into some technical aspects, it is accessible to an ordinary reader and short at only eight pages long (the same cannot be said of most financial statements published by public companies for the supposed benefit of their shareholders).

Disruptive Crypto

The events of last year are still fresh in investors’ minds. But crypto has become ubiquitous and it’s worth remembering that when disruptive innovations become part of our everyday lives it is usually accompanied by outsized returns for those investors who stay the course.

Like any innovation, Bitcoin emerged to solve a problem. Satoshi Nakamoto defined the problem in the very first paragraph of the white paper’s introduction:

“Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust-based model.”

The key word is trust. Satoshi Nakamoto’s core premise is that digital commerce suffers from its reliance on trusted third parties due to frictional cost and “payment uncertainties”. This is the why.

The solution?

“What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.”

The how is described as:

“We propose a solution to the double-spending problem using a peer-to-peer distributed timestamp server to generate computational proof of the chronological order of transactions.”

The so-called “double-spending” problem refers to the fact that in a digital world, money can potentially be copied and spent twice (or more) unless there is a way to verify transactions. Our modern electronic payment networks have evolved with trusted centralised entities performing the verifications such as banks, clearing houses, payment schemes (Visa and MasterCard) and, ultimately, statutory authorities such as nation state central banks.

Satoshi Nakamoto’s “peer-to-peer distributed timestamp server” is now better known as a blockchain. The peer-to-peer reference means that there is no central authority (or computer) but rather a loosely bound network of nodes that use cryptographic proof to verify the chronological order of transactions.

Proof-of-Work 

A key aspect of Bitcoin’s innovation is the use of a proof-of-work method to determine representation in majority decision making. Crypto observers will likely be aware of the two competing models for decision making in blockchain solutions, proof-of-work and proof-of-stake, with Bitcoin unashamedly adopting proof-of-work and the 2^nd largest crypto Ethereum recently migrating from proof-of-work to proof-of-stake.

Proof-of-work requires that a complex cryptographic calculation be solved to validate a block of transactions. Once solved, the block is added to the blockchain, and the growing chain then consists of the aggregate investment in computing power to solve of all of the blocks from the very beginning of the blockchain (in Bitcoin’s case, the so-called genesis block). Any attempt to corrupt the blockchain would therefore be hugely energy intensive and this built-in cost grows with every additional block.

Proof-of-stake relies upon nodes staking capital as a form of collateral against bad behaviour and is much less energy intensive as a result, however the peer-to-peer distributed consensus concept is similar.

Other proof mechanisms have also emerged since the emergence of proof-of-work and proof-of-stake, but all aim to solve the problem of how to verify transactions without a trusted centralised authority amongst a distributed network of nodes, each node containing a copy of the blockchain ledger.

Another important innovation was the concept of incentive. The Bitcoin protocol (rather than a central authority) issues a token, or coin, to the validated creator of the new block added to the blockchain.

“This adds an incentive for nodes to support the network and provides a way to initially distribute coins into circulation, since there is no central authority to issue them.”

Satoshi Nakamoto recognised that the incentive would encourage honest participation rather than any attempt to defraud the network via self-interest.

“The incentive may help encourage nodes to stay honest. If a greedy attacker is able to assemble more CPU power than all the honest nodes, he would have to choose between using it to defraud people by stealing back his payments or using it to generate new coins. He ought to find it more profitable to play by the rules, such rules that favour him with more new coins than everyone else combined, than to undermine the system and the validity of his own wealth.”

Bitcoin’s design also reflected an inflation-free future once the issuance of new coins had completed.

“Once a predetermined number of coins have entered circulation, the incentive can transition entirely to transaction fees and be completely inflation free.”

As of January 2023, over 19 million BTC has been issued from a final total of 21 million (estimated to occur around 2140). Bitcoin’s fixed and predictable supply schedule has been touted by some proponents as a solution to the loose fiat money policy that contributes to inflation and currency debasement.

Investor considerations

From an investor’s perspective, some key questions to ponder include:

1. Are the existing structures of our financial systems fit for purpose in the digital age?
2. Are the inefficiencies and risks associated with trusted centralised entities for verification and issuance so great as to warrant a decentralised alternative?
3. Are blockchains the solution to the problem and if so, which blockchains will survive and thrive into the future?
4. Are investment returns to be found by direct exposure to the base layer blockchain tokens (such as Bitcoin and Ethereum) or is a “picks and shovels” approach by investing in related businesses such as miners, validators, exchanges, DeFI, NFTs etc?
5. Are funds or other vehicles a better approach to diversify risk?
6. Do fundamentals exist in crypto or is crypto largely an opportunity to trade price volatility arising from supply and demand drivers?

As with all investments, smart investors who can educate themselves, weigh the pros and cons and form their own beliefs are likely to achieve a better risk / reward outcome. Crypto remains a nascent space and the events of 2022 demonstrate how risk and volatile the space can be. But disruptive innovations that become part of the fabric of our everyday lives can deliver outsized returns for investors with the appropriate risk appetite.