Cryptocurrencies and Non-fungible tokens are the vogueamongst new investors. Given that they seem to hold so much promise andincreasing interest, we explore what they are and why we’re sceptical aboutcrypto. This section of the newsletteralso explains a thought experiment known as the 2 generals dilemma as to whyit’s cheaper using an intermediary in financial markets. While cryptocurrenciesmay be in vogue now, it may not necessarily be in the future as governments andcentral banks will never allow them to be too big to fail. But, with that said,the innovation of blockchain technology will be applicable as it’s a means ofinnovation and applicable to various means of business.
Blockchain technology was created as a decentralised,ungoverned peer-to-peer data base that records and encrypts information ondigital assets in blocks, and chains them together in an unalterable,transparent timeline that is accessible in ‘real time’.
It’s impossible to discern what the true value of a digitaltoken as it does not have any discounted cashflows nor do they own any assets.This is known as an intrinsic value. It makes them impossible to value and anyvalue that is assigned to them are based by the general consensus ofparticipants in that domain. The belief that the price goes up just becauseeveryone else believes that the price will go up is purely speculative and isbased on the who’s the greater fool of investing theory.
It then begs the question are we in a bubble? A recentexample is that a Web source code NFT sold for $7.2 million at a Sotheby’sauction recently. Given the amount of quantitative easing and as most of theworld has been in a lockdown in the past year, it may have resulted in peoplespending their disposable income not in the usual places; travel was banned,restaurants and bars shut, cinemas and theme parks have been disrupted, livesport and sports betting were halted all over the world. According to a recentHarris poll, nearly 1 in 10 Americans spent their stimulus cheques to invest incryptocurrencies given the technologies novelty.
Given the speculative behaviour, these tokens are incrediblyvolatile. Already twice this year, a single Elon Musk tweet has seen Bitcoinand Dogecoin’s price drop more than 20%. As these tokens are extremely volatileit’s also hard to see Bitcoin or digital currency ever becoming a medium ofexchange. Its transactions are also slow and come at a high cost to the environment.The transactions aren’t cheap either with the average fee per transactionaround $US30; compared to Visa, which can distribute twenty-five thousandtransactions per second compared to Bitcoins four is an indicative guide thatthe network has a long way to go in order to be competitive. China has alsocracked down on many of it’s mining centres because of its energy consumptionand cost to the environment; Bitcoin mining globally uses as much energy as Argentina per annum.
Given the speculative behaviour, these tokens are incrediblyvolatile. Already twice this year, a single Elon Musk tweet has seen Bitcoinand Dogecoin’s price drop more than 20%. As these tokens are extremely volatileit’s also hard to see Bitcoin or digital currency ever becoming a medium ofexchange. Its transactions are also slow and come at a high cost to the environment.The transactions aren’t cheap either with the average fee per transactionaround $US30; compared to Visa, which can distribute twenty-five thousandtransactions per second compared to Bitcoins four is an indicative guide thatthe network has a long way to go in order to be competitive. China has alsocracked down on many of it’s mining centres because of its energy consumptionand cost to the environment; Bitcoin mining globally uses as much energy asArgentina per annum.
A common thought experiment as to why intermediaries areused in market places is known as the two general’s dilemma. This is applicableto blockchain technologies as they are prone to hacking and ledgers can becompromised. Simply put, why should you trust the person at the other side ofthe ledger given their anonymity.
The Two Generals' Problem is a thought experiment meant toillustrate the pitfalls and design challenges of attempting to coordinate anaction by communicating over an unreliable link. In the experiment, two generalsare only able to communicate with one another by sending a messenger throughenemy territory. The experiment asks how they might reach an agreement on thetime to launch an attack, while knowing that any messenger they send could becaptured. The crux of the dilemma is that two generals attempt to attack a cityfrom opposite ends (North and South); the only way they can communicate to oneanother is sending a messenger through the town. The risk that they take isthat the messenger gets captured and the agreement to coordinate the attackgets distorted or lost. Therefore, failing to capture the city.
The extension of the problem is that the generals from thenorthern and southern armies then turn on one another as blame shifts to who’sfault it is for the raid. Both generals fail reach an agreement as theyfundamentally don’t trust one another and despite the assumption they don’thave the resources to sack the town single handily, are incentivised to go italone as the winner takes all the spoils of war.
The only way for everyone to compromise is to have amediator involved, where both parties are forced to think win-win. In thisscenario, the town acts as a mediator, for example a central bank, and the two generalsare on either side of the exchange. The town is saved from being sacked as theycan make more money by trading with each army, either army saves face fromlosing and are better off as they have more access to resources. Everyone wins.This is the reason why we have clearing houses in financial markets and centralbanks; they act as a guarantor of the exchange and ensures that nobody iscompromised. And, the currency issued by central banks are back by the laws ofthat sovereign nation.
What’s to say that digital currencies like Bitcoin andDogecoin are disintermediated by central banks as governments will never allowthem to be too big to fail. China is developing their own digital currency, theFed and RBA plan on doing, Facebook is about to launch its own. Long storyshort, it’s cheaper to keep the peace, people respond to incentives, an absenceof trust is costly, it’s more lucrative to trade and expand an economy and allparties still irrespective of differences still have to contend with oneanother.
We liken bitcoin and other digital tokens to the speculationand euphoria of investing in bubbles similar to Tulips or a South Sea crashes.The key for investors is not to invest in something you don’t understand, andwhile crypto may be in vogue now, nothing lasts forever. And, the most likely benefitto come of this is the block-chain technology that is on offer.