Back On The Chain Gang

It is a complicated topic to cover, which is probably why many people have probably avoided attempts to delve in.  The concept has been around for decades and it has been actively used for at least the last decade.  Its recent popularity has thrown a light into what was once a small corner of a small corner of the investment world.  I am referring to none other than the blockchain and Bitcoin.  Because of their recent popularity, now is a good time to get a basic understanding of blockchain and what it means to your portfolio.

Block what?

Why don’t you just go right ahead and ask it.  “What the heck is blockchain?”  We have been hearing about it increasingly over the past 5 years since it first gained a cult following.  It has enjoyed some ups and downs in popularity, but recent developments have cemented its place in the traditional investment world and it now appears that it is here to stay.  So let’s start by getting some basics down.  We will start simple.

• Bitcoin is digital currency

• Blockchain is a technology used to facilitate Bitcoin’s use

Because this newsletter is principally about blockchain, I will start there.  A blockchain is simply a collection of data blocks connected together in a chain format.  Hence the term: blockchain.  It helps to understand it by visualizing data storage.  Most of us are familiar with spreadsheets which can contain a fairly large amount of data in rows and columns.  You might store a list of customers in a spreadsheet with each line containing important and unique information about the customer.  Each unique line might be referred to as a record.  If you need to reference some information about a customer, you might search down the rows of your spreadsheet until you get to the right customer and then read across the columns until you get the information you seek, such as a phone number.  A spreadsheet can be shared between a small group of users to ensure that everyone is using the most common and up-to-date information.  Most of us have used or currently use this method of data storage and sharing in one way or another.  The method works well but it has some limitations.  What if you have many, many customers and you would like to be able to not only reference basic information about them, but also detailed information like all of the customers’ historical sales/transactions, accounting/payment records, or even details on all historical contacts with the client?  What if you have many employees across many departments in different geographic locations who need to reference all or some of the data?  That is the job of a relational data base.  You can think of it as a very powerful spreadsheet that allows you to filter, search, and sort large amounts of data.  Data bases have been in use for many years and just about everything from financial transactions, to customer account lists, to medical records, to accounting records… the list goes on and on… all of these are stored in databases.  These, databases typically reside on servers which physically reside in a data center.  They can be stored across many servers in several locations, but they are generally controlled by a single entity.  That is, the data is centralized.  Everything you read on Facebook, browse on Google, buy on Amazon, or ask Alexa is stored on a data base controlled by those companies.

In contrast to these privately controlled, centralized databases is the concept of blockchain.  In a blockchain, every piece of data is stored in a block… a block of data.  Each of those data blocks is connected with a chain.  So, imagine, if we are storing customer information on a blockchain and we add a new customer.  A new block would be created and linked to the end of the existing blockchain.  The blocks are added first to last in chronological order, and they all reference the block ahead of it and behind it, making it easy to traverse.  More importantly, the format makes it difficult to break.  Of course, there can be public blockchains and private blockchains with the primary difference being who has access to the data.  It is important to note that almost anything can be stored in a data block, so it is not limited to basic data.  The concept of using a blockchain was first proposed in the early 1990s and basically sat on the shelf until 2009, when it was picked up by… wait for it… the pseudonymous Satoshi Nakamoto, the creator of Bitcoin.  Who? What?

Forged in strife

The year was 2009 and the world was just starting to emerge from The Global Financial Crisis.  During the crisis we learned that what we believed to be impossible was, in fact possible.  We witnessed a 158 year financial institutions collapse while countless other banks had to be bailed out by the governments using tax payers’ money.  The crisis exposed weaknesses in the global financial system which was one of the motivators for the creation of a decentralized currency.  The use of currency is a very old concept and dates back to around 750 BC.  Currency evolved beyond a physical IOU into a coin or object with intrinsic value.  Think of a gold coin being worth its weight in well… gold.  Eventually coins evolved into paper banknotes, which entitled the holder to an actual cache of precious metal.  At that point, it became critical to rely on centralized entities to facilitate the monetary system.  The gold had to be stored at a bank, which would, in theory redeem the note for the metal on demand.  Banks became part of a central banking system, which was administered by a central government.  Do you see where this is going?  Even though the dollar bill you hold in your wallet is your possession, it is only useful with a banking system behind it.  This reliance became even more critical when most of the industrial world shifted off of the gold standard to a fiat system.  At that point, a bank note’s worth was guaranteed by a government instead of a valuable metal.

The birth of Bitcoin

In January 2009 a research paper was released by Satoshi Nakamoto which described an “electronic cash system that’s fully peer-to-peer, with no trusted third party.”   In other words, the new currency would be decentralized and would not rely on a traditional banking system.  In order to do this effectively, there would have to be a detailed ledger which tracked each coin from mining on.  Each time a coin was used in a transaction, ownership had to be memorialized in a large ledger.  In order to determine if the coin actually existed, one needed to access the ledger, which needed to be transparent.  Nakamoto chose a blockchain format to store the ledger primarily because of its security and immutability.  That is a fancy way of saying that something cannot be erased or modified.  A block cannot be removed from the chain without destroying the chain, and proper record keeping would enable a broken chain to be fixed.  In the case of Bitcoin, the blockchain ledger is distributed and not centralized.  Imagine a data center which houses one of those big databases we discussed above.  The data is stored over thousands of servers in a few locations.  In the Bitcoin blockchain, the data is stored in thousands of computers controlled by lots of different entities.  Every time a transaction occurs a new block is created and is then attached to the last block of the Bitcoin blockchain.  The newly enlarged chain is then distributed across the Bitcoin network so that every computer contains a copy of every Bitcoin transaction that ever occurred.  This prevents hackers from modifying the record maliciously.  By malicious, I am referring to robbery.  If a hacker modified the blockchain in one or more locations, thousands of other distributed ledgers would identify the anomaly.  I am oversimplifying things a bit, but for the most part, bitcoin transactions involve a purchaser transferring currency from their ownership to the seller’s.  The transfer is logged on a ledger which is shared with everyone on the Bitcoin network, so everyone on the network is aware that the seller is now in possession of the coin.

Now that you know that Bitcoin is peer-to-peer digital currency which is transacted over a distributed, transparent, and secure blockchain, you are most of the way there.  Let’s explore a little further.

Multi-purpose

Though Bitcoin was first mined and utilized in 2009, it was primarily used by people of questionable repute in areas like the dark web.  While a coin’s existence can be easily traced from owner to owner, the owners’ identities are unknown.  Owners access their accounts via the use of a crypto key, a password of sorts, which is known to only them.  In 2015 Ethereum was launched utilizing a similar concept to the Bitcoin blockchain with a more ambitious goal.  I mentioned above that a blockchain can store any type of data.  Ethereum created a blockchain which would allow a user to store a contract or a distributed application intended to be general purpose.  Because it utilizes a blockchain, it is secure and decentralized like Bitcoin, but it has many more applications.  Users can store a smart contract which could make a payment when certain requirements are met.  The same software can be used to track and log commodities like produce to guarantee freshness.  Likewise fine wine ownership can be tracked to verify their authenticity.  The uses are countless and many private and public blockchains have been created using the Ethereum platform and the host of other competitors.  It is important to recognize that Ethereum, though it has its own freely traded currency, is not intended to be a competitor to Bitcoin, which is purely a currency. 

As you might guess, there have been many different cryptocurrencies created for all sorts of different purposes.  Though the moniker currency is used, it does not mean that the issue is an actual general use currency like Bitcoin.  A more recent development is a Non-fungible Token, or NFT.  These use a blockchain ledger to track the ownership of a digital asset.  An example would be digital art or music.  An original painting on canvas hanging on your living room wall is clearly in your possession and you presumably purchased it from the artist or another collector.  In the digital world, art which is made up of ones and zeros (bits & bytes) can be copied quite easily, diminishing its value.  However, if the artist certifies the work’s authenticity and transfers ownership to the buyer with the use of a unique token… a crypto token, the work has real value.  Many have made a joke of NFTs, but there have been some notable and reputable transactions.  Notably, the well-known digital artist Beeple, sold a digital work for $69.3 million dollars and it was transacted on a blockchain.  The interesting thing about the transaction is that there may exist many digital copies of the work (entitled Everydays – The First 5000 Days), but the deep pocketed buyer can rest assured that it is authentically theirs.  That is to say, they have the unique crypto key to prove it.  Many of these NFTs are developed on Ethereum, FLOW, and Tezos blockchains. 

A cryptographic future

Blockchain technology and cryptocurrencies are still in the early stages, but recent interest suggests that they are here to stay.  Mainstream companies are increasingly building infrastructures around crypto as a method of payment.  Further, many companies across multiple sectors are beginning to utilize blockchains in their daily workflows.  It seems that not a week goes by without a new type of currency or token being introduced to the market, as there are truly so many really useful applications for blockchain technology.  It is an exciting time, but it comes with big risk.  There are as yet, no standards and very little regulation on these currencies, tokens, and securities.  While no one likes regulation, it is safe to assume that when it comes to money and securitization, some oversight is likely to be well received.  The US Agencies that would be likely to get involved would be the Treasury and the Federal Reserve Bank, and both institutions have been increasingly focusing on the marketplace, so we can expect to get some more guidance in the months ahead.

How to invest today

For most investors, direct investment in cryptocurrency would be far too risky.  The most popular and liquid ones are Bitcoin and Ethereum.  Though they have enjoyed significant gains in the past year, they are still quite volatile.  However, if you believe that crypto has a bright future, you may want to check out the growing number of companies that focus on the technology rather than the coins/tokens themselves.  There are ETF’s that invest in blockchain technology companies.  Recently, Coinbase (COIN), an online crypto marketplace made a direct public offering.  Coinbase allows users to buy, sell, and store their crypto holdings.  With the increasing popularity of crypto trading, Coinbase has had a banner year in fees, generating over $1.2 billion in sales in the past 12 months alone, which is probably why the company has a market capitalization of around $60 billion.  While attempting to come up with an intrinsic value for Bitcoin is speculative, placing a value on a company that makes money regardless of the price of Bitcoin is far less speculative (though the stock price is closely correlated to Bitcoin).  Now is a good time to get acquainted with the technology, the securities, the tokens, and currencies because we will be hearing a lot more about them in the years to come.  It may seem daunting and even confusing, which is why the prescription for loss avoidance is strict due diligence, discipline, and risk management… no different than any traditional investment.