The Crypto Conundrum

First, if you were expecting a clear explanation of what cryptocurrencies are and how to go about valuing them, this isn’t your article. There are many other sources you can find, especially if you do a quick Google search on the matter. This is, however, my take on the interesting problems that have arisen due to the creation of these instruments.

I don’t usually change my mind on many things. In fact, I rarely have a solid opinion on anything before I’ve given enough time and consideration to all sides of a story. Whenever I write anything on this blog, I take care to qualify every opinion I give, unless I have absolute confidence in the conclusion I have reached. This was the case for my ICO piece, where I argued that ICOs would be beneficial to the VC industry as a whole, as it gives the market more liquidity to compete with traditional financial markets.

I’m here to say I may have been wrong.

Since the posting of that editorial, I’ve had the distinct opportunity to talk with many in the space, including a startup that’s working on a highly interesting product concerning cryptocurrencies, and students of finance who are studying in the greatest schools of finance the world has to offer. This is all in addition to the countless articles concerning the matter. What I’ve learnt in this journey has changed my perspective, albeit slightly, from ambivalent, to slightly bearish.

Allow me to explain.

Crypto Bulls

To be fair, not many issues are completely beneficial, nor are there many issues that are completely malignant. Crypto is the same. It’s rather complicated. There are benefits that exist in using this new financial instrument, and it’s where I want to start.

The biggest benefit of crypto, as it stands, is the fact that it’s highly secure — transaction wise. Essentially, the blockchain prevents problems that plague traditional financial services, including fraudulent transactions. If every transaction was done via the blockchain, bank errors would be a thing of the past. That’s how disruptive this technology is. In fact, it’s a huge part of why people are bullish over cryptocurrencies.

There are other benefits, too. The decentralized nature of crypto makes it useful when making transactions you’d rather keep off the books, which actually makes it a good substitute for cash in many day to day uses (sarcasm intended). Moreover, cryptocurrencies, despite its name, is accepted worldwide, which gives it an edge over traditional currencies in international trade.

So, then, what’s the problem?

Crypto Bears

Well, that’s the thing, there seem to be far more issues with cryptocurrencies, than exist benefits, hackers notwithstanding. The largest of these non-hacker risks associated with crypto is that it’s too volatile. One moment, the price will be at an all time high; the next, it’ll be renewing an all new low. To make matters worse, there’s no way to evaluate the performance of the asset, except for its historic trends. This is in stark contrast to other assets, such as stocks, where we have balance sheets, and profit forecasts we can use to extrapolate target prices.

But what about bonds, and gold, maybe oil, even? You may ask. Let’s tackle those one by one. First, bonds. What is a bond, but a title deed to debt owed by an entity, be it a corporation, or a government. For those entities, we have other statistics, other than bond return rates, to base our price targets off of — economic data, interest rate changes, government budgets. Gold and oil, and other natural commodities are also different from cryptocurrencies because they have huge, industrial demand and uses. So much so that it’s actually relatively easy to estimate demand. Moreover, these are physical objects, which are much easier to keep track of compared to things like Bitcoin.

This creates massive speculation based on radical assumptions, creating crazy price targets, and, sometimes, price manipulation.

Then there’s the whole problem of this speculation spilling over into crypto mining equipment, with many people hoarding GPUs and ASIC chips, only to sell them at a profit on the black markets. Yes, the speculation isn’t just limited to crypto — it’s spilt over into related silicon markets. In fact, it was a major reason for Nvidia’s surprise earnings report last year.

Then there’s the whole thing about keeping your private keys safe, which sounds easy, until you realize that crypto exchanges have been repeatedly hacked over and over and over again, from Japan to the Italy.

So, then, maybe keep the keys to yourself?

That seems to be the prevailing solution to the matter, but it’s less a matter of it being actually more secure, and more one of economies of scale. To a hacker, hacking an individual wallet is just as easy as hacking an exchange — so why bother? Except, most individual wallets tend to be networked devices (i.e. smartphones), which are notoriously easy to gain access to. And, even for offline wallets, they still need a network terminal to work. And the overall complexity of this drives people to using the path of least resistance — the exchange.

Crypto’s Downfall

I’m not saying crypto is doomed. Rather, I believe its backbone technology — the blockchain — will survive well into the future, decentralizing many of today’s centralized processes, like voting. The currency aspect of it, I’m not so sure.

Even if you disregard the hacking aspect; even if you ignore just how speculative it is; there’s still the issue of what it means to hold a unit of crypto. What does it mean to hold a Bitcoin, or Ethereum? Is it like a share, where one Ether gives the holder a title deed to current assets and future profits of the company? Or is it like gold, where you’re allotted a physical object? Many are calling Bitcoin the “digital gold” but what does that mean? Is it usable in electronics manufacturing? Or is it just using gold’s pseudo speculative nature to give itself cache?

The only application of crypto that makes any remote sense to me is for companies with illiquid equity shares to pin a unit of a proprietary crypto to a unit of their shares to make their equity stakes more liquid. These companies would be companies furthering the cause of blockchain technology, applying them to make current centralized, insecure processes and flipping them on their heads. Crypto would be a resulting byproduct of operating these blockchains, and holding these would be akin to holding equity stakes in these companies.

Will it supplant traditional currency? That’s a question I’m ill fit to answer. Based on my definition above, traditional currency, and, by extension, the current financial system is one of those industries that is ripe for disruption by the blockchain. And yet, crypto, as it currently stands, cannot do much more than be a placeholder for equity stakes in a company. It’s easier to liquidate Bitcoin and spend dollars than it is to spend Bitcoin, as it currently stands. Whether this status quo will remain is a question that’s yet to have a concrete answer, but that’s where I’m bearish.

Crypto in VC

So, then, back to my initial hypothesis: is this good for the VC industry? I said, earlier, that my views changed on the matter. So this is my answer.

I stated before that providing more liquidity to an otherwise illiquid market is always a plus, and I wholeheartedly stand by what I said. What I am changing my mind on, however, is whether this will become an increasingly standard practice. It won’t.

It won’t for a very simple reason — the speculative forces manipulating the prices prevent this from becoming something VCs would adapt. VCs, by nature, are speculative, but only in one direction. They’re not like hedge funds who make money on a myriad of ways, one of them being taking the short position on a stock. VCs don’t have that option. Nor do they want that option.

They don’t want that option because many VCs are ex-entrepreneurs themselves, and many more are people who are fundamentally driven by different sets of values than those that drive hedge fund managers. Moreover, they command a very different set of fundamental skills — a symptom of the long time frame required by traditional VCs. I’m not saying one’s better than the other. I’m just saying that crypto, be it purely speculative, or a substitute for an equity stake in a startup, is more in line with the goals of the hedge fund than it is for the VC.

Now, this won’t stop startups from issuing ICOs in the future. No, in fact, I see that trend only growing in the future. What it may do, however, is bring in another player into the startup ecosystem. Whereas before, the stakeholders were PE funds, VC funds, angels, and corporate investors, this high liquidity asset may create interest in hedge funds, particularly due to its high volatility.

Let’s remember, though, unlike PE and VC funds, hedge fund holdings are highly liquid already, meaning they can steamroll this market, potentially influencing prices significantly in the process (if this hypothetical comes to fruition).

Does crypto have a place in VC? Yes, definitely. Is it good for the VC industry? We’ll just have to wait and see.


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