Blockchain

Cryptocurrency owner types: commercial user and speculative user

Types of Users

Most users of Bitcoin and Ethereum are of one of the two types: the commercial user and the speculative user.

The commercial user uses bitcoin to purchase stuff from either physical or online store. Similarly, the commercial user of Ethereum uses Ether for staking against contracts such as the issuance of initial coins. Other applications could include supply chain payments, betting contracts and prediction markets.

The speculative user holds onto the crypto-currency in the hope that its value would continue to rise.  The commercial user pays a small fee each time he spends Bitcoin/Ether. This fees could be as low as 0.0001 BTC  (the median transaction fees is about 18 cents). You can look at how to calculate and choose your transaction fee here.

Supply and Demand

Bitcoin and Ethere, unlike any other form of asset e.g. Gold or diamonds or cash, is limited in supply. The table here provides the schedule for production of Bitcoin.  New Ethereum issuance would stop when Proof-of-stake is enabled by the nodes.

The total number of Bitcoins produced reduces exponentially, as time passes, and by about 2041, almost all new Bitcoin production would stop. New Bitcoins are produced as a consequence of mining. Each miner, who creates a new block after validating a set of transactions is rewarded in Bitcoin by the network. Over time (approximately 2-4 years time), these rewards halve.

As the number of merchants such as Microsoft X box store or Overstock starts accepting Bitcoin, the number of commercial users for Bitcoin would increase. Imagine remitting money or purchasing a digital good from a non-local store without needing to pay a 30$ transaction fee to the bank.   Here is a list of US merchances accpeting Bitcoins. Simultaneously, as awareness about Bitcoins and Ether increases, the number of buyers purchasing these for speculation increases.

Economics works until regulation

Given these facts i.e.

  1. A limited supply of bitcoin and Ether.
  2. Increasing commercial usage  (by means of increasing number of global merchants accepting BTC and using Ether).
  3. Increasing number of speculative users ( by means of real time trading and buy-and-hodl investing for BTC and Ether).

It is almost a no-brainer to see why conversion rates (for BTC-Ether) are increasing. We’re not accounting for the lost BTC/Ether per year.

However, these laws of economics hold only until some external event (what economists call shock) happens. For example, a regulatory authority decides that it is too risky for its citizens to bypass financial controls and engage with a global market. The regulator could then entirely ban BTC/Ether and make it illegal to hold/trade in the same within the country. This is what we saw during the past week in China. Venezuela another country that saw massive deflation of their local currency banned bitcoin earlier.

But most global markets that want to encourage a free flow of capital to their economy would not ban any asset, in the name of protecting it’s citizens from speculation. (For example, would any country prevent its citizens from collecting art, or vintage cars or any other antiquity in limited supply.)

Bitcoin speculation

Speculation

Speculation is described by the modern dictionary in two related yet different ways :(1) “the forming of a theory or conjecture without firm evidence.” and  (2)“investment in stocks, property, or other ventures in the hope of gain but with the risk of loss”. 

In the context of cryptocurrencies – definition (1) seems to have an impact on the definition (2). The past week has seen an immense number of theories – from the banning of exchanges by China, to a known name in the financial world calling cryptocurrencies frauds. The market reacts to every one of these news articles that are sourced sometimes from unconfirmed sources – irrespective of whether the player has any real investment in that asset class or not.

News

There are 160+ obituaries written for Bitcoin documented here since Genesis. Prices have dropped (sometimes significantly) each time any negative news makes it to the headlines causing significant profit booking by active traders. A classic event study will demonstrate the reliability of these markets on information from any source -reliable or not. Most of these news articles are the basis of Speculation but increase the “risk of loss” to long term investors.

Mature markets

Mature securities markets do not react with such swings in the face of unconfirmed news or rumours, since firms usually control their public announcements.The biggest difference between an evolving technological market, and, a mature one is  in the level of volatility (- mismatch in supply and demand -)  a market exhibits in the face of external news (- e.g. a trader who has zero stake in the Bitcoin ecosystem commenting about its problems without providing any evidence). Overall, mature markets will need more evidence, so as to increase the “risk of loss”.

In other words, the higher the evidence an actor provides to either support or oppose a viewpoint, the lower the “Risk of loss” would be. This maturity in terms of resilience (of supply and demand) is probably coming soon (and) will probably be a facet of these markets. Such maturity and reliance can happen only when we see mass adoption of applications such as the  “Brave Browser” , or, the instantaneous remittance application ABRA.

Banning Initial Coin Offers

Initial Coin Offers Banned

The role of governments has since time immemorial been to protect its citizens, the assets of citizens, and, businesses by whatever means. Sometimes it was through force, and other times it was through the rule of law. Initial Coin offers were a new way of holding assets of citizens, without governmental control and oversight. This past weekend saw an exercise in such control in China.

ICO's banned
Initial Coin offerings Banned

 

In China, Initial Coin Offers were banned in total.

While an “outright” ban bought the fledgling market to a grounding halt. Reasons that were attributed to this ‘ban” are many: a significant mushrooming of ICOs (Imagine about 50 online businesses helping create ICOs to raise public money); the high cost to enforce regulations; the extreme bypassing of national banking systems causing capital flight, etc…. There are two sides to the regulation debate. On one side, some proponents of ICOs claimed that a total ban was bad. On the other side of this debate, is the fact that regulations remove bad actors that harm the ecosystem. There are always going to be instances where regulations can completely kill a new market for innovation, but, developed societies always manage to find a balance based on the convictions of experts. The New York hearing in my previous post was an example.

Ease of creating Complex Contracts – bypassing regulation

There have been plenty of businesses raising money from gullible investors bypassing all known capital regulations. The underlying platform in this case Ethereum – per-se does not have a governance model for launching a new ICO. In fact, anyone can create an alt-coin- as documented here and here.  Ethereum is creating an easy to use graphical web-based interface to enable non-programmers to create tokens (as contracts). The platform can create, validate and transfer tokens across geographic boundaries, and, even financial-economic boundaries. To top it all, these tokens can be configured as a contract which can express complex functionality when it executes on the network. These complex functionalities could be as complex as either a second order derivative that can be traded on exchanges: an example would be Mortgage-Backed-Securities with a dividend option; or; as a simple security: one that holds value and increases as the business grows. These can be bought and sold on exchanges that support the alt-coin.

Hope for a Governance model for new ICOs

With such complex functionality supported, a few bad actors riding on speculative transactions can cause significant mistrust amongst citizens and the government’s ability to reign in bad financial actors. We wish that at some time in the future, either the Ethereum Enterprise Alliance or some other entity sets out a global order to govern new token (and ICOs) releases – so as to give them more legitimacy supporting the aspirations of nation states and their financial needs.

Interesting conversation – do you think Bitcoin is future proof?

Interesting Question

Last week, had an interesting conversation with an uber driver at New York, about Bitcoin.  He posed a question to me quite casually – “what do you think – is Bitcoin future proof?” – and then he gives me his insight into why he thought it is entirely not future proof, and, why he has not considered investing in it.

 

New York Question

He told me that – though he’s in New York and a lot of people are Bitcoin users there (almost an ATM every 5 miles), he is skeptical about the technology because it may not be future proof. He told me that once quantum computing (i.e. a computer that can theoretically compute at very high speeds ) becomes a reality, Bitcoin wallets and other storage devices that store the private keys of users could be attacked using Brute force.

He asked me if bitcoin’s and the other blockchains (such as the Ethereum chain) could withstand such attacks, if large computational and storage power became available, at low costs.  This leads to an interesting problem – if at all answerable.

Computational Power

How much computational power would be needed to compromise the network effects built over years – if at all feasible, if there were infinite computing power and infinite storage suddenly available? Traditionally Moore’s law has been applied to both computing power, and, to storage – and will continue with semiconductors and storage. However, if there were a technological development over and beyond current semiconductor and storage based developments, such as a leap-frogging to quantum computing, this law may become irrelevant.

To Ponder

PS: Question – What would be the computational power needed to brute force the components of the Bitcoin subsystem i.e. wallets, nodes, multi-sig, etc..?

 

Bitcoin’s Quadratic Hashing Problem

There have been many debates around why Bitcoin needs to scale, and, why transaction lags happen. One of the most common reasons attributed to transaction lags is the size limit of 1MB  per block of data, that has been hard coded into the Bitcoin core source code.

Quadratic Hashing

Each block in the Blockchain contains a hash of all transactions since the previous block was created.  This artificial size of 1MB limits the number of transactions that can get into each new block. If a transaction cannot be mined in a particular block, then it will have to wait till the next block is created to be mined. Many exchanges, and, service providers such as ATMs or money exchangers wait for up to 6 blocks after the initial validation to make sure that the transaction was indeed validated.

For the crypto-enthusiasts – and those interested in the details, the following link gives you a technical description of what happens when users have multiple signatures and when 1 MB is insufficient in size for miners to incorporate all new transactions since the previous block. This problem otherwise known as quadratic hashing – indicates that the time complexity to validate new transactions increases quadratically (i.e. by the power off) with respect to the number of signatures needed to hash each transaction.

Solutions to Quadratic Hashing

Bitcoin Cash

Many solutions have been suggested including in the link above. Bitcoin cash also proposes a solution wherein they increase the block size significantly (8 times, from 1 MB to 8 MB), which they claim is sufficient to prevent transaction delays in mining new blocks.

Current Block Mining Time and Segwit2X

Source: http://data.bitcoinity.org

The following link provides a list of the average time taken to mine a new block. on the main blockchain. As of this writing, the average time to mine a new block is about 15 minutes (Meaning every hour 4 blocks are mined on the network.). Imagine the delay if you were to either sell or buy anything on the internet using Bitcoin. Segwit2X is the solution that most ecosystem participants have agreed to roll out soon. Once the rollout of Segwit2X  happens, we will see a significant reduction in transaction time across the bitcoin network. The countdown to Segwit2X is listed here.

 

BTC and BCC

This week, Bitcoin forks. About 99% of the network including the miners, exchanges, user nodes will continue to support the original BTC, which has agreed to roll in the Segwit2X patch for scaling. However, many of these exchanges have taken a stand that they will not support the BCC chain.

Bitcoin Cash

However, the rest will move onto BCC (Bitcoin Cash), an alternative currency supported by a few miners, and, developers. ( Read more about BCC at its website https://www.bitcoincash.org/. ) There are quite a few main exchanges like Kraken that are neutral to BCC.

This has happened earlier with Ethereum – wherein two coins were born i.e. ETH and ETC, after the DAO hack. ETC continues to trade on several exchanges such as on shapeshift.io, but major exchanges do not support ETC.

In equity markets, when a stock splits or additional shares are issued as a bonus, the value of the equity does go down to reflect this – so as to retain the market cap of the firm issuing shares. Usually, in the short term, this increases the market cap because of each new share, becomes more amenable to the buyer’s “willingness to pay”.

In Contrast, with respect to Bitcoin – this is very unlike a stock split (or a bonus declaration). This is the creation, of a brand new coin and blockchain off the original chain. Ideally, every BTC owner can- after August 1st access both his BTC and BCC balance. The futures market of BCC, already shows the price of BCC to be between 0.08 and 0.01 BTC.

The Crypto-valuation roller coaster

New Domain announcement: The past 2 weeks for me were a vacation from posting, before I launched my blog http://www.notesnewtech.com. My old domain is hemangcs.com and will resume posts on purely academic work e.g. big data analysis, commentaries on my own research, math models, and course teaching activities.

Crypto-valuation roller coaster

In the past two weeks though we’ve seen an amazing amount of bad press, and pretty bad speculations about everything crypto currencies. A lot of hype around Bitcoin’s scalability approaches too followed i.e. Segwit, Segwit2X, Bitcoin-Unlimited. Consensus 2017 was the meet up wherein the entire ecosystem (i.e. miners, developers, and exchanges) worked hard to arrive at an agreement to back Segwit. Over time though in 4 months wedges developed amongst the miners and othe development community that led to an assumption about a Bitcoin hard-fork and the birth of 2 coins on August 1st, and a prolonged battle amongst exchanges for who would own the BTC symbol. As of date, though, there is a beautiful agreement that will roll forward as a compromise called Segwit2X that will accomplish a doubling of block-size to 2MB and an optimization of storage networks will take shape. As of NOW (8:29 am) at least 55% of the network has already migrated to Segwit2X. Coin.dance has an amazing visual about this real-time transition to segwit2x.  The market tanked about 40% in the past two weeks to recover 20% after the announcement that consensus around Segwit2X is a given and a split if at all happens will survive the larger market.

This market is proving to be information efficient. As sentiments shift (bad press coverage to good press coverage), backed by developer action (arriving at a consensus around Segwit2X  to no consensus) and engineering enhancements (Ethereum scaling) we see the shift in prices. The roller coaster in price movements is captured by the shift in sentiments amongst the crypto-ecosystem participants.

What we’ll see after migration to Segwit2X?

  1. Transactions will become significantly faster on the Bitcoin network. Block validation times (that today) translates to 40 minutes sometimes will reduce to a few minutes (if not seconds).
  2. Similarly, transaction confirmation times (that need at least 6 blocks validated) will take much shorter.
  3. This will make buying, selling, and trading with Bitcoin more common and we will see in the short term people using Bitcoin as money – till the 2MB size limit is hit.
  4. In the long term, however, Bitcoin – the main asset through which all other crypto currencies flow will see a huge upside.

In addition what we’re seeing is a large number of Global Initial coin offers. All kinds of ideas from prediction markets to sports analytics coins are being released and promoted. Even Daimler the parent company of the Mercedes Benz released a 100 million Euro bond modeled on Ethereum!!

Unsung – an App Hacking Hunger with Blockchain

I saw this app called Unsung – which is an awesome application using digital currencies for payments. Distributed – live streamed – sharing of food to the needy people in one’s community.

Unsung brings together  donors and recievers of food/groceries,  using real time streaming similar to uber. The donors and the deliverers i.e. drivers who courier the food to the needy, can earn donations using digital currencies, thus reducing transaction costs. One can also donate on the platform using cryptocurrencies or cards. Eventually, I’m sure they will generate their own colored coins, which will replace the existing reputation points based model. These colored coins can then be traded on Karma markets.

Its fascinating what can be accomplished using micropayment using digital currencies and a mobile application.

Gold vs. Bitcoin as a currency hedge

Gold has been used as a hedge for portfolio diversification in many countries. For example, these 3 firms in Kerala – India seem to make gold in any form fungible. Over a period of time they seem to have amassed more of the yellow metal than some of the world’s richest countries in their reserves. 

What makes this equally interesting is that since the past 2 years gold hast depreciated as an asset – globally.

 Bitcoin on the other hand has significantly appreciated in value during the same period.  However,  with bitcoin, fungibility has been a concern due to very few people exchanging bitcoin for real money. The ATM’s charge an average of 20% commissions and the buy/sell ratio for Bitcoin is about 20%. Moreover, financial instruments such as loans on NPV for bitcoin haven’t yet made their mark.

But my guess is this will happen – sooner than later, since storage and transportation of bitcoin is much less expensive than Gold. The storage cost component of the transaction cost of holding Bitcoin is almost Zero, and this makes it very attractive.

Sooner, than later this will become an alternative if not powerful hedge against government backed currencies.

Look at the 2  graphs for these two forms of fungible currencies.