How Many Cryptocurrencies Do We Really Need Anyway?

Whether you're a cryptocurrency fan or just a curious observer, you've very likely heard of the cryptocurrency Bitcoin. What you may not know is that new digital currencies are being created all the time, entering the market in what are called initial coin offerings (ICO). As of this writing there are 1165 cryptocurrencies in 5744 markets, with a captialization of more than 174 billion dollars.[1] The rabid hype over new coin offerings is well covered in the media so I will not say much more about that here. But as you hear about all the new crypto-millionaires and the incredible gains some of the ICOs are achieving (more than 80,000% in one case), you may be wondering what all the hype is about and the purpose behind all these new coins. Let me try and give you a sense of reality and where I think we are in the cryptocurrency journey.

Disclaimer: I am neither interested in nor qualified to give investment advice. If you decide to invest in cryptocurrencies I strongly suggest getting advice from qualified investment advisors. And as with any investment, never invest more than you can afford to lose.

Why do we have coins?

The first thing I want to do here is replace the word coin with token. Coins imply money or currency, and while that is the most commonly known use of blockchain technology, it's becomming so much more. With that it's important to understand is the purpose of a token. Blockchain-based decentralized applications (dapps) fundamentally require two things to be viable. First, they need to define the data that will be stored in their blockchain. Ultimately any data is part of a transaction which can be as simple as a record of ownership or as complex as a highly detailed legal exchange in the form of a smart contract. The second thing they need is a way to commit these transactions to their blockchain. Typically this involves a distributed network of computers processing algorithmic proofs, with the "winner" receiving some value in exchange for their work. (There is a lot of detail behind all this, which is beyond the purpose of this article. I'd recommend Blockchain by Aritemis Caro as a great primer on how this all works.)

This value exchange is where tokens come in. The value can come in the form of proof of ownership of a token, as is the case with Bitcoin. Or it can come in the way of proof of execution, such as with a smart contract. So the value here doesn't need to be monetary, it can be something else entirely, such as evidence that one party transferred an asset (like property) to another party, or that someone completed some work for someone else. The uses are almost limitless.

Unfortunately, I believe most of these tokens will be worthless over time.

If all this is a bit confusing, let me give you some practical examples of applications being built on blockchain and how tokens play a role.

Currency
Bitcoin is quickly becomming a household word, and while most people don't understand that blockchain is behind it, they understand that it's some kind of digial money. The token here, called Bitcoin, is the currency and it's both the exchange of value for doing the work of maintaining the blockchain as well as an asset that itself can be exchanged among owners.

Smart Contracts
Smart contracts are the digital version of the many types of contracts we use everyday. Whether it's a mortgage agreement with our bank or an employment contract or the terms of use we all agree to (but never read) when we download an app, contracts are part of daily life. The difference with smart contracts is that every detail can be encoded, and the transactions can be stored, indelibly, on the blockchain. Tokens in this case can represent both the contract, and the proof that some transaction was made against that contract. Etherium is a platform that lets anyone create smart contracts. The Etherium platform also has a currency token called Ether, though Etherium also lets application developers create their own tokens.

Identity
A quick look at the many identity breaches in the last few years will tell you we have a large and growing problem with securing an individual's identity in a digial world. Blockchain can help solve that by allowing for a self-managed identity scheme, where you own your own information. Your identity, then, would consist of a token or series of tokens that you can share or hide as you see fit. Since it's stored on a blockchain and you hold the key, no other entity can steal or change it without your permission. An organization called Evernym is attempting to solve this very problem.

Proof of action
The blockchain can record the fact that an action took place, whether in the digial world or in the real world. Imagine for example a music app built on blockchain technology. Such a service could create a record evertime someone listens to a song by a particular artist. When that happens, the app could deduct a very small predetermined fee from the listener, and pay it directly to the artist, and the transaction would happen in near realtime with no record label, distributors, or any other entity in the middle. The token in this case would be a record of the transaction (the action of listening and payment to the artist). The payment could be in the form of a cryptocurrency, or even a fiat currency, the terms being defined by a smart contract. The whole process would be highly efficient, and because the artist is getting much more direct revenue without all the middlemen, the cost of music to the listener could actually go down while artist earns even more for their work. Everyone (well, almost everyone) wins.

This is just a few examples of the hundreds of applications being built on the blockchain. Most of the developers building these apps are issuing their own tokens as they create their platforms. Unfortunately, I believe most of these tokens will be worthless over time.

The Internet Hype Machine

If you're old enough to remember the "internet bubble" of the late 90's, you'll remember that the hype around the internet at that time created a mass of irrational investment in anything with a .com as part of it's name. Dot-com "companies" were springing up everywhere, and investors were pouring money into them in an attempt to cash in on the craze. The problem is that most of those companies were not companies at all. They had no business model, and most were not solving any real problems, but just attempting to "digitize" some non-digital business. Outfits like Pets.com and Webvan spent lavishly to try and digitize a commerce business without the scale or infrastructure needed to actually make money. Other firms like Napster and Broadcast.com were just ahead of their time, and didn't have the business framework to be long term viable.

But despite the many failures, and the burst of the bubble in the early 2000s, the internet itself has been incredibly robust, and has helped usher in historic changes to the way we live. The firms that have built viable businesses on the internet, such as Google, Facebook, and Amazon are some of the most successful companies in human history. Those companies have changed the way we live, and investors in those firms have done extremely well.

The Coin Hype Machine

I believe we're seeing the same thing today with blockchain. Just as with the internet, there is a lot of investment in the technology by those looking to cash in on the hype. But in the late 90s one did not invest in "the internet", but rather invested in irms that built their businesses around internet technologies. Some were using the existing web technologies of the day, but others were pushing the technologies forward and developing new business models at the same time. The hard part for the average person was figuring out which ones were going to be viable over the long term and which were not.

Like the internet bubble I think most of the tokens being issued today in ICOs will end up being worth nothing as those applications wither and interest in the tokens dies off. There will be a lot of stories of these failures, and skeptics will point out that this blockchain thing is a fad and/or dangerous to the economy. They will reference the internet bubble, the housing bubble and any other bubble that attracted "irrational exhuberence" and destroyed wealth for the speculators.

But like the internet or housing, the fundamental benefits of blockchain are, I firmly believe, here to stay. I also believe we are just at the beginning of what could be a technology revolution on par with or greater than the internet itself, and while many many experiments will fail, the ones that succeed will change the world.

Picking the Winners

So is there a way to detect the winners from the scams? No. Anyone who tells you they can is either lying or trying to scam you. It's simply impossible to predict the future and know with any certainty which combination of technology, public acceptance, political support, and just plain luck will end up coming together to do great things. But there are a few questions we can ask that I think will give us a better chance at picking the winners.

  1. Does the app token exist to solve a real problem not solved by an existing token? A simple example is currency tokens. Do they exist just to try and be the next Bitcoin? Or do they attempt to solve a real currency problem that no other cryptocurrency solves? Bitcoin has some challenges for sure. Speed of transactions is one (Bitcoin is relatively slow to process transactions). But Etherium was created to solve many of the problems with Bitcoin, and indeed Bitcoin is work on addressing it's own problems. So do we really need new currency tokens to compete with these two?

  2. Does the app and it's token add some functional advantage we don't get with existing solutions. For example, if the app token only exists as proof of a transaction, Bitcoin and Ether already do that. If the token is there to provide identity or storage solutions, that may be some unique qualities about those applications that require a different token. It's important to look at what the application is trying to solve, and determine if a new token is really needed or if the app developers just want a token to raise money and keep people in their "club." If it's the latter, be wary.

  3. Where is the "smart money" going? Tokens, like any other store of value, is only valuable if other people agree it is. In the case of currency, it has to be a lot of other people. I won't get into the whole concept of money and value here, but the basic idea is that that something like a US dollar bill is only valuable because there's a consensus that it's valuable and people trust that its value is backed by the US government. There are many examples of where a fiat currency has failed and people's wealth based on that currency evaporated very quickly. That said, with something as new and speculative as blockchain tokens, it's a good idea to follow the smart money. This means we look at where successful organizations and people with either a direct stake in the tech or a track record in good bets are investing. This is certainly not a guarantee by any stretch, but by leveraging the insights and expertise of established players in the space, you can significantly reduce the risk involved in trying to figure it all out on your own.

  4. Is the application a platform? Just as there was no one way to invest in "the internet" during the dot-com craze, there is no one best way to invest in "the blockchain" today. While I'm a believer in Bitcoin (disclosure: I'm also an investor), I don't believe that it will be the one and only blockchain success. That's one of the reasons I like Etherium. Etherium is both a token (Ether) and a platform. Many other blockchain solutions are being built on Etherium. The more tracktion it gets as a platform, the more value it's token will have. There are other platforms being built as well. Many of them will never go anywhere, but some of them very well could take off.

So, how many tokens do we need? I don't know, and neither does anyone else. My strong instinct though is that the number will be pretty small. Tokens as a store of value and proof of transaction will power many apps, but there will not be a one-to-one correlation between apps and tokens. This is certainly not what we're seeing today though, and my worry is that as many of these utility tokens crash and burn, they may take some of the public confidence in valuable blockchain applications with them. While I don't see that inflicting any permanent damage, it could slow down the adoption of this truly remarkable technology.

Update: This piece from Vitalik Buterin is a must read on utility token valuations, and why using that model for medium of exchange can be economically unstable. http://vitalik.ca/general/2017/10/17/moe.html


  1. According to coinmarketcap.com ↩︎

About Me

Bill Pardi

About

I love things that just work. Born in New York, I now live in Washington State where I work at Microsoft, build things, write, and explore.