Let’s talk about cryptocurrencies and blockchain


Disclaimer

I've been thinking about writing this blog post for a while now.

But I've deferred, thinking "I'm too much of a noob. What value can I possibly add to the discussion?"

But that's the point. When I'm not sure what I think, what I like to do is write things down to better organize my thoughts. And, it helps me remember. Then later on I can come back and see what I thought at a certain point in time, and clarify my points of view.

So when it comes to blockchain and cryptocurrencies, you should beware, readers of this blog. By no means am I an expert on blockchain or cryptocurrencies. Some of the things I say here will be wrong (hopefully not too many). Some of you reading this will be more in-tune with blockchain than I am, and will cringe at the very things I say. Sorry about that.

But I need to write about blockchain. It's the only way I will get better at it.


Introduction

If you've been paying attention to the news, or maybe even if you have, you've no doubt heard about the phenomenal rise of Bitcoin over the past 12 months. You may not be sure what Bitcoin is, or why it's popular, or if it's in a bubble, or if that bubble may pop. You may even have FOMO and are therefore looking to see how you can get some... just in case.

I don't have time on this blog to discuss what Bitcoin is or how blockchain works, except to say that Bitcoin is a cryptocurrency that is built on top of blockchain. If you're not sure what either of those two things are, there's a ton of resources available on the Internet. For example:

You can also do your own searches. And then for Blockchain:

If you've never heard of Bitcoin or blockchain before, and you've gone and watched those videos or read those articles, then congratulations! You've graduated to having zero-knowledge to being a noob, just like me (on a scale of 1-10, I consider myself a 2.5).

Now that we have that out of the way, let me answer a question you may be having: if this blog is all about security talk, why am I talking about cryptocurrenices and blockchain?

Well, I first heard about Bitcoin in 2012, and since then I've kept loose track of it, watching it go way up and way down over the years. But this past September I listened to a talk by a venture capitalist about blockchain, and after that - for reasons I can't really explain  - I became really excited about it. I don't often get excited about technology, but this did it.

Since that time, I've started to research Bitcoin and blockchain a lot more, really ramping up my efforts over the past 6 weeks which is what has prompted this blog post. And the things I want to talk about is not how it works, but how blockchain will shape the future and whether or not it's worth me investing in a particular cryptocurrency.

This blog post does not contain investment advice, you should do your own research and evaluate your own financial position before making determination.

What's the brou-ha-ha about blockchain and cryptocurrencies?

The cryptocurrency aspect of blockchain is one thing, but to me it's not the most interesting thing. I think what is more alluring is the inversion of the value that protocols bring - from thin protocols with fat clients, to fat protocols with thin clients. These are not my terms, but it's part of what I've read.

If you think about the protocol that defines email, SMTP, it's a very "thin" protocol. It just defines the rules about how to exchange messages over the web. But nobody ever made any money by inventing SMTP. Instead, it's the ISPs, email service providers, and endpoints that have extracted the overwhelming value from email. SMTP sits on top of TCP/IP, and nobody made money by defining TCP/IP either.

Indeed, this is how a lot of Internet protocols work - HTTP defines how to exchange data over the web, but it's applications like Google, Facebook, Amazon, and Twitter that have created value out of HTTP, rather than the inventor of HTTP (Tim Berners Lee).

Blockchain inverts that model. Rather than a thin protocol like SMTP or HTTP that only defines the rules of data exchange, Blockchain lets you, as a protocol creator, define the rules and derive a ton of value right in the protocol itself. The application layer is much less important:

The applications are thin, and must compete with each other in order to compete for users and drive value for their creators. But these applications are distinct from the Blockchain protocol itself.

And what speaks to me about this model, especially as a software geek who cares so much more about building cool stuff than driving shareholder value [2], is that the Blockchain is decentralized. Whereas Facebook, Twitter, Google, etc. all own your data and it's hard or impossible to move your data out of those services, the Blockchain works by being replicated on many people's machines, so by definition you really can't centralize your data in any particular service.

Wait, that's not the interesting part to me.

No, what I like is that Blockchains create value by inventing protocols that solve a problem, and as they gain more widespread adoption, the protocol itself becomes more valuable. It means the geeks and nerds who designed it, wrote the code, and made it useful are extracting value out of it. As more blocks are mined by others on the network, the network becomes more valuable in and of itself - the Network Effect.

For example, Ethereum is a platform for creating Smart Contracts. That solves a problem. The creators of Ethereum will themselves have Ethereum tokens which would be useless by themselves; but as Ethereum is used as a platform to solve more and more problems, more and more Ethereum tokens are mined and drives up their value. And the creators of Ethereum - assuming they still have their tokens - see the value of their tokens go up which is the right thing because they invented it. You are rewarded for driving value, rather than needing a corporation to come in and drive value.

Corporations, of course, can do that to. And they should; and, they will derive value by building applications on top of the Blockchain. But the creators of the Blockchain are also rewarded for creating the protocol upon which many things are built.

This is where I differ from a blockchain being a "fat protocol, thin client". Whereas the reverse is true for the current web, I think for Blockchain it will need to be "fat protocol, fat or thin client" in order to drive value both for the protocol and for the application layer, otherwise no one will build applications. Or, if they do, they may have margins too thin to incentivize people to move to blockchain.

Categorizing the various types of cryptocurrencies

In doing my research, I've mentally divided cryptocurrencies into two different types:

  1. True cryptocurrencies
    .
    These are designed to act like money, and the most obvious example is Bitcoin [3]. More examples are altcoins (other cryptocurrencies that are not Bitcoin) like DashCoin, LiteCoin, and Monero.
    .
  2. Cryptocurrencies that aren't trying to be currencies
    .
    These are platforms upon which you can build apps, or blockchains that solve other problems. You can mine them, or you can speculate on them. Examples are Ethereum, Ripple, Cardano, and NEO.It's a misnomer to call them a cryptocurrency because they are not trying to function as a currency. However, you can buy some of them with US dollars, and others can only be exchanged from another cryptocurrency (i.e., you can't buy them [yet] with US dollars). So in that regard, the fact that you can buy them (and speculate on them) makes them feel like a cryptocurrency, but their main purpose is to act as a protocol that can be used to solve problems.Even among these cryptocurrencies, there are some that are more advanced than others. I'm still working my way through them, it's a tough slog figuring out which ones are good and which ones will bust.

I'm not sure that this is the correct way to think about cryptocurrencies. There are coins and then there are tokens. I'm not even sure what those are yet.

Thus, when it comes to distinguishing the hype around blockchain and cryptocurrencies, there are several questions to ask:

- Is it trying to solve a problem? In Bitcoin's case, yes. It's trying to be a decentralized currency that is resistant to manipulation by central banks, and it is trying to act as a store of value similar to the way that gold does. And unlike gold, it is easier to conduct transactions.

- In the case of Bitcoin, it seems like the only way to "play" it is to speculate in it, that is, buy and pray that it goes up in value at which point you can either sell it back into your local currency to exchange for goods and services, or purchase good or services from a retailer that accepts Bitcoin.

- For other cryptocurrencies (I will call them cryptos 2.0, even though some of them are probably cryptos 3.0), what problem are they trying to solve? Is it a legitimate problem? Or is it likely to be just another one of the tech world's false prophets? Cryptos 2.0 seem to offer opportunities to speculate, or build apps on them. Speculating in these gives a better dopamine rush, but building apps on them is better for the advancement of humanity.

Conclusion

I'm going to end this blog post here even though I have plenty more to say on it. How can I know which cryptocurrencies will go up [4]? How do I hedge my risk? How do I know which blockchain is worthwhile, and which other ones are fluff? What does it take to make one succeed? What resources can I use to better educate myself?

There really is a lot to take in. But truthfully, I haven't been this intrigued by a new technology in a long time. Let's hope it doesn't let me down.

 


[1] Don't get me wrong. Corporations play an important part of our market-oriented economy. There's no better mechanism that private enterprise to deliver a large percentage of goods and services. But they are not the best at all things, and the mantra that corporations should exist only to drive shareholder value seems very 1980's to me.

[2] I'm probably using the term "token" here incorrectly. Sorry.

[3] In the United States, the IRS disagrees that Bitcoin is a currency and instead treats it like a capital asset. What does that mean? It means it treats it like a stock or bond (actually, more like a stock that doesn't pay dividends). For example, say you have $10 and bought 1 bitcoin (assume 1 bitcoin = $10 USD). The price of bitcoin then goes up to $20 USD per bitcoin. You've doubled your money!

Now suppose you want to buy a popsicle at BitcoinPopsicles.com, and they are going for 1/2 bitcoin each, or $10 USD (they're good popsicles). You may think "Sweet. I've doubled my money in bitcoin, so I'll send over 1/2 a bitcoin which is $10 US, and I'll still have 1/2 bitcoin left over." The way I understand it, that's not what happens for tax purposes.

No, what happens is you first "sell" your bitcoins and realize a capital gain, and then send them over to BitcoinPopsicles. So, you sell 1/2 bitcoin and realize a gain of $10, and then spend that $10 on a popsicle. On your next year's taxes, you must report a capital gain of $10 and pay your normal rate of capital gains taxes. So, if you are in the 25% tax bracket, and your held your bitcoin for 30 days, then your tax liability is $2.50 US.

Thus, when you pay for stuff with bitcoin, you need to realize that it's going to cost you more than you think. You'll want to talk to an accountant. Also, see https://www.irs.gov/pub/irs-drop/n-14-21.pdf

[4] Another disclaimer: as of the time of this writing, I own a little bit of Bitcoin and Ethereum.

 

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