Programmable Money and value capture

Money serves three purpose – unit of accounting, a medium of exchange, and a store of value. Cryptocurrencies have been compared to Programmable Money. Anything programmable requires an experimentation platform for iterations and improvement. Bitcoin seems to have won the “store of value” battle. Ethereum has the developer mindshare and is the preferred experimentation platform. Multiple cryptocurrencies are still fighting the battle to be the medium of exchange.

BTC dominance chart from CoinMarketCap

BTC dominance chart from CoinMarketCap

The amusing part is that every cryptocurrency startup envies Ethereum’s developer ecosystem and is trying to attract developers. But there isn’t any real value capture being the experimentation platform. A successful product has a high chance of leaving Ethereum and migrating users to its chain. The real battle, I believe, remains in becoming the medium of exchange, being the programmable Visa & Mastercard equivalent.

Cryptocurrency trading

Background

There are three major types of financial exchanges

  1. Stocks and bonds
  2. Commodity exchange
  3. Foreign exchange (Forex)

Stock exchanges, where stocks and bonds are traded, are highly regulated and don’t transcend national boundaries. The listed companies have to follow disclosure protocols decided by the government and the exchange. The stocks that are traded on these exchanges are mostly unique to the exchanges. For example, Google is only listed on the American exchange of NASDAQ. So, to buy Google stock, you need to conform to American laws. Also, you can only sell these shares back on NASDAQ and that too only within certain hours of the day. Therefore, these exchanges have some monopoly power.

However, commodities can be easily resold and delivered on other domestic exchanges and with some effort across national boundaries as well. Therefore, unlike stock exchanges, commodity exchanges do not have a monopoly over what’s being traded on them. The only advantage they can offer to the traders is a marketplace where they can find counterparties to take a position against their trade. Traders don’t have to arbitrate, that is, buy from one market at a lower price and then sell to another at a higher. Just the fact they can do it ensures that prices differences are minimized. Crude oil is the most actively traded commodity in the world and unlike Google stock, a trader can trade in crude oil, practically, in any commodity exchange in the world. Some other commodities could be traded in exchanges specific to a country.

Foreign Exchange (forex) markets are different. In theory, one can be run a US Dollar – Euro foreign exchange in Nigeria. Therefore, these transcend national boundaries. Most forex markets, however, are regulated. Forex markets are practically 24-hours a day, 7-days a week. Since major currency pairs like USD-EURO can be traded in any major forex exchange on the world, these markets practically never close. This distinction is subtle but important. For example, consider Apple Inc. which is listed on NASDAQ in the USA. If some bad news related to say Apple is published in media on Friday evening after NASDAQ is closed for trading then the traders cannot trade their Apple stocks till the Monday morning. But if Britain’s exit from EU (Brexit) is canceled on a Friday evening then the forex market will react immediately to the news.

Another subtle distinction is that big stock exchanges can enforce their rules and if a trader behaves badly then they can ban him/her for life. Getting banned from a major exchange is career suicide. A trader who, say specializes in tech stocks or healthcare stocks of a country cannot simply move to another country and learn the rules there. Commodity and forex markets are different. One can simply register in a different jurisdiction and start trading. Thanks to the Internet, being registered in Malta does not require one to live in Malta.

Type Monopoly Restricted to a country 24-hours a day
Stock exchange Yes Yes No
Commodity exchange No Partially Yes
Foreign exchange No No Yes

Crypto Exchanges

What’s traded on crypto exchanges is not unique to those exchanges. Just like USD can be purchased on pretty much every exchange, one can buy Bitcoin from any exchange, 24-hours a day. But while Forex markets are trading on the optimism or pessimism around a nation’s economy, commodity markets are pure speculation around demand and supply of a commodity. Therefore, cryptocurrency exchanges are akin to commodity exchanges. And since the goods are virtual, they easily transcend national boundaries. Therefore, inter-exchange trading implies price arbitrage will be rare in the longer run. So, what decides one exchange will win over another? Given that an exchange does not have the monopoly over what’s being traded, the only major barriers I can think of are either regulatory or higher liquidity.

The “key” problem in cryptocurrency

All cryptocurrencies are eventually tied to a “private” key. You lose this key, and the funds are gone, forever. Millions worth of bitcoins have disappeared from the circulation due to lost keys. You can memorize the key by mapping it into passphrase consisting of memorizable words but if you forget that, like many others, the coins are unrecoverable. An alternative is to trust a centralized service like Coinbase, but then all the benefits of investing in a decentralized currency are gone. Lastly, one can use a hardware wallet, but again, if you lose the wallet, the key is lost. If you keep the key on your device, then a malware might target and try to steal it someday. Thus, even if you are bullish on cryptocurrencies, there are no good decentralized ways of holding a significant chunk of your net worth in cryptocurrencies.

The problems are compounded further by the fact that to a great extent, the key access is all or none. If you lose your key, you lose all the funds. If I got hold of your key, I could transfer 100 % of your funds, irrevocably. Compare this to your ATM debit card, if I get hold of it, along with your pin, there is only so much damage I can do before the ATM limit hits. Further, your credit card used on a malicious website can hit you with a limited amount of fraud before the fraud warnings block the card to prevent further loss of funds.

An ideal approach, hopefully, will consist of decentralized smart contracts comprised of multiple keys tied to the same passphrase with a different set of transfer limits. So that, if one forgets one word in the passphrase and cannot access 100% of the funds now but can access at most 1% funds every day and slowly drain out their account to a newer account. Some of these unlocking codes will be held at different places, some centralized services for custody and ease of use; some kept on the personal device for ease of use where even if they get stolen the damage is contained. A further addition could be a beneficiary account where the funds would be transferred to in case the account lays dormant for a certain period.