Ignore the giant stuffed bear

We have been working a fair amount in the blockchain world lately. Doing a lot of research. Talking to people. Working on a potential token sale. As we have noted, we are increasingly big believers in the potential for blockchain-based applications to become very important. So we offer this post as constructive criticism to certain aspects of that community.

One of the glaring things that stands out among the participants in this world is that the average age is very young. The leading figures are maybe in their 40’s, and many, many CEOs and aspiring blockchain enthusiasts are in their 20’s.  There is nothing wrong with this. If you just graduated college there are a ton of opportunities in the cryptocurrency world right now. Why not take a chance? The Internet started out that way, as did Web 2.0. There is an incredible amount of energy and enthusiasm around Bitcoin and all things blockchain right now. But at times that enthusiasm verges on a near-messianic belief that blockchain will ‘change everything’.

The problem is that this enthusiasm is largely directed at the financial world. And the Finance industry is filled with some… let’s call them… very sharp people, in multiple senses of that word. Believers in blockchain will argue that the Finance industry is antiquated, ossified and ‘corrupt’. One observer pointed out that most of the people in the community came of age in the middle of the 2007 Great Financial Crisis, and thus have no faith in traditional institutions. But there are lots of smart people in Finance, and they are all watching Bitcoin very closely.

This is going to lead to conflict, and we are not entirely clear who will come out on top. At its most extreme, there are a number of pure sham ICOs trickling around in the system. But that is the extreme case. A more prosaic problem is that so many blockchain start-ups seem to be re-inventing the wheel and ignoring history.

One of the most glaring examples we have seen of this are so-called ‘stable coins’. These are are cryptocurrencies that are designed to offer a fixed rate of exchange with fiat currencies like the US dollar. Again, the worst example is Tether, which claims to be backed 1-for-1 by dollars held in trust somewhere, but many people think it is a scam, or at least highly opaque. There are several other attempts at stable coins which seem more legitimate, some of them even have clever built-in mechanisms to ensure transparency. The problem is that there no way to completely eliminate exchange rate risk.

We often use the example of a balloon to describe this problem. Squeeze a balloon, and it just readjusts itself so its contents move around, but the total volume of the balloon remains unchanged. Similarly, a stable coin is just a mechanism for moving risk around. Ultimately, there is no way to entirely eliminate risk in anything, especially currency exchange. Double especially in highly volatile, poorly understood cryptocurrencies.

We are not saying that all stable coins are a bad idea, or that mechanisms to manage exchange risk are a bad idea. Instead, we think it is important that anyone trying this needs to understand the ‘conservation of risk’, and to build structures that appropriately reward people holding that risk. This concept is well-understood on Wall Street, but even in the traditional marketplaces for options and derivatives, there are immense information asymmetries which allow for ‘sharp’ actors to profit at the expense of the less well-informed. Moving all this to the blockchain will not eliminate the underlying problem. The saving grace for the blockchain world is that it has shown immense creativity in increasing transparency and improving governance.

Our point here is that many of the people proposing blockchain projects today have no or (even worse) just a little experience in finance. And the market for Bitcoin has only made this problem worse. Bitcoin has had two major drops in share price – one in 2014 and one early this year, as well as many smaller mini-crashes. But the overall industry is still in a very bullish stance. They say the true test of a trader or operator is how they behave in a major downturn. The crashes in Bitcoin have come and gone so quickly that they have conveyed a false sense of security that cryptoasset prices will always go up in price. Despite the limited quantity of supply, there is no way that the trends of the past few years will always hold. Eventually, we will hit a real downturn that will last for a prolonged period. And before that happens there will be all sorts of shenanigans and forced arbitrage opportunities. Experienced traders from the Street are finding and will find many more ways to exploit this.

As a closing note, some readers may have noticed that the image we attach to many of our blockchain posts is a row of carnival games. These offer many glimmering prizes, but are notoriously difficult to win in an economic manner. As you enter into the blockchain world, ignore the giant stuffed pink teddy bear, focus hard on the mechanics, and be careful that your counterparty in any trade may be a carnival barker.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s