I’ve been digging into the cryptocurrencies lately because the space had always interested me, and to be honest buying after a dip is tempting. After a dozen or so hours of research, I feel as if I’m still just scratching the surface! Perhaps I should have started researching much sooner.
One of the biggest struggles in researching cryptos is that I felt there was a severe lack of balanced analysis. There’s a ton of crypto enthusiasts out there that will pump up their favorite blockchains and just as many naysayers but they’re not what I consider objective. I tried to represent both sides of the argument in this post. Another surprising finding to me was how complex the conversations around cryptocurrency has become. I expected the majority of my time to be focused on learning the mechanics of the blockchain, but I instead found myself having to reach into economics, financial history, and even psychology to get a clear picture of what these coins represented.
I don’t consider myself an expert by any means, but hopefully my writings can help kickstart your own journey down the crypto rabbit hole!
Bitcoin
In today’s non-crypto world, if you want to send money to someone electronically whether it be via wire, credit card, or Venmo, a bank is involved to validate the transaction and provide security measures. The bank’s role is to make sure that you aren’t doing anything shady like double spending the money in your account and to prevent thieves from taking your money.
Bitcoin was developed in 2009 to allow for people on the internet to directly share electronic money with each other without using a bank. Instead of the bank validating the transactions, the blockchain was designed to do this. Imagine an encrypted spreadsheet or database that anyone could view, and that this database listed all transactions ever made. This is the blockchain. The public aspect of the blockchain protects against double spending as all previous transactions are visible. The blockchain’s structure and encryption exists to protect against hackers manipulating the transaction records.
The blockchain requires computing power so Bitcoin incentivized people to help validate these transactions and called it “mining”. Those who helped validate the transactions (via mining) were rewarded some Bitcoin themselves. Through this clever solution money could now be shared in a decentralized way.
Now that we have the basics down let’s answer a few commonly asked questions.
“Why is sending money without a bank such a big deal?”
For practical everyday use, it’s not very useful. It’s actually slower than many current banking tools.
Its biggest benefit is really that it is decentralized. Theoretically a bank could decide one day to change its rules and start charging you 100x the existing rate to send a wire. They could block you from transacting with certain merchants that they felt were undesirable. You’re subject to the rules of the bank. With Bitcoin you know this won’t happen because the blockchain isn’t operated by any one entity, it’s decentralized.
“That’s interesting but those aren’t current problems I’m dealing with so Bitcoin doesn’t sound all that useful in most cases. Why is the price of Bitcoin going up so much if the technology isn’t solving an every day problem?”
Very good question! Since it was created, Bitcoin has additionally taken on the role of being a currency. Essentially, it’s in limited supply, people desire it, and are willing to pay for it. It’s not a perfect analogy, but it’s kind of like gold. It’s limited nature and the group perception of its value drives the price.
“Tell me more about the limited nature.”
Scarcity is a key proponent of any currency. If leaves were the official currency of the US, everyone would be leaf rich and it would cost 1,000 leaves for a hamburger. Houses might cost a billion leaves. Soon people would start growing trees to get even more leaves, and as the leaf supply flooded the market the price of hamburgers would rise to 5,000 leaves. Scarcity helps us avoid this situation.
Traditional government currencies (sometimes called fiat) are backed by governments. Trust in the buying power of US dollar is based on trust in the US Federal Reserve (or Fed for short). The Fed is responsible for managing the country’s money supply and preventing the runaway inflation in the leaf example.
However, since the 2008 Financial Crisis, the Fed has been aggressive in increasing the monetary supply. They did this through a combination of asset purchases (bailouts, Quantitative Easing) and by decreasing interest rates. These strategies are credited with softening the market crash and accelerating the following recovery, but the price paid was a massive influx of monetary supply.
Fast forward to 2020, COVID shut down large parts of the economy. The Fed resorted to their same tactics, asset purchases and lowering interest rates. This time though our politicians added a new twist, they printed money and sent it to the people in the form of stimulus checks.
Needless to say, when you start adding a ton of monetary supply to the system, some people start to get uncomfortable with fiat. They start to question whether the government is being too careless, and whether US dollars are turning to leaves.
Enter cryptocurrencies. The supply is programmed to be limited and is not tied to any specific government. The supply of Bitcoin is predetermined and fixed. It should in theory hold up during inflation.
It’s notable that when inflation fears struck in 2008, investors flocked to Gold as a safe haven from inflation and the much expected inflation never arrived. It’s impossible to know for certain if today’s situation will play out the same as 2008.
“So you’re saying the rise in Bitcoin is linked to fears about the dollar. Yet I didn’t know any of this when I started reading and I doubt a lot of people buying it realize this. How do you explain that?”
That’s a fascinating topic! We’ll cover this in more detail when we get to Dogecoin, but essentially what really makes something valuable is the belief that it is valuable. For example gold on its own is not very valuable, its value comes from the fact that people have decided it should hold value. Same goes with Bitcoin.
“What are some criticisms or unanswered questions for Bitcoin?”
Bitcoin has a fixed maximum supply amount. One unanswered question is will there then be enough incentives for people to validate Bitcoin transactions when there is no new Bitcoin to be mined. Miners are currently are rewarded with a supply of new Bitcoin for validating transactions but the supply of new Bitcoin will eventually run dry.
Another concern with cryptocurrencies in general is government regulation. The argument goes that governments will not want to compete with decentralized currencies and regulate them out of existence. It’s notable that cryptocurrencies are already starting to see regulatory pressures in parts of the world, including China.
Some observers call Bitcoin a Ponzi schemes. They do not see value in the technology and think the idea of “believing” something has value is too squishy of a concept. They see Bitcoin as purely a way for early adopters to take money from late adopters before exiting.
Finally, although in theory the blockchain system is extraordinarily resilient to hacker attacks, there’s always the potential that there’s a yet unknown vulnerability that damages the integrity of the entire system.
Dogecoin
Dogecoin was created in 2013 as a joke currency alternative to Bitcoin and prominently features a Shiba Inu dog. The Dogecoin community has gained attention for its various stunts such as donating enough Dogecoin to fund a Jamaican bobsled team to compete in the Winter Olympics (they finished last) and sponsoring NASCAR racer John Wise (the car was nicknamed the Moonrocket). It’s also been more recently embraced by Elon Musk as the “people’s crypto” and he’s promised to send a physical Dogecoin to the moon.
The technology underlying Dogecoin is a little different than Bitcoin but it shares the same functionality in that it sends money to and from others in a decentralized way. One other difference is that it has an unlimited supply, compared to Bitcoin’s limited supply.
To the questions!
“This currency was invented as a joke? Clearly this is not a legitimate investment right?”
It actually doesn’t bother me that it was created as a joke. At the end of the day, Dogecoin and Bitcoin do roughly the same thing. If enough people believe it’s a currency, it can be a currency.
“I’m still having trouble wrapping my head around that statement. This coin with a cute dog on it can be legitimate currency?”
It’s certainly not risk free, it shares all the same risks as Bitcoin and then some, but yes there’s nothing unique stopping it.
“Isn’t it a problem that Dogecoin’s supply is unlimited?”
When we say unlimited, it doesn’t mean there are an infinite amount of Dogecoin in circulation. What it means is that there is a set amount of new coins released each year, and that this will continue on forever. At first glance this may seem bad, but digging deeper we find the answer to be more complex. The key concepts to understand here are Keynesian Economics vs Austrian Economics.
Keynesian economists believe that demand is the driver of economic growth. Creating more money creates an incentive to spend it and thus creates more demand for products and services. The Fed lowering interest rates and the government printing stimulus checks are examples of Keynesian economics principles. The goal is to create movement in the financial system and to keep the economy flowing even when there is little to no economic activity. Proponents of this theory of economics see this as a way to keep economies from completely crashing in a crisis.
The Austrian school of economics says the production of goods our economy produces is the most important component to creating economic growth. They think printing more money just to keep the economy going is dangerous as the creation of new wealth is not tied to the production of new materials. Creating more money without economic output is a recipe for inflation.
Based on the descriptions of the two economic models, it’s no surprise to see that Dogecoin aims to use the Keynesian model for currency and that Bitcoin the Austrian model. Which of these models is the best to use for our economy is subject of much hotly contested debate.
“You promised earlier that we’d get back to the social media phenomenon associated with crypto. Whatever’s going on seems to be the strongest with Dogecoin. So what’s going on?”
I did! So here’s the thing, what I’m about to say to you has no roots in classical economics or finance, instead I think the answer lies in behavioral science. What makes a currency successful is the belief of the people. That’s really it. If the world collectively decides that Dogecoin is worth something then it is. When comparing Dogecoin to other cryptocurrencies it has one key advantage. It’s a meme and people connect to it on a deeper level than other currencies.
Consider the (in)famous diamond hands to the moon meme from the subreddit r/WallStreetBets.
To the casual observer it’s just 3 emojis, but to those that regularly use this meme in their investing it conveys a much deeper meaning. The meme conveys a sense of desire to build wealth. It’s something that’s fun to say. It’s a rallying call for solidarity within a much larger community, telling others I feel the emotional pain you do with your losses, stay strong and together we can persevere. It even carries with it a sense of history with it, Gamestop, AMC, DeepFuckingValue, fuck the hedge funds, and this one’s for the little guy. All of this and much more with 3 emojis.
“Memes are complex pictures with a lot of meaning behind it. If a picture is worth 1,000 words, memes are worth 10,000.” -Elon Musk
Dogecoin is the clear cryptocurrency leader on the meme front. Doge is a meme that’s survived 8 years, an eternity on the internet. To those that grew up on the internet, Doge stands for so much more than a dog, it represents the fun parts of internet meme culture. If currencies succeed based on the will of the people, there are much worse bets that Dogecoin.
I also don’t believe any significant portion of people trading Dogecoin see it as anything more than a joke currency. People may have negative reactions to realizing that Bitcoin is not unique, whereas no one has any of these expectations for Dogecoin to begin with.
“What are some criticisms of Dogecoin?”
The ideas of memes as currency feels weird. There’s never been a currency based on a meme dog. This may ultimately be a hurdle too high for Dogecoin.
Another criticism of Dogecoin is that the ownership of the coin is highly concentrated. A single wallet owns 28% of all supply, this wallet could throw the market price into a tailspin should they decide to liquidate large amounts of the coin.
It also shares many of the same regulatory and Ponzi scheme concerns as Bitcoin does.
Ethereum
Ethereum was established in 2015 and has since grown into the most actively used blockchain. Unlike Bitcoin and Dogecoin, Ethereum aims to be more than currency. Ethereum allows for the creation and use of smart contracts and other decentralized applications.
Talking about Ethereum is a bit like talking about the first generation iPhone in 2007. You can tell the technology has a lot of potential, but you have to use your imagination to see what could be coming in the near future. For example, the first iPhone was capable of geotagging, adding geographical data to media, and early on this was used mainly to tag pictures with locations. It took years until we saw apps like Uber and Pokemon Go use geolocation data in truly innovational ways. Ethereum is best thought of as a platform from which other game changing innovations could launch from.
Now onto some questions.
“This sounds like something completely different that Bitcoin and Dogecoin.”
You’re not wrong. While all 3 coins use the blockchain, Ethereum’s goals are much different than that of Bitcoin of Dogecoin. The better mental model for Ethereum is an early tech platform.
“I get that it’s early, but can you give some examples of what people are doing with decentralized applications that could be a game changers?”
Fortnite serves as a great example for what the future may hold. In Fortnite users can purchase in game currency called V-Bucks to buy access to in game content and cosmetics. These coins and cosmetics don’t contain any value outside of the Fortnite ecosystem yet they account for $3 Billion dollars in revenue annually.
The technology exists on the blockchain for individual artists to create their own coins as does the technology to create exclusive digital cosmetics or art, also called NFTs (non-fungible tokens). Imagine an upcoming new musical artist who embraces this technology. They could engage fans by giving away their own crypto coins to their die hard fans. The coins, which would also be sold, could be redeemable for access to secret concerts or exclusive graphic art in the form of NFTs. Those who wanted to invest in the artist’s success could purchase coins to fund the artist in the short term in the hopes that the artist’s network continues to grows at which point they could sell the coins back for a gain.
Another interesting area in Ethereum is DeFi (decentralized finance). In today’s world if you want to open up a bar you have to go through a bank and apply for a loan. The loan process is antiquated and it’s not always clear by which measures the loan is approved. DeFi allows for a possibility in which your neighbors could directly back the loan for your bar through peer to peer lending because they want the bar to be built.
“If Ethereum is the platform, can you invest in the applications that launch on the Ethereum blockchain?”
In many cases yes, for example if the artist in the previous example I gave didn’t want to do the work themselves, they could use Rally (RLY) to build their economy and community. Rally’s communities are built on the Ethereum blockchain and you can directly invest in Rally Tokens.
“What are some criticisms of Ethereum?”
Decentralization applications (dapps) are slower than centralized ones and often much more expensive while not actually providing every day benefits to users. Perhaps because of this, there is not yet a killer dapp on Ethereum. While many things can be built on Ethereum, few people actually use Ethereum for anything other than investing. One reason being the very high fees (called gas fees*) required to transact on the platform.
Optimists hope that the popularity of NFTs may be the first of such dapps that bring a wider userbase to the platform. A wider userbase could then bring exponentially more value to the Ethereum blockchain as users grow accustomed to the platform and start to experiment with DeFi or other decentralized apps, which then creates values for an even larger set of people. This phenomenon is often referred to as the Network Effect and is used to explain the level of critical mass that were necessary to make platforms like Ebay and Facebook successes.
*Ethereum is expected to upgrade to Ethereum 2.0 starting in 2021, after which gas fees are expected to decrease significantly
That wraps us up!
If you’re interested in some further reading, I suggest the Bitcoin and Ethereum white papers as a great starting point. Goldman Sachs also recently put out a 41 page report that helps us understand how institutions are looking at these investments. Lastly, Patrick O’Shaughnessy’s Invest Like the Best podcast has several great episodes about cryptocurrencies.
Good luck out there!
