August 2018 Commentary

April 13, 2020

Bitcoin should qualify as a contrarian investment, since virtually the entire intellectual leadership of the investment community regards bitcoin and every other cryptocurrency as being in a valuation bubble. The financial media is even more strident in asserting that bitcoin is merely a bubble.

One of the bases of the bubble argument is that bitcoin is too slow to use as a practical mechanism for transactions. An example of this scalability problem is that the bitcoin transaction speed is now about only seven transactions per second. Visa reports that its VisaNet system is capable of handling as many as 24,000 transactions per second. On a normal day, VisaNet processes an average of 150 million transactions—6.25 million transactions per hour, 104,166 transactions per minute, or about 1,736 transactions per second.

On March 15, 2018, Lightning Labs launched a version of its Bitcoin Lightning Network in beta mode in real time. The non-technical explanation of Bitcoin Lightning is that it essentially eliminates traffic congestion on the bitcoin blockchain by permitting certain activity to take place in channels off the blockchain. With Bitcoin Lightning, the currency can change hands on a peer-to-peer basis. There is no limit to how many parties can be in a channel. For example, A can send bitcoin to B; B, in turn, can send bitcoin to C; C can send bitcoin to D; and so forth. The transfer is entirely within the control of the users and is only reflected on the blockchain when the channel is closed.

The objective is to increase speed and reduce confirmation time. The Lightning Network has been in test mode in different versions since early January 2018, and the results thus far suggest that it is a success. Another important point is that this is open source code that can be used, examined, enhanced, or tested by anyone. The code is available for download at GitHub.

Launching the Lightning Network is a seminal event because it makes cryptocurrency transaction volumes on the scale of Visa and MasterCard possible—and at even higher speeds. Incidentally, one should say cryptocurrency or consensus money—as opposed to bitcoin—since there is already a Lighting Network version for Litecoin. The cost of a transaction will be a very small fraction of a penny.

What I find really interesting is that when a centralized network like Visa has to scale up, it can only grow linearly. In contrast to Visa, Lightning nodes are decentralized and permission-less. Anyone who has bitcoins can launch a lightning node and receive routing fees for routing transactions on the Lightning network. So the growth of this network is exponential. Last month alone the number of nodes have grown by 60% in one month! This is possible because if Visa has to increase its throughput, it needs to acquire capital, deploy the necessary hardware and increase the support personnel. But creating a new lightning node can be done by any of the 7.5 billion people on the planet, making it significantly easier to scale. The following chart shows the growth of network in the second quarter. This chart was posted by Gregor Zupanc on Twitter.

Now that Bitcoin Lightning Network is a reality, one can easily see how the financial sector might become disintermediated. Maintaining balances in cryptocurrency is not even necessary for customers of a given merchant. For instance, suppose that Amazon wishes to side-step the credit card companies. It could simply purchase cryptocurrency itself, on behalf of its customers and then virtually instantaneously accept the cryptocurrency as payment for the merchandise that customers wish to purchase. Amazon would effectively take title to the cryptocurrency as soon as the transactions occur, so that the customers never accept price risk.

Nor would Amazon, for its part, have to accept price risk since, if bitcoin were accepted as payment, since it could always hedge that exposure with futures on the Chicago Merchantile Exchange (CME) and the Chicago Board Options Exchange (CBOE). In fact, at about the same time in December 2017, when the CME and the CBOE self-certified their bitcoin futures, the Cantor Exchange—an innovation of Cantor Fitzgerald—also established a swap contract for bitcoin. Coinfloor, the U.K. cryptocurrency exchange, will launch the first physically-delivered bitcoin future on April 18, 2018. The North American Derivatives Exchange (Nadex) launched a bitcoin difference contract or spread-based contract on December 18, 2017.

The launching of four contracts at roughly the same time by four different entities on one commodity is completely without precedent in the commodities world. Despite the price decline in bitcoin as well as other cryptocurrencies, even more contracts are being launched. Such activity is absolutely incomprehensible unless one understands the enormous potential to disintermediate the incumbent financial and banking systems that are tied to credit card transactions, and the likewise enormous scale of futures volumes that would be required to accommodate the price hedging requirements of that market.

According to Visa in its 2017 Form 10-K, there are 3.2 billion Visa cards worldwide. The total payment volume for Visa is $10.2 trillion, derived from over 46 million merchants in 160 different currencies. The MasterCard Network is almost as large. Payment is accepted in over 200 countries and jurisdictions.

This raises another important point. Daily foreign exchange trading can be measured in the trillions of dollars. The substantial spreads received on these transactions are an important source of profit in the banking system. Cryptocurrency payments—faster (i.e., virtually instantaneous), error-free, and cheaper—open this field to an unlimited number of new providers. Even if the banks ultimately accept cryptocurrency, they will not necessarily retain their current level of dominance.

Until recently, a novelist, songwriter, or musician needed to partner with a large corporation simply to sell content to the general public. The overwhelming part of the revenue generated from content is generally paid to the sponsoring corporation rather than to the artist. Micropayments can change this relationship. The blockchain is much more than a storage mechanism for cryptocurrency. Any digital asset, including a song, can be stored on a blockchain. In principle, an artist could charge 1/10 of a penny to anyone interested in listening to a song. Payment would be made instantaneously via the Bitcoin Lightning protocol. The artist could theoretically keep hundreds or even thousands of channels open for an indefinite time and only write to, or record the transaction on, the blockchain when the amount becomes sufficiently large to make this worthwhile.

Use of the blockchain would disintermediate not only the banking system and the content companies, but also Google and YouTube, since there would be no need and no mechanism to pay these companies. In principle, a movie is a digital asset that can be stored on the blockchain. The movie could be watched on demand without an intermediary such as Netflix. A content producer need not sell its content rights to Netflix. In principle, a popular movie could collect revenue directly from the viewers at the time of viewing. There could be a micropayment policy in which the first five minutes, or perhaps the movie’s trailer, would be free. The producer might actually pay someone a very modest sum to watch the trailer and then charge 1/10 of a penny for the first five minutes—perhaps 50 cents for the next 15 minutes and then $4 to view the movie in its entirety.

Society is well past the point at which one can reasonably debate whether cryptocurrency will be a real asset class. One can debate the valuations of some cryptocurrencies and reasonably take the position that some will fail, and others will succeed. The debate should now center around what might be the socially useful applications—not whether it is a bubble and will one day vanish. It is unlikely to vanish. This failure to discuss the recent advances and applications in Mainstreet media is quite deplorable.

The problem was not in finding a technological solution, because all the elements already existed. The challenge was to develop a technological solution consistent with the idea of a permission-less, distributed ledger. The bitcoin blockchain appears to be the best solution to date.

Managing Partner