May 2018 Commentary

March 23, 2020

I like to provide a quick update on the news in the crypto-world. It is quite evident that large financial institutions are slowly entering into bitcoin trading as they have realized that this is a new asset class.

  • Fidelity Investments, which manages $2.4 trillion in assets is planning to enter into bitcoin trading. Fidelity is known for being a very conservative asset management company and they can easily become a big player in the market.
  • Goldman Sachs has backed Circle Financial, which has purchased one of the active crypto-exchanges called, Poloniex. It was reported recently that Circle is trying to acquire a banking license with Federal Reserve.
  • It was also reported that the owner of NYSE, which is ICE (Intercontinental Exchange Inc) is working on a trading platform that allows people to own bitcoin directly.  Another large financial firm, Susquehanna International Group is opening trading for cryptocurrencies for a small group of its 500 clients and has plans to expand.

In a recent interview with the Times of London, CEO of Square and Twitter, Jack Dorsey thinks that bitcoin is going to be the native currency for the internet. What is especially interesting about Mr.Dorsey is that he contributed $2.5 million dollar seed round for Lightning Labs, which did a phenomenal job in building the next level layer protocol on the top of Bitcoin protocol. The Lightning Network is a system of smart contracts built on the top of the base Bitcoin blockchain that allows fast, cheap payments directly between two parties, without needing a trusted third party. 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 bitcoin transactional speed is now about only 7 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 or about 1,736 transactions per second.This Lightning protocol enables transactions as high as millions to billions of transactions per second at a price as low as 1 Satoshi, which is equivalent to 100 millionth of a bitcoin. This should really worry both Visa, Mastercard, Amex and a whole host of intermediaries living off their fat profit margins.

I have recently started reading Nassim Taleb’s book Antifragile. I am impressed with the book and highly recommend anyone to read to get fascinating insights into the complex systems’ inner workings. He describes the ‘fragile’ things as one which is harmed by volatility, disorder and any stressors to the system. We normally assume that ‘robust’ is the opposite of fragile. But according to him, robust is something that is neutral to volatility, disorder, and stressors. There is another category of things he calls them, ‘antifragile’ which gain from volatility, disorder and any stress that is put on the system. For example, a lit candle is fragile to a gust of wind. A stone is robust to the gust of wind. It is not affected much by it. However, a wildfire feeds on a gust of wind and grows stronger with the wind. So, a wildfire is antifragile to wind. As I read the book, I kept extending this antifragility concept to bitcoin and it fits it like a glove.

We could look at the fragile, robust and antifragile as a continuum, whereas you progress from left to right, it gains more from the disorder. We can extend this analogy further to our understanding of what money is and how different forms of money have performed over the years. We have many years of real-world information to articulate these characteristics.  The average life expectancy of fiat currency is 27 years. History is replete with examples of many countries having 4 different failed currencies in a span of 40 years. Gold has the ability to survive from inflation but it is centrally controlled and amenable to manipulation.

                       FIAT                        GOLD                          BITCOIN


                      FRAGILE                   ROBUST                      ANTIFRAGILE

(damaged by disorder)     ( resilient to disorder)        (benefits from disorder)

It should be obvious that our modern banking system which is based on the weak foundations of fiat currency is very fragile. Benefits of fragile things are often small and visible and the side effects are potentially severe and invisible. The most catastrophic side effect of fiat currency is inflation. Ask any citizen of Venezuela or Zimbabwe. It is an insidious tax that robs the poor from the fruits of their labor. This money is stolen silently from its populace and it is a ghost that reveals itself in the steady declining purchasing power of fiat currencies. It is very weak against blackswan events and time is the enemy of fragile things. As we have seen in 2008 financial crisis that fiat currency needs trillions of dollars of bailouts from central banks from time to time costing taxpayer enormous quantities of newly printed money or debt. We go through these episodes and banking system continues as if nothing happened.

I would consider gold more robust than fiat. It managed to survive as a store of value and a medium of exchange for thousands of years. Gold does not depend on government bailouts and it is more inherently stable due to its scarcity in earth’s crust. Gold derives its strength from its unique chemical properties. However, it is difficult to transport and centralized in the vaults of major central banks/kings around the world, exposing it to the whims of human corruption. Gold’s physical form makes it an easy target for people to steal.

Bitcoin is built on mathematics. I cannot think of a more solid foundation than mathematics. It is based on open-source code, consensus, and decentralization. Anyone can join the bitcoin network and become a full node. Bitcoin network’s motto is don’t trust anyone and verify. Every miner will verify the work of newly generated block and allow it to be added to the blockchain only if it satisfies the SHA-256 algorithm. Otherwise, it is simply discarded. So, how is bitcoin antifragile?

To understand that question, we need to understand how bitcoin got started. It was started with Satoshi Nakamoto describing his innovation in a research paperand writing the code to bring his conception to life. There are no legal tender laws enforced by any government to push bitcoin on its populace and nurture the growth of this currency. It grew organically in nature, by people understanding the power of a currency whose supply is fixed.  There is no patriotic rhetoric from any government pushing this on people. There is no marketing from any company. It does not have the military strength of US Government to force other nations to adopt it. It is as if you have taken a newborn baby and dropped the baby in a forest to fend for itself. Imagine your surprise, when you go back 10 years later to the same forest and see that there is a 10-year-old kid fighting lions and tigers with bare hands. You should wonder how did this happen. As of today, bitcoin has achieved a market cap of 115 billion dollars while starting from 0, without any central organization pushing it.

Bitcoin was subjected to massive attacks from numerous hackers from around the world. If a hacker can figure out a way to steal bitcoins and manage to double-spend the coins, they can steal all the 115 billion dollars. It is a bounty for all the hackers in the world to attack it but nobody managed to do so. It surprises me the sort of attacks bitcoin has taken and come out stronger. 7 Years ago, Mt.Gox exchange was hacked when this exchange alone was responsible for 99.9% of all the bitcoin trading. This exchange hack made the bitcoin drop from $17 to $1 in one day. If you were to compare bitcoin to a stock, how many stocks have survived a drop of 70% close to 5 times in 9 years of its existence and still managed to produce a return of 245,765% return to their shareholders?

Every day mainstream media calls bitcoin a Ponzi scheme. Major governments in the world tried hard to ban and kill bitcoin numerous times. Around September2017 46% of the bitcoin exchanges volume in the world came from China. Suddenly China has banned all of the bitcoin exchanges in a surprise move. Even today most of the bitcoin mining happens in China. China is one of the biggest players in bitcoin mining. One would have concluded that it will have disastrous consequences to the bitcoin’s existence. It made bitcoin orders of magnitude better because all the exchanges moved quickly to other countries and China became the loser with this move. China underestimated the power of antifragility of bitcoin. The harder you try to break it the stronger it becomes because this is a dynamic system that responds to attacks.

In October 2017 part of the bitcoin community wanted to double the size of the blocks to increase the throughput of the bitcoin network. This was called the Segwit2X upgrade, where only 10% of the bitcoin community was interested in this upgrade which caused enormous arguments for close to 2 years. The only way to resolve the dispute is by a hard-fork which creates two versions of bitcoin. Before this hard-fork, many users felt that this will be the death of bitcoin. But the hard-fork happened and numerous wallet providers, exchanges, miners, and users have all prepared for this eventuality. It was very contentious but bitcoin came through this disorder successfully pushing its price all the way to $20,000. Even though it looked very bleak at that time, bitcoin survived all these attacks and came out stronger. This hard-fork resulted in the creation of new coin, Bitcoin Cash. This led to many other hard-forks like bitcoin gold, bitcoin diamond, bitcoin private etc. and the community adapted by happily accepting the new coins in their wallets as free money.

I also think this anti-fragility is built into the system because there are no guarantees behind bitcoin. Fiat currencies are managed by trusted third parties like central banks. They have a vested interest to ensure the success of all the institutions that depend on them. We have observed this when Federal Reserve bailed out AIG, Fannie Mae and Freddie Mac in 2008 financial crisis. Since there is no entity or government guaranteeing the existence of bitcoin, all the stakeholders like miners, exchanges, wallets, users, and developers work together maintain this complex ecosystem.

Anti-fragile systems build immunity from attacks. Network Engineer, Andreas Antonopoulos calls Bitcoin software, “Sewer rat”. It is walking around all day in filth and dealing with deadly viruses. It is happily scurrying around carrying 6 strains of bubonic plague and just brushes them off like the common cold.All the sewer rats before have faced the same filth and viruses are part of their existence. The miracle of evolution makes sure that both the predator and prey, both evolve with time. All the generations of sewer rats before the current one has passed down the genes that gave this immunity. Just 2 days ago, Korean exchange Bithumb got hacked and the exchange lost $31 million. I hear a new attack on centralized exchanges almost once every week. Does that weaken bitcoin? No. If a bank is robbed of its gold, does not mean the price of gold is going to drop. It effectively means gold has changed hands from good guys to bad guys. However, it makes bitcoin network stronger because all other exchanges will understand the methods used by hackers and get vaccinated against it. Bitcoin exhibits this antifragility because of its decentralization. If you want to rob a bank, there is a single point of failure that you can attack. If you want to steal bitcoins, you need to go after multiple points of failure as there is no trusted third party. While these attacks are successful against individuals, the network as a whole grows stronger in response to them.

Antifragile entities thrive in disorder and chaos, not just weather them. They are more valuable in volatile times. Jamie Dimon, the CEO of JP Morgan called bitcoin a fraud. Western citizens (and senior bankers in particular) don’t get Bitcoin and don’t understand its value because they are living in a highly stable, highly predictable society, where the chances that everything you ever owned will one day disappear on a whim are virtually zero. Bitcoin’s utility for such people is very low, and it functions mainly as a speculative asset. In chaotic regions and countries, Bitcoin and other crypto assets shine. Bitcoin allows a citizen of such a country to keep his fortune out of the arbitrary hands of his regime. It allows immigrant workers to easily and securely send back money to their families abroad and allows refugees all over the world to take their assets with them regardless of where they go and what they need to tackle on their way. These are major innovations which will have profound, long-lasting implications on the human condition. We have barely scratched the full implications of sound money on our human civilization.

Managing Partner