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Q&A: Bitcoin and Beyond

As bitcoin grabs the headlines, blockchain technology is just getting started.

Since the first bitcoin transaction in early 2009, the cryptocurrency has moved from the fringe to the futures market. Investors are struggling to value this speculative instrument— part commodity, part currency, with some of the characteristics that we find in businesses with economic moats. They are also delving into emerging opportunities built on blockchain technology.

To explore this uncharted landscape, I spoke with two of our own experts in the field. Evan Morris is an analyst who leads emerging technology coverage at PitchBook. Kai Wu, a project manager with Morningstar Data, leads various blockchain initiatives internally and was recently featured among the “Top 40 Chicago Blockchain Thought Leaders” by FinTank. Our discussion took place on Dec. 5 and has been edited for length and clarity.

Jim Sinegal: Why are people buying bitcoin?
Evan Morris: People are buying bitcoin because they’ve been reading a lot about it in the news. There’s a price feedback loop, where the more it goes up, the more news it gets, the more people get into it, and the more they fear missing out on this revolutionary technology.

Kai Wu: You can broadly split out the people buying into bitcoin into three buckets. It is primarily speculation, where people see these astronomical returns and want to get a piece of it. There are a smaller group of people who are buying into it because of its utility, because they want to use what it offers. And there are other groups of people who are buying into it for the philosophy behind it: It’s a currency that’s not in control of a government.

But by and large, speculation is driving a good deal of the market. There is uninformed speculation, but there are also folks who are trying to actually understand the technology and its potential.

Sinegal: Bitcoin was invented as a way of conducting transactions. What kinds of transactions are happening now?

Morris: Bitcoin in the early days had a bad rap, because it was seen as facilitating illegal transactions by allowing for anonymous payments and circumventing governments. The technology has evolved to enable a wide range of payments. Some companies have developed their own private blockchains to facilitate internal crossborder transactions in the millions of dollars. It can be used for micropayments that can facilitate content monetization. Square SQ recently announced a technology that would allow people to use bitcoin in their peer-to-peer payments app, Square Cash.

Sinegal: A lot of people are looking at bitcoin as a potential store of value, akin to digital gold. There’s a limited supply of bitcoin, and that’s a lot of the appeal. Unlike fiat currency, which can be printed, the supply of bitcoins will forever be limited to 21 million.

Wu: To some extent, this store of value concept is in its way its own kind of speculation. People think that because supply is fixed, bitcoin will somehow retain its value beyond what it costs to produce those bitcoins as of now.

Morris: To extend that point, yesterday I visited a large bitcoin mining operation in eastern Washington state, which has very cheap electricity. If the price of gold were to go up 10 times in one year, the supply would increase significantly due to people investing in miners. Whereas with bitcoin, how much supply can be created in any given year is hard-coded. That provides speculators more justification.

Commodity or Currency?

Sinegal: Bitcoin obviously has gone up dramatically. How should we value it?

Wu: We’re still very much at the early stages of thinking of how to value these types of currencies. It comes down to taking existing valuation models and reconfiguring a bit.

You can either think of bitcoin as a commodity, or as a currency; each approach has its pluses and minuses. With a commodity, you’d normally look at both the supply and demand, but for bitcoin the supply is fixed. Looking at it as currency, you’d look at the velocity of money, among other things, and figure out how quickly people are turning over bitcoin and then compare against the supply.

Sinegal: As an equity analyst, it’s difficult, because it is useful, but it produces no cash flow. It’s like commodities, but has a much shorter history than gold or oil, which have been valued for hundreds of years.

At the same time, there are features about bitcoin that make it interesting according to our economic moat framework. Comparing it to companies, it does have a network effect. Bitcoin has developed a large network of users, a budding ecosystem. It has a fairly strong intangible asset. It’s the most well-known of the cryptocurrencies. And some of the appeal is its potential for processing transactions at a lower cost than existing payment networks.

Wu: Also, trust in the existing economic systems is faltering a bit, especially after the most recent financial crisis. Bitcoin is not owned by a central government or driven by the policies that a government might have. It’s owned in a decentralized network. Sinegal: What are some of the main risks of investing in bitcoin at this point?

Morris: Current risks, as we’ve seen in periods of high volatility, have been regulatory risks. This summer, China said that it was banning all sales of new tokens—initial coin offerings—and we saw the price dip pretty substantially overnight. Investors have developed somewhat of a buy-the-dip mentality, and the price rebounded pretty quickly. But as an investor in this asset class, you’re going to need to learn to stomach some volatility.

Sinegal: Joseph Stiglitz1 commented the other day that cryptocurrencies should be outlawed. What would happen if they were? Can they even be outlawed?

Morris: A good analogy would be China’s filtering of the internet. China has banned a substantial number of websites from U.S. companies. However, it has developed its own internet giants, like Tencent TCEHY and Alibaba BABA, as well as some pretty sophisticated workarounds of this firewall. Banning bitcoin would be similar to banning the internet: extremely difficult to pull off and incredibly unpopular.

Wu: After China banned cryptocurrency exchanges, informal over-the-counter markets appeared within various WeChats. There are always ways around these types of regulations, given that this currency exists purely digitally.

Sinegal: What could happen if one miner were to own more than 50% of processing power? It’s a majority-rule system, is that fair to say?

Morris: If one miner owns the majority of the network, they are essentially able to write their own record of who is transacting with whom. So, they could overwrite transactions and otherwise manipulate the veracity of the bitcoin network. There are some adverse incentives to control more than 50% of the network. One of the core features of blockchain is its trustless nature.2

Sinegal: If people knew that the blockchain had become co-opted, or nefariously altered, that would destroy the value of all bitcoins.

Wu: Yes, if one company controlled everything, that would fundamentally change the value proposition of bitcoin. You’d essentially just have a central protocol for processing transactions no different than Visa V or Mastercard MA. The risk with China is that, even though there are different companies processing these transactions, if China someday decides to take over all these miners, then they could forcibly take over the network.

Rising Competition

Sinegal: One of the risks that I see is that bitcoin could be supplanted by a similar but better alternative.

Wu: That’s the risk that I should say is most likely to happen. In terms of the underlying technology, bitcoin is starting to lag behind its various competitors—ironically, due to its decentralized nature. Because there’s no central group guiding its development, there is infighting among folks developing the protocol.

There are a number of coins that have emerged recently. The most prominent is Ethereum, which is built to host not just a cryptocurrency but also act as a platform for the decentralized applications on top of it. Not only that, but the actual bitcoin coin has been forked—you can think of it as “spun off”— into other coins called bitcoin cash and bitcoin gold, which have different takes on the same underlying protocol. Bitcoin as the original protocol is struggling to keep its technological edge.

Sinegal: We’ve seen that in the technology realm a number of times, where the first mover is not necessarily the eventual winner.

Morris: As a counterpoint, I think bitcoin does have a pretty significant moat in the nature of its hashing algorithm. To mine bitcoin, you need to go out and buy a specialized chipset. Some of these other cryptocurrencies like Ethereum rely more on GPU mining, a more commoditized and standardized type of chip that was originally developed for graphics cards. It’s much easier to switch over from Ethereum to another GPU-mined coin.

Sinegal: Can you explain what an initial coin offering is?

Morris: An ICO—many people call them token sales—is the mechanism by which new tokens are launched to the public. Typically, it’s set up as a smart contract, often using Ethereum, where people will send their digital tokens to a specific address and get these new tokens in return.

Note that virtually all of these ICOs are preproduct. Money is raised just on the background of the team and a white paper with a promise about what they’re going to do with the proceeds of the ICO or token sale.

Wu: These ICOs were designed to jumpstart a network. These token sales are springing up without a product because they’re trying to fund the creation of a network that will never produce an ongoing revenue stream, unlike a traditional startup, and there’s also not going to be multiple rounds of funding. You can think of it as a blend between an IPO and perhaps a Kickstarter. There’s no product in hand, but they will have something down the road.

Sinegal: You’re investing in a new type of asset in a startup application. I would argue it’s even more speculative than venture capital.

Morris: And from an entrepreneur’s perspective, it’s putting the liquidity event prior to the product development. There are some obvious conflicts of interest there and not much accountability at this point.

Wu: To translate it into more plain terms, to some extent they’re transferring the risk of failure from the actual entrepreneurs to the folks who are buying these tokens. And you do see in the market some shady ICOs.

Sinegal: What are the barriers to entry for ICOs?

Morris: The barriers to entry for retail investors are very low. All you need is a cryptocurrency wallet and to follow instructions. Now, however, the barriers to entry for institutions are getting lower, because a number of funds are popping up that invest both in established cryptocurrencies and at the early stage in these emerging ICOs and tokens.

Wu: Typically, more sophisticated investors will go into a new asset class first, given the complexity. Here, for an institutional investor, there are a lot of risks to consider. Regulations that govern what happens if things go wrong just aren’t there right now. That’s why you’re seeing investment vehicles come in—such as funds and futures—to give these institutional investors exposure to this space without some of the risk of investing directly into it.

Building on Blockchain

Sinegal: How does blockchain as a technology differ from bitcoin?

Morris: Blockchain is essentially a type of decentralized protocol that was pioneered in the white paper written by Satoshi Nakamoto in 2008.3 Bitcoin is the cryptocurrency that resulted.

Wu: Blockchain is a useful technology even without bitcoin or another cryptocurrency attached to it. Because it’s a distributed database with some features for collaboration among multiple parties, a number of companies have now co-opted it for use on their own private platforms.

Sinegal: Beyond payments, what are some of the applications for blockchain technology?

Wu: One is in the financial transaction space, where folks have started to invest quite a bit in these blockchain platforms. One example is the Depository Trust & Clearing Corp. The DTCC is responsible for clearing most of the transactions in the U.S. and settling them. It is planning to move its derivatives processing infrastructure onto a blockchain platform in the near future.

Sinegal: We are looking at the disruptive potential of blockchain technology. The most profitable companies we cover are based on monopoly control of information, being a centralized counterparty for transactions. Any of these decentralized applications the blockchain enables threatens those business models.

Morris: To provide some perspective about what inning we’re in, when PitchBook initiated coverage of blockchain in the summer of 2016, I had to convince my colleagues to call it the vertical blockchain rather than bitcoin because there really wasn’t much in the space beyond bitcoin. Ethereum existed at the time, so we knew the potential for it to serve as a platform for distributed applications, but actual development of many of these applications has only really commenced just this year.

Wu: It might be helpful to clarify the terminology. When people talk about blockchain, they could be talking about the specific technology of blockchain, which refers to a distributed database where transactions are collectively confirmed. Or they could be using it as an umbrella term for a stack of technologies layered together to create decentralized applications that might actually compete against some incumbent companies. Ethereum and these tokens are more of the latter. They’re creating decentralized applications that can potentially supplant existing companies, particularly digital service providers like Expedia EXPE in travel or Dropbox in cloud storage.

Meanwhile, there’s development in existing companies to replace workflows with private blockchain technology. It’s important to make that distinction between public and private blockchain.

Sinegal: A lot of companies are experimenting. Visa, which I cover, has partnered with a company called Chain to do cross-border business-to-business transactions. IBM IBM is doing a lot of work on blockchain. There are the exchanges, the custody banks. But it’s in the very early stages.4 It’s much like the early days of the internet. Are there lessons from that period that we can apply here?

Wu: In the 1990s, you’d see IPOs where dot-com companies with products without much substance to them ended up with billion-dollar valuations. Something similar is happening now.

Sinegal: So, a lot of the current ICOs are going to end up like the dot-coms from the 1990s?

Wu: That’s fair to say. But now that we have the benefit of 20-plus years of history, we can also say that the internet was a transformative technology. It may have taken longer than expected, but it is disrupting a lot of businesses now. You see bankruptcies like Toys R Us as a result of the emergence of online retailing.

Morris: When comparing the current blockchain revolution with the internet revolution in the 1990s, it’s important to remember that in order to invest in the internet, you needed to invest at the application layer in internet companies. Blockchain is unique in that you can invest at the actual protocol layer, like in bitcoin or in Ethereum. That would be equivalent to investing in TCP/IP, which would have been impossible. You could only invest in, say, AOL or Netscape.

Sinegal: It’s almost like owning a piece of the internet itself.

Morris: Exactly. I saw some analysis that said that the application layer would only capture about 3% of the value of the blockchain space, which gels well with what we’ve seen in ventures. Coinbase5 recently raised venture capital at over a $1 billion valuation, making it a unicorn. But if you’d invested in bitcoin at the same time as early investors in Coinbase, you would have been better off in bitcoin.

A Massive Experiment

Sinegal: What are the risks with this technology?

Wu: There are two pieces, the technology side and the governance side. On the technology side, a lot of these blockchains, specifically the public ones, have very little throughput. They’re trying to scale up that throughput while maintaining the security and “trustlessness” of the network. If it doesn’t play out, you’re stuck with a system that can only process three to seven transactions a second. If you’re familiar with databases, that’s a pittance: Visa processes around 150,000 transactions per second.

Governance for these protocols is largely ad hoc and haphazard. While bitcoin and Ethereum and a couple other coins are still standing, it remains to be seen if they have staying power. Sinegal: Decentralization has some advantages, but not always. Microsoft MSFT, for example, has some important advantages over open-source software.

Wu: What you’ll likely see moving forward, if blockchain is to succeed, is a little more formalization as to how to coordinate a decentralized group to reach collective goals. As you might imagine, that’s a social problem in addition to a technology problem.

Sinegal: There’s also a spectrum: private blockchains, public blockchains, and blockchains that touch both sides—partially public and partially private— to try to solve some of those problems.

Morris: It’s a massive experiment, and the sample size is growing rapidly every day.

Wu: A lot of these companies will fail, and that’s a natural part of having a new technology and a rapidly growing space. The few that do succeed have the potential to dramatically change the economic landscape.

Sinegal: It’s a gold rush. Some people are getting rich, but many will go home empty-handed. PitchBook has insight into some of the smartest investors in early-stage companies. Any interesting trends there?

Morris: Despite all of the press that blockchain and cryptocurrencies are getting, venture investment has more or less flatlined in 2017. These new fundraising options for early stage product projects, particularly in the decentralized protocol space, has either diverted capital to ICOs or perhaps displaced venture investors as early-stage partners for these companies.

Sinegal: So, entrepreneurs are able to decentralize their investor base, as well, due to these technologies?

Morris: Yes. But Silicon Valley has responded. Prominent investors and successful entrepreneurs have begun to set up access ramps for capital to flow into this new asset class and technology.

Wu: As we discussed earlier, the barrier to entry for the retail investor or the small home office is already relatively low. I could tell my grandma how to buy a cryptocurrency relatively easily right now. But should she? That is the key question for the average investor today.

Sinegal: And for regulators. The riskiest investments outside the cryptocurrency space are often restricted to, in theory, the most sophisticated investors. That’s not necessarily the case with cryptocurrencies.

Wu: To get back to the point that we started on, it is largely driven by speculation. But that doesn’t necessarily mean it’s a bad thing to put in your portfolio. You may want to just take an approach of putting in what you’re willing to lose. It’s like, for example, investing in your friend’s startup.

Sinegal: It offers opportunity as well as risk, and diversification. Cryptocurrencies are likely not highly correlated with a lot of other asset classes at this point.

Morris: Bubbles tend to emerge around things that fundamentally change industry and technology. Many companies went to zero in the internet bubble, but the technology that resulted is transforming the way we live, work, and play.

Sinegal: There wouldn’t be a gold rush if there weren’t gold somewhere.


This article originally appeared in the February/March 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.