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The only other currency Coinbase added (beyond its initial offering of Bitcoin) was Ethereum back on July 21st 2016, just a day after Ethereum’s hard fork. Ethereum’s addition to Coinbase produced an immediate 14% rally, although it’s hard to tease out the real effect given the volatility surrounding the hard fork. Ethereum’s accessibility on Coinbase (and then Gemini) likely contributed to its massive rally over the following 9 months.

Are these rallies rational? Yes. There is a very heavy accessibility premium in cryptocurrency valuations. As a cryptocurrency becomes easier to purchase and easier to store, it’s valuation should rise…and it clearly does.

What does this mean for investors? We enjoy a tailwind if we’re willing to invest in cryptocurrencies that are harder to access. If and when those cryptocurrencies then become more accessible either by being added to Coinbase, offered in trust form, or purchasable via ETF, we can expect the valuations to generally rise substantially.

First, let me try to convince you that cryptoccurency isn’t “winner take all”, although some specific niches within the crypto world probably are. Imagine if Uber tried to offer term life insurance? Imagine if Lloyd’s of London tried to sell virtual reality headsets? Imagine if McDonald’s tried to offer a 12-course $400 dinner with wine pairing? Imagine if Nordstrom tried to compete with Walmart with rock bottom pricing?

Some business models are natural fits for particular products. People want to buy their insurance from stable, long-lived, boring companies. And the companies best suited to compete on cutting edge technology offerings are generally smaller, leaner, and have an ethos of “move fast and break things.” IBM is a good example of a huge stable company that appears superficially to be a tech business, but really is a consulting firm that just happens to consult on tech. Similarly, Apple used to be a nimble tech innovator, but is now a consumer brand company, more comparable to something like Coca-Cola. The winning cryptocurrency in a niche will usually not be decided predominantly based on marginal technological differences relative to competitors. Launching a new cryptocurrency that aims to copy a market leader with a slight improvement is kind of like saying I’m going to create a product to compete with the Iphone with a better camera, or that I’m going to launch a competitor to Coca-Cola that tastes the same but with 10% fewer calories. I’m unlikely to get very far because the specs and price are just one small part of their success.

Turning back to cryptocurrency, there’s a critical idea that’s often overlooked: the role of community. In cryptocurrencies, governance is driven by that cryptocurrency’s community (developers, miners/stakers, users, service providers, etc). There’s often a positive feedback loop that makes the community more homogenous over time. Consider Ethereum’s hard fork after the DAO bug was exploited. Many of the community members (holders of ether, miners, developers) who strongly opposed the fork abandoned the ETH chain. Alternatively, people who liked the philosophy that led to the hard fork were attracted to the ETH chain. The result was that the community post-fork was substantially more homogenous than the community pre-fork. The community is often a key feature of a cryptocurrency because it contributes to governance via game theory. While the community can certainly change over time, it needs to be thought of as a core part of how a cryptocurrency functions, almost on par with the scripting language. To put it simply — the community makeup of a cryptocurrency directly influences how that cryptocurrency behaves. Cryptocurrencies are differentiated not only by their code, but also by their communities.

Bitcoin has a community that is mostly committed to stability. To the majority of Bitcoin users and developers, Bitcoin is IBM, it’s Lloyd’s of London. This makes technical innovation at the protocol layer very difficult in Bitcoin, but also lends it a great deal of stability. By “stability”, I don’t mean price stability, but rather protocol stability. If I buy 1 bitcoin today, I can be fairly confident that in 5 years I’ll own pretty much the same thing. In contrast, the Ethereum community has adopted a “move fast and break things” mentality. Ethereum is Uber, it’s Facebook 10 years ago. This community facilitates breakneck technological progress, but increases the risk of bugs, and makes it impossible to know what ownership of 1 ether will mean in 5 years.

We see a similar dichotomy in the protocols themselves. Bitcoin has a very simple scripting language which makes it difficult to build new features, but also relatively easy to avoid devastating bugs. In contrast, Ethereum has a complex Turing complete language which lets it do pretty much anything, but greatly increases the chance of serious error.

I don’t view one of these communities or scripting languages as superior to the other. Rather, each is optimized to fulfill a particular need.

What does the world need?

The world needs “digital gold” — an unseizable store of value, with great liquidity, a high market capitalization, stable protocol, and great security. While it would be nice if the cryptocurrency that filled this niche also had a quick confirmation and low fee, those things are not core to the value proposition, and those factors are unlikely to determine which cryptocurrency dominates this niche. I think this niche is likely “winner take all.”

The world also needs cheap, fast, and private, monetary transmission. Much of the infighting in the Bitcoin community today stems from the growing realization that it might not be possible to optimize a single cryptocurrency for both the “digital gold” and “monetary transmission” niche. For Bitcoin to do both well will probably require a secondary layer like the Lightning Network. Alternatively, the “monetary transmission” niche may be best served by an entirely separate cryptocurrency that may eventually be made interoperable with Bitcoin via parachains. Cryptocurrencies like Monero, Litecoin, Dash, and Zcash are primarily competing for the “monetary transmission” niche. For this niche, security is less important than speed and cost. I don’t need $1 billion worth of security if I’m only paying an $80 restaurant bill. Because there are different levels of security demanded for different transactions, this may not be a “winner take all” niche. I can imagine a scenario where there are 3+ cryptocurrencies providing varying combinations of speed-security-cost-anonymity for monetary transmission. For example, Zcash offers the best anonymity, but relatively slow execution if you’re on a smartphone since the algorithm is so intensive — this might be a welcome tradeoff for some uses, but highly inefficient for others.

The world needs a platform for decentralized applications (dApps). The cryptocurrency to provide that platform has to have a complex and evolving scripting language, and a community that embraces constant innovation (at least for the next few years until the technology is more mature). This is such a new area that I find it impossible to predict if the equilibrium is one dominant platform or multiple competing platforms with different network architectures and communities.

So far I’ve only explained why Bitcoin and Ethereum are the two biggest cryptocurrencies by market capitalization by far. I can’t say if Bitcoin and Ethereum will remain the dominant players in their respective niches forever, but if they get replaced, it will probably be by something that looks very similar to the incumbent in terms of both the code and the community.

What *else* does the world need? That will be the topic for Part 3.

Part 1 is an exploration of why extraordinary investment opportunities exist in cryptocurrency. To an engineer, that might seem like an obvious and uninteresting question, but professional investors generally start with the premise that it’s nearly impossible to find the kind of returns that we’re seeing. This is the essay that uses traditional financial theory to explain to your broker or pension fund manager why such a great opportunity exists.

Professional investors think of markets as mostly efficient most of the time. This comes from both academic research and experience. While market inefficiencies certainly occur, there are thousands of brilliant traders and investors competing to immediately exploit and eliminate those inefficiencies. It’s hyper competitive. This makes it extremely difficult to beat the market consistently. 90% of mutual fund managers and hedge fund managers underperform a passive index, and these are mostly brilliant and very hard working people. Competing in public markets is like playing in the NBA — you’re competing against a field of amazing athletes in what is effectively a zero sum game: for every outperformer there has to be an underperformer (and usually many more than one because of expenses).

But what if instead of playing in the NBA, we had the option of playing in a middle school recreational basketball league? What if we found a league where the best basketball players in the world couldn’t, or wouldn’t compete against us?

My personal investing idol is Seth Klarman of Baupost group — one of the best performing, most insightful, and most ethical investment managers. Klarman notes that investors are compensated by the market for taking on market risk (i.e. beta), and for illiquidity. Many investors stop there, but Klarman notes that we’re also compensated for complexity, operational challenges, and “psychological risk.”
Why do such compelling investment opportunities exist?

1. They’re complex along many axes: understanding the technology often requires a degree in cryptography and engineering (for which I depend on a growing network of professional blockchain developers). They’re also complex economically; similar to investing in Facebook before there was any serious monetization plan. Few people have thought seriously about how to value a cryptocurrency fundamentally — there’s no textbook to reference, and currently no consultants to query. And lastly, they’re complex in execution. Consider Initial Coin Offerings (ICOs) — every ICO is unique, but they increasingly require submitting customized data to an Ethereum “smart contract.” This complexity — in technology, in economics, and in execution, scares off much of the competition.

2. They’re operationally challenging. There are no established regulations, operational procedures, or accounting standards to deal with investments in cryptocurrency. Best practices for securely storing cryptocurrency are constantly evolving and the storage cannot be delegated. Storing cryptocurrency in a way that is both extremely secure, but redeemable in case I’m incapacitated, is a very time consuming process. These operational challenges discourage many potential investment managers.

3. They entail “psychological risk.” In 2008, many of the largest US bank stocks lost 80% of their value, some lost 100%. The stocks of big US companies are risky, but we don’t perceive them as such — if you lose your money owning Citibank or AIG, you won’t feel all that foolish and as a professional investor, you probably won’t be fired. In contrast, cryptocurrency investments are risky, but if we size the position appropriately for our portfolio, they’re no different from any other volatile asset. The main concern many people have is psychological. If someone ran a pension fund and lost 15% of their portfolio in financial sector bonds in 2008, they were “unlucky.” If that same pension manager loses 2% of the fund in a cryptocurrency pool, they fear they will be fired for being foolhardy. As investors, we’re surprisingly well compensated for the risk of appearing foolish. it’s a risk that most of the biggest money managers refuse to take, and thus they leave many of the best investment opportunities on the table.

Investing in cryptocurrency is currently like playing basketball in a middle school rec league. Most of the best basketball players aren’t yet in the game. This allows us to earn outsized returns by providing capital to the best cryptocurrency projects. In a few years it will be far harder to earn such returns because there will be a great many talented investors competing to provide capital to the same projects. As we see in the traditional venture capital industry today — this competition drives up the entry price, and drives down expected returns.

Check out more investment commentary here: https://thecryptocurrencyinvestor.com/