History of Cryptocurrency

It’s helpful to start from the very beginning.

Bitcoin’s pseudoanonymous creator(s), Satoshi Nakamoto, sought to create “trustless” money - a P2P payment system and store of value that could replace trust in central banks and financial institutions with cryptographic proof and game theory. Satoshi combined three elements:

  1. “Proof of work” mining – an economic and cryptographic system that incentivizes rational actors to participate productively in a network.
  2. Public key cryptography – asymmetric encryption that enables secure digital signatures.
  3. The blockchain – a new type of database, a distributed public ledger.

This combination allowed for trustless digital scarcity for the first time in human history. Prior to Bitcoin, transferring a digital asset meant producing a copy. If your friend emails you a picture, he or she still has the original picture. In the context of money, an electronic transfer previously required a trusted third party (e.g., a central bank) to ensure that the same electronic money wasn’t sent over and over. The central bank ensures that when Citibank sends money electronically to JP Morgan, Citibank’s account is debited by the same amount with which JP Morgan’s is credited. The introduction of the blockchain eliminated the need for a central bank or other trusted third party to ensure scarcity. Within the Bitcoin network, every transfer is recorded publicly, verified with “proof of work,” and secured with cryptography.

The Bitcoin network went live in January 2009 at the height of the financial crisis. Bitcoin didn’t have a market price until March of 2010, when it achieved a price of $0.08 per BTC (total Bitcoin market cap of $430,000) on the now defunct “Bitcoin Market” exchange. Over the next three years, Bitcoin faced exchange failures, thefts, and a serious protocol bug, all in the midst of ongoing development of the code and a steadily growing ecosystem. Litecoin (a spin-off fork of the Bitcoin protocol with some meaningful changes) was launched in 2011. The first Initial Coin Offering (ICO) was Mastercoin in July of 2013. As Bitcoin gained in price and attention, many more cryptocurrencies were launched, some hoping to replace Bitcoin and others aiming to be complementary offerings with unique value propositions.

In November of 2013, Bitcoin price reached a high of $1240, an increase of over 9400% for the year (likely facilitated by phantom buying on the Mt. Gox exchange in which BTC was purchased with non-existent US dollars). Bitcoin and cryptocurrency as a whole then faced a 13-month bear market, in which bitcoin lost 86% of its value and fell to $160. The current bull market began in March of 2015 and has seen total cryptocurrency market cap grow from $3.5 billion to $170 billion. During this rally, Bitcoin’s “dominance” slid to about 50% of the total market cap.

The biggest disruption to Bitcoin during this time came from the Ethereum network with its associated Ether (ETH) token. Whereas Bitcoin was viewed as a store of value and payment channel, Ethereum sought to become a global virtual computer and platform for decentralized applications. It inspired a new wave of adoption by engineers enticed by the possibility of coding “smart contracts” and tackling an almost unlimited series of potential new use cases. Ethereum broadened the scope of cryptocurrency from money to “internet 3.0.” 3

At the start of 2017, Ether (ETH) was trading at $8, and had a total market cap of about $700 million. Over the next 6 months, ETH rallied to over $230, exceeding a market cap of $20 billion. This massive wealth creation was supported by a wave of grassroots engineering interest in building on top of the network, as well as interest from established companies like Microsoft that joined the nascent “Enterprise Ethereum Alliance.” A seemingly minor innovation catalyzed the explosion of fundraising via ICOs: Ethereum introduced a standardized smart contract known as “ERC20,” an easily deployable feature allowing developers to easily launch their own tokens on top of the Ethereum network. Rather than having to recreate the underlying machinery of a blockchain network from scratch, they could borrow the security, development tools, and user-base of Ethereum to launch their own projects. Many of these new projects raised money by accepting ETH, prompting even more buying of ETH by speculators eager to fund ICOs.

It’s helpful to use the 1990s tech boom as a parallel for what came next. In 1990, raising money for a tech oriented company was difficult. In that environment, it was primarily dedicated engineers with credible business plans that first launched companies. Investments in these relatively high quality early projects produced great returns for investors and this led to high demand from venture capitalists to fund further projects. The resulting ease of fundraising spurred increased supply, where less credible entrepreneurs met the rising interest by raising capital for fundamentally weaker projects. This produced a bubble as low quality projects were valued exorbitantly as investors chased the returns of the earlier vintage companies.

We saw the same phenomenon in 2017’s ICO market. The incredible returns produced by Ethereum (itself a 2014 vintage ICO), led novice investors to re-invest their Ethereum profits into new ICOs. The ICOs of Q1 2017 were relatively high quality and reasonably priced. But as ICOs began being seen as a way to “get rich quick” by both entrepreneurs and investors, the quality of projects deteriorated and valuations for early stage projects rose precipitously.

The general rise in the cryptocurrency market capitalization brought increased interest and attention from all angles. At $5 billion total market capitalization, this asset class was uninteresting to Wall Street. At $100 billion, many large trading firms, hedge funds, and big banks began taking a serious look. Demand for service providers of all types surged, and entrepreneurs raced to meet the demand – trading and analytics tools, security solutions, OTC trading desks, arbitrageurs, and new exchanges burst onto the scene seemingly overnight across the globe.

Cryptocurrency was international almost immediately after its birth in 2009, with the most development and investment occurring first in the US, Europe, and Japan. In 2013, China became a major player in the mining and trading of Bitcoin. In 2017 Korea surged onto the scene and Japan’s participation grew dramatically. While accurate numbers are impossible to come by (exchanges don’t necessarily report accurate trading volume), we roughly estimate that the US is now 35% of the global market in terms of economic significance, with Japan, China, Korea, and Europe making up most of the remainder. Development on existing protocols and the creation of new credible cryptocurrencies remains mostly a US and European phenomenon, but that too is changing rapidly as credible development is now occurring throughout Asia (and other parts of the world).

Don’t ignore the competition

Cryptocurrency investors usually only look at the investable landscape.  They ignore those projects that are hard (or impossible) to invest in.  This is a big mistake when considering an investment in a competitive industry.

When I talk to cryptocurrency investors, they often defend an investment by saying, “great team, great technology, real use case.”  I then ask, “who are their competitors and why do you think that this team will be the winner?”  Usually…silence.  Sometimes, the person will respond by naming other competitors with an exchange listed cryptocurrency or an upcoming ICO.  Never do they respond with competitors that have no cryptocurrency.

Consider Ripple (XRP).  XRP has numerous competitors with no tradeable cryptocurrency like R3 and Digital Assets Group.  To decide if XRP is a good buy, you have to look at the competitive landscape and decide why you think XRP is likely to beat out the competition.

Civic (CVC) is another example.  Great project, great team, but they have at least a dozen serious competitors, some of which may have greater traction.  CVC may be a great bet on the blockchain identity use case, but we can only conclude that after comparing Civic to its long list of competitors.

It’s important to remember that most cryptocurrency is open source, and so the value is based primarily on network effects.  When looking at new projects that don’t yet have meaningful network effects, we’re mostly betting on the team’s ability to quickly establish a first mover advantage in a particular use case.  Making that call requires evaluating the level of traction the competition has achieved.

Table Selection

Back in my college days, I played poker. A lot of poker, at high stakes. I played online, in Atlantic City, in underground Philadelphia poker clubs, and against other UPenn undergrads. I was a very good player, but I had a few college friends who were objectively better. They were better at every aspect of the game…except one: table selection. And because of that one weakness, a couple of them were constantly broke.

These young poker players would make tens of thousands of dollars playing against “fish”, but would then take their winnings and sit down with the very best players in the world. They would challenge the best professionals, like Phil Ivey, to high stakes heads up games. Inevitably, they’d eventually lose to the superior players and often they’d lose everything. Then they’d borrow a few thousand dollars from friends and rebuild, only to lose it all again against the top pros.

I too occasionally tested myself against the best in the world, but I knew I was paying for a lesson, and would only sacrifice a small percentage of my winnings. I spent most of my time playing against weaker players. I realized early on that table selection was a part of poker too, and there was no shame in using that as a critical part of playing profitable poker.

“Table selection” refers to choosing a poker table at which to play. And it, more than anything else, determines whether you’re likely to end up a winner or a loser. Unless you’re the very best or very worst in the world, your expected value depends on your opponents. If you’re the 10th best player in the world but only play against the top 9 professionals, you’ll go broke. If you’re a mediocre player but exclusively play against even worse players, you’ll be profitable.

This concept applies throughout life. Venture capitalists know it’s a bad idea to invest in companies trying to beat Amazon at its own game. And as a trader, there are some tables I want to sit at, and others that I want to avoid.

Trading in many traditional markets is like sitting down at a table of the top professionals. It’s possible to win as a long/short equity trader, but you’ve got to be among the very best in the world. In contrast, cryptocurrency trading is currently like sitting at a table of weak players; there may be the occasional professional, but we’re not competing with the professional. Rather, we’re playing against the price insensitive retail investor – the person who panic sells BTC at $1800 that has never heard of BIP 91, or the person who buys ETH on margin at $400 without a glance at the network capacity or scaling roadmap. We’re not trying to impress with complex trade ideas. We’re not trying to show off by out-thinking other professionals. We’re here to win.

In practice, this means that we’re flexible. Back in April I was sitting at the ICO table. I invested in the Cosmos Network’s Atom token at an attractive valuation. Over the following month, the ICO table got much more competitive. Initial valuations skyrocketed as investor capital flooded into the space. And a great many of the professionals entering cryptocurrency are currently focused on ICOs. So…for now at least, I’m not. This isn’t to say that there aren’t attractive ICO opportunities – there are. But I see softer tables at the moment.

Table selection requires that we banish our egos. Avoid the temptation to compete against the best (even if you think you are the best.) Choose your opponents carefully.

Cryptocurrency’s “Nifty Fifty”

Usually in bull markets, the “high beta”, riskier securities outperform. This is what we saw over the last 7 months. Bitcoin rallied impressively but was dramatically outperformed by the more volatile and more speculative Ethereum, which was itself outperformed by some of the even more speculative and smaller cryptocurrencies. The tail end of such rallies are often “junk rallies”, with the strongest gains accruing to the fundamentally least attractive securities.

But this pattern doesn’t always hold true, and I think we’re about to see the exception. I think we’re likely to see a strong cryptocurrency rally that’s led by a handful of high market cap cryptocurrencies. For a historical analogue, consider the “Nifty Fifty” in the 1960s and 1970s. Institutional investors became enamored with about 50 growth stocks that came to be viewed as “single decision” stocks. People felt they could buy those equities with confidence they were both safe and high performing assets. That belief becomes self-reinforcing for a time – as money flows in and people buy every dip, the securities do indeed look both very stable and very lucrative.

Which securities are the cryptocurrency “Nifty Fifty?” Consider where institutional and retail money can flow most easily. Look at the cryptocurrencies offered by Coinbase, Gemini, and the investment trusts offered by Grayscale, and the equivalent companies in Asia. Look at the most liquid, most stable, and oldest cryptocurrencies, the ones that would be most appetizing to, say, a Family Office that wants to broadly invest in cryptocurrency in as passive a form as possible. What cryptocurrencies can most easily be thought of as “established”?

The Wall Street Moment

Over the last two years, the big investor in cryptocurrency was “Silicon Valley.” The high profile investors were mostly tech entrepreneurs and their family offices and venture capital firms.

I just finished a NYC roadshow with mostly that same type of investor (despite being on the opposite coast), but also had some surprising meetings with “Wall Street.” Today I spent an hour at a bulge bracket Wall Street bank and met with their prime brokerage and capital introduction divisions. They’re interested. They get that this is going to be big. Each of the half dozen senior bankers around the table kept saying, “I need to learn more.” Their research divisions are starting to publish detailed sell-side research on cryptocurrency and blockchain tech (including a very impressive 80 page report on blockchain disruption.) They’re holding internal informational seminars for their partners. They’re starting to think about offering prime brokerage, custodial services, capital introduction…the laundry list of services that Wall Street provides for every major asset class. They have a long road to building those platforms, but I suspect that within 9 months, they’ll start providing some of the services necessary to make institutional investors comfortable with cryptocurrency.

I also met with a couple reporters at two leading financial publications on background – and they’re in a similar place. They’ve been reporting on cryptocurrency, but usually as a one-off story. They report on sharp rallies and collapses in the price of bitcoin or ether and occasionally mention the small fund managers in the space, but usually it was presented as a quirky observation of something crazy happening. The reporters have a growing appreciation that this is here to stay but aren’t sure how to approach covering cryptocurrency. Do they treat a crypto fund manager like any other hedge fund manager? Do they report on individual cryptocurrencies like equities or commodities or as new technologies? They know they need to learn more.

Six months ago, I realized we were about to have “the wall street moment.” The pattern of adoption of cryptocurrency has (and I think will be) something like this:

Cypherpunks -> Engineers -> Silicon Valley -> Wall Street -> Institutional Investors -> Main Street

The Coinbase Effect

Coinbase added Litecoin for direct purchase today, and litecoin (LTC) is up about 30% as a result. The rumor of this addition may have also contributed to LTC’s 100%+ rally over the last 2 months.

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.

How To Think About Investing In Cryptocurrency (Part 2 of 4): What *needs* to exist.

Part 2 of the 4-part series “How to Think About Investing In Cryptocurrency” starts exploring the economic forces that will drive market segmentation to help us identify the future industry leaders.  It’s best to start by asking, what needs to exist?  What services does the world need that can best be provided by a public blockchain?

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, protocol stability and extreme defense against doublespends, is less important than speed, cost, and/or privacy.  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 may offer 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. We may soon have a world were crypto A is used for maximum speed and lowest cost, crypto B is used for perfect privacy, and crypto C is used when users want a hybrid compromise.

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.

How To Think About Investing In Cryptocurrency (Part 1 of 4): Why Exceptional Opportunities Exist

In this series, I’m going to start with high level investing concepts in part 1 and get increasingly specific and detailed through part 4.

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.

Scaling Bitcoin

Your mother taught you not to discuss religion or politics in polite conversation.  Bitcoin scaling is far more contentious.  The debate over how to enable the Bitcoin network to handle more transaction volume has divided the community into factions that hurl accusations of treason and conspiracy at one another and even launch DDOS attacks at “enemy” full nodes.  If you’ve been following the debate for the last two years, you’re probably exhausted or bored by it by now, quite understandably.  But it’s a debate that just won’t die because of its important practical implications for an $18 billion asset and the risk of a contentious hard fork.  If you’re a crypto expert, you’ll probably find my next post more interesting.  If you’re moderately familiar with bitcoin, skip to ” Technological and Game Theory Concerns.”  For those unfamiliar, start with “Background” and I’ll provide a little history and explain some of the jargon.


Bitcoin blocks are created about every 10 minutes. Miners all over the world compete to solve a complex math problem, and whoever solves it first gets the right to mine a particular block.  Mining a block enables the miner to collect the “block reward” of newly created bitcoins, as well as to collect any fees associated with the transactions they include in the block.  Miners generally want to include as many transactions as possible to maximize the fees they collect.  Any transactions not included in a particular block can be included by other miners in a later block.

Back in 2010, bitcoin’s creator Satoshi Nakomoto (a pseudonym for an unknown developer) put a cap of 1 MB on bitcoin blocks.  That means only about 3500 transactions can be included in each block, about 6 transactions per second.  At the time Satoshi introduced it, there were hardly any transactions at all, so the limit had no practical effects on the network; it was just intended to prevent a malicious actor from flooding the network with spam.  Over the last year however, bitcoin volume has been growing strongly and we’re now consistently at the 1 MB limit.  When people submit more than 3500 transactions, how do miners decide which transactions to include?  They pick the transactions with the highest fees.  Users can specify the fee they want to pay for their bitcoin transaction.  At times of peak network demand, the fee today exceeds $0.75 per transaction.  While that might sound small compared to a wire-transfer, it’s substantially more than many credit card transaction fees, and it makes paying for coffee with bitcoin uneconomic.  And since we’re at the upper bound of network capacity, every small additional increase in demand for transactions produces a large increase in fees; everyone has to compete to get their transaction included in the blockchain.

Why not raise the 1 MB cap?  One of Bitcoin’s core value propositions is that it is decentralized.  “Decentralized” can refer to a bunch of different things.  Here, I’m referring to the backbone of the network – full node operators and miners.  A full node is just a computer running software that propagates and validates bitcoin transactions – a $25 raspberry pi can do this.  Miners add blocks to the blockchain and secure the blockchain from doublespends (spending the same bitcoin twice.)  As long as there is one full node and one miner, the Bitcoin network is up and running.  By having full nodes and miners located all over the world, it makes the network resilient from both natural and man-made destruction.  If all of the nodes were in the US, the US government could more easily shut down those nodes and kill bitcoin.  So the bitcoin community greatly values having as many full nodes and miners as possible, located in as many distinct political jurisdictions as possible.

Technological and Game Theory Concerns

Currently, there are about 7000 full nodes globally.  Some of these nodes are run by bitcoin businesses that need to be able to validate transactions, but many node operators are just bitcoin hobbyists.  These hobbyists are willing to invest the time and money to keep a node running with no economic incentive.  The biggest cost associated with running a node is bandwidth: 1 MB every 10 minutes adds up.  For node operators in developed economies, this might be a small burden.  But handling that bandwidth in rural India or rural Peru is already prohibitive for some.  Raising the block size would directly increase the cost of running a full node.  I have yet to see a good estimate of how many nodes would fall off the network with an increase to, say, 2 or 4 MB, but it’s non-zero.  Many in the Bitcoin community are reluctant to raise the block size because it would likely result in a loss of full nodes in the most scarce areas: rural emerging and frontier market locales.  The vast majority of full nodes are in Western Europe, Japan, the US and China, so losing even a few of the full nodes in other countries would represent a meaningful loss in decentralization.  Additionally, a miner who solves a block receives a slight head start on the next block; other miners have to wait for the solved block to propagate to them.  Much larger blocks might take longer to propagate to some miners, which could encourage mining consolidation, a further loss of decentralization.

Further complicating the situation are second order effects.  The current cap on bitcoin transactions reduces its usage.  This may reduce the number of bitcoin businesses operating and the number of merchants that accept bitcoin (and are thus incentivized to run full nodes), so it may be that reducing the fee to transact in bitcoin would indirectly increase decentralization by encouraging adoption and thus the creation of full nodes.

Additionally, some economic uses may be priced out of utilizing the bitcoin network, which may encourage the growth of Bitcoin competitors.  For example, a pharmacy may not be happy with $0.75 transaction fees and might choose to utilize another cryptocurrency like Monero that costs less than 1/10 as much to transact.  These marginal use cases may give competing cryptocurrencies a foot in the door that helps them achieve network effects and eventually makes them generally competitive with Bitcoin.

This is mostly a timing issue.  All cryptocurrencies face similar scaling issues, but other cryptocurrencies have much less demand on their networks currently.  Eventually, all successful cryptocurrencies will have to utilize new scaling technologies or scale off-chain, but those solutions aren’t yet ready for widespread adoption.  So this is really a debate over how to handle the 6-18 month period where Bitcoin transaction demand exceeds the network cap, but other solutions are not yet available.


The Core team (a group that includes a plurality of Bitcoin developers) is trying to implement a slight increase in block size via a more complex change called “Segregated Witness” or SegWit for short. SegWit can be implemented via “soft fork” which will not produce two competing chains. SegWit would eventually be the equivalent of an increase in block size to 1.7 MB.  The SegWit soft fork also includes a number of technical improvements, including an end to “transaction malleability”, and an improvement in the efficiency of sighash operations.

The simplest immediate solution is to “hard fork”, to change the block size to 2 MB or 4 MB, but this may result in some reduction in decentralization.  Additionally, there is a concern that a hard fork could create confusion for consumers and investors by producing two competing blockchains.  Lastly, even for those who believe that the pernicious effects of bigger blocks on decentralization are unlikely to be felt at 2 MB or 4 MB, scaling via hard forks to bigger blocks is an inherently unsustainable approach, since we hope that demand for transaction volume will increase far faster than bandwidth costs fall.

Attempts to produce such a hard fork over the last 2 years have appeared in various software and marketing implementations and failed to gain traction.  The latest version is “Bitcoin Unlimited” and includes some additional important changes to the network.  Bitcoin Unlimited allows for miners to decide block size dynamically, which is viewed as particularly dangerous by some analysts because of the possible feedback loop in which the largest miners might enlarge the block size, encouraging miner centralization, thus giving themselves more power to push for additional block size increases.

Lastly, there’s a “hybrid” approach: adopt SegWit and hard fork to 2 MB.  Such a hybrid solution would provide Bitcoin with some room to breathe while longer term solutions like the Lightning Network can be rolled out, but it still stokes the fears related to hard forks in general.

The Politics

Some of Bitcoin’s earliest supporters were self-described cyberpunks and anarchists.  Many hoped (at least in Bitcoin’s first couple years) that Bitcoin would eventually replace all fiat currency.  Those who hope for Bitcoin to replace the US dollar recoil at the rising transaction fees that make such a replacement all but impossible.

Most of the Bitcoin community accepts that Bitcoin can’t compete with fiat for transactions until sustainable scaling solutions are in place (off-chain scaling, or other technological innovations).  The rising fees are viewed as an acceptable nuisance.  Some Bitcoin investors think of Bitcoin as though it was IBM – a big established company, with much to lose; they are risk averse and view hard forks as inherently risky.  In contrast, other Bitcoin investors view Bitcoin like Uber – a young upstart with little to lose and lots to gain.  Technologies generally have to “move fast and break things” to avoid obsolescence, and some members of the bitcoin community fear that Bitcoin will be left behind by newer cryptocurrencies if it fails to aggressively upgrade its protocol.  Other investors think that Bitcoin is unlikely to ever be able to compete with younger competitors on features or technology, and must compete instead on the strength of its stability and network effects.

There’s also a rift between people who believe that bitcoin decision making should be viewed amorally as a process of game theory including the inevitable politics, while others believe that decisions should be driven by consensus based on the technical merit of the proposal.  The former group accuse the latter of centralizing control of the Bitcoin network in the hands of a few developers.  The latter accuse the former of pushing their self-interest over the superior technical solutions that would benefit the network as a whole.

At first analysis, everyone in the Bitcoin community wants the same thing – the price of bitcoins to appreciate.  This is because most of miners’ income comes from the “block reward’ (a fixed number of bitcoins awarded to miners for solving blocks, currently 12.5 BTC per block) not transaction fees (currently averaging 1.6 BTC per block).  But in a couple years, transaction fees may be greater than the block reward.  Miners eventually want lots of on-chain transactions and high fees.  But miners understand that if fees get too high, it will incentivize the creation of off-chain scaling solutions.  Additionally, miners are competing against one another, and the largest miners may view Bitcoin Unlimited’s dynamic scaling as a way for them to gain an advantage over smaller miners.  There may also be perverse economic incentives for some Core supporters.  Some of the most prominent Core developers are employees of the private for-profit company Blockstream.  Blockstream profits by providing services related to off-chain transactions, so they may benefit from constraining bitcoin’s on-chain bandwidth.  I have no special insight into the motives of the players – I’m summarizing the political issues as perceived by major groups in the Bitcoin community in this paragraph, and nothing here should be interpreted as impugning the character of miners, Core developers, or anyone else.

The “Crisis”

Some of the biggest miners are threatening to hard fork the bitcoin network by supporting Bitcoin Unlimited.  Many Core supporters have said they will view any such hard fork as an illegitimate competing cryptocurrency, and even as an “attack on Bitcoin.”  Some Core supporters have said they will attack the Bitcoin Unlimited network via “zero day attacks.”  One miner who supports Bitcoin Unlimited threatened to spend $100m to attack the Core branch in the event there’s a fork and things get ugly.  The fear is that the two resulting blockchains might destroy one another, or at least produce general confusion and uncertainty that permanently impairs bitcoins as an investment.  Additionally, most miners are currently signaling that they will not implement SegWit, which means that even a modest on-chain scaling improvement may be far away or even politically unattainable.

The Future

I think it’s unlikely (<35%) that bitcoin suffers a contentious hard fork of any consequence in the next year.  Miners have too much to lose and too little to gain from such a hard fork.  In the event miners do HF the network in support of Bitcoin Unlimited, I think it’s likely to be a relatively minor event that doesn’t impair (economically or operationally) the Core branch for more than a few months.  I think it's about 50% that SegWit is implemented via soft fork in the next 12 months.  In the meantime, we are likely to see fees continue to rise substantially.  If SegWit is not implemented, I view that as a detrimental outcome, but one that does not fundamentally change the Bitcoin value proposition nor the investment opportunity.

ConclusionBitcoins (BTC) as an Investment

 There’s an almost daily announcement of a new exciting cryptocurrency project.  Some are competitors to Bitcoin, but most are not.  Some of these projects offer interoperability between blockchains, decentralized file storage, or trustless casinos.  Many of these projects are exciting and a few are great investment opportunities, but I think over the next 12 months, Bitcoin will remain one of the top investments in the cryptocurrency world.  I have about 37% of my cryptocurrency portfolio in BTC.

There’s a huge amount of capital poised to enter the cryptocurrency markets over the next year, and much of that will flow to Bitcoin due to capital market availability and liquidity – Bitcoin is the only cryptocurrency with exchange traded funds (GBTC in the US, XBT in Stockholm) and a liquid futures market.  While rising fees make Bitcoin unusable for small transactions, I think this is relatively unimportant in the short-term.   In the next 12-24 months, the vast majority of cryptocurrency demand is likely to come from speculative investment, not consumer usage.  And if someone wants to buy or transfer $5,000 worth of BTC for long-term investment, whether the fee is $0.05 or $5 is unimportant.

I’ll provide a lot more detail for how and why I expect capital to flow into Bitcoin in an upcoming post.