One of the things I hear a lot from people new to crypto currencies is that they think crypto currencies are just elaborate Ponzi schemes.
Is it e.g. just a like the Tulip Mania from the Dutch golden age:
At the peak of tulip mania, in March 1637, some single tulip bulbs sold for more than 10 times the annual income of a skilled craftsworker
Another famous bubble was the South Sea Bubble where the South Sea Company go a monopoly on South American trade, but actually wasn’t able to do much of any trade due to war.
The price of the stock went up over the course of a single year from about £100 to almost £1000 per share. Its success caused a country-wide frenzy — herd behavior as all types of people, from peasants to lords, developed a feverish interest in investing: in South Seas primarily, but in stocks generally. Among the many companies to go public in 1720 is — famously — one that advertised itself as “a company for carrying out an undertaking of great advantage, but nobody to know what it is”
Which doesn’t sound all the different from what we see with Crypto Currencies, where all sorts of people are getting involved with speculation, not always having much idea of how the underlying technology works.
This is what I want to do in this article. Explain how the technology of different crypto currencies affect its value.
It is often leveled against crypto currencies like Bitcoin that it has not intrinsic value, as opposed to say gold. Gold has industrial and medical uses. People also appreciate gold jewelry. So clearly it has some value, but whether the present value of gold is a reflection of its intrinsic value is debatable. As Warren Buffett said:
Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.
Still, gold is a not a fair comparison to crypto currency. Fiat currency like dollars, rubles or pounds don’t have any intrinsic value either. They are not worth the paper they are printed on.
So why would anybody want fiat currency, or why is there a market or demand for fiat currency?
- By law people have to accept payment in the national currency.
- The government demands that you pay your taxes in the currency they issue from their central bank.
Of course if anybody could print or copy the money it would be worthless, which is why fiat currencies have artificial scarcity and can’t be easily copied. This is very similar to crypto currencies.
A bank note is printed in a complicated manner which makes it difficult to replicate, while a Bitcoin is secured against copy by the use of cryptography.
Then central bank limits the supply of fiat currency, while the Bitcoin mining process limits the supply of Bitcoins.
Intrinsic Value of Bitcoin
Of course Bitcoin is not a mandated currency for payment or taxes anywhere, so that is no way of securing a market for Bitcoins.
On the other hand, lots of things have value without being mandated by government. A soccer card with the signature of a famous player, is just a cheap piece of paper with some ink on it. Yet many people will place a high value on it.
A lot of art is the same. The value of the paint is limited and so is the utility of the painting. It does of course have a certain value with respect to pleasure people take in looking at it and having it on their wall to decorate a room.
However most of the value of an art piece derives from its exclusivity. A perfect copy of a master piece, would only be worth a fraction of the value of the original despite giving the viewer the paining the exact same experience.
Hence there is no objective way of assigning value. Things are worth whatever people think they are worth. So the question is why might people assign value to e.g. Bitcoin?
One reason is the utility of Bitcoin. There will always be a desire for anonymous or pseudo anonymous payments. Cash of course offers this, but not in a convenient manner online. People might want to purchase something only anonymously, which is not possible with a credit card. This could either be buying something they find embarrassing or it could be something illegal. E.g. the online service Silk Road was famous for selling drugs online taking payments in Bitcoins. Another dark side of Bitcoin is its usage for Ransomeware payments.
As long as people want to buy drugs online or extort each other there will be a demand for Bitcoins, which means it will have some value. What value is almost impossible to define. There is however a lower limit, define by the electricity cost for computer mining new bitcoins.
But of course most of the value of Bitcoin today, is derived from speculation. People buying it in the hope that its value will increase.
Speculation is of course not entirely useless as it creates liquidity for those who desire to use Bitcoin for payments.
But why does Bitcoin have value over any other crypto currency. Anybody could in principle duplicate the Bitcoin source code and make their own crypto currency, which is in fact what people do.
The advantage of Bitcoin is in first mover status and the network effect. Bitcoin is already established, the competition is not. There are already a huge number of companies and services involved with Bitcoins. You can get a whole host of applications for Bitcoins, there are many currency exchanges which allows you to buy Bitcoins, and many companies have built money transfer services around Bitcoin such as Azimo and Currencyfair. These offer much faster and cheaper international money transfer, especially for remittance than traditional banking or established players such as Western Union.
To the user of these services the usage of bitcoins is transparent. Customers just transfer money from to the service provider, which uses that money to buy bitcoins. These bitcoins are in turn sold in the target country for local currency which is transferred to the recipients bank account. Hence a slow and expensive cross border bank transaction using say SWIFT never happens. It is all local cheap bank transactions. The cross border movement of funds is facilitated with bitcoins.
Centralized money transfer services like Paypal could in principle do this as well, but this is quite expensive.
International Personal Payments:
If you send or receive an international personal payment using your PayPal balance or bank account, you’re charged a cross border fee, which can range from 0.5% to 2% of the payment amount.
For purchase payments it is even more expensive. The problem with centralized payment schemes as Paypal is that they are built on top of old and expensive bank infrastructure and they hold a monopoly positioned when buying and selling currency. If you hold dollars in your Paypal account and want Euros, then Paypal has a monopoly on making that transaction. Hence they give a poor exchange rate.
If you hold Bitcoins on the other hand, nobody has a monopoly on exchanging those for a different currency.
So as long as there are many companies using Bitcoins as a bridge currency for money transfer, as well as people needing it for anonymous transactions it will have some value.
A problem both Ripple and Ethereum solves is that there is originally not particular reasons to buy a crypto currency. New crypto currencies tend to be bought exclusively because people are making a speculative bet that they would be worth something in the future.
Ripple and Ethereum on the other hand has made their crypto currency a necessity for the services they offer. Bitcoin doesn’t really offer any services beyond a system of transferring ownership of Bitcoins.
Ripple in contrast is a money transfer or payment system similar to SWIFT presently used by bank to transfer money internationally. In fact Ripple is working closely with banks to integrate Ripple as a way for the bank to transfer money cheaply and quickly to other banks. For instance SWIFT can require days to perform a money transfer while a Ripple payment is done in a mere second.
A Guaranteed Need For XRP
Ripple was made to transfer fiat currency, and even ownership of assets like gold. But here is the kicker. Every transaction in Ripple requires XRP. So even if you want to just transfer dollars to another person, you still need to acquire XRP to perform that transaction. This serves several purposes:
- It avoids the public ledger of transactions being spammed with lots of pointless transactions. Hackers can’t overload the system with millions of frivolous transactions because they would have to buy a lot of XRP to do so.
- It gives a way for the Ripple company, to charge for the service they offer. Ripple is open source and anybody can run a ripple node, so it is not through hosting an online service in the traditional sense that they get paid.
Ripple held all the initial created XRP coins, and have been gradually selling and giving them away. This serves as an alternative to funding through selling stocks. Ripple sell XRPs to fund their operation. As more financial institutions start using Ripple to perform transactions between each other, the higher the demand for XRPs will become and hence the price and their ability to capitalize on it.
So far Ripple has signed up something like 60 banks and financial institutions to their network. In this sense it is a more centralized system than Bitcoin. The Ripple company function in many ways as a regular central bank. If the currency sees too sharp value swings, they dump XRPs on the market to stabilize the price. Ripple wants a stable value on XRP as that facilitates trade more easily. Bitcoin in contrast is based on decentralized mining. Bitcoins can spring into existence on any computer. Hence there is no central control of the money supply. This also means higher volatility of the Bitcoin price.
However Ripple is not a centralized system when compared to e.g. PayPal. The Ripple company is not a central authority on money transactions. There is no single Ripple database of account balances that they update. Rather there are distributed servers each keeping a copy of the Ripple public ledger. Transactions are verified by cryptography just like with Bitcoin. It means government couldn’t just suddenly shut down Ripple as there would always be Ripple nodes in other countries maintaining the public ledger which does not depend on the existence of the Ripple company. As they software is open source, anybody could continue its development.
XRP as a Bridge Currency
Because there is a guaranteed need for XRP since it is required to perform transactions, It can serve a second purpose which is acting as a bridge currency. As mentioned with Bitcoin money transactions, a crypto currency can be used as an intermediate to perform a transaction between two banks. If the banks don’t have an established relationship, they could still perform transactions with each other and avoid counterparty risk by using XRP as a middleman.
These factors contribute to creating a demand for XRP. As long as people value the transaction services offered by Ripple, XRP will have a value.
Ethereum, a Further Abstraction
Bitcoin could be used to perform transactions of just one currency. Ripple could perform transactions of any currency. Ethereum takes a big step forward and allows performing almost any financial transaction or contract. You could use it to handle ownership transfer of a house, selling movie tickets, escrow services, Kickstarter style funding of projects where people pledge money to a project, but it only gets transferred if the project raise the target amount.
To accomplish this Ethereum is essentially generic platform for running software, referred to as smart contracts.
Understanding how this works and understanding the full implications is not something I found easy initially, so I’ll try to explain it in terms of my misunderstandings, hopefully to avoid giving you the same misunderstandings.
Ethereum has its own sort of virtual machine, which runs a particular kind of byte code. Although you can program in higher level languages which compile down to this bytecode.
My first critical thought when looking at this, was that they language looked too loosely typed and dangerous. It will be too easy to write a faulty program, which has a bug was my thought. You really want to avoid that when dealing with money or financial assets. So I thought it was weird they did not use a sort of strict language like Haskell.
The thing to realize is that there are many ways of creating safety other than through language design. First of all, it is a completely sandboxed environment they run in.
Also remember how Ripple prevents people from going crazy with transactions by requiring some XRP for each of them?
Well, Ethereum is similar. Running a program is going to cost Ether, which is the Ethereum crypto currency. But how do you calculate how much? With e.g. Bitcoin the cost of a transaction is sort of market driven. People assign higher fees to get their transactions through if it goes slowly.
Likewise if your Ethereum programs aren’t running you will pay more Ether to get them to run. So there is a price controller by supply and demand which prevents the Ethereum nodes from getting overloaded. However since with Ethereum each program run will require different amounts of resources unlike a Bitcoin or Ripple transaction, they can’t be priced the same. Instead Ethereum solves this by assigning a cost of each operation in a quantity called gas. Hence running a program will consume a certain amount of gas. Ether is used to pay for this gas, but you can’t hold a balance of gas. Instead you pay for gas with Ether as you go.
Which brings up the next question, who exactly pays Ether to run a program (or smart contract) on the Ethereum platform? Is it the creator/owner of the smart contract or the users of it?
Smart contracts are not like something like Google App Engine apps running continuously. They are more like hooks which run for just a short amount of time in response to events. One of those events would be sending a transaction to a smart contract. In your transaction you specify an operation you want to perform with the smart contract. A smart contract is essentially an API with a set of supported operations. Alternatively you can look at it in an object oriented fashion. They are objects with state and a set of methods which can alter that state.
If you as an external entity want to alter a smart contract state, then you have to invoke one if its methods by specifying which one, and give arguments in a transaction. In this transaction you also provide Ether to pay for the gas, which will be consumed when invoking this Smart Contract method. You specify how much you are willing to pay for each unit of gas, and how much gas you are willing to pay for. This sets and upper limit for how much Ether will be consumed.
If you specify too low price for gas, then the Ethereum node, might not want to include your transaction and run it, similar to how Bitcoin transactions with a too low fee will not get included, or might have to wait a long time to be included.
Once the contract method is run, you will get back any unspent Ether. However if you provided too little Ether to run the contract method, then you will not get anything back. It will be lost. So there is an incentive to provide enough. This also means that buggy contracts with things like never ending loops won’t run indefinitely as they will run out of gas. It also means the operations in the contract will not get performed.
Smart contracts can be used together with regular software to create dapps (distributed apps). A bitcoin client is an example of a dapp. You got a client running on say a smart phone interacting with bitcoin software running on a Bitcoin node, performing transactions you put together in the Bitcoin client. Likewise developers can create any number of mobile phone apps or web clients which create particular Ethereum transactions to interact with particular kinds of Ethereum smart contracts. This could be a client for buying movie tickets, sell and buy a house or pledge money to a project.
Of course these sorts of applications or services already exists, so what is the new thing now? At the moment all of these applications require building your own infrastructure or paying to host such a service on e.g. Google App Engine. It also requires trusting a multitude of companies. E.g. trusting that if you pledge money to a project, the company running the pledge service isn’t going to run away with your money. With Ethereum you know that no single company owns the Ethereum network.
The Huge Need for Ether
This is what is going to drive a large demand for Ether. As companies build a multitude of dapps for trading stocks, buy and sell houses, place bets on horse races, pledge funding to projects, buy subway fares etc, the need for Ether will rise as all of these apps will require Ether to run. The more people who use these apps the more Ether will be required.
This makes the future for Ethereum possibly brighter than Bitcoin, because there is nothing you have to have Bitcoins for, but you will have to have Ether to run the services on the Ethereum platform.
But to raise one important point of contention. Ethereum is still dog slow, just like Bitcoin. It is fine now, but if volumes should grow, the present solution won’t scale. This is an advantage for Ripple, which although less flexible than Ethereum has lightening fast transaction processing, because it is based on a consensus protocol rather than proof of work (mining) as used by Bitcoin and Ethereum.
Part of the advantage here is gained from Ripple working with the established players like banks to build their network. This also makes idealists suspicious of Ripple.
Ethereum creators have claimed however that they plan on transitioning to a proof of stake protocol which will give much faster transaction and smart contract processing. It remains to be seen how this will work out.
I think Ethereum has the biggest potential, however it is more risky because we don’t know how well they will implement proof of work and with the flexibility of smart contracts, it is hard to foresee potential problems.
Ripple seems like a solution with great potential but with much less risk. It has already successfully signed up many banks and is essentially a proven solution.
While Bitcoin has less technical advantage it has a huge advantage at the moment in terms of first mover status, momentum and much larger mindshare. Almost everybody has heard about Bitcoin and it is easy to get started trading it. Many companies build services on top of Bitcoin which kind of offsets its limitations.
This is why I think all of three of these cryptocurrency systems have the most potential for long term investment.
From a technical standpoint there are of course many other interesting solutions such as ZCash and Monroe exists. In particular these aim to provide absolute anonymity which neither of the solutions I’ve described in this article do. However my speculation is that pseudo anonymity provided by Bitcoin will be more acceptable to most users seeking some level of anonymity.
What will drive adoption by users will most likely be what you can do with the solution and how easily accessible it is.