Two innovators approached a well-heeled investor asking for money. Their sales pitch was very convincing. They told this investor that their innovation was so incredibly cutting-edge that only the hopelessly uninformed would fail to recognize its value. The innovators said that they had picked him because he was smart and forward-thinking enough to see the potential. The investor, who prided himself on being and looking very smart, gave them money.
The innovation sold to this investor was related to textiles, design and the fabrication of clothing. Their beta version was a suit they were making just for him. A launch date was planned.
On the day of its public debut, the innovators prepared the investor’s new suit and dressed him. Crowds had assembled for the launch. The investor’s team members ooh’ed and aah’ed about it before he stepped outside to show it off, remarking on the incredible innovation he was about to unveil. Out the investor went, proudly showing the world the newest innovation in clothing design and manufacturing.
It was immediately obvious to the assembled crowd that something was very wrong, but the fear of being cast as “hopelessly stupid” kept anyone from speaking out. Eventually, someone said what everyone else thought and knew: The investor’s new suit was nothing more than his birthday suit. Only after that one person said something did everyone feel it was okay to chime in and remark that the investor had been duped.
The story, as I’m sure is now clear, is the famous Hans Christian Andersen children’s fairy tale, “The Emperor’s New Clothes,” published in 1837.
It’s a storyline with some very strong parallels to the cryptocurrency stories being told and the investments they now garner.
The Crypto Has No Clothes
The ability to use an anonymous single currency to power a decentralized, permissionless distributed ledger operating over the public internet, where miners compete to solve the math problems that enable the processing of transactions, is a remarkable innovation.
In concept.
Like the Emperor, investors are eager to get a piece of the innovation that cryptocurrency advocates, which investors and enthusiasts strongly and forcefully defend as the future of our global financial services system. These early advocates have stimulated a vast amount of investment into this vision: $1.7 billion has been invested into bitcoin/crypto-related ventures over the last eight years.
Anyone who disagrees, however, is immediately dismissed as lacking the intelligence needed to understand the potential that these new currencies will create, free of the legacy shackles and stifling regulation that they say keeps innovation in financial services way too low and the cost of moving money around the world way too high. They are deemed stupid, Luddites or just too freaking old to know that crypto is the future just like the internet was way back when.
Innovators, who see the willingness of many to invest in building this new future, take the money. They build applications that run on top of existing cryptocurrencies — mainly bitcoin — and create new ones; today there are more than 1,000 offspring of bitcoin. Innovators also find new use cases for these new currencies, including Initial Coin Offerings (ICOs), to raise money to fund innovation outside the realm of existing securities regulation.
Bankers and corporates, who already feel vulnerable to FinTech innovators and are told they’re behind the curve, convince their boards to invest time and money creating crypto prototypes. Not doing so only cements their image as stodgy, lumbering corporate Neanderthals destined to die, they say.
Few people speak out. When they do, they are publicly slammed as too fearful of being disrupted to open their eyes to the future — and not visionary enough to see the great potential that crypto-powered networks will deliver.
Others, observing the strong public rebuke, wonder if they really are missing something. Venture capitalists (VCs), after all, are the visionaries who see and invest in a future that most don’t have the capacity to recognize, so there must be something to it.
So, everyone keeps investing in the buildout of a new global financial services network, moving money between endpoints outside what exists today. Even though, deep down, something doesn’t really feel right about the notion of a global financial network — that moves trillions of dollars around the world every day — built on top of an unregulated global currency like bitcoin or Ethereum.
The Need for a Balanced View
I wrote a piece a few years back that told the side of the bitcoin story that wasn’t being told. I was compelled to write it after the din of bitcoin as the cornerstone for “the internet of money” reached a ear-piercing decibel level — an oversimplification of what I thought was the complexity of safely moving money around the world and even how the internet works.
In those pieces, I acknowledged bitcoin was an interesting, even fascinating, innovation, but not the salvation of our global financial system — not even close.
The points that I made in those pieces then remain the same today and extend to the cryptocurrencies that have cropped up since. And they remain especially true now, three years after observing the growth of bitcoin, which remains the kingpin of cryptocurrencies.
—No one believes in the merits of a global cryptocurrency, except bitcoin zealots. The notion that central banks will give up monetary control of their fiat currencies for a global cryptocurrency, especially bitcoin, is just not happening, so we should stop talking about it. Even economists who never agree on anything, agree on that. Besides, a currency that swings between $1,000 and $5,000 over the course of two years, and between $3,000 and $5,000 in the course of a few weeks, isn’t exactly a good basis for operating a strong and stable foundation for a global financial system. Even the miners making $7 million a day processing bitcoin believe it’s a bubble and don’t understand why it’s trading so high.
JPMorgan Chase CEO Jamie Dimon’s point last week at the IMF Conference in Washington, D.C., that the only economies that embrace bitcoin are those ruled by corrupt and oppressive governments, like North Korea and Venezuela, is right on the money.
To take an example, researchers at FireEye report that North Korea’s President Kim Jong-un loves bitcoin and crypto because of the anonymity and ability they give him to operate outside regulatory oversight. It’s also ideal for money laundering and the purchase of raw materials to build nuclear weapons and skirt UN sanctions while still engaging in trade.
—Bitcoin has only two proven use cases after eight years: criminal activity and speculation. I honestly don’t understand why this continues to be dismissed in the face of mountains of evidence to the contrary. In the eight years since bitcoin has been a currency, transaction volume in the support of legitimate commerce is virtually nil.
People use it to speculate — buying and holding it in the hopes that it will appreciate, like they buy and hold other commodities. (Yes, of course, I wish I had bought it at $10 and sold it at $5,000. I bet a lot of people also wished they’d invested in Bernie Madoff’s funds and sold while the getting out was good, too.) They also use it to move money out of countries where strict currency controls exist. And, of course, criminals use it to grow their businesses.
Bitcoin’s innovation — anonymity and irrevocability — have taken the friction out of crime. Hackers take over computers and demand ransom in bitcoin. The dark web’s thriving ecosystem — all fueled by bitcoin — is where criminals shop for anything they want to buy in the pursuit of illegal activities: stolen financials, personal information, military grade ammunitions, illegal drugs, sex slaves and more. Bitcoin not only makes it easier for criminals and terrorists to buy those things; it fuels a growing demand for their supply.
—This is why bitcoin, unfortunately, has gotten scale — it found a use case that feeds both buyers and sellers. It’s also why so many blockchain use cases rely on it, because it now has an ecosystem to support its scale. To think that any other cryptocurrency would even come close is implausible. At least I hope so. Bitcoin’s core principle of anonymity is anathema to operating a safe and secure global financial system. Regulators require that financial institutions (FIs) know their customer — and for good reason: so that they don’t become unwilling accomplices to money launders and terrorists. Those who say algorithms and machines can take care of that should tell that to the policymakers and regulators who’ve observed foreign governments buying ads and posting fake content on social networks or criminals and terrorists that use marketplaces to set up fake storefronts to launder money. All further begging the question about the relevance of cryptocurrency beyond using it to do things that cannot be lawfully done with fiat currency.
—Bitcoin is anything but fast or free. Bitcoin’s scale has taken a toll on how quickly transactions move across its network. Today, it takes roughly an hour for a bitcoin transaction to settle, up from ten minutes not that long ago. Transactions that exceed the capacity of a block — and block sizes are limited — get stuck in a queue until the miners give it the all-clear. And that’s still on relatively small volume. The notion that bitcoin is going to power a global financial network that moves and settles trillions of dollars in real or near real time is implausible.
Bitcoin is also anything but free. Miners now expect a fee for their work and won’t process transactions for which they are not paid. That means that those costs are passed down the ecosystem to end users. There’s no such thing as a free lunch, even in the land of bitcoin.
—Bitcoin’s infrastructure is highly concentrated and not all that secure. Processing bitcoin requires enormous computing power. Miners, understandably, set up shop where the cost of power is cheap. As a result, bitcoin mining is concentrated in two countries: China, with 60 percent, and Georgia, with 15 percent of bitcoin processing power. The U.S. has a 3 percent share, with the remaining 20 percent spread across the world. The notion that we are going to build an entirely new global financial system that moves trillions of dollars around the world every day on top of a processing infrastructure based in China and Georgia seems a non-starter.
The rising value of bitcoin has made exchanges prime targets for hacking, and thus has made hacks there quite lucrative. The Mt. Gox hack netted $500 million, Bitfinex $72 million, Bitcoinica $460,000, Bitfloor $250,000 and Bitstamp $5.2 million. South Korea’s Bithumb hack last summer — the exchange that serves 75 percent of the South Korean market for bitcoin — resulted in tens of millions of dollars lost for the 30,000 customers affected. Even the wallets that store bitcoin are vulnerable.
The FBI reports that some $28 million in losses were reported to them in 2016, triple what they saw in 2015. But that’s only what’s reported. It’s hard to imagine a money launderer or terrorist emailing the FBI to let them know they were hacked and lost money. That means that no one actually knows how much money has been lost to hacking, but the anonymity and irrevocability associated with bitcoin transactions means that the money lost is also irrecoverable.
—The use cases bandied about for alt currencies like bitcoin lack an understanding of how money moves today. An interview with the head of the International Monetary Fund (IMF) reported a use case for cryptocurrency as making it possible for women in developing countries to use mobile phones to conduct commerce safely. But that’s already happening today — without bitcoin and without cryptocurrency. M-Pesa, for example, has been in market in Kenya for a decade. Today, with 26 million users who’ve sent and received 184 billion Kenyan shillings over the last ten years, government officials and regulators report that Kenya “runs on M-Pesa.” FYI: 184 billion Kenyan shillings is nearly $1.8 billion in USD, using nothing more than a feature phone.
M-Pesa’s original use case was to digitize the paper currency that was once sent back home to villages via paper bags and buses. M-Pesa would have never ignited but for the ability to convert digital money into the currency that people are able to spend in their local markets. Setting up agent networks to convert digital money into the cash they would use to pay merchants ignited M-Pesa. That’s all to say that thinking women in Africa or any developing country get value by receiving money in cryptocurrency fails to understand the problems that paying them in crypto creates. Not only does it subject them to the volatility of the underlying crypto, but also forces them to find a place where they can exchange it for a currency that a merchant in their village accepts.
Africa isn’t the only developing market where efforts to digitize, move money and settle transactions is happening without cryptocurrencies. China has, in effect, digitized money with Alipay and last month made news by shutting down its cryptocurrency exchanges. India is using QR codes, existing rails and its own fiat currency to enable digital payments between people in the aftermath of its demonetization. Western Union moves money, settles transactions all over the world — and in developing economies — and has for more than 160 years without needing cryptocurrencies. As do MoneyGram and Xoom and PayPal. You get the point. This stuff all happens today and has for decades — digitally — without the need for crypto.
Cryptocurrencies are also being heavily scrutinized by banks and regulators everywhere in the world, including some of the countries that one might have thought would be open to the idea. In Russia, China, Vietnam and Bangladesh cryptocurrencies are already illegal or being banned. Singapore is shutting down the bank accounts of those dealing in cryptocurrency, and the head of the Singapore Cryptocurrency and Blockchain Industry Association said that he’s heard reports that the same holds true for banks in FinTech hubs.
Then, of course, there are the ICOs fueled by the emergence of cryptocurrencies and the ability to create one out of thin air, outside existing securities regulations.
With an ICO, an innovator who wants to raise money issues a cryptocurrency — a token — in exchange for a promise that the token will be worth more than its face value someday. The volume of money poured into ICOs is nothing short of staggering. Pitchbook reports that ICOs have raised $1.3 billion so far this year, while $634 million in venture money went into crypto-fueled startups over that same period. And why should VCs invest more when they can wait to see what ICOs, if any, end up creating viable companies?
ICO investors don’t get equity or even a real measure of the return on their investment, but as one investor said, they do face a sizeable risk losing all their money. All except for hedge funds, which seem to be getting rich on ICOs. They buy tokens at a discount and resell them for big profits almost immediately. Their actions, some say, just give the unsophisiticated retail investor false confidence, which reprise concerns by many of a bubble that, when it bursts, could make the Dotcom crash look like a speck on the head of a pin.
—Cryptocurrencies and the ability to innovate financial services are conflated — suggesting that one is not possible without the other. Satoshi Nakamoto’s innovation was a distributed ledger network powered by bitcoin running over the internet. The unsavory nature of bitcoin gave rise to alternative distributed ledger schemes powered by new cryptocurrencies, such as Ethereum or XRP.
And it assumes that innovation of financial services globally, including real-time settlement of digital assets, is only possible if a cryptocurrency is inserted into the mix.
It also begs the question: why?
While bitcoin and ICOs command the headlines, innovations are emerging that take the best of distributed, permissioned, secure and private ledger technology and digitize assets issued by regulated financial services companies and governments to enable transactions in near real time. This concept decentralizes the ability of anyone who’s a part of this network to digitize such assets — including stocks, loyalty points and contracts — and to move and settle them in near real time, globally, at scale. And it does it within existing secure and compliant environments using the fiat currencies of the endpoints in between those transactions.
If it sounds a lot like how global card networks operate, it should. In an interview that Visa’s Founder, Dee Hock, did with The New York Times in 1981, he said, “Visa is a device for the exchange of value. In short, it’s the next thing to money.” As global networks, Visa and Mastercard both coordinate the operation of decentralized, distributed, secure and compliant private networks of issuers, cardholders, merchants, acquirers and processors to enable the settlement of card transactions between anyone on a global scale. They used technology and computing power to create the framework for the payments ecosystem that now powers global commerce.
When Steve Jobs launched the iPhone in 2007, he didn’t feel compelled to rebuild mobile broadband as part of his product scope. He leveraged existing infrastructure and built on top of it. As the iPhone gained momentum, those ecosystems and that infrastructure evolved too — from 3G to 4G and now soon 5G to remain relevant and to monetize their place in that ecosystem.
The conversations we are having now about bitcoin and cryptocurrencies seems to have lost sight of the problem that needs solving as we look at the evolution of global financial services and the networks that power them. No one will argue that things could be more efficient — and that the ability to digitize, secure, make smarter and settle digital assets in real or near real time is worth exploring — and has a great potential upside.
But does that require bitcoin to do it? Or one of the thousand cryptocurrencies issued by unregulated entities that create new networks to operate?
Only if you want to build something that operates completely outside the current global financial services ecosystem.
I have no doubt that I’ll be told by thousands how wrong I am.
That’s okay, though; I sort of like the company I’ll be keeping.