Understanding Cryptocurrencies: Bitcoin, Ethereum, and Altcoins As An Asset Class
Understanding Cryptocurrencies: Bitcoin, Ethereum, and Altcoins As An Asset Class
Understanding Cryptocurrencies: Bitcoin, Ethereum, and Altcoins As An Asset Class
Understanding Cryptocurrencies
Ariel Santos-Alborna
Understanding Cryptocurrencies:
Bitcoin, Ethereum, and Altcoins as an Asset Class
10 9 8 7 6 5 4 3 2 1
Description
Understanding Cryptocurrencies is perfect for both introductory investors
to the digital asset space and experienced investors seeking to gain practical
insight into frameworks for understanding digital assets and valuation
metrics. The book provides in-depth analysis of Bitcoin, Ethereum, and
the different types of Altcoins in the ecosystem. The author demonstrates
an empirical approach to explaining how digital assets can fit into a
diversified portfolio of traditional financial assets, or as a standalone port-
folio in a parallel financial ecosystem. The book contains fundamental,
technical, and on-chain analytic tools for investors to better understand
Bitcoin price cycles that will ultimately lead to better returns. The capital
from these price cycles oftentimes migrates to other digital assets, creating
a robust ecosystem and providing opportunities for enterprising inves-
tors to generate additional alpha. In Understanding Cryptocurrencies, the
author also offers options for asset custody and counterargument break-
downs to create better informed investors. Lastly, the author provides
poignant insight into the economic inefficiencies created from decades of
Central Bank interest rate manipulation and monetary expansion. These
inefficiencies have had social, political, and economic implications. It is
ultimately due to these inefficiencies that a global sound money vacuum
exists for digital assets to exploit.
Keywords
bitcoin; ethereum; altcoins; digital assets; cryptocurrencies; blockchain;
decentralized finance; scarcity; gold; stock-to-flow; transactions; pay-
ment; money; store of value; medium of exchange; utility; mayer mul-
tiple; market capitalization; real capitalization; bitcoin mining; miner
capitulation; hash rate; hash ribbon; difficulty adjustment; diversifica-
tion; portfolio management; technology; central bank; liquidity; interest
rates; debt; growth; value; liquidity waterfall; risk curve; volatility; digital
scarcity; price cycles
Contents
Introduction������������������������������������������������������������������������������������������ix
Conclusion�����������������������������������������������������������������������������������������117
Notes�������������������������������������������������������������������������������������������������123
References�������������������������������������������������������������������������������������������127
About the Author��������������������������������������������������������������������������������133
Index�������������������������������������������������������������������������������������������������135
Introduction
This book answers two simple questions: what is Bitcoin and why should
I invest in it? One of the most frequent complaints of Bitcoin literature
is its opacity and overinclusion of coding or other language that prevents
it from resonating with the average investor. This book is simple in its
construction and written in a manner that is accessible to the lay investor.
My hope is that this book serves as a starting point for understanding dig-
ital assets from a portfolio management perspective. The primary source
to understand any digital asset is its white paper. I begin with an expla-
nation of Bitcoin, with a large portion of the information taken from
the white paper of Satoshi Nakamoto, Bitcoin’s pseudonymous founder.
I also incorporate my own analysis of Bitcoin as a digital store of value
and a technological breakthrough. At its core, Bitcoin is software applied
to the problem of fiat money.
In Chapter 2, I explain why Bitcoin deserves allocation in every inves-
tor’s portfolio—diversification and extremely high growth potential. The
level of investment depends on the individual investor’s risk tolerance
and conviction. There exists an allocation percentage for skeptics, alloca-
tion that provides true diversification, and, for full believers, the route of
adopting the Bitcoin network as your personal savings account or treasury
asset. As a macroeconomic investor and writer, the third chapter explains
how decades of interest rate manipulation and money printing coming
to a head has created the perfect storm for the price of Bitcoin. The eco-
nomic inefficiencies created by Central Bank monetary policy created a
sound money vacuum that Bitcoin will exploit in the coming decades.
Experienced investors will likely consider Chapter 4 the most import-
ant. Here, I explain Bitcoin valuation metrics to include a more in depth
look at the Stock-to-Flow model introduced in Chapter 1, the Mayer
Multiple, explaining network effects through Metcalfe’s Law, and much
more. Traditional models of discounted cash flows or venture capital val-
uation models do not work with a monetary network. Examining scar-
city dynamics and number of users on the network assist the investor in
x introduction
What Is Bitcoin?
The millennial generation and later, as natives to the Internet, seem to
register the utility of cryptocurrencies more than generations before
them. As an inverse of this observation, older generations understand
the utility of investing in and storing physical gold. The value of each
investment derives first and foremost from its scarcity. In addition to
scarcity, Bitcoin contains characteristics that liken it more to a payment
network such as Visa and PayPal than a store of value asset. To add
complexity, we now see borrowing and lending systems with Bitcoin
collateral and the steady introduction of new regulations concerning its
custody and classification. How do investors classify something with such
unique and diverse qualities?
Although there is no straight answer, I offer a three-pronged solution
to the question posed as the title of this chapter. First and foremost, Bitcoin
is a decentralized payment network; or as Twitter CEO Jack Dorsey states,
“the best manifestation” of a global currency native to the Internet.1 Due
to its programmed scarcity in the face of fiat currency supply inflation, it
also serves as a store of value. Any asset whose price appreciation outpaces
the devaluation rate of the currency used to measure it can be said to
sufficiently store value. Bitcoin, therefore, is also savings technology that
allows you to store liquid dollars in a scarce protocol to avoid the Federal
Reserve’s programmed 2 percent devaluation rate. Lastly, Bitcoin is
software applied to the problem of money and can therefore be likened to
a high-growth tech stock, though it cannot be valued as such.
Peer-to-Peer Cash
All online payments not on the Bitcoin network necessitate a trusted
third party in the form of a bank or credit card company to process the
transaction. These financial institutions verify these transactions and
2 Understanding Cryptocurrencies
prevent fraud in a process that takes time and fees. The average cost
for credit card processing is between 1.3 and 3.4 percent.2 Bitcoin, and
blockchain technology in general, is revolutionary in that its decentral-
ized nature eliminates rent-seeking behavior from those standing in the
middle of value transactions. Bankers, lawyers, supply chain managers,
and human resource representatives are all examples of professionals that
will all be affected by this technology, whether they realize it yet or not.
The biggest issue with digital money has historically been double
spending. This is where a fraudster spends the same digital token with
multiple merchants. A trusted third party mediates transactions to prevent
double spending of funds, but Bitcoin uses a distributed ledger system
that records and confirms all transactions on the blockchain. While coins
with digital signatures provide proof of ownership, a verifiable distributed
ledger prevents the double spending fraud problem. Transactions are final
once published on the blockchain, hence the cash aspect. Risks of a hack
where an attacker owns over half of the nodes (a 51 percent attack) was a
risk early in Bitcoin, but becomes less possible as its market capitalization
reaches trillions of dollars. The more the network grows, the more secure
it becomes. In addition to its near impossibility, hacking the Bitcoin net-
work would undoubtedly crash its price. From a game theory perspective,
the incentive structure of the network strongly discourages anyone from
attacking it. All cases of Bitcoin fraud or hacks were really just phishing
scams where the victim willingly gave up their private keys or sent funds to
a fraudster. One is more likely to have his or her card information hacked
from a company’s centralized database than from the Bitcoin network.
Lastly, traditional banking takes time in addition to incurring fees and
third-party risk. While micropayments occur instantly, larger payments
such as international wire transfers take between one and five business days
to settle. It is faster to physically send large sums of cash via express mail
than conduct digital transfers under the current system—a perplexing fact
given the current state of technology caused by the fact that technology
has never really challenged financial infrastructure. Bitcoin transactions
occur instantly and the funds post in the several minutes it takes for blocks
on the chain to approve the transaction. At its core, Bitcoin allows
individuals to send value over the Internet without a bank or trusted third
party. While technologically impressive, I admit that this itself does not
serve as a large enough catalyst to create parabolic price action.
What Is Bitcoin? 3
Digital Gold
What drives value? The Austrian School of Economics contends that
all things contain utility value, scarcity value, or a mixture thereof. The
air we breathe has ultimate utility value in that we need it to survive;
however, its abundance makes it worthless as a sold good. A market for air
manifests itself once it becomes scarce. Take Delhi in India, the fifth worst
polluted city in the world. Oxygen bars have popped up for customers to
breathe pure air for 300 rupees, roughly 4 dollars, per 15 minutes.3
Gold is the quintessential scarce good. Roughly 190,000 tons of
gold have been mined historically, while an average of 2,900 tons are
introduced each year through mining. One will find slight differences in
these figures depending on the source used. The stock of 190,000 divided
by the annual flow of 2,900 gives gold a Stock-to-Flow (SF) ratio of 66.
That is, in 66 years the current stock of gold will double. For comparison’s
sake, silver has an SF of 22, platinum of 1.1, and palladium of 0.4. The
obvious correlation is that the higher the SF ratio, the higher the market
price due to a scarcity premium. Gold has served as a store of value for
over 5,000 years because it has a limited supply and limited flows. It is the
harder asset, with an inflation rate of 1.5 percent that is excellent
compared to fiat currencies historically. The British pound, for example,
has lost 99.5 percent of its value since its inception in 1209. A 13th-century
British family could store their wealth in gold and still provide value to
their relatives centuries later.
The argument in this section is as follows: if scarcity drives value,
and scarcity can be measured by the SF ratio, a higher SF ratio means
4 Understanding Cryptocurrencies
higher value (or price). Gold’s scarcity is unforgeable due to its chemical
properties. Bitcoin’s scarcity is unforgeable due to its code. Bitcoin serves
as a technologically enabled, perfectly scarce good. Except for the time we
spend on this planet, perfect scarcity does not exist in the physical world.
To understand Bitcoin’s scarcity, we have to understand the mining
process. A mining reward occurs roughly every 10 minutes, when a miner
uses electricity and computational power to find the hash that satisfies a
proof-of-work requirement. It is the equivalent to finding the solution
to a complex puzzle. Instead of a gold mining operation with machinery
and manpower, think warehouses filled with servers. The mining reward
started with 50 Bitcoin and is halved every 210,000 blocks, or roughly
four years. The mining reward at the time of this writing is 6.25 Bitcoin.
Price action tends to increase substantially following a halving event.
Why? Because the incoming flow was cut in half, the SF ratio doubles. If
demand remained the same and supply gets cut in half, price increases.
If demand increases at the same time, which we have seen with Bitcoin’s
adoption by CashApp, PayPal, Square, MicroStrategy, and retailers such
as Microsoft, Whole Foods, and Starbucks, the price goes parabolic.
Taking behavioral economics into account, increased price action also
creates attention that attracts a growing investor and user base.
Bitcoin’s SF doubles every four years. Its current SF of 50 nears gold’s
ratio of 66. Following the next halving event in 2024, Bitcoin will become
more scarce than gold. The market capitalization of gold is roughly
9 trillion dollars. If investors own gold due its premium as a scarce store
of value in the face of inflation or uncertainty, and Bitcoin will be more
scarce than gold, it is possible that Bitcoin steals market capitalization
away from precious metals. If Bitcoin attained a market capitalization
of $9 trillion, the price per coin would be $500,000. In 2140, there will
be no more Bitcoin to mine as the stock reaches 21 million. That means
that Bitcoin will become the only asset in existence to achieve absolute
scarcity. With an SF ratio of infinity, it will be the only investable asset
as scarce as the time you spend on this planet. Its demand will increase
as investors take note of its utility as a cheaper payment mechanism
and a scarcer and more liquid store of value compared to physical gold,
real estate, fine art, and so on. Programmed, decreasing supply couples
with steadily increasing demand in what Bitcoiners refer to as “number
What Is Bitcoin? 5
money than they had gold reserves. In 1965, French President Charles
de Gaulle sent the French Navy across the Atlantic to exchange France’s
dollar reserves for physical gold. When Germany attempted to do the same,
Nixon ended convertibility. This was in fact a default on the currency.
The United States did not have the gold reserves to keep true to its
promise of convertibility. This action compromised the scarcity of money.
With no check on spending, deficits ballooned and inflation continuously
eroded the value of money in circulation.
We currently straddle between two incomplete forms of money. Gold
is durable and scarce, but not portable, divisible, or an accepted form of
payment. It is a great store of value due to scarcity, but not an accepted
medium of exchange. To test this theory, try paying for your groceries
in gold coins. Dollars, or fiat currencies in general, are the recognized
medium of exchange but a terrible store of value due to the ability of
governments to print money without consequence—and print they do.
By January 2021, twenty-two percent of all U.S. dollars in circulation
were printed the previous year. The Federal Reserve prints money in
order to avoid a deflationary collapse with the current amount of debt in
the system. It also targets a 2 percent annual inflation rate. An achieved
2 percent inflation rate will lead to $1 becoming $2.59 in as little as
50 years. Chapter 3 will delve into why inflation targeting exists and why
the present and future must involve more money printing than generations
past. This inflation does not manifest itself equally among all goods and
services. However, newly created paper money has no value. Instead, it
takes value from the currency in circulation at the time, primarily hurting
those with savings and fixed salaries.
Bitcoin is savings technology that solves the inflationary problem
of fiat money. The current system punishes workers by continuously
debasing their wages and grants exorbitant privilege to the government,
banks, and corporations allowed to borrow at low or negative real rates. It
rewards large debtors. Think of the interest rate as the cost of borrowing.
The real interest rate is the nominal interest rate minus inflation. For
example, if you took out a personal loan with no collateral at 9 percent
interest, which is quite typical for the average borrower, a 2 percent
inflation rate means your real rate is 7 percent. The biggest debtors of all
are the U.S. government and large corporations. The U.S. government
What Is Bitcoin? 7
issues bonds to spend money it currently does not have and pays interest
to the bondholder. The current rate on a 10-year treasury note is
0.93 percent. With a 2 percent target inflation rate, the real rate becomes
0.92 − 2= −1.07. That’s correct, inflation allows the government to
continue its debt-based growth and spending patterns. In fact, they receive
a premium when they issue debt. In Europe and Japan, the epitome of
monetary policy run amuck, governments issue negative yielding bonds.
The interest rate on AT&T’s 10-year corporate bond is 1.9 percent at the
time of this writing, meaning AT&T and similar indebted corporations
can also issue money for free. The toxic combination of low borrowing
costs and inflation is essentially a tax on savers and employees with fixed
wages to fund U.S. government and corporate spending.
Nominal yields may not remain at such subdued levels under condi-
tions of a robust recovery or rising inflation fears. Additionally, the Federal
Reserve does not directly dictate corporate bond yields. However, loose
credit conditions set by the Fed reverberate through capital markets in
their entirety. A policy set by the Federal Reserve of below free market
level interest rates and above free market level inflation incentivizes the
aforementioned dynamic of cheaply raising capital through debt issuances.
This system also rewards asset owners. Why would the price of stocks
and real estate reach all-time highs in the middle of a pandemic, where
millions of Americans cannot pay rent and small business are forced to
close with a lack of cash flow? For one, the financial system needs inflation
if it has any chance to service the debt and prevent a deflationary collapse
brought about by higher debt service costs. It also needs appreciating
asset prices because U.S. equity market capitalization is 160 percent of
Gross Domestic Product and 200 percent of annual personal consump-
tion expenditures derive from a combination of capital gains and taxable
Individual Retirement Account distributions.5 Luke Gromen, Founder
and President of the research provider Forest for the Trees, aptly states
that in the United States, the stock market is the economy. If 65 percent
of U.S. GDP is consumption, and consumption is inextricably linked
to capital gains from a growing stock market, the Fed cannot afford for
stock prices to go down without creating a recession in the real economy.
Furthermore, the mechanism by which newly created money enters the
economy means that it stays within the financial system and fuels asset
8 Understanding Cryptocurrencies
appreciation first. A system that lifts asset prices while suppressing wages
results in an ever-expanding wealth gap. Putting your savings in a scarce
and liquid store of value allows you to opt out of the implicit savings tax
imposed by economic central planners. That is why Bitcoin solves money.
Bitcoin also solves the exchangeability problem of physical gold.
The list of merchants accepting it grows every year. Even if some major
merchants never accept Bitcoin as a medium of exchange, its digital nature
allows for a seamless transition to U.S. dollars, dollar-backed stablecoins,
or whichever fiat currency the consumer needs. Contrast this to taking
physical gold coins to a gold buyer in your local city or town, and one can
see the benefits of digitization. Technological breakthroughs oftentimes
solve a problem we did not know existed. With Amazon, we do not need
to rely on physical retail locations to make purchases. With Google, we do
not need to rely on books or encyclopedias to obtain information. With
Apple iPhones, we do not need to rely on one device for calls and texts,
one device for e-mails, and one device for music. With Bitcoin we do not
need to rely on a dollar that will continually devalue as a matter of policy.
Investors have a perfectly liquid market to store their dollars for future
use. Though they currently have to convert it back to dollars for most
transactions, this may not always be the case.
Conclusion
As readers can tell, the answer to the question posed at the beginning
of the chapter is not a straightforward one. Bitcoin has qualities that
liken it to a payment network, digital gold, and high-growth technology
companies providing a valuable service. These qualities put together make
it a valuable asset to have in the portfolio. As Chapter 4 will explore,
we can use certain models to assign a numerical value. Bitcoin’s value
proposition makes it an alternative asset whose rightful place belongs
with gold, real estate, collectible art, technology stocks, and venture
capital. It connects the age-old concepts of scarce money with 21st-century
concepts of breakthrough technology. Once we see it as an asset wor-
thy of our investment, the question arises as to how much to allocate.
Again, the answer is nuanced and depends on an investor’s conviction and
risk profile.
Index
active addresses, 42, 50–52, 113 Central Bank Digital Currencies
Altcoins, 64, 69, 88, 99–103, (CBDCs), 12–13, 27, 35, 37,
108–110, 112, 113, 116, 120 38, 77–78, 119
“Anti-Fragile Portfolio,” 105, 106 Chainlink, 102, 113, 115
CHECKTEMPLATEVERIFY (CTV)
Bancor Network Token, 102 code, 98
Bank for International Settlements, Chicago Board Options Exchange
The, 37 (CBOE), 55, 81
Basic Attention Token (BAT), 101 Chicago Mercantile Exchange
Bitcoin, 1, 74, 78–79, 84 (CME), 81
digital gold, 3–5 China, 71, 82–86
and disgruntled populists, 77 Chinese Communist Party (CCP),
distribution of probabilities, 13 84, 85
energy consumption, 73 Civic, 101
liquidity waterfall, 115–116 Coinbase, 58, 77, 84, 90, 94, 108
mining, 48, 56, 69–71, 82–85 cold storage, 12, 58–60, 62, 70, 80
money, 5–8 Commodity Exchange Act, 81
network, 1–3, 63–66, 68, 71, 77, Commodity Futures Trading
78–83, 95, 98, 115 Commission (CFTC), 81, 82
peer-to-peer cash, 1–3 Consumer Price Index (CPI), 36, 117,
populism, 74 118, 120
scarcity, 4 corporate bond, 7, 14, 19–20, 35
S&P and, 109 Cosmos, 102, 108
vs. Ethereum, 94–99 COVID-19, 14, 43, 55
see also investment; portfolio cryptocurrencies, 1, 53, 58, 63–67,
management; value of Bitcoin 72, 77, 81, 86–89, 94, 98,
Bitcoin Cash, 63–65, 99, 100 100, 102, 103, 107
Bitcoin GitHub, 79 custodial wallet, 57–60
Bitcoin Improvement Proposal, 79
blockchain technology, 2, 27, 35, 37, Dalio, Ray, 13, 32–34
38, 45, 61, 65, 67–70, 85, debt, 6, 7, 19–22, 26–35, 38, 42, 77,
91–101, 107 102, 106, 107, 117–119
brokerage account, 53–60, 66, 101, decentralized applications (DApps),
111, 115 88, 92, 93, 98, 99, 107
Buterin, Vitalik, 87, 88, 96 Decentralized Autonomous
Organizations (DAOs), 89,
Cantillon Effect, 18, 35, 36, 38 95–96, 109
Cantillon, Richard, 35 decentralized exchanges (DEx), 89,
Case-Shiller Housing Index, 36 90, 94, 99, 101, 102
Central Bank, 12, 18, 29–38, 61, 82, Decentralized Finance (DeFi), 27, 38,
106, 107 87, 90–96, 98–103, 108, 111
136 Index