“There are a lot of investors where custodianship was the final barrier. Over the next year, the market will come to recognize that custodianship is a solved problem. This will unlock a big wave of capital.”
Kyle Samani Hedge Fund Manager at Multicoin Capital
In the January 2019 edition of the Crypto Research Report, we extensively covered institutional grade cryptocurrency custody. We interviewed three firms in the space including Crypto Vault AG, Crypto Storage AG, and Coinfinity. This article explains custody from the perspective of a user, including information on how to store keys privately, and what questions to ask when considering using a storage company.
“Custodians are necessary as the next step towards crypto-assets being seen as a safe and attractive financial asset option for large FIs and perhaps for market confidence in general… Major institutional custodians providing a secure place to store large amounts of crypto-assets could provide the protection necessary to reduce the risk of hacks and increase the trust of the investing public in crypto-assets.” Attorneys at Perkins Coie
Storing your gold or other physical assets comes with two
options: either at a facility you completely control in all aspects (self-custody)
or at a service provider, who holds the assets in your name secured in a
facility you have no access to (service custody). The same principle applies
for storing your digital assets like bitcoin. However, digital assets require a
digital vault to provide the highest security standards. But what exactly needs
to be stored safely in case of digital assets? It is the so called “private
key” which provides access and control over the digital asset and thus the
right to transfer it to someone else. In the case of Bitcoin, the private key
is a 256-bit number represented in hexadecimal form. Storing these keys is
basically a physical issue as they could be simply written on a piece of paper
or engraved in metal and put into a safe deposit box to limit physical access
and digital exposure to the internet where they could potentially be accessed
and copied by a hacker. As a private key is needed to sign a transaction (prove
ownership), software is required to execute the signature generating process
and the key needs to be revealed to this software. In order to facilitate this
procedure, specific hardware wallets were introduced which enable not only a
hardware secured environment for generating the necessary signatures without
exposing the key to the internet, but also can handle an infinite amount of keys
deriving from a master private key following a standardized process. This
standardization of key derivation enables users to backup just the master
private key and recover all necessary keys on a new device in case of
malfunction or loss.
Using only N of M private keys makes it possible to store e.g. another key somewhere as a backup. Should one of the keys be stolen or lost, the secured Mth key can be retrieved.
The next step to attain an even higher level of security
would require one to build something which could be described as a digital
vault. A digital vault typically involves the creation of multiple master
private keys and storage of them on special hardware wallets with secure
elements at different geographic locations.
The transaction then needs to be signed by N out of M
private keys depending on the spending rules implemented when originally
receiving the funds. This concept is called multisig – short for “multi
signature scheme”.
In order to deal with malfunction of key storage hardware, a
proper backup plan is crucial. The most common practice is to either perform a so-called
key rotation or to securely store encrypted backups to be able to recover the
master private keys. Both methods come with advantages and drawbacks.
Figure : Example of a “Multisig-Scheme”
Source: Incrementum AG, Daniel Wingen
The execution of a key rotation becomes necessary if one decides that the master private key should never leave the secure element of the hardware wallet, which makes backups impossible. This is great for reducing attack vectors as long no device malfunctions, but if there is an incident, all funds need to be moved to a setup of completely new generated master private keys. Moving millions or even billions worth in digital assets is a very critical and expensive endeavor which takes time and introduces a lot of attack vectors if not planned and executed accurately. Backing up the master private keys on the other side also opens a new attack vector for collusion or social engineering to extract the private keys.
Figure: Two Major Ways of Protecting Against Hardware Malfunctions
Source: Incrementum AG, Daniel Wingen
A key rotation scheme means that you have to replace the entire set of keys. This is because if you lose one of three and you need two out of three keys to sign a transaction, you have to act quickly. The coins need to be moved to a new address where you again own all three keys, because if one additional key would be lost, all the coins are lost forever.
Social engineering can be described as a psychological strategy in which attempts are made to gain access to digital safes through targeted manipulation. Attempts in this context means that company employees come together internally to gain access to digital safes.
This means a well-functioning digital vault for digital
assets requires an elaborate technical solution for:
key
generation
signing
procedure
the
storage of private keys (and backups) at different geographic locations.
Social engineering can be imagined as a psychological strategy in which attempts are made to gain access to digital safes through targeted manipulation. But apart from that, a well-designed digital vault should have further features to make it more secure. First, we have a closer look on how the private key is stored ideally before we go into more details on the signing of transactions.
“From the perspective of IT security, the aspects of recognition performance and security are of particular importance when considering biometrics.”
Federal Office for Information Security, Germany
In general, it is very common to secure devices which hold
the private keys in a physically secured bank vault which is similar to gold
storage, however, there are some important differences. To begin, the devices
on which the private keys are stored should be protected with additional
digital security measures. Only specific predetermined persons may access the
device with identification through biometric data such as fingerprint. In
addition, entry is only allowed at specific predefined times or else if
specifically authorized by the board of directors of the company operating the
digital vault. This reduces the probability of unwanted signature generating
events virtually to zero.
Cold vs. Hot Storage Custody of Cryptocurrencies: If the wallet is connected to the Internet, this private key is exposed to potential hacker attacks. Because of the online connection to internet, this type of storage is called hot storage. A cold wallet, in contrast, is a storage space that is not connected to the Internet. The keys with which you can manage your digital money are stored offline. This of course reduces the risk of DDoS attacks and hacker attacks considerably.
Most importantly, only transactions authorized by a predefined quorum of decision makers may be signed with the corresponding private keys. In order to achieve that, typically an additional cryptographically secured authorization layer is put in place. This layer is an addition to the cryptography securing the digital asset itself. Each digital vault operator defines its own authorization processes which can be adapted to different internal processes or client needs. For example, one could agree that the authorization process of a transaction must involve at least three people on the client side signing a transaction approval with their individual authorization keys stored on personal security devices. The authorization process should involve biometric data or other second factors like chip and pin. In order to prevent theft by colluding employees within a custodian, it is reasonable to include a business logic that technically requires the authorization by the client. However, the board of directors could mutually change the business logic of the authorization layer to access the digital assets without authorization by the client. They could even just access the master key backups directly if not properly secured through profound business continuity management (BCM). This is why it is important to rely on a custody provider with trustworthy management that is audited by regulatory authorities. Also, the custody provider must show a thoughtfully implemented segregation of duties since human interaction is the most critical point of failure.
An example of such a BCM rule could be this: Nobody can access the safe deposit box which stores the backups without having registered with the safe company a week in advance. Upon this “one-week in advance registration”, everyone in the company would receive an email/SMS message announcing the registration. Then, only one person with biometric data and/or two-factor authentication can access it on that day at that specific time. In addition, in order to change this rule with the vault company, a quorum of management approvals through formal request and verification would be required. A similar approach could be established for hardware wallets to access them for firmware updates. This could be in the form of a certain quorum of signatures from managers that would be required to overwrite the bootloader and allow firmware updates etc.
If you plan to store your digital assets at a custody
service provider, it is of utmost importance to check their technical solution
on whether it is designed according to industry standards which reduces risk
for loss, theft and fraud of private keys to the lowest possible. A good custody provider should provide the
following:
A digital vault (cold storage) with at least 2
out of 3 multisig.
Distribution of partial keys on
different geographic locations in countries which are considered to have a
stable system in regard to respecting proprietary rights (USA, Singapore,
Switzerland, Germany, etc).
Safe
backup of the private key which should again be distributed geographically, or
alternatively, a sophisticated key rotation scheme.
Trustworthy
management audited by regulatory authorities.
Authorization
layer that requires customers’ consent to sign transactions.
“James Howells is a multi-millionaire – and somehow not. Thousands of Bitcoins are slumbering on his hard drive, which is now worth 75 million euros. The catch: The hard disk is buried in a dump.”
N-TV.de
The obligation to hold the assets under management means no more than that the funds must be placed externally within a depositary.
The above chapter showed that the process of setting up and maintaining a
digital vault to secure a significant amount of digital assets does require a
lot of specialized knowledge and well thought through security procedures. Such
a complex setup is currently hardly feasible for a private person or small
company without investing a significant amount of resources in research and
development. This will very likely change in the future, but currently self-custody
always comes with reduced security if proper knowledge and secure technical
implementation is absent. To achieve a certain level of security, one has to
know the technology quite well and understand the digital assets specific
mechanics of the public private key methods used. Then, one needs to store the
private key safely in a way that it cannot easily be stolen or lost. If the
private key is lost, then the digital assets cannot be accessed by anyone
anymore which equals a total loss of the assets. Understanding the technical
mechanisms of accessing digital assets with a private key requires time and can
be very difficult to grasp for the less tech savvy people. In addition, one
needs to make sure that one’s heirs may obtain access but only when the time
has come. This problem can be easily solved with serviced custody, but it is
rather difficult to solve in self custody. Self-custody for corporations is
even more complex since access to the private keys must be split and
distributed to several people to ensure that no single person has access to all
funds. If only one person had access and this person gets involved in a deadly
accident, then all funds of the corporation would be gone – a situation which
shall never occur. Depending on the jurisdiction, financial service providers
are even obliged by regulation to store their assets under management in
custody. In Germany, however, the separation between financial service
companies and custody was eliminated by law.
The idea behind Bitcoin, however, is decentralization and
censorship resistance. Bitcoin technology hands people back their financial self-sovereignty
and creates a level playing field where every individual, company or bank has
the same entry barriers to transfer the asset globally with near instant
settlement – but only if one controls the private keys. In line with this,
there is a common perception of “not your keys not your bitcoin” which
encourages self-custody.[1] We see it
as reasonable to have a balanced perspective on self-custody and serviced
custody by looking at the pros and cons of both. Deciding on the custody
solution for your digital assets should include:
your
knowledge on the technical solution,
the
general pros and cons of the options as well as
the
amount of funds to be stored
and
the specific use case.
Private individuals can simply store smaller amounts of digital assets
with consumer grade hardware wallets which are easy to use and provide
reasonable security if handled with care and a basic knowledge of the mechanics
involved.
“New obligated parties (of the 5th AML Directive) are platforms for exchanging virtual currencies and providers of electronic purses (wallets) for virtual currencies (e.g. Bitcoin) etc.”
Paytechlaw.com
The 5th Anti-Money Laundering (AML) Directive is the most
important regulation for digital assets in the European Union so far. The
directive lays out the anti-money laundering obligations imposed on
cryptocurrency businesses which includes the requirement for Know Your Customer
(KYC) processes to identify customers. This legislation provides more clarity
for national states and businesses on how digital assets are regulated.
Germany pioneered the issuance of crypto custody licenses
that came into effect on the 1.1.2020. Crypto custodians now have to apply for
a “Kryptoverwahrer” license to provide custody services for digital assets,
however, existing custodians are allowed to keep up their business until a
decision on the license application is made by the BaFin, the German financial
market authority.
Austria made amendments to their Austrian Financial Markets
Anti-Money Laundering Act (“FM-AMLA”) and the Beneficial Owners
Register Act (“BORA”). Crypto Custodians need to be registered with
the Financial Market Authority since 10.1.2020. In Austria, no license is
needed to provide crypto custody service. The AML amendments merely require
enhanced due diligence measures if a high-risk third country is involved in a
transaction.[2]
The 5th AML directive does not apply to Switzerland since
the directive is EU law. According to the Swiss Financial Market Supervisory
Authority FINMA, “Switzerland has always applied the Anti-Money Laundering Act
to blockchain service providers”.[3] In 2019,
FINMA granted SEBA Crypto AG and Sygnum Bank AG a full banking and securities
dealer license.[4]
“[Custody] is the missing piece for infrastructure – it’s a treacherous environment today. Hedge funds need it, family offices need it, they can’t participate in digital currency until they have a place to store it that’s regulated.”
Mike Belshe, Co-Gründer & CEO von BitGo
We have identified more than 20 custody providers
operating at the end of 2019 with Coinbase, BitGo and Bakkt being the largest.
Coinbase has become famous with its exchange services. The company is managing
assets with a value of USD 7bn in 2019.[5]
Bakkt is created by CE the company behind NYSE and known for introducing
Bitcoin futures that are fully backed with “physical Bitcoins”- in line with
the company’s name. This means that the
bitcoin to fulfill a buy position that is scheduled for the future is already
available by Bakkt. BitGo provides clearing and settlement services that are
connected to several exchanges, OTCs, hedge funds and more. The customer may
decide which party to choose and to settle a trade with while the funds are
locked during settlement which minimizes counterparty risk.
Figure: Projected Tokenized Market Volume until 2027
In Germany, ING Diba, the most famous direct bank, announced to apply for the crypto custody license[7] as well as Solaris Bank, the banking as a service provider for startups[8]. According to Finoa, a Germany based custody provider, the amount of tokenized assets under custody will reach 1 trillion by 2020 and 24 trillion by 2027. However, these statistics mostly focuses on equity, debt and tokenized real estate, neglecting the expected increase of Bitcoin market capitalization according to the Stock-to-Flow model.[9]
Bitcoin is a technology that has only existed for 12 years and has risen to prominence in an even shorter period of time. As such, there is still a lot of confusion regarding many of its facets, from its economic status, to its monetary status, to its long-term viability.
One under-explored facet of bitcoin is its legal status. Specifically, how can ownership be determined for bitcoin (or other cryptocurrencies)?
The reason we care about this is because there has been increasing scrutiny on regulating bitcoin. In order to have effective regulation, there must be a deep understanding of what is being regulated. If regulators thought the first airplane was able to travel faster than the speed of light, it’s very possible that regulators would have put rules in place that would have crippled the industry.
Similarly, everyone must be on the same page when it comes to understanding the very basics of bitcoin, lest we might see some unnecessarily confusing, contradictory, and industry-destroying patterns of regulation.
Before we can begin to answer the question of how to determine ownership in bitcoin, we must understand what ownership means, review how bitcoin works, and then combine the two concepts together. The short answer is: it’s complicated, but there is a case to be made that nobody owns your bitcoin.
First, a review of what ownership means. There are two
senses in which the word is used: economically, and legally. Economically, ownership
refers to physical possession—the ability to physically control a good.
Legally speaking, ownership entails certain rights and responsibilities. You
may or may not need to be in physical control of a good to retain legal
ownership.
This distinction was also noticed by the eminent Austrian
economist Ludwig von Mises in his 1922 book, Socialism: An Economic and
Sociological Analysis:
“Thus the sociological and juristic concepts of ownership are different. This, of course, is natural, and one can only be surprised that the fact is still sometimes overlooked. From the sociological and economic point of view, ownership is the having of the goods which the economic aims of men require… The Law recognizes owners and possessors who lack this natural having, owners who do not have, but ought to have. In the eyes of the Law ’he from whom has been stolen’ remains owner, while the thief can never acquire ownership. Economically, however, the natural having alone is relevant, and the economic significance of the legal lies only in the support it lends to the acquisition, the maintenance, and the regaining of the natural having.”[1]
The distinction can be made clear with an example: you may
own a car legally even if you have lent it to a friend for an hour. However,
during that hour, your friend is the person who owns the car economically. If
your friend does not return your car within the specified amount of time, you
can seek legal action against him for theft.
Furthermore, there are some things you cannot own. Economically, you cannot own something that isn’t physical. When we talk about “manipulating ideas”, we are speaking in metaphor. Ideas, information, patterns, etc., are not physical things, and so they are not scarce. As they are not scarce, they cannot be subject to economization: there is no need to economize on the idea that two plus two equals four, as infinitely many people can hold the same idea and it would not diminish in my mind.
It is also crucial to note that economic ownership has nothing to do with “value”. Value can be ascribed to both physical and immaterial things. Diamonds are valuable, but so is a sense of accomplishment. A mosquito has very little value, as does the thought of an alternative reality where everything is the same except we refer to red as “blue” and blue as “red”.
Similarly, legal ownership also has nothing to do with value.
You may have legal ownership in objects with little value, such as a stack of
dusty old newspapers. You may also be legally prohibited from owning scarce
goods that are highly valuable, such as the surface of the ocean.
The key for determining whether something can be owned economically is only whether it is a physical object. On the other hand, while the law can only ascribe rights to economic goods in a fundamental sense (how can you have a legal right to something that you can’t physically control?), the law may ostensibly declare a right to anything.
This discussion may strike some as academic hairsplitting. However, in lieu of strict definitions and rigorous logic, we may end up with analysis by metaphor, simile, and figures of speech—in other words, fantasy storytelling instead of dealing with reality seriously. When these confusions are then applied to cryptocurrencies, serious issues can arise. As all metaphors are imperfect, bad metaphors will give rise to bad arguments in favor of bad regulations, leading to bad results.
Hence, the necessity of wielding the sword of logical consistency against the chaotic dragon of analogy. Armed with this new terminology, we can now analyze what it means to own a bitcoin.
A bitcoin is not a concrete, discrete physical thing. It is a pattern of information, first and foremost, and (just as crucially) it is stored on a distributed, virtual ledger. Specifically, the ledger is distributed among millions of other computers, which share updates about changes in the ledger with each other over the internet.
So immediately, we can know that there can be no economic ownership of bitcoin. Even if you have a “paper wallet”, the paper is not your bitcoin. If your wallet is on your computer, it is a convenient metaphor to say that your bitcoin is “in” your computer. Your bitcoin is a pattern of information; a set of instructions to a computer.
Furthermore, you do not have full control of what you can do with your bitcoin: you require consensus from other nodes in the network. Those other nodes are other people using their own computers on their own property. They can be located anywhere in the world.
You do not physically own their computers, their property,
or the individuals. To “own” bitcoin in any sense would necessarily require
your economic ownership of the computers, property, and even minds of other
individuals.
What would it mean to legally own bitcoin? To repeat from
above, legal ownership gives certain rights to you that creates certain
obligations in others. Specifically, it is about returning to the legal owner
property that is in the physical possession of someone else.
So let’s say you had one bitcoin, stored on a wallet on your
laptop. Then, late one night, Sneaky Suzan breaks into your house, opens your
laptop, gets access to your wallet, and transfers your bitcoin to her wallet,
then carefully places are your stuff back to their original locations before
running out of the house.
Suzan is clearly guilty of breaking and entering, trespass, computer trespass, and other property crimes. But did she steal “your” bitcoin? To figure out if she stole something, we need to figure out who the original owner was. To say you “own the bitcoin”, says patent attorney and legal theorist Stephan Kinsella, implies:
“you have some legal right to control how the ledger is represented on many people’s private computer memory devices. And because they own their computers, and you don’t own your computers, you have no right to tell them how to update the ledger stored on their computer.”[2]
Naively, it would mean that Suzan would have to give you
back “your” bitcoin (plus other damages). But what if she spent it already?
Would bitcoin miners be obligated to revert back to the point in the blockchain
before the theft, creating a new fork? In the view outlined in this article,
this is an untenable idea. A much better solution is to give the cash value of
the bitcoin at the time to the victim. (The “cash value” approach would also
work even if bitcoin became the most commonly accepted medium of exchange.)
A final problem: what if someone, by sheer luck, guesses your private key and is able to access the wallet on your laptop and spend the bitcoins at will. They have not committed any property crime; but neither have they committed a bitcoin crime. They followed the rules of the protocol, and the result was exactly the same as though you had your bitcoin “stolen”.
The legal theorist Konrad Graf has an interesting approach
to this: this problem is analogous to a businessman who copies a competitor’s
business plan and wins market share as a result. As Graf tells it:
A businessperson Dan sees rival
Tim’s more efficient work method by observing from across the road and then
begins to emulate it. This increases Dan’s competitiveness. Tim claims he has
lost sales, market share, and business value due to this “idea theft.” Tim had
a reputation as the market leader. Now, he has been rendered one competitor
among others, next to Dan, and it is Dan’s fault. Not only has Tim’s market
share dropped, but also his reputation value.
Tim’s legal claim would have to be dismissed according to principles of action based property theory, because the work method that Dan observed and then emulated is not itself ownable. An idea or opinion is not a rival good. Dan did not otherwise trespass or infringe on Tim’s property. Dan observed from a location that Tim did not own and later emulated certain practices that he observed. None of these acts violated a valid property right of Tim’s.[3]
In a sense, “your” bitcoin is only yours because you know the password for transferring it. Nothing else about bitcoin is ownable in the economic sense: it is a pattern of information, it is distributed across many other properties, and those properties necessarily are owned by other people. As a result, it is impossible to legally own bitcoin, as it seems it would require obligations to people you have not met or contracted with. And, as a shocking but necessary conclusion: if no one can legally own bitcoin, then no one can be charged with stealing it, either.
To echo the opening of this article, there is still a lot of
work to be done in understanding the legal principles behind bitcoin.
For several years legacy financial
companies have started to integrate blockchain technology in their existing
business model. While digital-native and decentral-native start-ups have been
able to directly build on public blockchains like Cosmos, Tezos or Ethereum,
legacy finance firms with their complex IT infrastructure started to test
private blockchains in order to become familiar with the technology, remain regulatory
compliant and experiment in a controlled and surveyed environment with their
clients. R3 Corda for example has become the primary permissioned blockchain
platform for the legacy financial service industry.
While many companies believe that this
is the ultimate goal, several banks, like Goldman Sachs for example, have
already left the Corda platform. They belonged to the early joiners, but
already left in 2016. However, just last week, Goldman Sachs and Citi announced
to conduct the first blockchain equity swap on an Ethereum inspired platform. To conduct
this swap, they are collaborating with a new market player called Axoni.
Developments in the Permissioned Blockchain
Space
Axoni gave an interesting talk in Prague at DevCon 4 in 2018.
They introduced AxLang as a new programming language for secure and reliable
Ethereum smart contracts. The
speech can still be viewed on Medium. Similar to Hyperledger or Corda,
their approach is to use a permissioned distributed ledger platform based on
open source software in order to help legacy firms use blockchain technology to
operate more efficiently with their customers. Axoni specifically focuses on
derivative markets.
The big advantage is that their infrastructure is built on Ethereum,
which is still the largest used blockchain for DeFi applications. According to
Defi Pulse, the total value locked in Defi surpassed USD 1 billion on February
9, 2020.
Figure 1: Top 5 DApps on Ethereum
Apart from the Lightning Network, which builds on Bitcoin, all DeFi applications
are based on the Ethereum blockchain. This finding is confirmed by State of the
Crypto Report, which shows the
strong developments and progress around Ethereum and Bitcoin.
Previous market players have struggled to implement Ethereum based
permissioned applications. Bank Vontobel, previously a Premium Partner of
the Crypto Research Report, for example wanted to launch a certificate on
ethereum as well, but there was one main problem. The legal situation and
the lack of a payment token recognized between banks has prevented them from
conducting the complete process exclusively on the blockchain.
Hence the news around the US investment banks Goldman Sachs and Citi
using the Ethereum blockchain is even more positive. Especially with regards to
the status of US crypto regulation, where the SEC is extremely reluctant and
causes many roadblocks.
While there are just a few crypto
advocates in the US, like the so called “crypto mom” Hester Peirce, the EU is
overall much more crypto friendly, especially in Germany. Since the Money
Laundering Act came into force on January 1, 2020, in which BaFin financial
institutions were allowed to conduct crypto asset transactions, more than 40
institutes have shown interest in crypto custody business.
Solaris Bank for example has taken a similar approach
to Fidelity with cryptocurrency custody. The young German bank Solaris AG
founded the subsidiary Solaris Digital Assets GmbH in December 2019 as digital asset
custody service provider. They consider themselves as tech company with a
banking license. Alexis Hamel, Managing Director of Solaris Digital Assets
says:
“We commit ourselves to become the leading infrastructure provider for the European digital asset ecosystem. We trust that by lowering the hurdles for digital asset pioneers, we are contributing to the development of a functional and secure decentralized world, which will transform the way we exchange value around the globe.”
Alexis Hamel
Private blockchains can constitute the perfect testing environment for legacy firms in order to learn about the technology and make their clients familiar with it. However, in order to unlock the full potential of DLT solutions, the ultimate goal should be the use of public blockchains and full business integration of digital assets.
Are digital currencies the wave of the future? Sweden, Switzerland, and Brazil move towards digitalized financial systems, exploring new possibilities of adapting to the ongoing FinTech revolution. E-krona, Swiss franc stable coin, and Pix system are all national responses to the growing cryptocurrencies’ market.
The potential of digital currencies is undeniable: the number of Blockchain wallets has grown over 4 times in the span of the last 3 years, from 10,98 million in late 2016 to 44,69 million by the end of 2019.[1] Powered by people’s enthusiasm, the planet of digital currencies attracts the attention of national banks all around the world. This month, Swedish and Swiss national banks decided to step into the future with the plan to create their own digital currencies, while Brazil came up with its own payment network Pix to lower costs of the national financial system and smoothly transition into the world of Fintech. Governments can no longer ignore the technological revolution, so they join it instead.
Inspired
by Blockchain technology, Sweden has started working on its own version of
digital currency: e-krona. The pilot project is expected to run for a year and
finish by the end of 2021.The Riksbank’s goal is to discover how e-krona could
function in Swedes’ everyday life. Envisioned as a user-friendly, secure
alternative to cash, it is set to work with cards and smartwatches to guarantee
maximum comfort at minimum difficulty. The technical aspects of the project draw
from Distributed Ledger Technology (DLT), used also by Blockchain. The exact
process of creating e-krona is yet to be decided, and there is no fixed date
for its debut. The Riksbankwants to
understand the inner working of e-krona before issuing it, so the one-year
project is mainly the market research. In all certainty, there is a need for a
fintech solution in Sweden, where cash is slowly fading into obscurity,
replaced by smartphone applications.
Sweden is not the only country, which announced the creation of
its own digital financial system this week. Brazil, where 18% of surveyed
people have already had experience with cryptocurrencies[2], is an immense market for
fintech innovation. The central bank of Brazil decided, however, to take
matters into its own hands and test a brand-new payment network – Pix. To offer
the optimal coverage and easily blend into the Brazilian financial landscape,
the system will be used by all major financial institutions, including the
country’s biggest banks, effectively becoming integrated into 90% of all active
bnks accounts in the country.
Pix is set to operate through an application, which allows for
instant money transfer and QR code scanning. The tests have just officially
begun, but in nine months’ time – November 2020 – Pix may be open to the public
for the first time if things go right. The officials’ plans are definitely
ambitious: the mass adoption of the system is scheduled for 2021. In fact, the
president of the Brazil’s central bank, Campos Neto, acknowledged the need for
the new payment methods in the digital age, saying that “the world demands a payment
instrument that is cheap, fast, transparent and secure” and he called Pix one
of the most important projects of the year, stating that it would be the Brazilian
answer to bitcoin and cryptocurrencies. Designed to enable a wide range of
transactions, including paying government fees, and mandatory for the country’s
major financial players, Pix might be Brazil’s digital future in the making.
In
the midst of the fintech revolution, Switzerland doesn’t remain a passive
bystander. Swiss Central Bank announced plans for its pure digital currency to
dive into the digital future on its own terms. While the project’s exact
details and likely launch is unclear, Swiss transition into to the digitalised
banking continues in 2020, with the launch of Swiss Digital Exchange (SDX)
planned for the end of the year.
As the increasing number of
governments acknowledge the need for new banking systems, the future of digital
currencies looks bright. With Brazil’s ambitious plans to accelerate its own
fintech transformation, Sweden’s hopes to offer its citizens the institutional
replacement of obsolete cash, and Switzerland’s slow but inevitable financial
adaptation, the world is ready to move into the post-cash era and redefine the
way we view money.
The price of Bitcoin, by far the biggest player among all cryptocurrencies, fell more than 10% within the last few days. Other major cryptocurrencies, such as Ethereum, Litecoin and Bitcoin cash, have also decreased in value, but Bitcoin’s decline generates the most headlines, as earlier this year, it noted the record $10,000 per bitcoin and was showing no signs of slowing down. In the course of the last few days, Bitcoin lost $30 billion in value, going down 0,22% within the last 24 hours. Created by unknown individual(s), Bitcoin was designed to enable fast, cheap transactions without using traditional banking, and when its price went up at the beginning of the year, many started to regard it as a ‘safe-haven asset’ and the answer for the global trade crisis connected to coronavirus. China’s participation in the cryptocurrencies’ market is enormous, so given the latest course of events regarding the virus, the cryptocurrencies’ decline seems natural for some, while other industry experts, such as Vitalik Buterin call it “rationalised bullshit”.
Despite Bitcoin’s drop in value, many remain positive about its future, as it is driven by demand, rather than GDP. The entire business model of Bitcoin is based on scarcity, much like the former monetary programs, which only allowed printing the amount of money corresponding to the actual amount of gold. To ensure such scarcity, Bitcoin invented the process of halving, or simply reducing the total supply over time to boost the value of the cryptocurrency. Typically, Halving takes place every four years and the next one is set to take place in May 2020. Experts predicted that the price of Bitcoin would increase several times and reach up to $70,000 per bitcoin. Whether it is wishful thinking or an accurate prediction, only time will tell.
Nevertheless, it is without a doubt that Bitcoin continues to develop and improve its services, particularly in terms of privacy and scalability. In the first half of 2020, we can expect the launch of a consumer application for Bitcoin and cryptocurrency purchases. The app will be supported by Starbucks, Microsoft, and Boston Consulting Group. Despite a sudden decline in value, Bitcoin’s market capitalization equivalent is substantial. According to Statista’s database [1], between the first and last quarter of 2019, it increased by over 57%, from 72,37 billion dollars in the 1st quarter to 169,44 billion dollars in the 4th quarter. Square, one of the companies, which included Bitcoin in their payment methods, observed a 60% rise in the number of active users in the last quarter of 2019. The company’s revenue increased by 41% within a year, reaching over $1,3 billion dollars. Why is their success attributed to the Bitcoin adaptation? Half of $361 millions produced by Square’s Cash app were generated by Bitcoin transactions – in just 3 months. Numbers seem to be in favour of cryptocurrencies, even when investors are not. During the meeting with crypto representatives, the famous investor Warren Buffet was reported to have donated all cryptocurrencies he was given to the charity, stating that “I don’t own any cryptocurrency. I never will.” Regardless of the current crypto landscape, Bitcoin’s kingdom is yet to fall, but will it quickly recover? Remains to be seen.
Change is the only constant in the world of cryptocurrencies. Although Bitcoin lost $30 billion in value within just a few days, it continues to attract customers across numerous applications, having generated half of Cash app’s revenue in just 3 months. Powered by demand, it may rise again, once scarcity’s in play.
Several blockchain-based companies are publicly listed on stock exchanges throughout the world. Some of them are trading at an unwarranted price given their revenues and earnings potential. Some have even already gone bust like Riot Blockchain Inc. (RIOT) that dropped 97% from an all time high of $46 in 2017 down to the current price of $1.33, or they have switched business models like Fortress Blockchain Corp. now called Fortress Technologies Inc. (FORT) after quarters of consecutive million dollar losses.
This article is a sneak peek of the Crypto Research Newsletter published every week to our subscribers. We do not often publish these posts publicly, so if you would like to receive professional financial analysis of crypto assets weekly subscribe here: https://cryptoresearchnewsletter.substack.com/
In this week’s edition of the Crypto Research Newsletter, we discuss how to value publicly listed blockchain stocks, and how some investors with deep pockets are turning overvaluation into an opportunity.
There are several ways to value a publicly listed stock. This week, we wanted to evaluate if Michael Novogratz’s Galaxy Digital Holdings Ltd. traded on the Toronto Stock Exchange with ticker GLXY was a good buy or not. Galaxy Digital does venture capital, they sell investment products, they do lending, and they do market making, amongst other activities.
The market capitalization of Galaxy Digital is $88.56 million Canadian Dollars (CAD). The stock price is $1.32 CAD. Is this a good buy at $1.32 or not? There are many ways to answer this question, but a simple way is just to compare Galaxy Digital’s price to comparable firms.
Comparable blockchain firms that are listed on the Toronto Stock Exchange include Hive Blockchain Technologies Ltd., Bitfarms Ltd., Cryptostar Corp., Neptune Dash Technologies Corp., Fortress Technologies Ltd., and AnalytixInsight Inc. The market capitalization, revenue and Price to Sales Ratio (P/S) are listed in the table below.
Table 1: Price to Sales Ratio of Publicly Listed Blockchain Companies
Just a quick glance at the table shows that Galaxy Digital is relatively low priced compared to other blockchain firms. Galaxy Digital’s Revenue in 2019 was $156 million, higher than the company’s $92 million CAD market capitalization. This gives Galaxy Digital a P/S Ratio of 0.59 compared to the group average of 13.9. Galaxy Digital’s stock has increased 26% since the beginning of this year from $1.05 to $1.33. However, the company is still not turning a profit after costs.
A quick glance at Table 1 also shows a humungous outlier. Namely, Neptune Dash Technologies Corporation. Neptune Dash is a company that hosts masternodes on the Dash network. They currently have 16 masternodes, or approximately 16,100 Dash worth around $1.7 million USD and they have invested in Cosmos (ATOM). Even though everyone says that Tesla is overpriced, Tesla (TSLA) is still only trading at a P/S Ratio of 6.5x their annual revenues. Apple (AAPL) trades at 5.5x their annual revenue.
Figure 1: Neptune Dash Stock and Dash are Highly Correlated
Figure 2: Grayscale GBTC Stock and Bitcoin Are Even More Correlated!
So how can a 73x P/S Ratio be warranted? One interpretation is that 73x could be a very early stage startup multiple meaning that investors expect for Neptune Dash to earn a lot more in the future than they are currently earning.
Another interpretation is that institutional investors cannot easily hold privacy coins directly in their portfolio, and are therefore, willing to pay more for a publicly listed stock that gives them access to privacy coins. There is some evidence of this with stocks like Grayscale’s GBTC Bitcoin tracker that has more often than not traded at a 20%-30% premium over the spot price of Bitcoin during the past few years.
Grayscale has 303,363,800 outstanding each worth $11.72 USD, and each share is backed by 0.00096645 Bitcoin, worth approximately $9.33 USD. This means that GBTC shares are trading at approximately 25.6% premium over the spot price of Bitcoin. An obvious trading strategy would be shorting GBTC and holding Bitcoin long, but this has not worked well in the past for traders, because GBTC’s premium has persisted month after month. Grayscale has approximately 293,185 Bitcoin under management and charges a 2% annual fee on a passive investment strategy, which at first glance, seems high, but is actually quite reasonable given the fact that cryptocurrency custody is not that straightforward.
When comparing the Neptune Dash stock price to the Dash price, an average 90-day rolling correlation of 70% is found over the past two years since Neptune Dash was listed on the Toronto Stock Exchange. The only time that these two assets had a negative correlation was during December 2019 and early January 2020, when the price of Dash was going down and the price of Neptune Dash stock was going up. This can most likely be explained by the fact that the drop in Dash’s price triggered a massive selloff of Dash masternodes, which meant that the existing masternodes earned more. Since Neptune Dash runs masternodes, this means that their earnings went up on each node.
In contrast, the GBTC average 90-day rolling correlation with Bitcoin is much higher, at 83% over the past five years and 92% over the same time span that the Neptune Dash and Dash correlation was calculated over.
One final note on this peer group of blockchain firms: there is an unfortunate back story to Fortress Technologies Ltd. The company was listed on the stock market in 2018, and is currently trading at $0.12 CAD. This is the epitome of a crypto penny stock. The company has basically no information on their website and the last post that Fortress Technologies Ltd. made on their Twitter account was in 2018 shortly after being publicly listed. We were surprised to find that Roy Sebag and Josh Crumb from Goldmoney are part of the Fortress team. Apparently, their attempts at Bitcoin mining did not pan out as expected, as they officially removed “blockchain” from their name in April of 2019 after consecutive quarters of layoffs and losses.
In conclusion, Grayscale and Neptune Dash seem grossly overvalued when comparing their share price, number of shares outstanding, and earnings. This is most likely a symptom of all stock prices being grossly overvalued because the Fed’s faucet of money is flooding the market and investors are betting on scarce crypto assets as being a hedge against fiat inflation. This will not last forever, but as Keynes said, “markets can remain irrational a lot longer than you and I can remain solvent.”
This Week’s Top Cryptocurrency News
Wyoming’s Blockchain lady, Caitlin Long, is starting the first Bitcoin Bank called Avanti. We are personally excited at the CryptoResearch.Report, because Caitlin is one of the few people in the Blockchain space that combines competency, hard-work, and honesty – all qualities needed for a company to have long-term success in the crypto world! Read more.
Tomorrow, Wednesday the 26th of February, the U.S. Securities Exchange Commission will decide if the Wilshire Phoenix exchange traded fund (ETF) on Bitcoin will be approved or not. If approved, the ETF will have fees of 68 basis points (0.68%) per annum and a maximum share price of $2,500 USD. Read more.
No Central Bank Digital Currencies (CBDCs) have been officially launched so far, but Sweden will probably win the race with their e-krona. Read more.
Winners and Losers
Everything that goes up must come down, and this week was not very kind to Chainlink or the crypto asset market in general. Chainlink is down – 13.64% this week, but is still up 116% year to date with a current price of $3.91 compared to $1.81 on January 1, 2020.
The past week’s largest cryptocurrency winners from the top 50 market capitalization are Cosmos (3.02%), Litecoin (1.63%), and MKR (0.73%).
The biggest losers were Chainlink (-13.64%), Bitcoin Cash SV (-11.82%) and Dash (-10.96%).
Figure 3: Largest 7-Day Returns for Top 50 Market Capitalization Coins
Bitcoin has had a second week of losses, and is down 1.21%. Due to the wide diversification of the assets held in the Crypto Research Portfolio, the weekly return for the portfolio was positive. This is mainly do to our gold coin Pax Gold shooting up 8.2% in value after the stock market sell-off. As of February 25th, 2020, the portfolio’s value increased by 205 basis points or 2.05% in the last six days since the last edition of the newsletter was published on February 19th, 2020. Gold is an interesting asset given the economic uncertainty surrounding the Corona Virus.
Facebook’s Libra coin is meeting strong resistance from governments and central banks. But there is also a lot happening in the “traditional” crypto sector. Several players are laying foundations for a regulated market that could attract institutional investors. And Bitcoin reacted to the recent rounds of easing by central banks.
The year 2019 is slowly coming to an end. What was the best place for an investor’s money this year? Prices for Bitcoin have more than doubled since January – even though they have recently fallen sharply again. From April 1 to June 24, they rose by 250 percent – from just under $4,000 to just under $14,000. At the time this report was prepared, Bitcoin was priced at around $9,000.[1]
Figure 1:Almost 1 Million Active BTC Addresses Per Day
Source: Coinmetrics.io, Incrementum AG
“Facebook’s digital currency, Libra, is a mixed blessing for Bitcoin and other digital currencies.” Forbes
Forbes
Whichever way you look at it, Bitcoin beats the second-best asset of the year, namely US technology stocks, by far. This year, they have risen by about 30 percent. Even gold, which is experiencing a quite respectable year, is just up 17 percent. The broad S&P 500 index gained 21 percent. All this fades in comparison to Bitcoin’s growth by more than 140 percent – from $3,300 in January to about $8,200 per coin in October.
Figure 2: Non-Monetary Demand For Gold and Silver Declining (in Tonnes, 2010 – 2019)
Source: The Silver Institute, Refinitiv GFMS, Metals Focus, World Gold Council, Incrementum AG
Still the crypto space has been rather quiet lately. The rise in prices alone was not enough to satisfy the mainstream media hunger for new stories. In addition, Altcoins look rather bad at the moment. Take Ethereum, for instance. The second most important cryptocurrency rose by “only” 80 percent between January (around $100) and October (around $180). The focus of politicians and the media has for some months now not been Bitcoin or Ethereum but the Libra project initiated by Facebook.[2]
One almost has the impression that Libra has displaced Bitcoin from the podium of the most important crypto projects. Especially in the mainstream media, where many journalists have specialized in crypto. And they don’t seem to get enough of the drama around Libra. But: Libra does not yet exist. Worse still, the alliance around the project is already beginning to crumble. [3]
According to Szabo, Bitcoin is more secure that Ethereum.
The currency coins that Nick Szabo is interested in are Mimblewimble-based coins and some of the of the privacy coins including Monero, ZCash, and Dash.
Demelza Hays. Do you think Bitcoin is Turing-complete? What can Ethereum do that Bitcoin can’t? Nick Szabo: No, the Bitcoin main chain is not Turing complete. It does have a Turing-complete sidechain called RSK. Ethereum’s programming language can do open-ended loops for example (up to gas limits) and Bitcoin main chain (layer 1) can’t. Programming Ethereum or RSK gives you the full expressive power of programming whereas programming on the Bitcoin main chain does not. This makes Bitcoin safer and is more appropriate where the main functionalities are store of value and medium of wealth transfer but makes Ethereum and RSK better for smart contracts.
Nick Szabo speaking with Richard Olsen at Money Museum in Zurich, 2016. Source: Google Images.
Demelza Hays: Do you think Bitcoin is digital cash or digital gold? In ten years from now do you think that we will be paying for our coffees with Bitcoin or some derivative of Bitcoin? I think Bitcoin and gold are too inelastic to be used as a unit of account. As the coinbase reward tapers, do you think the Bitcoin main chain will have many transactions with a small fee or do you think there will be few transactions with large fees?
In my opinion, setting an artificial data size limit for each block is similar to the government setting a price ceiling or floor on a good or service. I would allow the block size to be determined each block by the miners. This would be more similar to the free market. If the miners make the size too small in an attempt to earn more from fees, then users will switch to other blockchains that are a substitute service. If the miners make the size too large and certain miners gain an advantage because they can propagate blocks faster then users will switch to a substitute service.
Nick Szabo: Layer 1 is digital gold and Layer 2 is digital cash (among other things it can be — RSK is an example of Layer 2 for smart contracts).
Demelza Hays: Over the past decade, the correlation between Bitcoin and gold has been between positive 0.2 and negative 0.2 and has a slightly positive uptrend at the moment. Since some of gold’s demand comes from non-monetary purposes such as jewelry and industry, we argue that gold will always be less volatile than Bitcoin in terms of purchasing power of real goods and services over time. We have an investment strategy which intends to arbitrage between Bitcoin and gold. As Bitcoin becomes relatively expensive to gold, we sell Bitcoin and buy gold, and vice versa. Do you think the correlation in returns between gold and Bitcoin will go up in the future?
Nick Szabo: Very probably yes.
Demelza Hays: Are there any blockchain projects that piqued your interest recently?
Nick Szabo: The various Mimblewimble-based coins, some of the other privacycoins (Monero, ZCash, Dash), RSK (an Ethereum-like sidechain for Bitcoin).
Demelza Hays: Where do you see the US in ten years from now? Do you see Libra and Bitcoin competing or do you see a David Crowley-style Gray State? Nick Szabo: I suspect Libra will get buried under a political blizzard and doesn’t stand much of a chance. It would compete far more with payment systems like PayPal, and is more akin to things like Tether, than it would compete with or is akin to Bitcoin.
“With a commitment in a structured product,
specifically a tracker certificate, one does not invest directly in the
cryptocurrency but follows the price movements like a shadow. Investment risk
depends on price losses and creditworthiness of the issuer (default risk).
However, the investor must remain vigilant. Just because he has purchased a tracker
certificate from a bank, it doesn’t mean that it’s iron-clad. Should the price
of his cryptocurrency crash or even disappear from the market, there is, of
course, a total default risk here as well.”
Jürgen Kob and Paweł
Sobotkowski
We want to sincerely thank Lucas Ereth and GenTwo Digital for contributing this chapter. Lucas is a managing member of GenTwo Digital (https://www.g2d.io). Our readers can sign up for a free newsletter at https://www.g2d.io/blog. Please note, that GenTwo is a premium partner of the Crypto Research Report.
Lucas Ereth
This chapter features a sneak peek into
the life of the Managing Partner of GENTWO Digital and Forbes DACH 30 Under 30,
Lucas A. Ereth.
What does your business do?
To put it simply, we’re securitization experts working to bridge
the gap between traditional finance and the emerging crypto market. While our
parent company GENTWO creates securities for all asset classes, GENTWO Digital
specializes in the securitization of digital assets. In other words, we convert
digital assets, like cryptocurrencies, into structured products. These products
are then outfitted with an International Securities Identification Number (or
ISIN, for short) ‒ the de facto standard for securities trading internationally ‒ which ensures that the product is “infrastructure
compatible” with every bank and large scale/institutional investor.
In doing so, we turn a digital asset into something that is
bankable and manageable within traditional investment portfolios inside the
global banking system. Why would we do that? Well, large private and
institutional investors were having quite a bit of trouble accessing the market
for digital assets due to different aspects of the traditional functional
framework. So, we set out to provide a service that would make crypto assets
accessible for qualified investors from around the world via GENTWO and GENTWO
Digital.
How are tokens different from
structured products?
Structured products are flexible investment instruments that offer
an attractive alternative to direct financial investments (such as stocks,
bonds, currencies, etc.). Thanks to their flexibility, structured products
allow for the creation of investment solutions that are suitable for different
risk profiles and market expectations, even in demanding market environments.
New, next-generation structured products can now be utilized to give access to
a myriad of digital assets.
Tokens, on the other hand, are digital assets themselves, and are
not necessarily considered financial instruments. Both structured products and
tokens can be used for similar purposes, but the two are not the same thing.
Tokens also live on the blockchain, while structured products are financial
products that live in the banking system, and asset managers, banks, and
professional investors use them in their daily lives to get access to assets
and markets.
What are advantages of securitization vs.
tokenization?
I think that within today’s investment
landscape, one could make use of both, as they are each tailored to different
purposes and clientele.
A token offering, for instance, is limited to investors that can
handle the complexity of crypto wallets. At this stage, most crypto wallets are
best suited for retail investors that usually invest in small ticket sizes.
With the help of securitization services (this is where we come into the
picture), you can now take a crypto portfolio or a portion of any token and
convert it into a traditional financial structured product. This “real”
security is now suddenly made available to banks, family offices, pension
funds, high-net-worth individuals etc. So, big investors who generally do not
make use of digital wallets are, thus, granted the opportunity to actively
participate within the crypto market.
What makes securitization attractive to
traditional market participants?
Institutional investors can invest in new assets with their proven
and compatible form of investment. Structured products are investment
instruments that are very familiar to traditional market participants. So,
institutional investors can finance a crypto venture, and serve as a strong,
key member of the project supporters’ community, all while using the same daily
financial instruments that they are already used to. This is a wonderful
example of how structured products and tokens complement each other. At GENTWO,
we firmly believe that this setup will not only grant access to but actively
attract investors of the highest caliber. We’re essentially allowing the
investor to choose which format he or she prefers: a fully digital asset that
lives on the blockchain and in a digital wallet or a traditional investment
certificate (structured product) that lives in your bank account and represents
a digital asset. Securities are issued through a tailor-made and segregated
issuance vehicle that is unique and stays off of a client’s balance sheet. With
this design, the so-called issuer risk is (by default) eliminated.
As someone who works with many
structured products on a daily basis, what would you personally invest in?
I personally currently hold 27
different coins and tokens in my crypto portfolio. If I were to create my own
structured product, I would most probably turn my portfolio into a so-called
Actively Managed Certificate (a structured product with an actively managed
strategy behind it) and make it available for qualified investors. This is
actually one of our most common use cases at GENTWO Digital – traditional or
crypto asset managers who utilize us to turn their strategy into an investable
asset. Our platform provides the tools to facilitate the process from start to
finish, from converting the AMC into a Swiss-compliant security to getting a
Swiss ISIN. All within 5 to 15 business days.
Just to be clear, this is my personal view; cryptocurrencies are
highly volatile, and it’s important to remember that while there are attractive
return opportunities, you have to be willing to expose yourself to high risk
and the chance of losing your principal if you choose to embrace crypto
investments.
What is the biggest opportunity for
entrepreneurs who want to make a successful business in the crypto space?
Today’s digital world is quite
literally at our fingertips. I would encourage entrepreneurs to try to look
into the future and play around with connecting the dots between what is
present and what is possible. Making use of and/or sometimes just breaking up
and reshuffling certain dots can make all the difference.
I also think that making crypto-based
services or applications so accessible that an individual user does not even
realize that he or she is interacting with a blockchain-powered product or
service still remains the biggest challenge for mass adoption, and therein lies
the biggest potential for entrepreneurs within the crypto space.
What should entrepreneurs be aware of?
As always, everything starts with a
good business case, a business plan, and a good execution strategy ‒ I’d say that applies regardless of
whether or not you throw blockchain into the mix. Once you’ve laid that
foundation, you now need to evaluate how to use and leverage blockchain
technology for your specific case. Also, and I can’t stress this enough, ask
yourself if it even makes sense, because in most cases blockchain alone
probably won’t be the sole, magic ingredient that will ensure your business’
success.
What is the biggest threat to the crypto space?
I would say a lack of
understanding and public disinterest. If people fail to recognize or
acknowledge the benefits, value and possibilities of cryptocurrencies, Bitcoin
and the like will eventually die out as the hype and fanfare of even the
starkest supporters begins to wane.
Where do you expect the sector to be at the end of 2020?
It looks as though 2020 is set to be
the year where blockchain technology may (for the first time) reach billions of
people at once, as big tech firms like Facebook become active participants
within the space. I think this will mark the real start of the Internet 2.0,
with the potential to usher in an era of trust and digitized value.
Decentralized services will definitely help shape the future development of
this planet.
“The only reason that cryptocurrencies exist is because of regulations that stop us from using gold as money.”
Peter Schiff
Key Takeaways
Similar to gold-ETFs, all of the gold-backed cryptocurrencies on the market are centralized. This means they have counterparty risk. Unlike storing your own physical gold, gold-backed cryptocurrencies require you to trust a company for storage.
There are three main types of centralized, collateralized stablecoins: fiat, commodity, and crypto. Gold-backed cryptocurrencies are considered to be centralized and “off-chain-backed coins.” The most famous gold-backed cryptocurrency is the Digix Gold Token (DGX). DGX has a market capitalization of approximately USD 4mn and a daily trading volume of approximately USD 240,000 over the past year. Even though Digix is backed by gold, it often trades at a discount to gold, and Digix’s return is extremely volatile compared to gold’s return.
Gold-backed cryptocurrencies have higher costs and risks than ETFs and managed gold funds. Investors can suffer loss of value due to faulty private key storage, double-spends from weak blockchain security, regulatory uncertainty, lack of liquidity, and non-transparent accounting of gold vaults.
The first version of this article originally was published in the sister report of this publication, the In Gold We Trust report 2019. Interested readers can download the publication here: https://ingoldwetrust.report/
Last
year in the sister report of the Crypto Research Report called In
Gold we Trust, we featured an article exploring the intersection between gold
and Bitcoin.[1]
The article focused on how gold impacts Bitcoin’s application as a global store
of value. Now an even newer competitor
to gold is emerging: stablecoins. Stablecoins promise to improve on gold by
being digital and to improve on Bitcoin by being stable. But can the companies
behind these stablecoins deliver or are they just modern alchemists? This
chapter gives a rundown of the stablecoin market with a focus on gold-backed
stablecoins, which are in many ways similar to gold ETFs. Bottom line: All of the gold-backed stablecoins on the market are
centralized, which means they have counterparty risk. Unlike storing your own
physical gold, trusting a company to store your gold is required.
Gold has fascinated mankind for thousands of years. So far, more than 190,000 tons of the precious metal have been mined.[2] How much is still underground remains unknown. One thing is clear, however: The extractable quantity is finite and subject to diminishing returns. Similarly, the number of bitcoins that can be mined is limited: The mysterious inventor of Bitcoin has set the maximum amount to 21 million coins.[3]Unlike fiat money, gold and Bitcoin cannot be created by central banks at will in response to demand shocks. While the average annual growth rate of the gold supply is around 1.7 % with a rather small standard deviation,[4] Bitcoin’s inflation rate is currently 3.69 % and on a downward trajectory.[5] As mentioned in last year’s In Gold We Trust report, the supply of newly mined bitcoins follows a preprogrammed, transparent, and predictable schedule, which remains unaffected by fluctuations in demand.[6]Their inelastic supply makes the prices of gold and Bitcoin dependent on their demand.
Overall,
the supply trajectories of Bitcoin and gold show that Bitcoin is expected to
have a lower inflation rate by 2021. Every
210,000 blocks, the reward the miners receive per block is halved. This
roughly corresponds to a four-year “half-life.” Observers pay very close
attention to the schedule, because the so-called “halving” is regarded as an
important indicator of price movement. There is only little experience so far,
since there have been only two such “halvings.” But they show that the price
has always risen in the months before the actual event. Specifically, the
Bitcoin price found its bottom in the first bear market that came 378 days
before the first halving and again in the second bear market, 539 days before
the second halving.[7]
This equals an average of 458 days, and we are currently approximately
350 days from the next halving, which will probably take place towards the end
of May 2020. If the pattern observed so
far is confirmed, the bottom should have occurred somewhere between December
2018 and May 2019.
Source: bitcoinblockhalf.com, World Gold Council, Incrementum AG.
When we compare the supply of gold to the supply of Bitcoin, we notice
that both are being mined, albeit in their own particular ways. Gold can be
found in soil, rivers, and rocks all over the world, regardless of borders.
Similarly, independently of their location, Bitcoin miners receive a reward for
providing the network with computing power to verify and settle transactions. The main difference when it comes to mining
is that mining is what secures the Bitcoin network and the price of Bitcoin on
the market. In contrast, gold mining does not secure the price of gold.Therefore, we would like to make the subtle
distinction that Bitcoin is not a bearer instrument in the same sense that gold
is. Paying with gold requires absolutely no dependence on a network for
settlement. However, Bitcoin transactions can take hours to settle; and
trusting the software, hardware, and internet that support Bitcoin is a type of
counterparty risk even though the “party” is not human.
To make Bitcoin and gold even more scarce, a certain amount of Bitcoin
and gold becomes unusable every year. Previously, gold was used in quantities
that made smelting and recovery cost-effective and common. For example, the
gold in your mother’s necklace may well have in it metal mined by the Romans,
then used by the Tudors, etc. Now we see gold used in tiny amounts in high-tech
goods, amounts that may not be cost-effective to salvage for a long time. The British Geological Survey estimates
that around 12% of current world gold production is being lost for this reason.[8]This means gold is being consumed in
an absolute sense for the first time in history. Again, this is similar to
Bitcoin’s annual loss of coins that are unspendable due to lost private keys
and fat-finger mistakes while typing cumbersome recipient addresses. Two
different cryptocurrency researchers, Chainanalysis and Unchained Capital, have created an upper bound of 3.8 million
for the total number of Bitcoins lost.[9]
Overall, the supply trajectories of Bitcoin and gold show that Bitcoin is
expected to have a lower inflation rate by 2021.[10]
Since many young investors consider Bitcoin to be
digital gold with a payment option, some may suspect that the demand for gold
is adversely affected by the success of cryptocurrencies. As of yet, the correlation between gold and Bitcoin returns is still
low and slightly positive, indicating that the demand for gold is not adversely
affected by cryptocurrencies.
Source: Coinmarketcap, Gold.org, Incrementum AG.
This
secure demand strength of gold is due to the unique advantages it has over
Bitcoin. First, gold is far less volatile than cryptocurrencies and will
remain so for the time being. In 2017, Bitcoin was about 15 times more volatile
than gold. In addition, gold is much more liquid. On average, USD 2.5bn in
Bitcoin is traded daily.[11]
This amounts to just 1% of the total gold market: The daily trading volume of
gold is around USD 250bn. Furthermore, gold trades in regulated and
well-established venues and has long been accepted by institutional investors
as an investment alternative. This is not the case for cryptocurrencies.[12]
The US dollar’s hegemony is under increasing
pressure from China and Russia, as US national debt reaches record highs. Instead of returning to a gold standard in
support of a fiat currency, the 21st century could witness the
emergence of a gold standard involving a cryptocurrency.
The notion of a monetary system based on a cryptocurrency may be
surprising, given the fact that cryptocurrencies are the most volatile asset
class. Many Bitcoin holders have experienced a ride from USD 1,000 right up to
USD 20,000, and then steadily back down, culminating in a long, choppy sideways
market followed by the recent rally to USD 8,000. Enter stablecoins. Stablecoins promise to offer all of Bitcoin’s
benefits while fixing the problem of volatility.
While the decentralized and independent nature of their supply makes
gold and Bitcoin good stores of value, there are major differences with respect
to other monetary features. Following Dobeck and Elliott[13]
and Berentsen and Schär[14],
the next table gives a quick overview.[15]
Source: Incrementum AG.
However, the promise is most likely to be optimistic, as promises often are in the cryptocurrency space. For several decades, countries around the world have tried to peg their exchange rates to other more stable currencies. Not a single fixed peg has lasted in the long run.
Take for example the European Exchange Rate Mechanism (ERM), which
attempted to keep the plethora of European currencies within a narrow band of
each other during the ‘80s and ‘90s. Since the UK could not keep their print
presses turned off, George Soros and other speculators were able to mount a
speculative attack and profit from breaking the peg. This is because whenever a currency holds fractional reserves,
arbitrage opportunities arise between it and other currencies. Therefore,
stablecoins that are not fully backed are trading off between stability in the
short run and blow-up risk in the long run, because keeping a fixed peg without
investing in the underlying asset makes the peg fragile to black swan events.
Source: Incrementum AG
However, Bitcoin is volatile, and many cryptocurrency users are now
demanding stability. To meet this
demand, the new stablecoins are combining the advantages of gold and Bitcoin.
Gold-backed stablecoins are similar to gold ETFs. For example, the most famous
gold ETF, SPDR Gold Shares (GLD), is a fund that buys physical gold and divides
the ownership of it into shares.
In theory, gold-backed cryptocurrencies are supposed to work the same
way. However, there are currently no
cryptocurrency exchanges that are licensed to trade tokenized ETFs. Even if
regulators eventually approve an application for such an exchange, they will
require KYC/AML on each transaction.[19]
This begs the question: How is a
centralized gold-backed stablecoin any better than a gold ETF?We have still not found a suitable answer
to this question. In fact, the solution seems inferior at first glance,
because investors still have to safely protect the private keys that control
the gold-backed stablecoins, and if the tokens are traded on a public
blockchain like Ethereum, then the coins will be subject to volatile and
increasing transaction fees when they send and receive the gold tokens. Then
there are all of the problems associated with public blockchains, such as
latency, lack of scalability, and security.
As shown on the next figure, there are three main types of
collateralized stablecoins: fiat, commodity, and crypto. Gold-backed cryptocurrencies are considered to be centralized “off-chain-backed
coins” because they generate value by a counterparty’s depositing gold, gold
certificates, or other gold-related securities into a vault. Similar to
fiat-collateralized coins like the infamous Tether, gold-backed
cryptocurrencies are supposed to be listed on cryptocurrency exchanges so that
gold positions can be opened and closed within seconds by retail and
professional investors alike.
Over 50 cryptocurrencies are
somehow backed to gold. The next section summarizes just a handful of the
gold-backed projects. The projects selected were drawn from responses to an official
@CryptoManagers tweet
on Twitter. We asked our followers what coins they wanted to learn more about.
We also selected a few coins from the German-speaking countries, including
Vaultoro, Novem, and AgAu. Finally, we have included an update on the
gold-backed tokens that we covered last year.[20]
Source: Incrementum AG.
*Please be advised that the table includes fees
such as transfer fees, custody fees, subscription fees, and redemption fees. We
included all information which was provided to us by the companies. However, a
substantial cost that investors will have to bear may be the spread between the
price of gold on the market and the price of gold that each company charges
investors. This markup on the price of
gold is often not stated clearly in the whitepaper. The table is not
complete because the information was unavailable. Readers are responsible for
their own due diligence on each firm, and this is not investment advice.
Digix
Gold Tokens (DGX)
There are two tokens
associated with this company: DGD and DGX. The DGD crowdsale in March 2016 was
the first crowdsale and major DAO hosted on the Ethereum network. A
decentralized autonomous organization (DAO) is a type of decentralized application
(dApp) that allows owners to make business decisions by voting electronically,
and execution of the business decisions is performed using smart contracts.[21]
The second is the DGX token, which equals one gram of standard gold.[22]
The company reportedly procures its gold from LBMA-approved refiners. The
tokens are issued by Pte. Ltd. in Singapore, and the gold is stored at The Safe
House in Singapore. As you can see in the next chart, the daily trading volume
is approximately USD 243,000 over the past year, and USD over the past month.
The next chart shows that the Digix Gold Token is not correlated with the price
of gold. The token is more volatile and often trades at a discount to gold.
AnthemGold
What makes
AnthemGold unique is that it is the first insured, fully gold-backed stablecoin
based in the US. The token is open to citizens of 174 countries, and the vault
where the gold is stored can be viewed on video, on the AnthemGold homepage.[23]
Currently, there are 20kg of gold there. The gold is insured through Lloyd’s;
there is zero FACTA reporting required for investors; and according to the
founder of AnthemGold, Anthem Blanchard, the gold has zero risk of bank deposit
freeze or closure. There is a 0.40 % storage cost per year, extracted from
metal (which is the same as the GLD gold ETF fee structure).[24]
AgAu
AgAu is a gold-backed token that is being developed by
Thierry Arys Ruiz and Nicolas Chikhani, the former CEO of Arab Bank in Geneva.
Their offices are located at the Zug-based blockchain incubator, Crypto Valley
Venture Capital (CV VC). Their coin will be audited by E&Y and built as an
ERC-1400 smart contract on the Ethereum blockchain. The gold is 1 kg LBMA bars
stored at Trisuna in Liechtenstein. AgAu will be engaging in a token generation
event (TGE) to raise the initial round of capital that will be used to buy the
gold required for backing the tokens. The storage fees are 0.2 % per annum, and
each transaction has a maximum total cost of 0.4 %.
HelloGold, a Malaysian-based company founded in 2015, offers a token
backed by 1 gram of 99.99 % investment-grade gold. The tokens can be converted
into physical PAMP Suisse gold, and the shipping is insured. The total GBT
supply is limited to 3,800,000 (representing 3.8 tons of gold). Users also have
the opportunity to convert their gold into a digital gold token (GBT) if they
have a “pro” account, which requires standard AML/KYC. This enables them to use
the stored gold as a value outside the HelloGold system.
In addition, people may use their gold as collateral for loans made available by Aeon Credit Services, giving them access to personal finance. Finally, HelloGold offers a Smartphone app with which users can trade their tokens and exchange them for their corresponding shares of investment-grade gold. When they redeem their GBTs for physical gold, they receive the corresponding amount in bullion, coins, or jewelry via recorded mail.
GBT accounts are charged an
annual fee of 2 %. Interestingly, the HelloGold blockchain operates on a
private network to reduce fees and transaction latency and avoid the risk of
independent developers adding their own contracts to the blockchain. This means
that HelloGold and its nodes control block times as well as the execution of
the gold transactions.
Due Diligence on Gold-Backed Stablecoins
Can the cryptocurrency be converted into physical gold on demand? How easy is the process?
Does the company disclose how it stores the gold?
Who is storing the gold that backs the cryptocurrency? Is that company trustworthy?
Is the gold insured?
Does the company have a well-known and reputable auditor? If the company is not audited, then it can easily issue more tokens than gold, thereby creating fractional reserves.
What happens if the company goes bankrupt? Is it a limited liability company that could leave investors empty-handed?
What blockchain are the gold tokens built on? Is that blockchain secure?
Do you know how to store the private key to the wallet that controls the gold tokens? What happens if you lose the key? What happens if the key is stolen?
Gold-backed cryptocurrencies are similar to ETFs, which may make them subject to securities laws in Europe and the US. Is the company selling the cryptocurrency regulated? Does it store the gold in a country that has approved their token?
Where can the gold-backed token be traded? Gold ETFs are traded on exchanges, but there are currently no cryptocurrency exchanges that are licensed to trade tokenized ETFs.
How much liquidity does the gold-backed cryptocurrency have? Can you really close a position in case of a liquidity trap? The largest gold-backed cryptocurrency, Digix Gold Token, has a small daily trading volume of USD 243,000 over the past year, and USD 27,000 over the past month.
What is the total expense ratio for the tokenized shares of the gold fund? The most famous gold ETF, SPDR Gold Shares, has a management expense ratio (total fund costs / total fund assets) of only 0.40 %.
What is the business model of the coin? How do the people who created the coin make money? If there is not a clear way that they are profiting, then be suspicious of indirect costs or high risk.
Conclusion
A gold-backed cryptocurrency promises to be digital gold: no
weight and stable. However, no one has figured out yet how to make a
decentralized gold-backed stablecoin. All gold-backed stablecoins are
centralized in the sense that you have to trust someone to store the gold for
you. Similar to an exchange-traded gold fund, gold-backed stablecoins have
counterparty risk. In the cryptocurrency world they say, “Not your keys, not your crypto.” Well, the parallel for gold would
be something like, “Not your vault, not
your gold.”
Backing a cryptocurrency in a way that an intermediary is required – a custodian or a bank for instance – actually conflicts with one of Bitcoin’s central tenets, namely, that users do not have to trust any intermediary. The security of Bitcoin and other cryptocurrencies is based on cryptographic technology. In contrast, the gold-token projects we have presented above are managed by real companies. They are responsible for the safekeeping of the gold. Therefore, the user has to trust that no state or private actor will be able to steal or confiscate the gold from the vaults.
Furthermore, the coins are often traded on a public blockchain structure such as Ethereum, which means the coins also suffer from all of Ethereum’s problems, such as scalability and security. Finally, there are over fifty gold-backed coins currently, and most likely, many of them will fail. It will take a few years for the market leaders to emerge, gain widespread exposure, and thus secure the standing of gold-backed tokens as a store of value. This year will be pivotal in identifying which projects are going to take the lead in this endeavor.
[3] In this context, we should note that the edge
length of the cube that could be cast from the total amount of gold already
mined is roughly 21 meters, which may have been Satoshi Nakamoto’s inspiration
for the arbitrary 21 million hard cap.
[12] This may change quickly, however, as more and
more countries open their financial markets to blockchain-related investment
vehicles. To give an example, the Liechtenstein Financial Market Authority
(FMA) has recently approved three alternative investment funds (AIFs) for
crypto-assets. See “Liechtenstein gives green light to crypto
funds“, Liechtenstein.li –
official website of Liechtenstein Marketing, March 6, 2018
[13] Dobeck, Mark F.; Elliott, Euel: Money.
Greenwood Press, 2008, pp. 2-3
[14] Berentsen,
Aleksander and Schär, Fabian: Bitcoin, Blockchain und Kryptoassets. 2017, pp. 16-17
[15] This table was inspired by a presentation
given by Frank Amato at the LBMA/LPPM Precious Metals Conference 2018 in
Boston, Massachusetts.
[17] Transfers within the Bitcoin network can be
tracked indirectly due to the transparent nature of account balances. Companies
such as Chainanalysis offer to analyze the entire Bitcoin blockchain in order
to forensically detect transfers between addresses and identify the owners of
the accounts. The US tax authorities are already using this service to track
cases of money laundering and tax evasion.
[18]
The counterparty of Bitcoin defined as functionality of the Network
[19] Know your customer (KYC) and anti-money
laundering (AML) are standard protocols that require a customer to verify their
identity in order to use specific services, such as bank accounts and
cryptocurrency exchanges.
“XRP
Recently in Green, But Outsized Risks Prevail. XRP’s recent rally is unlikely
to endure, in our view. Ripple’s litigation risks and the prospect of XRP being
classified as a security were largely ignored over the past three months as XRP
staved off the effects of the broader crypto-price collapse. This stalling has
helped to make XRP the second-largest asset of its kind by market
capitalization.”
Bloomberg Crypto Outlook
Key Takeaways
Ripple Labs Inc. claims that they are not the creators of the coin XRP.However, the company Ripple Labs Inc. has earned over $890 million in revenue from selling XRP coins on the market. In June 2019, the company Ripple moved 1,000,000,000 XRP from their escrow account to the market, which could generate approximately $300 million more in revenue from selling XRP.
Ripple was created by Jed McCaleb, the creator of Mt. Gox. McCaleb has since sold most of his 9 billion XRP coins, and he has abandoned the project. McCaleb now is the leader of Stellar and owns approximately 1 billion lumens.
The coin XRP does not need to be used by the Ripple Network for settling transactions. Various investment reports value XRP at close to zero in worth, and XRP could be an unregistered security in the US.
Soaring
3000 %, XRP was one of the ultimate high-flyers during the 2017 crypto boom. At
USD 0.31 the cryptocurrency lost 89 % since its all-time high of USD 3.31 in
January of 2018.[1]Ripple has been on the Forbes Fintech 50 List for
three years in a row by Laura Shin; however, Shin recently changed
her position on Ripple and XRP. In
episode 39 of the Unchained podcast, Shin discusses the main problems with
Ripple and XRP.[2] We highly recommend the
interview. The main questions
that were discussed include:
What is Ripple?
What is XRP’s Elevator Pitch?
Is XRP an unregistered security?
Who owns and uses XRP?
Is XRP centralized?
We will be addressing these questions in this
article.
Most investors do not know this, but the
concept for Ripple came in 2004 from Ryan Fugger, way before Bitcoin was
created in 2008. However, the Ripple we know today, Ripple Labs Inc.,
was handed over in 2012 to
Chris Larsen and Jed McCaleb.
Jed McCaleb (left) joined Ripple in 2011. Chris Larsen (right) joined the company in 2012. Source: BitMEX Research.
If Jed McCaleb sounds familiar, it’s because he was the original founder of the
infamous Mt. Gox Bitcoin exchange. When McCaleb sold Mt. Gox to Mark Karpelès,
80,000 Bitcoin were missing.[3] However, the contract of a
sale stated that Karpelès could not hold McCaleb legally accountable. Years
later, McCaleb’s login details for the backend of Mt. Gox were still valid, and
they were used to hack into Mt. Gox in order to steal Bitcoin.[4] To this day, the perpetrator
of those hacks remains unknown.
XRP Ledger,
RippleNet, xCurrent, xRapid, and xVia
The first
information to untangle is what exactly is XRP? XRP coins are accounting units in an open source
distributed database called the XRP Ledger (XRPL). In contrast with XRP and the XRP Ledger, Ripple Labs Inc. is a company
that provides a closed source software called RippleNet to companies, and
Ripplenet contains a suite with three tools: xCurrent, xRapid, and xVia. The myriad of products and information surrounding the
products befuddles investors and distracts them from understanding what XRP is.
We briefly describe each of the three products in this section.
XRP Ledger
The XRP
Ledger is a distributed ledger that stores information regarding XRP
transactions and balances. The main question: Is XRP Ledger’s consensus
mechanism decentralized? We searched for a
comprehensive technological analysis of XRP’s consensus mechanism, but one does
not currently exist. A plethora of articles exists online, with answers ranging
from the XRP Ledger consensus mechanism is centralized to decentralized and
everywhere in between. What is clear is that RippleNet’s xCurrent and
xVia are not using the XRP Ledger, so they have centralized consensus.
According to the latest whitepaper written by Ripple
Research by Brad Chase and Ethan MacBrough, to come to consensus on what
transactions are valid and what transactions are invalid, the XRP Ledger uses
the XRP Consensus Protocol, which is “a Byzantine Fault tolerant agreement
protocol over collectively trusted subnetworks.”[5]
Binance Academy explains in simple terms how XRP Ledger’s consensus works,
“The XRPL is managed by a network of independent
validating nodes that constantly compare their transaction records. Anyone is
able to not only set up and run a Ripple validator node but also to choose
which nodes to trust as validators. However, Ripple recommends its clients to
use a list of identified, trusted participants to validate their transactions.
This list is known as the Unique Node List (UNL).
The UNL nodes exchange transaction data between each
other until all of them agree on the current state of the ledger. In other
words, transactions that are agreed upon by a supermajority of UNL nodes are
considered valid and the consensus is achieved when all these nodes apply the
same set of transactions to the ledger.”[6]
However, as BitMEX claims this
entire process is unnecessary because, in order for a node to support a
proposal for a new set of transactions, a node must download private keys from
a server that is controlled by Ripple.[7]
“The software indicates
that four of the five keys are required to support a proposal in order for it
to be accepted. Since the keys were all downloaded from the Ripple.com server,
Ripple is essentially in complete control of moving the ledger forward, so one
could say that the system is centralised. Indeed, our node indicates that the
keys expire on 1 February 2018…, implying the software will need to visit
Ripple.com’s server again to download a new set of keys.”
According to BitMEX Research, XRP’s Ledger is unable to achieve distributed consensus:
“For
example, one user could connect to five validators and another user could
connect to five different validators, with each node meeting the 80%
thresholds, but for two conflicting ledgers. The 80% quorum threshold from a
group of servers has no convergent or consensus properties, as far as we can
tell. Therefore, we consider this consensus process as potentially unnecessary.”
Another problem regarding the single point
of failure aspect of XRP Ledger’s consensus mechanism is that there is no fee
for validating transactions. This means there is no incentive for becoming a validator in
the Ripple network. According to Ripple, institutional participants will be
incentivized to run nodes at their expense for the health of the network.[8] For some,
this assumption seems arduous: One could argue that large financial institutions will not run an XRP node because of
potential legal recourse that could ensue. As Joe Kendzicky points out:
“Imagine the PR backlash a bank would receive if it came
out that one of its UNL peers was a darknet market, and the bank themselves
played a direct role relaying drug and money laundering related transactions.”[9]
In
general, Byzantine Fault Tolerant consensus mechanisms are more centralized than
Bitcoin’s proof-of-work and longest chain consensus mechanism. Since XRP Ledger’s
is expected to migrate to a different consensus algorithm called Cobalt at a
date that has not been determined yet, we will leave the discussion on
consensus here and hope for an unbiased analysis of exactly how decentralized
XRP’s consensus really is.[10] Moving on from the XRP Ledger is RippleNet, which
is a closed source software that contains three main products: xCurrent,
xRapid, and xVia.
xCurrent
xCurrent’s peer-to-peer
structure is similar to the Lightning Network discussed in The Crypto Research Report March 2018 edition. If Bank A wants to pay Bank B with US dollars, but Bank B
wants to be paid in euros, the xCurrent protocol layer could route the
transaction. Bank A would submit a transaction to convert the US dollars to euros
(in the form of an IOU) to a global order book. xCurrent then acts as a
path-finding algorithm to find the cheapest route for the US dollars amount to
be exchanged to euros.
One
of the most interesting and at the same time most widely ignored features of
Ripple are the fact that transactions on
Ripple’s xCurrent software do not need to be denominated in the network’s
native currency, namely XRP.[11] Contrary to common belief,
the network can manage IOUs denominated in any type of asset.
“The use of XRP is totally independent of the Ripple
network in general; that is, banks don’t actually need XRP to transfer dollars,
euros, etcetera which is what many small investors might be missing when they
are buying the token.”[12]
Source: Jason Bloomberg, Forbes.com
While the
xCurrent protocol layer is currency-agnostic, there is a small transaction fee
(~.00001XRP) to access the exchange.[13]This transaction fee is not collected by anyone, but rather destroyed
once payed. The stated idea behind the fee is to prevent spamming on the
network.[14] However, burning XRP also
makes Ripple Labs richer. When the network burns the
transaction fee in XRP, the remaining amount of XRP in existence are worth more
because the supply is decreasing with constant demand, ceteris paribus. Since the developers and Ripple Labs own
the majority of Ripple, each transaction fee makes the developers and Ripple
Labs wealthier.
xRapid
xRapid
is built on top of the XRP Ledger and can be used to settle transactions
denominated in the native XRP token. xRapid is the only one of RippleNet’s
three-suite software package that is built on top of the XRP Ledger, which
means that as xRapid gains more adoption, there is more demand for XRP.
In
order to use xRapid, banks or other participants either need to hold XRP
reserves, as the bridge currency, on their balance sheets, or have dedicated
liquidity lines operating on the xRapid layer, which is what the Ripple Lab
Inc. would like to see because this would give value to XRP, of which they own
approximately 60 % of currently. But why
would banks just give away their wealth away to Ripple Labs by buying up XRP
off of the open market in order to settle international payments? In
order for banks to use xRapid, they would need to invest in XRP and potentially
hold reserves of XRP. Why would banks accept the currency
risk of holding on to XRP reserves in order to use xRapid, when they can just
use a stablecoin or central bank cryptocurrency?
One reason is if the bank
also owns XRP or is a private investor in Ripple Labs equity shares. One of the banks that is
often cited as a user of XRP, Strategic Business Innovator (SBI) Remit Co. Ltd.,
is actually invested in the private equity shares of Ripple Labs Inc., and has
a financial incentive to promote positive news headlines regarding the company
and XRP because when more banks are shown as using XRP, then Ripple Labs Inc.
earns more in quarterly sales revenue from XRP sales.[15]
xVia
Various YouTube videos and Twitter tweets
state that Ripple is a competitor to the Society for the Worldwide Interbank
Financial Telecommunications (SWIFT) network. However, many investors do not
even understand how the SWIFT network works. Actually, SWIFT does not settle a
single transaction. SWIFT is only a messaging system between banks and
settlement systems, such as the Clearing House Interbank Payments System
(CHIPS). xVia is
the messaging application for RippleNet users that need to send invoices or
other information to other users. This is the part of the technology that would
compete with the SWIFT network.
Unlike SWIFT, Ripple Labs is an enterprise
software company that has a negative customer acquisition cost because they can
pay people in XRP to use XRP. In Ripple’s 2017 October market report, they
explain that they offer a 300 % rebate on integrating the Ripple software.[16]
The rebate is paid in XRP. This means that any costs that a firm has for
integrating RippleNet into their system will be rewarded with a 300 % return.
They seeded a $300 million accelerator fund that helps cover the costs of
integrating RippleNet into existing companies.[17]
They are willing to lend XRP to market makers at zero cost, which allows market
makers to add millions in revenue to their bottom line.[18]
Although, this encourages firms to work with the Ripple network and with XRP,
some financial analysts say that Ripple’s free distribution of XRP to banks
that are willing to experiment with RippleNet borders a bribe.[19]
The current security problems that SWIFT has regarding fraud and hacks would be
the same with xVia because xVia is part of RippleNet, which is closed source
and has centralized consensus and is a single point of failure.
Ripple and Libra are both effectively trying
to become a global private central bank. The main investment argument made by
XRP enthusiasts is that retail investors can front-run banks that eventually
will adopt XRP for cross-border settlements. Since the banks will rush in and
buy reserves of XRP to use as a bridge currency, the price will go up,
rewarding early investors with an XRP appreciation. But why would banks give up
their market share to XRP voluntarily? Banks currently settle international
payments and incur a cost of approximately 20 basis points per transaction.[20]
Ripple noted that their system could reduce settlement costs by six basis
points, and an additional two basis points if XRP is used on the xRapid
network.[21]As
CEO and founder of Messari pointed out, Ryan Selkis,
there is a negligible benefit of using XRP for cross border settlement compared
to the cost banks will have to incur to hedge fluctuations in the exchange rate
of XRP.[22]
Furthermore, the token XRP is volatile, which
impedes its ability to compete with the US dollar as a global reserve currency.
To manage XRP’s volatility, professional
market makers ensure that sell walls in XRP order books on cryptocurrency
exchanges are reduced when good news are released and buy walls in the order
books are built-up when bad news are released.[23]
This makes XRP less volatile than other cryptocurrencies that do not have
professional market makers.
The addendum to this article discusses how
interbank settlement works in order to explain the business of banks that Libra
and XRP are both vying to takeover.
The
first important clarification is that XRP coins do not convey ownership because
Ripple Labs Inc., is a privately-owned company with a valuation of USD 410
million.[24]Unfortunately, many retail investors falsely believe
that if Ripple the company makes profits, their XRP coins will go up in value
because they think of XRP coins as equity shares of the company’s balance
sheet. XRP coins are not equity shares.
Despite
the fact that XRP coins are not tokenized equity shares of Ripple Labs
Inc., XRP coins can be considered investment contracts according to the Howey
Test, which is a tool used by US regulators at the Securities Exchange
Commission to determine if a company falls under their jurisdiction or not. Former Chairman of the Commodities
Future Trading Commission Gary Gensler explained that Ripple coin is a security
according to the Howey Test[25], and Ripple is facing their third security fraud court case in the United
States.
Why is this?
This is because Ripple’s XRP coin sales
are similar to an initial coin offering that never ends. Izabella
Kaminska wrote that Ripple’s issuance of XRP is like an exchange-traded fund:
“It is entirely centrally controlled, operating more like
an ETF unit than anything else since the issuer has the capacity to release or
absorb (pre-mined) tokens in accordance with their valuation agenda. More egregiously though, the token plays
little part in Ripple’s central business case.”
According
to the latest Bloomberg Crypto Outlook,
Ripple is at risk of being classified as a security.
“Ripple’s risk in suits by XRP buyers is a court ruling that XRP is a security, which would subject XRP to stricter SEC regulation that could curb transactions. Classification as a security could allow purchasers to rescind buys, would require Ripple to register or find exemptions for XRP sales, and would hinder XRP’s ability to be listed on U.S. virtual marketplaces, which have reportedly been reluctant to list XRP due to the risk of facilitating the sale of a potentially unregistered security.”
When Bloomberg’s report came out in 2018, the two largest exchanges in
the US, Coinbase and Gemini, did not list XRP, despite Ripple offering an
interest-free loan of $100 million worth of XRP to Coinbase and a $1 million
direct payment to Gemini.[26]
However, Coinbase did decide to finally list XRP on Coinbase Pro, formerly
known as GDAX, earlier this year in February. They reportedly did not receive
any compensation from Ripple in order to list XRP.
But Ripple Labs is now claiming that XRP does not belong
to the company.During a hearing in front of the
British Parliament regarding Ripple, Ripple’s Director of Regulatory Relations
claimed that Ripple Labs Inc. did not even create the coin XRP.
“XRP is open
source and it was not created by our company, so that existed as an open source
technology. We created a company that was interested in modernizing payments
and then began using that open-source tech to do so … We didn’t create XRP …
What we do have is we do own a significant amount of XRP, it was gifted to us
by some of the open-source developers that created it. But there’s not a direct
connection between Ripple the company and XRP.”
Ryan Zagone, Ripple director of regulatory relations
However,
Zagone’s claim is strange given Ripple used to state explicitly on their website
that they created XRP. This image was found on an Internet archive explorer
because Ripple has removed this statement from their website.
Figure 4: Ripple Originally Claimed That They Invented
XRP.
XRP
coins were created all at once in the genesis block in 2012. This was possible
because the protocol does not use proof-of-work mining. The initial distribution
of the coins was extremely centralized, and still is centralized today. The
creators kept 20 billion XRP coins for themselves (20 %). The remaining 80 % or 80 billion XRP were gifted to Ripple Labs Inc.
If
you look closely at the XRP listing on Cointmarketcap.com, you can see that the
circulating supply and the total supply are very different. This is because the
company Ripple is forcibly keeping coins off the market. Ceteris paribus, when
the supply of a scarce good is restricted given a constant level of demand, the
price can be kept artificially high. If you imagine that the coins locked away
are also worth $0.31 each, then XRP’s real market capitalization is closer to
$30 billion.
However,
the price of XRP would most likely decline if Ripple sold more than 1 billion
per month, which is their stated limit on monthly XRP sales. Ripple the company was valued by investors
as being worth $410 million, which begs the question: Why would investors value
Ripple at $410 million when they own 60% of the outstanding XRP, worth
approximately $8 billion in current prices? Overall, the fact that Ripple
Inc. effectively controls a large part of the XRP supply opens up
non-systematic risks unique to Ripple.
Figure 5: Ripple’s Real Market Capitalization Would Be
USD 31 Billion.
Source: Coinmarketcap.com
In
2018, Ripple Labs decided to partly lock up 55 billion XRPs in an escrow-like
account that releases 1 billion XRP per month to Ripple Labs Inc. to be used as
they wish. The remaining XRP coins that Ripple owns are distributed “methodically”
to incentivize market maker activity.[27] XRP’s official supply
metrics are tracked on their homepage; however, some data is missing.[28]
Ripple
has sold on average 300 million XRP tokens per month since 2016. This money
goes directly to Ripple Labs’ revenues. In January of 2018, the creators of
Ripple were billionaires.[29] Ripple’s executive chairman,
Chris Larsen, owns 17% of the private company and controls 5.19 billion XRP.
Larsen was estimated to be one of the richest men in the world worth $60
billion when XRP hit an all-time high of $3.31 in early 2018. Ripple CEO, Brad
Garlinghouse, is estimated to have $10 billion in personal wealth.
Several
of the 2018 court cases regarding Ripple are because of the escrow account. The
news of the escrow account made the price shoot up, and many investors are
claiming that Ripple Labs profited financially by manipulating the price and
investors. However, the Ripple founders are notorious for selling large amounts
of their Ripple coins. Jed McCaleb wrote online in May of 2014 that he was
selling 9 billion of his XRP coins.
“I plan to start selling all of my remaining XRP
beginning in two weeks. Because I have immense respect for the community
members and want to be transparent, I’m publicly announcing this before I
start. So just fyi… xrp sales incoming.”
The
price dropped by 60 % following his post. He has now moved onto his third
project, Stellar, which is like Ripple but with smart contracts. In 2015,
McCaleb got into trouble for trying to sell more Ripple on Bitstamp than he was
allowed to.
All of Ripple Labs Inc.
shenanigans has led to 16 court cases in the United States and multiple
encounters with regulators in other countries. Table 1 outlines the major
cases that Ripple Labs has fought in the US.
Table 1: Court Cases and Fines Involving Ripple.
Source: Legal databases, User brjXRP17 on xrpchat.com
The 100 most active XRP wallets own an
estimated 97 % of the existing XRP. Dogecoin creator, Jackson Palmer,
created the website arewedecentralizedyet.com and showed XRP as being by
far the most centralized coin. McCaleb’s project after XRP, Stellar, is also
very centralized.
Figure 6: Ripple is Considered to be Centralized.
Source: Arewedecentralizedyet.com
However,
Palmer received so many messages from XRP users that he removed XRP from the
website entirely.
Figure 7: XRP Army Attacked Are We Decentralized Yet Website Owner.
After Demelza Hays expressed her disapproval of XRP on
Twitter, she received nearly a thousand comments in favor of XRP, including
several harassing comments that attacked Demelza personally. It is well known
among crypto Twitter that the “XRP Army” is one of the most toxic communities.
Although the community includes many real XRP supporting enthusiasts, the
XRP Army benefits from automation and thousands of inauthentic accounts—that
ultimately function to create the illusion of a larger, more robust community
than is reality. Collectively, the XRP Army engages in “coordinated
inauthentic behavior” (this activity violates
Twitter Rules; more specifically, around platform
manipulation).
Figure 8: Twitter Accounts that Commented on Demelza’s Tweet.
The XRP Army is notorious for attacking accounts which share
anything that opposes the narrative they are pushing. One of the more frequent
targets of their attacks has been Geoff Golberg, a social media manipulation
researcher and founder of SocialCartograph, a social media mapping firm. Geoff
dissected the XRP Army in great detail in this August 2018 post.
His research has helped surface social media manipulation across the world,
including that of India’s Bharatiya Janata Party (BJP; link
1; link
2), and, more recently, People’s Mujahedin of Iran (MEK; link),
among others. More on his work may be found here.
Specific to the XRP Army, Geoff has received death
threats simply for posting data-driven analyses that highlight how the group
violates Twitter Rules. In the case of the MEK, Geoff’s research has even
resulted in him being doxed. Doxxing
is the process of attacking someone online with private details of that
person’s life.
Figure 9: Many Twitter Bot Accounts Suspended Since Posting
(Note @ceramika74, which has since been suspended). Source: @geoffgolberg
In addition to @ceramika74, there are several other
XRP-focused accounts from this dataset that have been suspended since the data
was collected (December 2018). Here are a few examples:
Figure 10: Many Twitter Bot Accounts Suspended For Being Fake.
One common tactic employed by the XRP Army, according to Golberg, is to create XRP-focused sockpuppet accounts (personas) around locations (cities, states, countries). Their goal, effectively, is placing XRP-branded billboards all over Twitter to create the illusion that the XRP community is larger – and more geographically represented – than is reality. Examples include @XRP_Europe, @XRP_Norway, and @XRP_Spain_Army (to name a few). Then you have accounts on Twitter that do not even try to hide that they are a bot just retweeting XRP whale tweets like @XRPRetweeter.
Twitter’s Platform Manipulation and Spam Policy states
that “you may not use Twitter’s services in a manner intended to artificially
amplify or suppress information or engage in behavior that manipulates or disrupts
people’s experience on Twitter.” One such tactic employed by the XRP Army,
states Golberg, are inauthentic engagements—more specifically, engagements
(follows, retweets, likes, replies) that “attempt to make accounts or content
appear more popular or active than they are.”
The first step to determining if the accounts are
fake or not is to see if they were all created in and the around the same time
period. The second step is to look at the patterns in the bio section. Many of
the bots will contain the same words in their bio section, in the case of XRP,
the main word to contain for a bot is XRP. This helps bots find which other
bots they should follow and retweet from. The second step is to see how often
they tweet. Some accounts tweet on average of 700 tweets a day, which is about
once every two minutes. The next step is to look at the clustering of accounts.
This means that all accounts are only following and retweeting posts from other
accounts within their group, and they are not following or retweeting posts
from other non-XRP related Twitter accounts. For example, a normal person that
likes XRP should also be following a certain percentage of famous Bitcoiners
accounts or regulators in their country. However, Twitter bots will only follow
and retweet what they are programmed to follow and retweet. The final step is to
go on to the Twitter profile and actually looking at their feed for signs that
they are fake.
Conclusion
As the US dollar’s reserve status becomes
increasingly challenged, more and more banks will lose their USD correspondent
bank for settlement, and there could be demand for an alternative reserve
currency and global private bank. Many articles online claim that large banks will use XRP as a
global bridge currency or reserve currency to settle international
transactions. However, banks can create their own native assets to settle
transactions on the network with as well. Although settlement times and fees
for Ripple transactions are lower than Bitcoin or Ethereum’s, banks will prefer
to settle in whichever cryptocurrency establishes itself as a global reserve
currency. Lightning network on top of Bitcoin, proof-of-stake coins, directed
acyclic graph coins such as Byteball and Iota, and masternode structures, like Dash,
are all attempting to make fast, reliable, and cheap transactions in order to
become global stores of value and medium of exchange. However, all of these are
volatile and will not be used as units of account, which is a requirement of a
global bridge currency.
A lot of members of the crypto community have
received large payments of XRP from Ripple Labs Inc. in order to test XRP;
however, this also may incentivize these members of the community to be quiet
regarding XRP’s myriad of problems. Ripple Labs Inc. is also attempting to make
inroads into Switzerland by inviting politicians and high-net-worth individuals
to special events, such as the dinner at the Dolder Grand that occurred in
early summer 2019. The strategy may even remind readers of the original formation
of the US Federal Reserve on Jekyll Island in November 1910.[30]
The cross-border payment market is estimated
to settle USD 180 trillion every year in volume.[31]
To put this huge number into perspective, the entire annual economic production
of Switzerland, as measured by the GDP, is USD 0.705 trillion.[32]
According to Ripple research, cross-border payments are estimated to cost
senders and receivers of cross border payments USD 1.6 trillion per year.[33].
For example, PayPal charges a fee of 2.9 % for payments plus an additional
transaction fee will be charged for international payments, which is the spread
in exchange rates that accrues to market makers. These costs for consumers
translate into to profit centers for banks and financial intermediaries. Recent entrants like TransferWise
or Revolut offer international transfers to retail investors at substantially
lower costs, but the field of traditional payments is still dominated by
long-established banks with little transparency and close to no competition.
How a Domestic Transaction is Settled
If UBS has an account at the SNB, this is
referred to as a nostro account because it means “our” account at “their”
bank. Nostro is also referred to as “Due from Bank Account” in accounting
terms. As shown in Figure 11, UBS has nostro accounts showing up as credits on
their balance sheet because this is UBS’s money held at other banks. In
contrast, UBS’s nostro accounts show up as vostro accounts on each of the other
bank’s balance sheets, and this why it is shown as debit or liability. In
contrast, vostro means “our” or “Due to Bank Account” in accounting terms.
Imagine that
Alice is a customer of Bitcoin Suisse (and Bitcoin Suisse’s July 2019
application for a Swiss banking license is approved), and she has a bank
account with a balance of 500 CHF. If Alice wants to send 100 CHF to Bob’s bank
account at Falcon Private Bank, then Bitcoin Suisse’s balance sheet would show
their nostro account with Falcon Bank being debited 100 CHF, which means their
assets are being decreased. Falcon Bank’s balance sheet would show Bitcoin
Suisse’s vostro account as debited 100 CHF as well because this is 100 less of
a liability for Falcon Bank to Bitcoin Suisse. The complimentary transactions
would appear on Falcon Bank’s balance sheet in order to finalize the
transaction.[34]
Figure 11: An Expensive Way to Settle a Domestic Transaction.
Source: Incrementum AG.
However, this
is a very expensive way to settle a domestic transaction because this means
that each bank has to have an account with cash deposits at every single other
bank. This opens the bank to counterparty risk in the case that the bank where
their account is can go bankrupt. The liquidity also has an opportunity cost.
Instead of just leaving the cash deposits idle in a bank account at another
bank, the bank could be using that money to earn interest from lending.
Instead of a bilateral
model, all banks could just have one bank account at the central bank as shown
in Figure 12.[35] This would reduce the counterparty
risk and liquidity required each bank.
When a
domestic bank has an account at the central bank, this is called a
correspondent bank. When a domestic bank does not have an account at the
central bank, then they are called a respondent bank. Settlement at the central
bank between correspondent banks occurs in two main ways.
The first is DNS systems, which settles transactions at the end of the day, for
example, CHIPS in the US. The second is real-time gross settlement systems
(RTGS), which have instantaneous settlement. An example of an RTGS system is
Fedwire in the US.
Banks that have an account at the domestic
central bank (correspondent banks) can charge fees to lower status banks
(respondent banks) that need to use a clearing bank to access RTGS/DNS systems.
This introduces
substantial fixed costs, transaction fees, and time delays, which is why
payments are both costly and slow.
Figure 12: A More Efficient Way to Settle a Domestic Transaction.
Source: Incrementum AG.
How an International Transaction is Settled
Banks can open a branch in a foreign country
by getting a banking license in that foreign country or if a bank does not want
to deal with the cost associated with getting a banking license in a foreign
country, then a bank can open an account with a bank in a foreign country or
open an account domestically with a bank that has a branch in foreign country.
For example, UBS can have a nostro account
denominated in Swiss francs at the SNB in Switzerland, but they can also have a
nostro account at Citibank in the US denominated in dollars. Both are “our”
accounts at other banks. UBS can also use SNB’s nostro account at the Federal
Reserve in the US to clear US dollar transactions.
There are several different ways that a foreign transaction
can occur. First, it is important to understand that dollars do not leave
the US during a foreign exchange transaction. Instead, all that happens is
basically accounting wizardry.
The most common way to settle a foreign exchange transaction
is for an international bank to have branches in two different countries. When
the international bank receives $100 in their US branch, they make a liability
and show the $100 as an amount payable in the future to the home branch of the
bank in Switzerland. In the Swiss branch of the international bank, they credit
the accounts receivable for the Swiss franc amount of the $100 at the spot
rate, which, for example, could be 98 CHF.
Until the bank closes the accounts payable, the bank has
exposure to currency risk from the spot price of the exchange rate changing. If
the Swiss branch needs the Swiss francs right away, then the bank must settle
the accounts payable in their American branch with the accounts receivable in
their Swiss branch. In order to close the accounts payable, they must go to the
foreign exchange market and sell their $100 and buy the CHF. When the Swiss
branch buys CHF, this means that a counterparty bank is willing to sell them
CHF. For example, if Citi Bank in Switzerland wants to sell 98 CHF Swiss francs
to UBS for $100, then Citi reduces the asset side of their balance sheet by 98
CHF.
The SNB reduces its liability to Citi by subtracting Citi’s
account at the SNB by 98 CHF. SNB shows UBS’s bank account as having more CHF
in it after the sale, and that represents a new liability for the SNB to UBS of
98 CHF. On UBS’s own balance sheet, they use the recently purchased Swiss
francs to clear out their accounts receivable on the asset side and
simultaneously increase their reserves on the asset side. The New York branch
of UBS clears out the Accounts Payable, since it has now been paid and they
must reduce their asset side of $100 in reserves because they sold the reserves
to Citi. This shows up on the Federal Reserves balance sheet as $100 less in
liabilities to UBS and $100 more in liabilities to Citi. Citi show their asset
side of their balance sheet increase by $100 in the capital account.
This is an example of a swap, and each bank is dealing with
the central bank in their domestic country for final settlement. No Swiss
francs or US dollars actually leave the country.
About 85 % of all global transactions are settled in US dollars through the Federal Reserve System in the US. Therefore, the Federal Reserve is not only a central bank for the US, it is also a central bank for the whole world. Citi Bank is able to charge foreign exchange fees to settle an international transaction even if they do incur any fees themselves because they have bank accounts in foreign currencies all around the world. However, the fees that Citi incur are somewhat justified from the fact that Citi has to keep liquidity tied up in foreign currencies available for settling transactions, which has an opportunity cost. This is the market that Ripple Labs Inc. argues that XRP can disrupt. However, XRP would need stable purchasing power, and Ripple would need to be a lender of last resort. In order for XRP to really gain adoption as a bridge currency, that would mean that we also need to trust XRP and Ripple Labs Inc. more than we trust the US dollar and the Federal Reserve.
[34] For the best explanation of a domestic transaction see “Flow of Money – Payment System” [YouTube video], Wayne Vernon, October 1, 2015.
[35]
For the best explanation of a foreign exchange transaction see “Flow
of Money – Foreign Exchange” [YouTube video, Wayne Vernon, September
17, 2016.
“Money is an honest ledger that individuals use to keep track of real wealth, defined as productive assets. Sorry Facebook but real wealth doesn’t include ‘bank deposits and short-term government securities. That said, thank you Facebook for widening the conversation about what money really is. That is a true service to society. Libra is the first denationalized ‘money’ that billions of people in the world will encounter.”
Libra is challenging the US dollar. If every Western depositor were to move a tenth of their bank savings into Libra,its reserve fund would be worth over USD 2 trillion, making it a big force in financial markets.
Libra is viewed critically by many economists, politicians, and public intellectuals. Their concerns revolve around privacy, trading, national security, and monetary policy. The Libra Association based in Switzerland will be responsible for managing the financial reserves that back the currency, and this will always be a single point of failure that makes it more centralized than Bitcoin.
Although many state officials have a negative perspective on Libra, Facebook’s digital currency could turn out to be a boon for government, since Libra could funnel third-world savings into first-world debt. That is why Libra is a wolf in sheep’s clothing.
Will we witness the end of state money monopoly during
our lifetime? Andreas Antonopoulos recently gave a speech in Scotland about
how the next decade will witness competition between three types of money:
state money, corporate money, and decentralized cryptocurrencies.
Over the past decades, the state money monopoly has rarely
been called into question. In the 1970s, Nobel laureate Friedrich August von
Hayek articulated the idea of competing, non-state currencies in his book The
Denationalization of Money. For a long time, Hayek’s ideas were regarded as
theoretical thought experiments far removed from economic and political reality
and, therefore, received no broad public attention. Five decades later,
however, with the advent of the Internet and the development of Bitcoin, we are
returning to the debate. The phenomenon of cryptocurrencies has led the broader
public to focus on the issue of money, what is money and how to create the
optimal money?
Facebook announced
that they will be launching a cryptocurrency named Libra. In collaboration with
28 large companies including PayPal, eBay, Visa, Mastercard, and Uber, Facebook
has raised USD 280 million and hopes to raise USD 1 billion in total before the
launch of the coin in 2020. What is called the Libra Association is projected
to reach one hundred different members, which are supposed to be geographically
dispersed through the globe. None of the members shall have more than one percent
of the votes within the system – not even Facebook. The conglomerate of
companies will base their operations in Geneva instead of the USA because of
Switzerland’s friendliness towards the blockchain technology. Facebook has
plans to integrate a wallet called Calibra on the Facebook messenger
applications and on WhatsApp, which combined has over 1.7 billion users around
the world. At the same time, Calibra is set up as a regulated subsidiary to
ensure there will be a separation of social and financial data. This way, Calibra
is aiming not to share customers’ account information or data with Facebook
unless the subsidiary is to prevent fraud or comply with certain regulations.
On the more technical
side, Libra is structured as an open-source project, allowing all sorts of
developers to read, build, and provide feedback.[1] As marketed, this open-source protocol will go
by the name of Libra Core, while the Libra network is supposed to be powered by
what is called the Libra Blockchain. The latter will be using Merkle trees and
a Byzantine Fault Tolerant (BFT) consensus protocol, both of which are
technologies associated with the blockchain technology. Nevertheless, Libra
will neither be using blocks nor a chain, but rather a single data structure
that records the history of transactions and states over time.[2]
The Libra network
is referred to as a permissioned blockchain. Unlike Bitcoin, the Libra network is not open for anyone to run a node. As
for now, members must be given permission to connect their servers in order to
record and validate transactions on the network. Only in the future, the Libra
network is supposed to be transitioning to a public blockchain, according to
Facebook. This obviously is a bold statement to make. If Libra will be able to
pull this off and become a permissionless system, it’d be really one of a kind.
If history tells us anything though, chances of the Libra project becoming
decentralized are rather weak. In this context, Nic Carter, partner at Castle
Island Ventures and cofounder at Coinmetrics, with great irony pointed to a
famous quote by Friedrich Engels talking about state become obsolete at one point
in time:
“The interference of the state
power in social relations becomes superfluous in one sphere after another, and
then ceases of itself. The government of persons is replaced by the
administration of things and the direction of the processes of production. The
state is not ‘abolished’, it withers away.”[3]
As we know today,
things have turned out quite the opposite from what Engels imagined. And even
if Libra should succeed in becoming more decentralized over time, there remain
central points. After all, as long as Libra will be tied to a basket of
reserves, there’s always the need for a third party to manage the reserves,
which would mean the project would at least have one point of centralized
control.
The most interesting
aspect of this new medium of exchange and its basket of reserves is that the
value will not be pegged to the US dollar, which means that it will have a
floating exchange rate with the dollar. The currency’s value will be backed by
a basket of assets including currencies and bonds from all over the world.
Facebook’s stock responded kindly towards this news with a 4 % increase on the
day of the announcement as shown in the figure below. Regulators in the US and
Russia have already expressed their concerns regarding the currency and rightly
so. As longtime Bitcoin enthusiast and CEO of Shapeshift Erik Voorhees has
expressed, the fact that Libra is not backed by the US dollar alone, will have
profound implications. As Erik envisions, Libra could arguably become a
medium-term replacement to any single government fiat currency because it is a
conglomeration of many different fiat currencies, which makes it into a more
diversified asset.[4] In our age of currency wars, this could be a
very desirable feature going forward.
Figure 2: Price Hike of Facebook’s Stock in Response to Libra.
Source: Yahoo Finance, Incrementum AG.
Since the media
depicted Libra as a fierce competitor to banks – it is interesting that no
single bank has been announced as one of the 28 founding members. Since this is
also a competitor to the US dollar, it was no surprise that politicians reacted
in a negative tone towards Libra.
For the banks, the
Libra project could indeed become a nightmare. In terms of reaching customers, Facebook is
way beyond what even the biggest banks like JP Morgan, Citibank, or Goldman
Sachs, could ever reach. If every Western depositor were to move a tenth of
their bank savings into Libra, its reserve fund would be worth over USD 2
trillion, making it a big force in bond markets.[5] This would certainly affect banks badly, since
they would see their deposits shrink, which could then trigger a panic over
their solvency. In our world of today, banks have become too big to fail. A
competitor like Libra that could seal their fate and be the nail in their
coffin, doesn’t come over unnoticed. In a quest to critically assess the newly
planned digital currency, economists, politicians as well as other technocrats
have turned their attention to Libra.
Above all is the US
government, which is taking Libra quite seriously. In a letter from the US House
of Representatives to Mark Zuckerberg, Sheryl Sandberg and David Marcus, the
representatives openly express their concern about Libra being a direct rival
to US monetary policy and the US dollar.[6] Consequently, Zuckerberg and his associates
were requested to agree to a moratorium on any movement forward on Libra, so
issues regarding privacy, trading, national security, and monetary policy
issues could be discussed.
First paragraph of the US Committee on Financial Services’ letter to Facebook. Source: Crowd Fund Insider, see reference no. 6.
As always, this is
only one side of the coin. In fact, there are also many reasons why the US
government should support Facebook’s Libra. The main one being the ability for
regulators to access information regarding financial transactions if necessary.
As such Libra has already been described as Facebook’s GlobalCoin, since it
could enable a global techno-panopticon that could be used by governments
around the world to monitor people’s financial affairs.
What sounds bad from a
Libra user’s perspective, could, be bullish for Bitcoin in the long run. This
could bring the world one step further towards Bitcoin and co., with the next
decade witnessing a fierce competition between centralized currencies like
Facebook’s Libra, Apple Pay, Google Pay, and decentralized currencies like
Bitcoin. Interestingly enough, the genie of private money is out of the
bottle. Politicians and other functionaries will have to come to
acknowledge that the future will be a future of competing monies – there is
nothing anybody can do to stop it.
Two Scenarios for Regulators
Bitcoin is not even used by 1 % of the world’s population,
but Bitcoin is ruffling the feathers of the top 1 %. Even the highest
political bodies will have to get used to being increasingly confronted with
this issue.
Scenario One: Governments are Really Against
Libra
Various high-profile US officials have raised concerns about
Libra. In June, the chairman of the US Federal Reserve, Jerome Powell, spoke at
a hearing before the US Senate in which he was asked several times about
privately issued currencies such as Facebook’s Libra, but also about decentralized
cryptocurrencies, such as Bitcoin. Powell stated, “Libra raises serious
concerns regarding privacy, money laundering, consumer protection, financial
stability.” Because of a whole lot of open regulatory questions, the project “cannot
go forward” without having clarification on matters concerning regulations and
the law in general. This is also why the US central bank had already met with
Facebook representatives before the announcement of Libra and set up a working
group to work tête-à-tête with the tech giant.
Taking the same line was Treasury Secretary Steven Mnuchin,
signaling concerns that Libra could be a criminal’s tool for money launderers
and terrorist financiers. Counterarguments pointing out the fact that the US
dollar is by far the most laundered currency in the world were played down by
Mnuchin referring to the fact that the US anti-monetary standards are among the
strictest in the world. The treasury secretary’s message was clear: Regulators
will do everything to protect the stability and integrity of the overall
financial system from abuse through private monies. As he stated, they will
make sure that Bitcoin doesn’t become the equivalent to Swiss numbered bank
accounts.[7]
From a more skeptical perspective, it could be said that concerns about money laundering and terrorist financing are just a pretense. What politicians and other state officials are really worried about is losing their monopoly power over money, which enables them to buy votes from voters by promising “free” stuff and then quickly turning on the printing presses. But to camouflage their plea for money they don’t have, officials disguise their criticism as a lack of trust vis-à-vis Facebook and their endeavor to launch a private currency.
However, the regulators seem to have come to grips with what the new development of corporate money and cryptocurrencies really means. There’s a high chance that the regulatory screws will be tightened going forward, which will affect cryptocurrencies like Bitcoin as well.
Scenario Two: The US Government Figures Out That
This is Good
Rahim Taghizadegan of Scholarium
in Vienna cleverly pointed out that western governments should actually be in
support of Libra. Since Libra will hold a significant amount of western
government debt and their currencies, this can actually facilitate an enormous
redistribution of wealth from the Asia, the Middle East, and South America to
the western world. Since each Libra will be fully backed, this means that Libra
can tap into global household savings and use those savings to buy US and
European government debt and fiat currency. Along the same lines, Pascal Hügli,
a journalist from Switzerland and frequent contributor to this report, has
described Libra as a sort of tool allowing the first world to extend its
expansionary monetary policy to the third world. In his view, Libra is one more
attempt at keeping our fading era of paper money from coming to an end – an end
that is inevitable and is slowly but surely ushered in by the new digital age
accompanied and fostered by Bitcoin and things coming from it![8]
So contrary to current political opinions, Libra could
actually turn out to be a life buoy for the dollar by propping it up for
another decade while Facebook quietly siphons of savings from households in South
America, Africa, and Asia and into the coffers of the US government via bond
purchases. Since third world savings would be funneled into first world debt
via government securities, the governments’ respective currencies, especially
the dollar, would appreciate, or at least not depreciate as quickly as would
absent Libra. Although it is true that the Libra Association isn’t bound to
back Libra with US treasuries, there is a realistic chance that Libra and US
government will go hand in hand to negotiate a win-win deal for both of them.
[1]
S“Libra will be open-source under an Apache 2.0 license, allowing developers to
read, build, provide feedback, and take part in a bug bounty program. Testnet
is launching soon. Mainnet will be launched in 2020.” [Tweet],
Larry Cermak, Twitter, June 18, 2019.
[4]
See “Thoughts on Libra (and my first
tweetstorm!): first, zoom out for a second and realize how far this industry
has come. The biggest companies in the world are now launching
cryptocurrencies. BOOM.” [Tweet], Erik
Voorhees, Twitter, June 18, 2019.
[5]
See “Weighing Libra in the balance. Facebook wants to create a global
currency,” The Economist, June 22, 2019.
[7]
See “Are you saying cash has never been
used for illicit purposes, @joesquawk
asks in response to Mnuchin’s concerns about #btc ‘We are going to make sure that bitcoin doesn’t become
the equivalent to swiss numbered bank accounts’ says @stevenmnuchin1” [Twitter Video], Squawk Box, Twitter,
July 18, 2019.
