What a summer this is shaping up to be! Last time we spoke, Bitcoin was trading at $9,150. We have rallied over 50% since then and proceeded to give back much of that gain. I will take my customary look at the markets later on but it is safe to say that we are in for an incredible remainder to this year.
In this edition of State of the Crypto I cover:
The Excess of Platform Protocols
Q3 Market Outlook
Ethereum 2.0 - A Brand New Blockchain
I am sure that most of you have a familiarity or have heard of Ethereum and it's crypto asset ETH. For those who have not, Ethereum is a blockchain designed for things called smart contracts and decentralized applications (DAPPS).
Smart contracts refer to code-based contracts that can self-execute specific functions when certain preconditions are triggered. For instance, if Alice wants to buy a product, she might send 1 ETH to a smart contract. The contract would then verify this payment and send commands for the delivery of the product.
DAPPS are as the name implies, applications that do not run on a centralized server or infrastructure. Traditional internet services like Facebook, Google or Twitter all operate on top of centralized and proprietary systems. This centralization allows for the high speeds and customer experiences we encounter. However, this also brings with it multiple drawbacks such as susceptibility to hacks, abuses of personal data and most importantly, censorship. Decentralized applications seek to reverse this dynamic and return autonomy to the user. The Ethereum blockchain serves as the underlying infrastructure to these services.
While Ethereum solves the problems of censorship, data autonomy, and infrastructure fragility, it has had to make the tradeoffs of scalability and speed. The decentralization of Ethereum and similar blockchains depends on its network of thousands of nodes. These nodes all run the Ethereum software and constantly validate the state of transactions and the blockchain. Every computation has to be checked and approved by every Ethereum node. For several reasons, this means that Ethereum is incapable of handling anywhere close to the capacity that it aims to.
For the past several years, Ethereum developers have delivered several incremental upgrades to the existing blockchain. However, recognizing the extent of its capacity deficit, developers are working towards a brand new blockchain called Serenity with a radically new design. Supporters of the project hope that this new and improved Ethereum can support DAPPS and other decentralized systems capable of altogether replacing the existing internet giants.
This new blockchain introduces three main new features.
Proof of Stake
The first among these is a brand new consensus model based on Proof of Stake (PoS). Right now Ethereum uses Proof of Work (PoW), commonly referred to as mining to secure its blockchain and verify transactions. Critics argue that this process wastes electricity and is vulnerable to consensus attacks. The most common form of these attacks is a so-called 51% attack. This happens whereby a malicious party gathers enough mining equipment to control the majority of mining power. Through this control, the attacker can control the state of the blockchain, reverse transactions and undermine the censorship-resistance that makes blockchains so powerful. Unsurprisingly, the extent and ramifications of this threat are far more nuanced than we have time for. Advocates of PoW defend it vociferously, believing it is the optimal security model. With Ethereum’s new PoS consensus model, however, mining will disappear and be replaced by users locking up and ‘staking’ their ETH. By holding and locking up this ETH, users help to secure the network and in turn, will be rewarded with additional ETH on a regular basis in tune with the inflation rate. Arguably this will democratize and decentralize the consensus process, as differentiating electricity costs will no longer affect the ability to participate. That being said, you will likely need a large amount of the asset (estimated at 32 ETH) to become a staker. Aside from these changes, PoS leads the way to the second new feature, sharding.
Sharding is a proposal to split the Ethereum blockchain into hundreds of sub-components or ‘shards’. As such, it will allow for a vast increase in capacity. Developers hope that sharding will deliver a 1000-fold improvement in scaling, increasing the capacity from the current 15 transactions per second (tps) to 15,000 tps. The implementation of this technology will take two years for full integration, with finalization expected in 2021.
The final change relates to Ethereum’s handling of computations. The Ethereum Virtual Machine (EVM) is responsible for handling the computations of all the DAPPS, smart contracts, and token exchanges. Currently, the EVM is written in a programming language, unique to Ethereum called Solidity. Ethereum 2.0 will replace this EVM with a new machine called the Ethereum flavored Web Assembly (EWASM). The EWASM will instead allow developers to write their DAPPS in a variety of different languages. This should, in turn, reduce frictions to development and allow for more secure applications. Like sharding, the EWASM should go live in 2021.
The above three components are the main initial changes, delivered by Ethereum 2.0. Beyond this, developers have plans for super-quadratic sharding which could lead to exponential scalability increases, privacy upgrades through zero-knowledge proof technology and radical changes to the tokenomics through the introduction of storage rent.
The full transition to this new blockchain will take several years and delays should be expected given the cutting-edge nature of the project. While there should be notable milestones in 2020, the benefits of Ethereum 2.0 will most likely not be realized until 2021.
Capitalizing on Ethereum’s slow development, many rival projects have positioned themselves as ‘Ethereum killers’. Projects such as EOS, Cardano, Tron, Tezos and Neo have claimed that they can serve the needs of DAPPS with much faster speeds and lower costs. All of these blockchains, along with Ethereum fall into what I call platform protocols.
Platform protocols are a distinct category of crypto assets and should not be conflated with monetary assets like Bitcoin, utility tokens or other emerging categories such as stablecoins and security tokens. Platform protocols are typically neither designed nor marketed to be used as money. Rather, they are built to serve as the underlying infrastructure for DAPPS and sophisticated smart contracts.
You may have noticed that beyond the projects already mentioned, there are a plethora of competing platforms. It is my contention that the majority of these rival projects have little fundamental value. Indeed overall, this category of crypto assets is over-valued relative to monetary assets.
Total Addressable Market
The monetary crypto assets like Bitcoin, Litecoin, Bitcoin Cash, Monero, DASH and Zcash among others have a clear and quantifiable target market, namely money and currency. The latest figures on the total world supply of money and currency stand at $86.47 trillion according to the CIA. That sum represents the total addressable market (TAM) for crypto monetary assets. Not only is this an enormous amount, but most importantly it is objective and measurable.
The same cannot be said for the platform protocols. Despite the advancement of valuation models in this space, there is still no solid methodology for quantifying the TAM for any of these platforms, simply because their target market does not clearly exist. Bear in mind these blockchains aim to replace the existing foundation of the internet. However, there is no good way to measure the current value of this infrastructure. It certainly pales in comparison to the value of money.
Notwithstanding these valuations problems, there are several other major problems that grip these blockchains. For one, it is highly debatable whether many of them actually are decentralized at all. Projects such as EOS, for instance, have sacrificed true decentralization for speed and scalability. Making such a sacrifice, in my opinion, undermines its entire value proposition. Decentralization and the censorship-resistance that this offers is the main purpose of using a blockchain in the first place. Without this guarantee, developers would be just as well using the current legacy infrastructure available.
Furthermore, there is insufficient evidence that there is sufficient demand for all of these platforms. Outside of finance and perhaps the gaming industry, there have been very few successful use cases of DAPPS. The blockchain industry has the habit of creating an echo chamber whereby we assume that everything should be decentralized. This is at best naive and at worst delusional. Over time we can expect applications to migrate towards this state, however, for now, there is insufficient incentive for the kind of mass exodus that would be needed to justify the number of platforms we currently have.
There is insufficient differentiation among all these protocols and I expect most to either wither away or experience slow growth. While I do not give advice, my own approach is to never have much more than 10% of my crypto portfolio in such assets. Of that 10%, the majority is in ETH. The existing network effect of Ethereum with the number of active developers and the extent of its supporting ecosystem, in combination with the deployment of Ethereum 2.0 makes it the most attractive platform to me. For this to change in a meaningful way, I would have to see a major fundamental failure to the project or rapid development and growth from its competitors to warrant a change to this investment thesis.
As of today, Bitcoin stands at $11,250 and the total crypto market cap at $321 billion.
After the BTC top at $13,850 on 26th June, we are experiencing consolidation and a tightening. As the chart below shows, Bitcoin is coiling up, with lower highs and higher lows, alongside falling trading volume, something typical of such patterns.
This pattern will have to be resolved within the next few days. Given the strength of the prior move up, we have to lean bullish and consider a break-up as the most likely scenario. A break of the upper resistance line and falling trend line with an intersection at $11,650 would serve as a bullish signal for a breakout as shown. Conversely, a break below $10,800 would be a bearish signal. Please note these are both early signals and do not ensure a clean break either way. These should be considered as warnings and confirmed by breaks of secondary support ($9,850) and resistance ($12,400), also marked as red lines.
If Bitcoin breaks bullish and beyond the local top of $13,850, I fully expect it to move to $20,000 and all-time highs soon after. There is some weak resistance in the $17,000 region, however, is unlikely to prove strong enough to block a move to and beyond $20,000.
Given that bullish scenario for BTC, I continue to expect the altcoins to begin to outperform BTC significantly.
As you can see below Bitcoin dominance is extremely high relative to the past two years. Bitcoin dominance is simply a percentage of Bitcoin’s market cap as a share of the total crypto market cap. It measures the strength of Bitcoin relative to the rest of the market cap. It currently stands at 62.3%. Bitcoin has previously run up to this number and subsequently fallen twice before, in October and December of 2017. This marks an area of historical resistance. It is, of course, possible that this resistance could be broken and the altcoins could continue to underperform, however, given the historical significance of this level, it pays to respect it and prepare for a decoupling.
An alternative scenario and one akin to late December 2017, would be for BTC to test its all-time highs, pushing its dominance to 75-80%, followed by a rapid outflow into the altcoins and a collapse of BTC dominance. Although this is perfectly feasible, given the already high dominance level, I would rather be mainly positioned in the major alts.
This week I continued to buy, however, mainly positioning into the major altcoins in preparation for this decoupling. We should expect the major altcoins such as Ethereum, Litecoin, Bitcoin Cash, etc to start off the strongest, followed by the medium and small-cap altcoins, as capital flows through the market.
I hope that you found this edition useful and informative. As ever, none of this is investment advice, please do your own research!
I would love to hear your feedback on these newsletters. If there is a particular topic or angle that you would like me to discuss, then do please let me know and I will be sure to tackle it in future editions.
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