Author: shyam

define: ethereum

an alternate parallel digital universe

A 17-year old boy looks at bitcoin and sees the possibility of creating a world computer that can run an alternate universe. His name: Vitaly Dmitriyevich “Vitalik” Buterin.

Vitalik dropped out of school in 2014 when he was awarded with a grant of $100,000 from the Thiel Fellowship to work on Ethereum full-time.

To understand Ethereum, one needs to first understand massively multiplayer online role-playing games (MMORPGs.)

Games, Networks and Virtual Universes

Parents have been yelling at their kids since the days of Atari’s Pac-Man about spending too much time in front of the screen.

It will melt your brain! Why don’t you go out and play like normal kids!

Over the last four decades, games got progressively realistic, immersive, networked, multiplayer, and pervasive. People started spending more on games, gaming rigs, and consoles. Video game makers moved away from a one-time, hit-based production system to creating virtual spaces where gamers can write their own story. The metaverse was born.

The metaverse is to game makers that SAAS is to enterprise software. Once a metaverse crosses a tipping point, network effects kick in and revenue explodes. Some gamers, the whales of the metaverse, spend an obscene amount of real money buying virtual goods. Everything is for sale – avatars, dresses, weapons, skills – inside the metaverse.

Globally, recent estimates for annual virtual-goods revenues have totaled over $52 billion.

Gaming evolved into a sub-culture onto itself.

Boredom Kills

Metaverses have a big problem: they can implode if they get boring.

Back in 2003, Linden Lab launched Second Life – an online virtual world. By 2013, it had about one million regular users. Users, or residents, as they are called, can login using client software and create virtual representations of themselves, called avatars, and are able to interact with places, objects and other avatars. They can explore the world (known as the grid), meet other residents, socialize, participate in both individual and group activities, build, create, shop, and trade virtual property and services with one another.

The platform principally features 3D-based user-generated content. Second Life also has its own virtual currency, the Linden Dollar, which is exchangeable with real world currency (wikipedia.)

At the peak of its hype-cycle in 2006, American Apparel had a virtual store and even IBM had set up a “property.”

And then it died.

While media articles on its failure focus on buggy software, missing the switch to mobile, etc, the biggest reason was that it was owned by a company (centralized decision making,) that had to host and pay for the servers themselves (centralized scaling,) and there could be only one Second Life.

Ethereum is a platform on which another Second Life can be created on a distributed network not owned by a single corporation.

Ethereal

In a nutshell, the Ethereum platform allows programmers to write code that runs on a distributed network. To incentivize miners to run the code, they are paid in Ether (ETH.)

The code is called a smart-contract and to run it, you need to supply it with ETH. The code will do the work and consume the Ether. Both the code, and the ledger keeping track of ownership of the Ethers, are on a blockchain.

Technically, the code runs on many computers across the world, computing and storing data locally, but networking globally, to create a distributed ledger which is sometimes also called “a blockchain”.

With these basic building blocks, one can construct self-contained virtual worlds with virtual goods, etc.

Cryptokitties

CryptoKitties was the first mainstream use case for Ethereum’s blockchain. It operates as a non-fungible token (NFT), unique to each CryptoKitty. Each CryptoKitty is unique and owned by the user, validated through the blockchain, and its value can appreciate or depreciate based on the market. These virtual kittens (tokens) are also traded on crypto exchanges.

What is fascinating is not just the technology but the storytelling that made it real. The kittens are unique, supply-constrained, have traits (some of which are rare) that can be passed on through breeding, etc. There is an ecosystem of tastemakers and specialists around it that keep the story alive. And consumers willing to part with real money for virtual kittens.

DeFi – Decentralized Finance

Imagine a global, open alternative to every financial service you use today — savings, loans, trading, insurance, and more — accessible to anyone in the world with a smartphone and internet connection.

There are DeFi dapps that allow you to create stablecoins (cryptocurrency whose value is pegged to the US dollar), lend out money and earn interest on your crypto, take out a loan, exchange one asset for another, go long or short assets, and implement automated, advanced investment strategies.

This is a nightmare for regulators like SEBI and the RBI who are tasked to protect consumers. Who are you going to sue and who are you going to jail when there is no “owner” as in the real world?

For better or for worse…

Ethereum is the biggest crypto-currency after Bitcoin. There is a large ecosystem around the infrastructure breathing life into this alternate parallel virtual universe. It is here, it exists, and it is growing.

Some think that the current economic and political order is an accident of history. What if we had the opportunity to evolve an alternative? What would it look like? Don’t we owe it to ourselves to find out?

We leave you, dear reader, with these thoughts and a recording of our fascinating conversation with someone who is working on a PhD in crypto-currencies and who also happens to be a dear friend of mine. Enjoy!

Further reading: An Economic Analysis of Ethereum

Previously: define: bitcoin

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define: bitcoin

an infinitely divisible digital collectible

The Problem

When faced with a cash-crunch, whether due to wars or natural calamities, the first instinct of governments since time immemorial has been to debase their currency.

Take the Roman empire, for example. The major silver coin used during the first 220 years of the empire was the denarius. During the first days of the Empire, these coins were of high purity, holding about 4.5 grams of pure silver.

However, with a finite supply of silver and gold entering the empire, Roman spending was limited by the amount of denarii that could be minted.

This made financing the pet-projects of emperors challenging. How was the newest war, thermae, palace, or circus to be paid for?

Roman officials found a way to work around this. By decreasing the purity of their coinage, they were able to make more “silver” coins with the same face value. With more coins in circulation, the government could spend more. And so, the content of silver dropped over the years.

By the time of Marcus Aurelius, the denarius was only about 75% silver. Caracalla tried a different method of debasement. He introduced the “double denarius”, which was worth 2x the denarius in face value. However, it had only the weight of 1.5 denarii. By the time of Gallienus, the coins had barely 5% silver. Each coin was a bronze core with a thin coating of silver. The shine quickly wore off to reveal the poor quality underneath.

By 265 AD, when there was only 0.5% silver left in a denarius, prices skyrocketed 1,000% across the Roman Empire.

Traditionally, citizens of a country have limited options to escape a government hell bent on debasing their own currency. They could buy gold, but the government can find ways to restrict how much gold one could own. For instance, the US restricted gold ownership for over 40 years claiming that “hoarding” of gold was stalling economic growth and worsened the depression. In some left-leaning countries, people default to using the US Dollar as a store of value. But often, like in the case of Argentina in 2001, the government can freeze bank accounts and restrict withdrawal of hard currency. One could try to accumulate hard assets, like land, for example. However, real-estate is not portable and can always be sized by the government, like India in the 1950’s and South Africa in the mid-2000’s.

Each of these traditional assets have trade-offs.

  • Gold: cannot be used for electronic payments. But everybody knows its price and is a trusted store of value.

  • US Dollar: centralized clearing either through SWIFT or ACH means the US Government can shut you off at any time. But it is a widely accepted medium of exchange (world trade is denominated in it.)

  • Hard assets: not portable, one-of-a-kind, tough to value and transact with a high liquidity premium. But is known to hold its value through inflationary environments.

Bitcoin was designed to overcome most of these problems.

The Solution

Bitcoin is meant to be a decentralized, fixed-supply, infinitely divisible, digital currency.

Decentralized: there is no central ledger or clearing-house for bitcoin transactions. All bitcoin transactions are written on a blockchain. To win the right to write to the blockchain, miners compete and if they win, are awarded bitcoins. Anyone can become a miner, so transactions are settled by a distributed network of miners that does not require a central authority.

Fixed-supply: there can be only 21 million bitcoins in total. This makes it impossible to be debased like regular currencies.

Infinitely divisible: bitcoin’s smallest unit is called a “satoshi.” It represents one hundred millionth of a bitcoin, or 0.00000001 BTC ($0.00035 USD, at current price.)

Digital: you access your bitcoins through a unique 34-character key. There is no other identifier tying you to your bitcoins. You can use many such keys to send, accept, and store your bitcoins anywhere in the world.

A shared illusion

As far as I can tell, money is a shared illusion. We have a lot of beliefs in various systems, whether it’s the universe or government or organized religion, that serve more of an existential function to give us a sense that there is some order in the world. A big part of money’s function is the ability to help us measure things in an understandable way. – Adam Waytz, Kellogg School of Management

Money is whatever a group of people can agree on that is

  1. a store of value

  2. a medium of exchange

  3. a unit of account

It is not necessary to use a government-issued currency (fiat) to achieve these ends. However, since taxes can only be paid in fiat and the government can use violence to extract the taxes owed, it is often convenient to keep using it.

It is no wonder that even though the technical pieces of bitcoin have been around since the mid 90’s, it took the shock of the 2008 Global Financial Crisis to breathe life into it. With widespread panic, bank runs, countries at the brink of default, and evaporating faith in the global financial system, the time was ripe for an alternative to emerge.

An elegant solution to a well defined problem… with trade-offs

From a technical point of view, bitcoin does what it says on the tin. And the code that drives all of it is public. There are no surprises. But every solution has tradeoffs. Bitcoin’s biggest trade-off is that settling transactions is extremely slow and expensive.

There is no hard limit to how long bitcoin transactions can take to be confirmed. It can take anywhere between 10 minutes and over a day. The two biggest influences on the confirmation time are the amount of transaction fees and the activity on the network. This is not something that can be used for micro-payments, like buying a cup of coffee. But this is only one part of the problem.

New bitcoins enter circulation as block rewards, produced by miners who use expensive electronic equipment to earn or mine them. Every 210,000 blocks, or roughly every four years, the total number of bitcoin that miners can potentially win is halved. But the consequence of this dropping block reward is that eventually, it will dwindle to nothing.

In a few decades when the reward gets too small, the transaction fee will become the main compensation for nodes. I’m sure that in 20 years there will either be very large transaction volume or no volume. – Nakamoto

When you learn that the total annual energy consumption of the Bitcoin network is comparable to the power consumption of Chile, you’ll immediately understand why this is a problem.

This makes #2 of what makes something money questionable in the context of bitcoin. If you can’t use something to transact for everyday needs, is it really money?

Volatility kills accountants

The volatility of Bitcoin is roughly three times higher than that of most country currencies. Compared to a currency pair like USDCAD or USDEUR, which barely breaches 2% (10-Day) volatility even during the Great Financial Crisis, Bitcoin at its lowest volatility is lucky to be below 2%. And this is true even if you compare it with other least-developed country currencies.

The problem with this kind of volatility is that if you own bitcoin denominated assets, what is it worth? This makes the #3 reason of using something as money questionable in the context of bitcoin.

Bitcoin is more like art, less like money

Picasso’s Les femmes d’Alger was sold for $179.4 million in May 2015.

What makes a piece of art valuable? It just sits there and does nothing. So, like bitcoin, it obviously has no intrinsic value. And, like bitcoin, supply is usually capped because the artist is usually long gone. Also, like bitcoin, there is an ecosystem around art comprising of auction houses, galleries and museums that promote a shared myth.

The #2 and #3 use-cases of money is barely met by bitcoin. But bitcoin fits nicely into the art metaphor. With two big differences.

  1. Art, unlike bitcoin, is not divisible. This means that the price of a piece of art is capped by how much someone is willing and able to pay for it. Bitcoin has no such constraint. If someone with $10 buys a fraction of bitcoin for $50,000, then that price gets printed.

  2. Bitcoin is completely digital. Bitcoin represents digital scarcity, which, before Bitcoin, had almost no solutions. Before bitcoin, only things in the real-world were not “copy-pasteable.”

This makes bitcoin an infinitely divisible digital collectible.

We leave you, dear reader, with these thoughts and a recording of our fascinating conversation with someone who is working on a PhD in crypto-currencies and who also happens to be a dear friend of mine. Enjoy!

Sources:

Currency and the Collapse of the Roman Empire

Executive Order 6102

Corralito

Zamindar

Land reform in South Africa

Money: The myth we all believe in

Crypto Assets

How Long Do Bitcoin Transactions Take?

Bitcoin Halving, Explained

Bitcoin Energy Consumption Index

Why Bitcoin Has a Volatile Value

Evolution of bitcoin: Volatility comparisons with least developed countries’ currencies

The Value of Art: Money, Power, Beauty

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Cross-Asset Time-series Momentum

Trend-following systems typically use the past performance of a particular asset to trigger a buy or a sell on that asset. A research paper that came out in 2019 looked at whether the historical performance of multiple assets can be used to trade them.

Pitkäjärvi, Aleksi and Suominen, Matti and Vaittinen, Lauri Tapani, Cross-Asset Signals and Time Series Momentum (January 6, 2019). Available at SSRN: https://ssrn.com/abstract=2891434

From the abstract:

We document a new phenomenon in bond and equity markets that we call cross-asset time series momentum. Using data from 20 countries, we show that past bond market returns are positive predictors of future equity market returns, and past equity market returns are negative predictors of future bond market returns.

Unfortunately, the paper did not look at Indian markets to check if this worked. So, we rigged up a simple backtest to see for ourselves.

Rules

A simplified equity-bond cross-asset trading strategy at the beginning of month t can be constructed as follows: Compute the past 12-month equity return (E past) and the past 12-month bond return (B past). If:

a) E past is positive and B past is positive: Buy equity
b) E past is negative and B past is negative: Sell equity
c) E past is negative and B past is positive: Buy bonds
d) E past is positive and B past is negative: Sell bonds
e) Otherwise, invest in the risk-free rate.
Hold the portfolio for one month and then repeat the same procedure in month t+1 (source.)

Backtest

We used the NIFTY 50 TR index to represent equities, NIFTY GS 10YR index for bonds and the CCIL Index 0-5 TRI for risk-free rate.

Since our risk-free index starts only from 2004, our backtest only goes back 16 years. However, the markets have been through a lot since then, so it is unlikely we are losing much by not being able to go back much earlier.

The 12-month look-back approach massively under-performs the NIFTY 50 TR buy-and-hold. We shortened the look-back to 3-months to see if we could make the strategy more responsive to trend reversals.

To our dismay, we saw only marginal improvements in overall returns but the draw-down profile of the long-only portfolio was much better.

Conclusion

While the approach outlined in the paper might be valid for the selected subset of markets, it fails a simple backtest on Indian market indices.

Code for the backtest can be found on github.

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Book Review: Lords of Finance

In Lords of Finance: The Bankers Who Broke the World (Amazon,) author Liaquat Ahamed goes deep into the personalities of central bankers in the years between the first and second world wars – their many foibles and their obsession with the gold standard.

Some interesting titbits regarding the gold standard

Experts thought that the First World War would end a couple of weeks because European economies were so tightly intertwined that the cost of a prolonged war would be unbearable.

So smug were the bankers and economists that they even allowed themselves to be convinced that the discipline of “sound money” itself would bring everyone to their senses and force an end to the war. The experts seemed to have forgotten that among the first casualties of war is not only truth but also sound finance.

In four years of constant and obsessive battle, the governments of Europe had spent some $200 billion, consuming almost half of their nations’ GDP in mutual destruction.

After the War, there was a universal consensus among bankers that the world must return to the gold standard as quickly as possible. The biggest obstacle to such a return was the mountain of paper currency issued by the central banks of the belligerent powers during the war.

Take Britain, for example. In 1913, the total amount of money circulating in the country—gold and silver coins; notes issued by the Bank of England and by the large commercial banks; and the largest category, bank deposits—amounted to the equivalent of $5 billion. This supply of money, in all its various forms, was backed in aggregate by the country’s $800 million of gold.

By 1920, the Bank of England had lent so much money to the government to help pay for the war effort that the total money supply had ballooned to the equivalent of $12 billion. Britain’s gold reserves meanwhile remained roughly the same. Thus, whereas in 1913, there had been 15 cents worth of gold within the country for every $1 dollar in money, in 1920 each $1 of money was backed by less than 7 cents.

Maynard Keynes was strongly against the resumption of the gold standard.

His main point was that under current arrangements, given that U.S. gold reserves were so dominant, to tie the pound to gold in effect meant tying it to the dollar and the British economy to that of the United States—and by implication, to Wall Street.

However, the US and Europe decided to tether themselves to the gold standard. And the rest, as they say, is history.

Take-away

History is often presented as a linear sequence of pre-ordained events. However, reality is a lot more random. People responsible for setting the course of history are, at the end of the day, human. They act out in anger, claim the moral high ground and dig themselves into irreversible positions, often putting their egos ahead of doing the right thing.

In hindsight, the triggers for the First World War seem trivial, the punishing restitution imposed on Germany by the Allies seems petulant, the moral arguments in favor of returning to the gold standard seem anachronistic and the inability of the US Fed to decisively act against bank failure in the early 30’s seems like a huge failure. However, for the people making those decisions, it seemed entirely rational, logical, right and inevitable.

Recommendation: Read the epilog first and the rest of the book if you find that interesting.

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Moats are for never

Be wary of #neversell

When Buffett-heads are asked about when they are likely to sell a stock, they often bring out this quote from the Master:

A common-sense parsing of the actual quote would over-weight the “outstanding businesses” bit over “forever.” However, the quote has been deliberately misinterpreted by asset-managers (who are paid as a percentage of AUM) to keep investors tied into their funds in spite of extended periods of underperformance.

Corporate history is replete with examples of companies that once had the widest of moats but withered nonetheless. The most recent posterchild is Intel.

Over the last decade, Intel (INTC) trailed the broader S&P 500 and Nasdaq indices with the final death-blow being dealt by Nvidia.

Twenty years ago, could you imagine a world without Intel? Now you can. Apple, Samsung, Amazon, Google and Microsoft are all in the process of developing or have already developed processors to run their operating systems and power their data centers. For a deeper dive, read this excellent piece by James Allworth.

And it is not just hardware. Twenty years ago, could you have imagined that Infosys would beat IBM and the S&P 500? Yet, it did.

Oh! But that is tech, you might say. What about the “real” economy stocks?

Remember GE? Their six-sigma blackbelts were supposed to be cream-of-the-crop problem-solvers who could be parachuted into any situation.

While you can argue that the above companies were cherry-picked, the base-rates are more shocking

A recent study by McKinsey found that the average life-span of companies listed in Standard & Poor’s 500 was 61 years in 1958. Today, it is less than 18 years. McKinsey believes that, in 2027, 75% of the companies currently quoted on the S&P 500 will have disappeared. (IMD)

table 1 companies exiting and entering_smaller454

Often, experienced managers are experts at solving problems for an old world order. The “best” managements often miss creative destruction happening in their own backyard, like Kodak. Incentives typically are setup to reward reaching local maximas. So, it is entirely possible to hit every single quarterly number while steadily marching toward bankruptcy.

The Coca-Cola Company is an example where initial high expectations were merely met (and not exceeded) to the dismay of common-stock holders.

And what is true about individual companies it true about the broader market as well. A visit to Japan will blow your mind. But as an investment?

In fact, a simulation of historical country-index returns show that only DENMARK, USA and SWITZERLAND had an extremely small chance of posting negative buy-and-hold returns. Out of the 43 Country specific MSCI indices we analyzed, half had more than a 10% chance of giving negative returns to buy-and-hold investors. India had a 6% chance (The Buy and Hold Bet.)

No company lasts forever. No market will always remain the best one to be in. No investment strategy will always deliver market-beating returns. No investor can consistently beat the market year-in/year-out.

No investment is forever.

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