Thomas Kirchner

Thomas Kirchner is a fund manager at Quaker Event Arbitrage Fund. He studied at King's College London, at the Institut d'Etudes Politiques de Paris and at the University of Chicago Booth School of Business. He worked in Frankfurt for the Banque Nationale de Paris and in Washington, D.C. for Fannie Mae. Today he lives in New York.

Source: shutterstock Balkanizing: crypto currencies

Cyber money bubble:Six Reasons Why Crypto Currencies Fail to Meet Expectations

On Bitcoins, frauds and limitations of technology

Venezuela has a crypto currency, the Petro. Reports of its launch in March alone should have been a warning to anyone considering investing in crypto currencies. It illustrates how the current hysteria around cryptos attracts fraudsters and shady treasure hunters just as much as technologists.

Crypto currencies are not necessarily bad and certainly no threat to the financial system. Many anti-crypto arguments advanced by central bankers, politicians and academics locked in their ivory tower range from irrelevant to plain dumb. But similarly naive is the unreflected enthusiasm of crypto advocates, some of whom have gained untold riches in the current bubble, an experience that appears to have clouded their judgment. Crypto currencies are technically immature and are still in an early stage of development. Too early to be of value for the general public.

1. Crypto currencies are obsolete and balkanized

Anything involving crypto-this or blockchain-that is considered hip and innovative. So innovative, that it creates problems of its own. Every week, someone comes up with an idea how to improve crypto currencies and then launches a new crypto currency that incorporates this improvement. For example, if you are worried about lack of anonymity in the blockchain, there is a crypto currency that addresses exactly that (Bytecoin and its derivatives), or you may be environmentally conscious and concerned about energy efficiency – well, there is a suitable crypto currency for that, too (Burst Coin). But practically no currency incorporates more than one incremental improvement. What if you are concerned about both energy efficiency and anonymity? There is no crypto currency for you – yet. Your solution? Launch your own crypto currency and hope that you will find enough like-minded followers to get rich.

The result is a complete balkanization of the crypto space. 1,500 are said to have been created so far, and there are more every day. However, their number is not a good indicator for the speed of innovation. Of the 1,500 a large portion was launched by fraudsters, opportunists and fortune hunters, who simply copy an existing crypto currency, give it a new name and a hip webpage, and then wait for their millions to be minted without ever using any brain cells to create something innovative. Only a small fraction of the new launches makes any actual technical improvement to existing crypto currency technology.

Normal industries with a high degree of technical innovation undergo a phase of consolidation. For example, Cisco acquired many smaller network technology providers and integrated their products into its routers. Pharma giants make mergers and acquisitions their business models, constantly acquiring small, innovative firms whose new drugs are added to their global manufacturing and distribution network. Even Microsoft is today a conglomerate of multiple businesses, whose products have been integrated with Windows with varying degrees of success.

But crypto currencies are really hard, if not impossible to merge and to achieve synergies. Instead of seeing a steady improvement of the dominant cryptocurrencies, we see a balkanization of numerous currency each with marginal improvements over the others. Balkanization instead of consolidation is unlikely to become a recipe for success.

It gets even worse: whenever one crypto currency is due for a technical change, the teams backing it get in a fight, with traditionalists dogmatically opposing any change to the holy code base. The currency then splits into two, referred to as ‘fork’ in the crypto world. One currency without the improvement, another with.

Bitcoin, the original crypto currency, is also the most outdated one, yet it has gained the most following. It is unusual for an obsolete technology to win the popularity contest, but not without precedent. In the 1980s the winner of the video cassette recorder wars was VHS, even though Betamax had the superior technology, because of its more widespread adoption. For crypto currencies, we could experience the same phenomenon: the obsolete Bitcoin currency may win over its technically superior rivals. Of course, in the end VHS became obsolete as consumers moved first to DVDs and then online streaming today, and existing collections of VHS cassettes are completely worthless. So it’s likely that the current generation of crypto currencies will eventually be superseded by an entirely new form of digital currency, which will render today's crypto currencies worthless.

If we were dealing with video recording technology this cycle of obsolescence would be generally accepted as the cost of progress. But we are talking about currencies here. Whether a mediocre crypto currency that wins the current crypto race is so much better than a universally recognized fiat currency like the Dollar or Swiss Franc is a matter of opinion. We will not know for sure until a few decades from now.

2. Exceptionally high failure rate

Of the 1,500 crypto currencies that have been created so far, roughly 800 have already disappeared, mostly because they were scams. Readers can find scary anecdotes on, mostly along the line of “...the website stopped working and the money was gone ...” Others failed because the developers lost interest. The resulting failure rate is currently 53 percent and rising as more and more of the current crop of crypto currencies will meet the same fate.

The oldest crypto currency, Bitcoin, is a mere decade old. The crypto boom didn't gather steam until some five years ago. This means that most crypto currencies, some of them worth a billion or more, are not even five years old. If we factor in the short lived nature of frauds then the life expectancy of a crypto currency is likely to be of the order of 2-3 years, possibly even shorter.

Defenders of the current crypto boom point to the weaknesses of fiat currencies, each of which historically has lost all of its value and disappeared. But the speed of failure of crypto currencies exceeds that of fiat currencies by a multiple. The average life expectancy of fiat currencies is 27 years. Even the Euro, a fiat currency often attacked for its flawed design that has been weakened further by various rescue attempts, has thrived for two decades already. A failure rate of 53 percent and a life expectancy of 2-3 years do not make crypto currencies an alternative to fiat money. They make fiat money a viable alternative to crypto currencies.

3. Payments lack anonymity

The media like to spread the idea that Bitcoin and other crypto currencies are anonymous. They void that story line when reporting the next drug bust, most of which nowadays involve the seizure of a stack of Bitcoins. Clearly, if police can seize Bitcoins that easily there can’t be much anonymity.

Crypto currencies use a public ledger that lists all payments in the currency. Anonymity exists only insofar as wallet addresses are strings of letters and numbers that contain no direct identifying information of their owner. For each wallet address anyone can trace incoming and outgoing payments, because the ledger is public. For example, if you know the wallet address of a publication that is critical of a government, you can assemble a list of all wallets whose users have made payments to that publication, presumably to pay for their subscription. For government snoops with full access to log files of internet service providers it is very easy to then identify the individuals who sympathize with regime critics. For hobby detectives this is much harder but still feasible for at least some accounts by cross referencing other public data from the internet with the ledger.

How far private investigators can go to unmask identities even without the State's police powers was illustrated recently by a private IT security firm that investigated the computer virus WannaCry, a virus that extracted ransom payments from its victims earlier this year by hiding their data behind a password. The security experts determined from the Bitcoin ledger that ransom payments were split 80:20 between the perpetrators and the virus programmer. The programmer’s Bitcoin address, in turn, was known because he had previously used it to sell other viruses in the dark net. Even if the programmer’s real name could not be determined, it is known that he or she lives in Ukraine and has made a small fortune through the sale of viruses.

It is shocking how much information can be gleaned from the ledger of an allegedly anonymous crypto currency.

4. Uncertain legal status

The crypto community cheers whenever a country enhances the local legal status of crypto currencies. Amidst all the excitement it is often overlooked that the most relevant country of all, the United States, has not moved at all in that direction. Sure, you can now pay your taxes in Seminole County, Florida with Bitcoin. But that doesn't change the legal status of crypto currencies: they are considered moveable goods, not currencies.

This distinction may not appear significant, but it has serious legal repercussions. Many of the freely circulating Bitcoins have at some point been stolen by hackers. Anyone receiving a Bitcoin today runs the risk of acquiring stolen goods. That would not be a problem if Bitcoin were a fungible currency under the law. But because it is a good that is not fungible, the former owner from whom the coin was stolen can demand the return of the coin. The only option for the good-faith buyer is to seek restitution from the hacker, which will be difficult if the hacker has since disappeared in Nigeria or the depths of the Siberian tundra.

And this is where the lack of anonymity comes in. Due to the public distributed ledger the path of each Bitcoin can be traced, so that the new owner of a specific, stolen coin can be identified.

So far, no case is known where the victim of a hack has sued for restitution in a U.S. court. But as long as the law allows it in principle it is just a question of time until an enterprising lawyer, encouraged by a contingency fee, will try it out. In light of the extraterritoriality of the American system of justice, buyers of a coin may not even be protected if they live outside the U.S.

5. Blockchain is overhyped

The decentralized public ledger, known as blockchain, is at the core of cryptocurrencies' payment systems and is considered a substantial innovation. It is central to many start-ups that are trying to revolutionize other industries with this technology. Instead of in a central data base, information is stored in the blockchain in a decentralized manner. The blockchain is secured through cryptographic algorithms in such a way that it can’t be tampered with. In the case of a crypto currency a distributed ledger may well make sense. Many computer experts and investors are so fascinated by this technology that they have poured millions into further development.

However, although blockchain is an elegant technical solution, it is a solution for which problems yet have to be found outside of crypto currencies. Almost always a central database is more efficient than a distributed ledger. The higher costs of a decentralized ledger are only worth it if the integrity of a centralized database is at risk. For currencies, clearly manipulation by governments is such a risk and it makes sense to use it. But other applications with pressing problems are hard to come by. Advocates of distributed ledgers believe that securities trading ought to become blockchained in the future. But when was the last time that a shareholder register has been tampered with? For 100, if not 150 years shareholder registers have been maintained centrally by trusted authorities. Clearly, existing practices and regulations are sufficient.

Moreover, the utility of storing all transactions in a blockchain ledger for all eternity is quite dubious. Bitcoin's blockchain still contains the very first transaction from a decade ago. If there is no fundamental update to blockchain technology aged payments will use up more and more storage space and processing power without adding any value to today's payments.

If you look hard enough and long enough you will probably find at some point a suitable use where decentralized blockchain technology is a perfect match. But the market for such a product is unlikely to be large enough to justify the large sums thrown at the development of this technology today.

6. Technical limitations

Decentralized ledgers require substantial storage and computing capacity and, of course, electricity. Electricity consumption has been a point of contention of critics of crypto currencies. It is claimed that Bitcoin mining in the aggregate consumes more electricity than the entire country of Ireland. Depending on one's political preference one can also state that it consumes more electricity than almost all African countries. This is a poor comparison because other activities consume just as much electricity, such as worldwide computer gaming or TV viewing of the World Cup, not to mention the electricity wasted for promotional neon signs.

A more serious technical argument is the enormous size of the decentralized blockchain, which currently amounts to 50 Gigabytes in the case of Bitcoin. Should Bitcoin become adapted more broadly so that 1.5 percent of all worldwide payments are conducted in it, the daily increase of the blockchain would be 50 Gigabytes, or the cumulative size it has attained over the last decade. Clearly, data volumes would become unmanageable after a few months. Only large data centers would have sufficient processing and storage capacity. What was supposed to be a decentralized system would become a highly centralized one, the exact opposite of the philosophical appeal of decentralized ledgers.

Whenever you talk about the limits of technology you run the risk of ending up like the Club of Rome, which has forecast for some 40 years the imminent demise of economic growth due to a lack of resources. So far, human ingenuity has overcome the dire predictions. We can only hope that this will also be the case for cryptocurrencies. However, as long as no solution is in sight for handling the potential flood of transaction data, it is the responsibility of crypto enthusiasts to convince us of the viability of these currencies. Especially if they claim that they are ‘money.’

Translated from eigentümlich frei, where the original article was published on 22nd May 2018.

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