Cryptoasset Foundational Fundamentals
The most popular book right now in the cryptoasset investing space is Cryptoassets: The Innovative Investor’s Guide to Bitcoin and Beyond, by Chris Burniske and Jack Tatar. It’s a great read for experts and novices and cohesively broken down into the “what”, “why” and “how” of cryptoasset investing.One of my favorite sections of the book is when the authors discuss six fundamental aspects of evaluating any cryptoasset: (1) the white paper, (2) the decentralization edge, (3) valuation, (4) developers and community, (5) relation to digital sibling and (6) issuance model.What follows is a further explanation of these elements and my own thoughts.Overall I highly recommend the book for anyone interested in the cryptoasset space.
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1. White Paper
The white paper outlines (1) the problem the cryptoasset addresses, (2) where the cryptoasset stands in the competitive landscape and (3) what the technical details are.A good white paper should be easy to understand. An overly complicated white paper could mean that the developers don’t have a good grasp on the technology (or, even worse, are simply riding the cryptoasset hype and purposefully obscuring an impractical use case) or that the platform will be too complicated for users to adopt.One thing to look out for is white papers that place less importance on the practical use case and technology and too much importance on the ICO and investment potential. These white papers look like marketing brochures and are pretty easy to spot. There will usually be lots of pictures, colors and overly stylized formatting and emphasis on things like getting listed on exchanges. In these instances, unless there is a separate technical document (which may be referred to as a “yellow paper”), you should stay away.Overall the white paper is a good initial litmus test for whether to invest in a cryptoasset. And if you can’t explain how the cryptoasset works after reading the white paper, then you should not invest. Buying this cryptoasset would be more akin to gambling than investing.
2. Decentralization Edge
The decentralization edge is the advantage the platform gains from not being centralized. It’s the reason a blockchain is needed.A blockchain should only be used if the platform benefits from being distributed, secure and censorless. If not, centralized models often provide better speed, cost, scaling and UX.Cryptoassets uses Steem as an example here, which is a decentralized platform that rewards content creators and curators. The question to ask is whether users will give up platforms like Facebook, Reddit or Medium for Steem. I would argue that this is unlikely and at best content creators will duplicate publications onto Steem and that most readers will remain on the centralized platforms.Following this line of reasoning, even bitcoin seems to lack a decentralization edge as a currency because centralized platforms like Venmo and Paypal are very easy to use. But it’s important to realize that using Venmo or Paypal requires a bank account, which most of the world does not have. In evaluating the decentralization edge, it’s important to think globally and beyond one’s own ordinary life.
3. Valuation
Valuation is what gives the cryptoassets value and can be split between utility value and speculative value.The utility value comes from the fact that the platform does something that people find useful and that the cryptoasset is required to use the platform. For instance, cryptocurrency platforms like Bitcoin, Ripple and Monero transfer value and bitcoin (BTC), ripple (XRP) and monero (XMR) are each the vehicle through which that value is transferred on the respective platforms.It’s possible the platform itself is valuable but that the cryptoasset captures none of that value and is therefore worthless. This would be the case if the supply of cryptoassets is too high or if velocity (which is the frequency at which one unit of the cryptoasset is used) is so high that users only need to hold the cryptoasset for a short time. In both cases the supply of tokens would exceed demand. For instance, Ripple’s goal is to accommodate the multi-trillion dollar industry of interbank transfers. But if Ripple transactions become so fast that the ripple themselves can readily change hands, then each individual unit of ripple will be worth less than if it was required to hold them for longer.Most cryptoassets claim to have value because they are required to participate in the network. But in evaluating value it is important to consider whether anyone cares about the use case and the importance of the cryptoasset to that use case.Speculative value on the other hand is simply what investors and traders think a cryptoasset will be worth once it’s utility value is fully achieved. If we think of utility value and speculative value as a ratio, most cryptoassets start at a low ratio and increase over time as the true functionality of the cryptoasset is realized.
4. Developers and Community
The developers and community are the builders and supporters of the cryptoasset and its platform.Because cryptoassets are so new, it’s important for developers to have a strong foundation in the underlying principles such as cryptography, distributed networking, economics and game theory. Doing a Google and Linkedin search on the developers listed on the website or white paper can be very revealing and indicate whether they have the technical background to build a well-designed cryptoeconomic protocol. Additionally, advisors with backgrounds cryptoassets and investments from cryptoasset funds are also indicators that the project is at least worth further considering.The project’s communication on social media (e.g., Twitter, Reddit, Medium, Slack and Discord) is a good indicator of their commitment to the project. Silent or dodgy projects are usually a bad sign.Reviewing the content on social media platforms is also a good way to quickly learn sentiment around the project. For instance, searching “$” + [token abbreviation] (i.e., $BTC) on Twitter is a quick way to see what others are saying about the project. It’s important to keep in mind that content on these platforms will often be from users with investment objectives, time horizons and other incentives that may be different from yours. A obvious harmful example of this would be a pump and dump group.It’s also important to keep in mind the type people using each social media platform. For instance, Discord tends to be people who have already invested in the cryptoasset since the Discords are cryptoasset-specific, whereas Twitter is more diverse and is usually anyone with an opinion. It’s also easier to determine the quality of posts on Twitter in contrast to Discord because Twitter provides user metrics.
5. Relation to Digital Sibling
A relation to a digital sibling exists if the cryptoasset is a fork of an existing cryptoasset. For example, litecoin is a fork of bitcoin and ethereum classic is a fork of ethereum. If the cryptoasset is not a fork, then it was built from a new blockchain. Ripple is one example of this.If the cryptoasset is a fork, then it’s important to consider what aspects are being changed and why. Litecoin’s justification for forking was to improve speed and alter the proof-of-work mining protocol. But there are other forks, like ZClassic forked off the ZCash protocol, which really just looks like an attempt to profit from a new low market cap cryptoasset rather than offer any useful new functionality. For example, sudden increases in ZClassic’s market cap seem to revolve around them arbitrarily burning ZClassic tokens to reduce supply or rebranding themselves.It’s also important to consider that popular cryptoassets protocols like Bitcoin and Etherum already offer a lot of functionality. It is therefore important to question whether platform needs its own native token and could not more easily run using bitcoin or ether.
6. Issuance Model
The issuance model is the rate of increase of supply of cryptoassets and the initial distribution of cryptoassets. These features both set the stage for the cryptoasset’s future value.Part of the value of cryptoassets comes from their scarcity. So if supply is too high then it will exceed demand and harm overall value. Similarly, if supply increases too much then it will dilute existing holders, further harming value. On the other hand, if supply is too low, then each individual cryptoasset will could be prohibitively expensive. Although one of the benefits of cryptoassets is that they can be divisible into millionths, most individual units of cryptoassets are valued in cents or dollars. This is probably by design to improve marketing, as it would look weird if a new cryptoasset’s individual unit was greater in value than one bitcoin.It’s also important to make sure the distribution of tokens is fair. Some projects will premine or instamine tokens, which results in the founders having a lot of control over the ecosystem because they own a surplus of cryptoassets. In some instances, however, this is okay because the founders will use these funds to fund further development of the platform. It’s important to get a good understanding of the founders’ intentions, which you can usually get from the white paper.
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Conclusion
As the cryptoasset space further developers, it’s important to always have an investment framework in mind to evaluate each cryptoasset and any potential investment.Cryptoassets is a great contribution to the crytpoasset investment space and in the future I hope to further describe and analyze the many other enlightening sections of this book.