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A framework for understanding CryptoCurrency aka. bitcoin

Since entering mainstream public knowledge a few years ago, interest in cryptocurrency has skyrocketed. In 2011, one bitcoin was worth $1.00, today its value is near $3000. Not surprisingly, the astronomical value of bitcoin has caught the attention of speculators seeking to capitalize on cryptocurrency as an alternative/compliment to trading ETFs. Yet despite being the worlds most valuable cryptocurrency, limitations in its technological implementation (http://fc16.ifca.ai/bitcoin/papers/CDE+16.pdf), philisophical divisions in its programming communities (https://blog.plan99.net/the-resolution-of-the-bitcoin-experiment-dabb30201f7), and the control of its future feature set resting in China, has inspired numerous alternatives (altcoin). To date, there are over 700 digital currencies, many of which claim to offer significant benefits over Bitcoin and other alternative cryptocurrencies. Some currencies utilize the same protocol as Bitcoin, some use something completely different. Some currencies focus on transaction speed, some on privacy, and some have different philosophies. So how does one make sense of it all?

Where does one start?

For the beginner who has just heard about bitcoin and cryptocurrency and is interested in trading it for profit, the difficulty in learning to do so is very real.

First, how does one select a currency to purchase? In ETFs, one can research a company, its CEO, its sales/revenue performance, and product line and/or services. If one decides to trade an ETF, one just signs up to a brokerage and makes the trade. Online brokerages such as e-trade make things incredibly easy and related documentation accessible on the internet is for the most part up to date and straight-forward to follow. The process for the most part, is well defined and in line with expectations.

With Cryptocurrency, things are not so straightforward. Information on a currency is sometimes sketchy if it exists, with information offered sounding more like a startup pitch deck than real facts. There are no easily offered frameworks to vet one competing currency over another. Turning to bitcoin discussion forums also seems to be counterproductive, as advice offered by members tend to trigger more doubts and confusion rather than quell it. If one manages to educate oneself on the merits of one particular currency and desires to purchase it, he may find the process convoluted as limitations on purchases, requirements for verification, and the immaturity of the various platforms involved leave much to be desired.

Well, that was my experience when I started to research bitcoin/digital currency…It was so frustrating, I figured I would write an introductory guide on how to get started to help others who were just like me and wanted to get started despite knowing very little about the digital currency landscape.

A framework for understanding digital currency

For the beginning investor in cryptocurrency, it may help to know a few things:

There is no universal regulatory standard for digital currency to which providers must adhere
The value of any digital currency is not tied to its utility (important to keep in mind!)
The value of any digital currency is tied to its perceived value and in many cases, is pure speculation.
The emotional value of a digital currency seems to be worth more than the merits of the currency’s technological benefits.
Some currency is backed by an underlying business (such as ripple – xrp)
Some currency is just a open source program maintained by unpaid programmers (bitcoin)
Currency software can be very insecure and buggy

*Something to consider: Bitcoin was never intended to be an investment, but rather just an alternative currency. This can probably be safely applied to all cryptocurrency. Never purchase more than you can afford to lose.

The current landscape

In order to illustrate some of these points lets take the most currently popular crypto currency, Bitcoin (Satoshi Nakamoto) and ask ourselves why the current value of a bitcoin is as high as it is now.

The positives:

The satoshi Bitcoin was the first to become popular within news, social media, and nerd talk. It’s only recently where talk of other alternative digital cryptocurrency is being highlighted in the media. Because it was the first and now most popular, interest in it has skyrocketed.
Due to its popularity. Investors are taking notice of cryptocurrency, some are even trying to create a bitcoin exchange traded fund (http://www.cnbc.com/2017/05/30/bitcoin-price-hedge-funds-not-investing.html).
Governments are legitimizing Bitcoin (http://asia.nikkei.com/Markets/Tokyo-Market/Bitcoin-getting-interest-paying-accounts-in-Japan) which lend credibility to it as an asset or commodity. This also influences the increases the receptivity of the currency for the mainstream population.
Bitcoin is currently the central point of liquidity in the purchase and exchange of other digital crypto currency. Being one of the first and most popular, the currency is commonly used to change to and from another altcoin. For example, coinbase, one of the largest Bitcoin platforms for buying, selling, and storing digital currency, only allows one to purchase Bitcoin, Ethereum, or Litecoin from regular Fiat currency (ig. USD). In order to buy another altcoin such as monero (if just using coinbase), one needs to buy bitcoin from coinbase then head over to another website to exchange the bitcoin for the monero. If one wants to exchange Monero back to regular fiat currency using coinbase, one would need to convert monero back to bitcoin then sell it (using coinbase).

*However with new sites such as shapeshift.io, other currencies can be exchanged between each other.

The negatives:

Despite its popularity, the Satoshi Bitcoin has scalability limitations rooted in its technology which undermine its widespread adoption. Currently, the currency can only process 7 transactions per second (27 TPS if a larger 4mb block is used). Compare this to a Visa credit card which confirms a transaction within seconds, and processes 2000 transactions/sec on average, with a peak rate of 56,000 transactions/sec. This technological limit should be a very weighty negative blight on the adoption of the Satoshi Bitcoin. However, this isn’t the case as the value is still many times higher than other altcoins which do not have this technological limitation.
The comunity of bitcoin developers have also run into ideological differences and have for all intents and purposes, split (https://blog.plan99.net/the-resolution-of-the-bitcoin-experiment-dabb30201f7).
Bitcoin implementation is guided by a concept where miners (those who create bitcoin and contribute to its blockchain) can vote on which new features are implemented. This voting system gives miners with larger hash power control of its technological improvements. However, most of the miners are located in China whose interests are counter to the technological improvement of the currency. To change and improve on the currency may lead to the the destabilizing of their income stream (https://blog.plan99.net/the-resolution-of-the-bitcoin-experiment-dabb30201f7).

There is no reason why Bitcoin should be valued so highly considering its technological limitations, its own community of developers at war with each other, and its future resting in the hands of another country. However, the popularity and legitimization by governments has given a reason to place a high value on the currency despite it being technologically flawed. Much of it however, is hype and emotional value vs true utility based on superior tech and legitimate development.

At first, I viewed the digital currency landscape as one where technology nerds who knew lots about the product and took part in the development of the coin were the ones raising the value of the coin. However, upon deeper research, it seemed to me that the biggest contributor to the value of digital currency tended to be the emotional and capricious nature of the market rather than the merit of the coin. Despite this, I believe there is money to be made in the crypto currency market if one has the right perspective.

The psychology of it all (updated 12/08/17)

Bitcoin (Satoshi), despite its technological flaws, still commands the highest price of all the cryptocurrencies on the market. Because of this we must give thought as to WHY it is so, yes we have covered that it was the first, it gets most of the publicity, and yes it has become a backbone currency from which to buy and convert to when trading altcoins. But I believe it commands the highest price simply because its captured our imagination (in other words, its hyped in our minds!).

Crypto currency is very much being regarded in a way that the mp3 format was back in the 90s. Back then, tech savy kids who frequented dial-in bulletin board systems would trade music with each other “illegally” (instead of paying for the song), and because of its compression, it would only take about 5 minutes or so per song using a dial-up modem (compared to the 40 minutes or so using just the standard wav compression). It was considered a terrible thing by record labels, and the pushback was heavy from the “establishment.” Its use amongst the early adopting youth created a cohort which spoke of Mp3s as a sort of underground tool which only people “in the know” knew how to access and use. In the end, which took several bumpy litigation filled years, the establishment conceeded to and eventually worked out the legalities and promoted the use of the mp3 format. Mp3s are now everywhere (yet distributed by only a few large vendors…which is a discussion in and of itself but you can see where we’re headed…).

Does it capture the imagination?

Bitcoin much like the Mp3, captured the imagination of tech savy early adopters, which I believe were the disruptive, somewhat anti-establishment, “would be criminal if they weren’t so scared” types (http://www.newsweek.com/silk-road-founder-ross-ulbricht-appeal-rejected-life-sentence-stands-618322). It spread amongst that cohort (which I bet were the same cohort which discovered Mp3s on the BBS’s as kids), and then was actually used by those who needed the privacy and unregulated nature of the platform, those who were actually criminal. In a sense, Bitcoin provided the opportunity to exercise what those “would be criminal if they weren’t so scared” types had a natural propensity to do…The news and talk surrounding this “Bitcoin” all contributed to the vibe and reputation which bitcoin has now, and this makes all the difference in the world for its price.

Where are we now?

In diffusions of innovations (https://en.wikipedia.org/wiki/Diffusion_of_innovations#CITEREFRogers1962_5th_ed) the author outline stages of adoption for any new technology. In the image below you’ll see the stages and the natural willingness to adopt whatever technology it is.

I would posit that we are now somewhere in the early adopters and early majority stage. With early adopters (much like the mp3 loving youth), they just needed an inkling of why the technology, in this case, the Satoshi bitcoin is worth buying into. They dived right in, seeing the merits of crypto-currency and being the type who would naturally gravitate toward the somewhat underground and practical nature of the Bitcoin (it appealed to their idealism). This happened around 2014 till late 2016.

Then comes the early majority (2017ish) and they dont quite believe the hype Bitcoin is generating. Bitcoin still isnt ready for primetime, and yet they seek out something which builds on more than just buying and selling, and something which solves some of the technological problems of bitcoin. They find this solution in the crypto currency Ethereum (middle 2017), which is currently #2 in the rankings and Dash (fall 2017). Both are practical, has good following, but its price still isnt as high as the Satoshi Bitcoin. Why?

I would say that Ethereum and Dash both simply haven’t captured the imagination of the early adopters nor early majority as to its merits over bitcoin.

Lets take XRP and XLM as another example. Both of these cryptos are in all essense superstars in terms of technological soundness and practicality. Fast transaction times, low fees, partnerships with established entities (such as IBM and many banks), backed by a star development team, yet they trade at extremely low prices. Then look at Monero (XMR) and Zcash (ZEC) as they are both way ahead of both XRP and XLM in terms of price (both these cryptos focus strongly on privacy).

Why? Because Monero and Zcash focus on the ideals which the original Bitcoin sought to fulfill (decentralized, anti-establishment, anonymous), and has thus captured the “imagination.” XRP and XLM while technically and ideologically sound, focus on values which are actually counter to what Bitcoin sought to acccomplish (establishment, centralized, managed). XRP and XLM build on values which seem to me are really what the late majority will be looking for in a cryptocurrency.

What to expect

At this early adoption/early majority stage of crypto currency, people want to buy into the idea of Bitcoin but the framework of it all is what most investors are working on as the crypto currency world is still so unknown. People just coming into the foray don’t know enough about the multitudes of crypto-currencies available, so they gravitate towards the one they know best, the Satoshi Bitcoin. The Satoshi has captured the early adopters’ imaginations (because news), and its recent astronomical gains build upon the pomp and circumstance which only serve to promote and further build upon the ideas which capture peoples imagination (get rich quick, to the moon!, from $9000 to $17000 in three days!). The Satoshi Bitcoin has captured the worlds attention and the price reflects directly.

On a smaller scale, we see high quality cryptocurrency being heavily undervalued (XLM, XRP) vs those which offer discreet transactions. Its almost a completely psychological value proposition – both capture the imagination differently, but with one side aligning itself more towards the profile of the early adopters (and the price reflects that).

The late majority, when we get there, will usher in a completely new era of trading, as the psychological framework brought in with those individuals will shape the value of the different crypto-currencies. I also believe it is with the late majority and with the govenmental regulation that comes with it, where the Satoshi Bitcoin price will come back down to earth, and crypto will no longer be as volatile as it is now.

A framework for selecting digital currency for trade:

In my opinion, a digital currency should be selected on three main criteria depending on a short or long position:

If long term

The niche of the currency (security, anonymity, transaction speed)
Its technological benefit to alternative currencies (smart contracts, more efficient banking transactions, etc.)
Its adoption in the market (heavily related to the niche and technological benefit).
Its development team and whether or not it is in active development. Crypto currency is only as good as the software being utilized. If the development has stopped (DOGE), updated security and bug fixes wont be applied which ultimately makes the platform unsafe and not a good choice for investment.

If short term

Price – What is the current price on chart and whether or not its just beginning to be covered by the media? Is it cheap? Is it too expensive compared to what its exposure in the press alludes to?
Hype – Has the coin gained too much coverage and is now at the peak of its media coverage and hype? There may not be any more room to grow…
Usage – who is using the coin? Honestly, I haven’t seen much correlation between who is using the coin, to the price/value of the coin. However, I have seen that the higher the adoption of the coin by the mainstream population, the higher the media coverage, and thus the higher price/value of the coin. Essentially, the resulting media coverage generated from more widespread adoption whether in mainstream or niche markets, ultimately pumps the price of the coin higher, rather than the adoption/usage of the coin.

*Watching the behavior of various cryptocurrency, it seems as though the majority of current investors are holding short term positions and seeking to pump and dump for a quick profit. Because of this, one will see volatile behavior on the beginning/end of the month as speculators may be seeking to cash out their profits.

Summary

Cryptocurrency values depend on many factors, however certain factors weigh more heavily on the price of the coin. From my experience, hype and media coverage account for the majority of its perceived value compared to its technological benefits or development performance. Even the adoption and usage of the coin is not a major motivator for the price, but contributes to the media coverage of the coin which in turn raises the coins price values instead. As well as it seems to me, the fundamentals which tend to be evaluated when investing in traditional stocks are ignored when observing the behavior of cryptocurrency trading as ive noticed volatile behavior in daily and monthly cycles. This could be a strong indicator that the majority of current investment in cryptocurrency tend to be short term positions.

Before taking a position in a certain currency, ask yourself who the main players in the market are at the current time. It could be that the environment has changed and the players are no longer early adopters, but are now early majority/late majority players which operate on a different value system. This WILL affect the prices and value of the currency.

Ask yourself what psychological factors are involved with each currency (and the reason you want to select it), and weigh the merits of those with other individuals in current forum discussions pertinent to the currency you are researching.

I feel that by evaluating the frameworks in their respective positions (short or long term), evaluating the psychological factors in the market, and taking note of what stage the market is in, one will have at least a starting point in evaluating the many crypto currencies out on the market today. As of this latest update, the currency Monero has jumped from $49-$50 in late August to $271 in December.

If you would like to try your hand at trading crypto currency, try using coinbase. By using the link below youll receive $10 free to play with!