A few weeks ago, while the prices of the biggest cryptocurrencies were careening lowering, Goldman Sachs released what we described as the closest thing to 'initiating coverage' on cryptocurrencies, with the big takeaway being that the bank saw Ethereum overtaking bitcoin as the world's most popular cryptocurrency in the not-too-distant future.
After its release, we suspected that the report was a harbinger of Goldman potentially announcing an expansion of its crypto business as it scrambles to stay a step ahead of megabank rivals like JPMorgan, Citigroup and others. As it turns out, we were correct.
Because on Monday, Mathew McDermott, head of digital assets at Goldman, told Bloomberg News that the bank is planning to sell options and futures for ether and bitcoin via its newly restarted crypto trading desk.
Even JP Morgan, whose CEO once famously bashed bitcoin, is expanding its own crypto business, claiming its clients demand it. The global banking regulators at the Basel Committee also gave a begrudging green light for international banks to deal in cryptocurrencies (though they need to hold plenty of capital in reserve for any crypto on their balance sheet).
According to McDermott, even after the drop in crypto prices, hedge funds are still eager to trade crypto. And Goldman is looking to invest in more crypto-focused companies.
"We’ve actually seen a lot of interest from clients who are eager to trade as they find these levels as a slightly more palatable entry point,” McDermott said in a phone interview on Thursday. “We see it as a cleansing exercise to reduce some of the leverage and the excess in the system, especially from a retail perspective.” Goldman tapped McDermott, 47, to head its digital currency efforts last year. Under his watch, the business has grown to 17 people from four. The bank has also invested in crypto start-ups. It put $5 million into a fundraising round by Blockdaemon, a firm that creates and hosts the computer nodes that make up blockchain networks. In May, Goldman led the $15 million investment into Coin Metrics, a cryptocurrency and blockchain data provider to institutional clients, and McDermott joined the company’s board. “We are looking at a number of different companies that fit into our strategic direction,” he said. Other banks have also expanded their crypto operations. Cowen Inc. plans to offer “institutional-grade” custody services for cryptocurrencies. Standard Chartered Plc is setting up a joint venture to buy and sell virtual currencies, though HSBC Holdings Plc is avoiding Bitcoin for now.
Circling back to the report we mentioned above, Goldman and its team of analysts have clearly explored the pros and cons before deciding to expand its business.
The term “cryptocurrencies”—which most people take to mean that crypto assets act as a digital medium of exchange, like fiat currency—is fundamentally misleading when it comes to assessing the value of these assets. Indeed, the blockchain that underlies bitcoin was not designed to replace a fiat currency—it is a trusted peer-to-peer payments network. As a cryptographic algorithm generates the proof that the payment was correctly executed, no third party is needed to verify the transaction. The blockchain and its native coin were therefore designed to replace the banking system and others like insurance that require a trusted intermediary today, not the Dollar. In that sense, the blockchain is differentiated from other “digital” transactional mechanisms such as PayPal, which is dependent upon the banking system to prevent fraud like double-spending.
In order to be trustworthy, the system needed to create an asset that had no liabilities or contingent claims, which can only be a real asset just like a commodity. And to achieve that, blockchain technologies used scarcity in natural resources—oil, gas, coal, uranium and hydro—through ever-increasing computational-power consumption to “mine” a bit version of a natural resource.
From this perspective, the intrinsic value of the network is the trustworthy information that the blockchain produces through its mining process, and the coins native to the network are required to unlock this trusted information, and make it tradeable and fungible. It’s therefore impossible to say that the network has value and a role in society without saying that the coin does too. And the value of the coin is dependent upon the value and growth of the network.
That said, because the network is decentralized and anonymous, legal challenges facing future growth for crypto assets loom large. Coins trying to displace the Dollar run headlong into anti-money laundering laws (AML), as exemplified by the recent ransoms demanded in bitcoin from the Colonial Pipeline operator and the Irish Health service. Regulators can impede the use of crypto assets as a substitute for the Dollar or other currencies simply by making them non-convertible. An asset only has value if it can either be used or sold. And Chinese and Indian authorities have already challenged crypto uses in payments.
As a result, the market share of coins used for other purposes beyond currencies like “smart contracts” and “information tokens” will likely continue to rise. However, even these non-currency uses will need to be recognized by courts of law to be accepted in commercial transactions—a question we leave to the lawyers.
The network creates the value, unlike other commodities
Unlike other commodities, coins derive their entire value from the network. A bitcoin has no value outside of its network as it is native to the Bitcoin blockchain. The value of oil is also largely derived from the transportation network that it fuels, but at least oil can be burned to create heat outside of this network. At the other extreme, gold doesn’t require a network at all.
Derived demand leaves the holder of the commodity exposed to the risk of the network becoming obsolete—a lesson that holders of oil reserves are now learning with decarbonization accelerating the decline of the transportation network, and, in turn damaging oil demand. Likewise, bitcoin owners face accelerated network decay risk from a competing network, backed by a new cryptocurrency.
As the demand for gold is not dependent on a network, it will ultimately outlive oil and bitcoin—gold entropy lies at the unit, not the network, level. Indeed, most stores of value that are used as defensive assets—like gold, diamonds and collectibles—don’t have derived demand and therefore only face unit-level entropy risk. This is what makes them defensive. The world can fall apart around them and they preserve their value. And while they don’t have derived demand, they do have other uses that establish their value, i.e. gold is used for jewelry and as a store of value.
Transactions drive value, creating a risk-on asset
Crypto doesn’t trade like gold and nor should it. Using any standard valuation method, transactions or expected transactions on the network are the key determinant of network value. The more transactions the blockchain can verify, the greater the network value. Transaction volumes and the demand for commodified information are roughly correlated with the business cycle; thus, crypto assets should trade as pro-cyclical risk-on assets as they have for the past decade. Gold and bitcoin are therefore not competing assets as is commonly misunderstood, and can instead co-exist. Because the value of the network and hence the coin is derived from the volume of transactions, hoarding coins as stores of value reduces the coins available for transactions, which reduces the value of the network. Because gold doesn’t have this property, it is the only commodity that institutional investors hold in physical inventory. Nearly all other commodities are held in paper inventory in the form of futures to avoid disrupting the network. This suggests that, like oil, crypto investments will need to be held in the form of futures contracts, not physically, if they are to serve as stores of value.
Crypto assets aren’t digital oil, either, as they are not non-durable consumables and can therefore be used again. This durability makes them a store of value, provided this demand doesn’t disrupt network flows. The crypto assets that have the greatest utility are also likely to be the dominant stores of value—the high utility reduces the carry costs.
So what is crypto? A powerful networking effect
The network provides crypto an extremely powerful networking externality that no other commodity possesses. The operators—miners, exchanges and developers—are all paid in the native coin, making them fully vested in its success. Similarly, users—merchants, investors and speculators—are also fully vested. This gives bitcoin holders an incentive to accommodate purchases of their own products in bitcoin, which in turn, creates more demand for the coins they already own. Similarly, ether holders have an incentive to build apps and other products on the Ethereum network to increase the value of their coins.
Because the coin holders have a stake in the network, speculation spurs adoption; even during bust periods, coin holders are motivated to work to create the next new boom. After the dot-com bust, the shareholders had no commodity to promote. In crypto assets, even when prices collapse, the coin holders have a commodity to promote. They will always live for another boom, like an oil wildcatter.
It’s all about information
As the value of the coin is dependent on the value of the trustworthy information, blockchain technology has gravitated toward those industries where trust is most essential—finance, law and medicine. For the Bitcoin blockchain, this information is the record of every balance sheet in the network, and the transactions between them—originally the role of banks. In the case of a smart contract—a piece of code that executes according to a pre-set rule—on Ethereum, both the terms of that contract (the code) and the state of the contract (executed or not) are the information validated on the Ethereum blockchain. As a result, the counterparty in the contract cannot claim a transfer of funds without the network forming a consensus that the contract was indeed executed. In our view the most valuable crypto assets will be those that help verify the most critical information in the economy.
Over time, the decentralized nature of the network will diminish concerns about storing personal data on the blockchain. One’s digital profile could contain personal data including asset ownership, medical history and even IP rights. Since this information is immutable—it cannot be changed without consensus—the trusted information can then be tokenized and traded. A blockchain platform like Ethereum could potentially become a large market for vendors of trusted information, like Amazon is for consumer goods today.
Crypto beyond this boom and bust cycle
By many measures—Metcalfe’s Law or Network Value to Transactions (NVT) ratio —crypto assets are in bubble territory. But does the demand for “commodified information” create enough economic value at a low enough cost to be scaled up in the long run? If the legal system accommodates these assets, we believe so. While many overvalued networks exist, a few will likely emerge as long-term winners in the next stage of the digital economy, just as the tech titans of today emerged from the dot-com boom and bust. This transformation is happening now—there are already an estimated 21.2 million owners of cryptocurrencies in the US alone. However, technological, environmental and legal challenges still loom large.
Ethereum 2.0 is expected to ramp up capacity to 3,000 transactions per second (tps), while sharding—which will scale Ethereum 2.0’s Proof of Stake (PoS) system through parallel verification of transactions—has the potential to raise capacity to as much as 100,000 tps. For context, Visa has the capacity to process up to 65,000 tps but typically executes around 2,000 tps. PoS intends to have validators stake the now scarce and valuable coins to incentivize good behavior instead of having miners expend energy to mine new blocks into existence, as under Proof of Work, making crypto assets more ESG friendly. PoS also can significantly boost computational time in terms of transactions per second, which will further incentivize technological adoption. Ironically, this is likely where the value of and demand for bitcoin will come from—being used as the scarce resource to make the PoS system work instead of natural resources.
While overcoming the economic challenges will likely be manageable, the legal challenges are the largest for many crypto assets. And this past week was challenging for crypto assets with confirmation that the 75 bitcoin ransom over the Colonial Pipeline was actually paid. This is a reminder that cryptocurrencies still facilitate criminal activities that have large social costs.
For Ethereum, new companies which aim to disrupt finance, law or medicine by integrating information stored on the platform into their algorithms are likely to run into problems with being legally recognized. If crypto assets are to survive and grow to their fullest potential, they need to define some concept of “sufficiently decentralized” that will satisfy regulators; otherwise, the technologies will soon run out of uses.
In summary: the talk in the crypto community lately has focused on whether ether is finally supplanting bitcoin since the former has more utility, and therefore a greater potential for a network effect.