Cable news, business talk shows and investor forums have all been abuzz in recent months over bitcoin’s surging price. The cryptocurrency’s rising value has captivated Wall Street, with its ascent fueled by the accelerating rate of institutional adoption. Legacy financial providers from Bank of New York Mellon, the nation’s oldest bank, and BlackRock, the nation’s largest asset manager, have both warmed to the idea of bitcoin as a sort of “digital gold.” In the current ultra-low-rate environment and in light of the Federal Reserve’s unprecedented money printing campaign, where it printed close to 25% of all U.S. dollars ever produced in the past twelve months, investors have found bitcoin’s “digital gold” narrative particularly salient. Against this uncertain macroeconomic backdrop, the case for bitcoin has come into focus, resulting in a soaring price. However, the bigger story, which has been lost amid the rush to riches, is that the crypto space is much larger than just bitcoin, and bitcoin is not even the most disruptive cryptocurrency.
Bitcoin was created in January 2009 by a mysterious founder who went by the name Satoshi Nakamoto. Mr. Nakamoto, whose identity remains a mystery, was motivated by the Great Recession of 2007-2008 and sought to create an alternative financial system, which could function independent of the existing system. This idealistic approach drew an eclectic bunch of early adopters to the digital coin, including anarchists, tech geeks and libertarians. However, as bitcoin adoption expanded beyond these ideologically driven factions, reality set in. The Bitcoin network is plagued with high fees and long wait times, and, when compared against legacy payments systems, such as Visa or Mastercard, Bitcoin loses in a landslide. For this reason, Satoshi’s vision of Bitcoin as a global payments system and a replacement for cash seems unlikely. However, this is not to say that Bitcoin failed— much the opposite, in fact. Bitcoin’s supply is hard-capped at 21 million, meaning that there will only ever be 21 million coins in circulation. This rigid monetary policy contrasts sharply with the existing fiat currency system, which is inflationary and destroys citizens’ wealth by continually increasing fiat supply (i.e., U.S. dollars). The coronavirus pandemic unleashed the most expansive monetary experiment in the history of financial markets; central banks in the United States, Europe, Japan, and other major economies printed unparalleled amounts of fiat, effectively creating money out of thin air and pumping liquidity into the reeling global economy. The experiment has achieved its intended effect, stabilizing markets and allowing capital to safely remain in the system, thus averting a prolonged financial collapse, like in 2007-2008. However, sophisticated investors intuitively understand that the music must end at some time down the line. When the inevitable crash will occur and everyone stops dancing, is anyone’s guess. Unfortunately, the question is not a matter of if but when.
Even today, as Bitcoin’s price breaches the psychologically significant $50,000 mark, most investors fail to understand the revolutionary and massively disruptive technology that Bitcoin’s creation introduced to the world. This new technology is called the blockchain, a public ledger (i.e., record book) of all past transactions. It offers a transparent way to track the exchange of goods or money in a distributed or non-centralized fashion. Although it may not seem like much, blockchain technology is already transforming industries. It will likely be one of the most powerful technologies of the 21st century. Bitcoin is the world’s first-ever blockchain and allows anyone, anywhere in the world, to view in real-time the exchange of bitcoins across its blockchain. As mentioned before, Bitcoin’s monetary policy is rigid, and this rigidity applies to the rest of its architecture. Satoshi Nakamoto and the developers who continue to maintain Bitcoin’s blockchain have prioritized safety and security over considerations like scalability and speed. For this reason, the Bitcoin blockchain is rather clunky and difficult for developers to build applications on top of. To alleviate Bitcoin’s inherent constraints and leverage the incredible blockchain technology it introduced, a young 19-year-old Russian-Canadian programmer named Vitalik Buterin came up with an idea he called Ethereum.
Ethereum is a decentralized blockchain featuring smart contract functionality that was first proposed in 2013 and went live in July 2015. Currently, Ethereum is the second most valuable cryptocurrency, behind only Bitcoin. It is also the most actively used blockchain, besting Bitcoin by a steadily growing margin. While Bitcoin was created as an alternative to fiat currencies and aspires to be “digital gold,” Ethereum intends to be a platform that facilitates immutable, programmatic contracts and applications via its native currency known as ether. Just as Bitcoin introduced a transformative technology—the blockchain—to the world, Ethereum similarly introduced smart contracts, which promise to be equally, if not even more, disruptive. A smart contract is a piece of code programmed onto a blockchain, which defines the terms of a particular transaction. Upon the receipt of a given trigger of input, the smart contract will execute and perform its assigned task(s). Smart contracts can range from being relatively simple to incredibly complex. For example, your parents could write a smart contract that says that each year on your birthday at exactly 9:00 am EST, $100 will be withdrawn from their bank account and transferred into yours. Once they write this contract and execute the code, the action will be repeated without any further intervention every year for eternity. At first glance, smart contracts may seem mundane and unexciting, but this elementary example belies the technology’s extraordinary potential. These contracts allow people worldwide to transact with one another without needing an intermediary, massively reducing costs. Because there is no third party involved, there is no risk of manipulation or theft. Global supply chains and logistics networks have been among the first industries to adopt the nascent technology. Using blockchain technology, which bitcoin introduced, supply chains can provide a transparent and permanent record of the transit of goods between multiple vendors. With the addition of smart contracts, payments can be executed automatically upon the receipt of delivery, and inventory levels updated automatically in real-time. These contracts can handle unique complexities that vary by industry or user. Going back to the supply chain example, a company can write a smart contract that accounts for its shipping containers’ temperatures. Suppose internal temperatures drop below a certain level needed to preserve a company’s perishable goods. In that case, payment to the transportation company could be withheld or revoked. A process that previously would have taken hours, days or even weeks to reconcile can now take milliseconds. Smart contract applications such as this example are the tip of the iceberg in terms of future commercial applications.
As a result of Ethereum’s robust and flexible architecture, developers have opted en mass to build “dapps” (decentralized applications) on the Ethereum network instead of the Bitcoin network. There are currently over 3,000 dapps in operation on the Ethereum network, and many close observers have called DeFi, or decentralized finance, Ethereum’s first “killer dapp.” DeFi seeks to decentralize the entire financial industry by utilizing smart contracts on the Ethereum network to remove intermediaries, lower fees, and democratize previously expensive financial services. The total value locked in DeFi is currently $39.65 billion, up from $1.22 billion a year ago. One of the most significant “projects” or decentralized protocols in DeFi is Uniswap, a decentralized cryptocurrency exchange that facilitates automated transactions between cryptocurrency tokens on the Ethereum blockchain using smart contracts. Uniswap is unique because of its decentralized nature and use of a relatively new type of trading model called an automated liquidity protocol. Automated liquidity protocols differ from the legacy system of order book-based trading, where buy and sell orders are presented in a list along with the total amount placed in each order. The amount of open buy and sell orders for an asset is known as “market depth.” To make a successful trade using this system, a buy order must match a sell order on the opposite side of the order book for the same amount and price of an asset, and vice versa. For example, suppose a seller wants to sell one bitcoin for $50,000 on a centralized exchange like Coinbase. They would need to wait for a buyer to appear on the other side of the order book looking to buy an equal or higher amount of bitcoin at that same price. The main problem with this legacy system is liquidity, which is the depth and number of orders there are on the order book at any given time. If there’s low liquidity, it means traders may not be able to fill their buy or sell orders. Another way to think of liquidity is to imagine a lively street market. If the street market is busy with many stall vendors selling goods and people buying produce and products, it would be a liquid market. If the market is quiet with little buying and selling going on, it would be an illiquid market.
Uniswap is an entirely different type of exchange that is fully decentralized – meaning it is not owned and operated by a single entity – and uses a relatively new kind of trading model called an automated liquidity protocol, as mentioned above. The Uniswap platform, created in 2018, is built on top of the Ethereum blockchain, the world’s second-largest cryptocurrency project by market capitalization. Uniswap solves centralized exchanges’ liquidity problem, as described in the street market scenario above, through an automated liquidity protocol. This works by incentivizing the people trading on the exchange to become liquidity providers (LPs). Uniswap users pool their money together to create a fund used to execute all trades on the platform. Each token listed has its own pool that users can contribute to, and the prices for each token are calculated using mathematical algorithms. With this system, a buyer or seller is not forced to wait for an opposing party to complete a trade. Instead, they can execute any trade instantly at a known price, provided there is enough liquidity in the particular pool to facilitate it. In exchange for putting up funds, each LP receives a token that represents the staked contribution to the pool. For example, if you contribute $10,000 to a liquidity pool that holds $100,000 in total, you will receive a token for 10% of that pool. This token can be redeemed for a share of the trading fees. Uniswap is just one of the many exciting projects currently being developed in the DeFi ecosystem, which itself is only one application on top of the Ethereum blockchain.
None of this innovation would have been possible without blockchain technology, which Bitcoin first introduced. It would also be impossible without smart contracts, which Ethereum introduced. Although there is still substantial fear, uncertainty and doubt, aka “FUD,” surrounding these crypto projects, their innovative technologies are indisputably transformative, disruptive and here to stay. As both the Bitcoin and Ethereum ecosystems expand and more people become familiar with their value propositions, the value of their underlying currencies – bitcoin and ether – will likely appreciate substantially. While a $50,000/bitcoin price and $2,000/ether price may seem grossly overvalued now, it will probably look laughably cheap in a few years. I hope you have the intellectual curiosity to explore these emerging technologies and consider investing in a piece of the future. Welcome to the crypto age.