Peruse crypto-Twitter for any reasonable amount of time and one will quickly notice the tribalism that exists within Bitcoin and Ethereum crowds. The Bitcoin tribe will claim that “ETH is not money.” Ethereum does not have a supply limit and the current number of coins in circulation can only be approximated. The approximation results from Ethereum’s use of an account model as opposed to Bitcoin’s unspent transaction output (UTXO) model that verifies every transaction. Though not exact, an account-based transaction model better supports the application of smart contracts. Due to this, hard money enthusiasts dismiss Ethereum as no better than fiat currency. When asked about the total Ethereum supply, Vitalik Buterin, cofounder of Ethereum, claimed that “we roughly know what it is according to protocol rules.”1 As the Bitcoin crowd continued to pressure Buterin based on this statement, he refuted claims that he and his cofounders are “inflationist technocrats” when, in June 2020, he pointed out that Ethereum’s supply was 40 million coins less than expected from estimates in the original whitepaper published in 2013.2
Ethereum proponents point out that the entire Decentralized Finance (DeFi) trend interrupting traditional banking and payment rails is in fact built on the Ethereum network. For early adopters, Bitcoin’s core philosophy has a libertarian, anti-establishment tilt. These adopters praise anything that forces governments and large institutions to downsize or anything that imposes more responsibility on what they see as reckless and rent-seeking behavior. Unless, of course, that something is another cryptocurrency. Those in the Ethereum tribe will ask the question, how could Bitcoin be the winner of DeFi if all the applications are built through Ethereum? Any tribe-like social circle is likely to miss important nuance in their zeal to support their tribe over the other. Ultimately, Bitcoin and Ethereum both play vital roles in the current cryptocurrency ecosystem as it currently stands.
My conclusion is that Bitcoin, as blockchain-based monetary technology, constitutes the fundamental layer of the cryptocurrency ecosystem because it enables the transfer of value in a nonmanipulatable manner. It has a stated use case and stable demand as the only hard money in existence. Ethereum is blockchain-based application technology currently challenging the traditional financial infrastructure. Some will claim that it has the potential to surpass Bitcoin in market capitalization as its applications continue extending outside of finance. Though up for debate, Ethereum plays a role in the portfolio as a slightly more speculative bet on the proliferation of blockchain-based, decentralized applications (DApps). The next chapter will examine ways to incorporate Ethereum and Alt-coins into a portfolio while expanding upon the risk/return profile of all digital assets. For most investors, wading into the cryptocurrency ecosystem begins and ends at Bitcoin. For those who want broad exposure to multiple digital assets, one can incorporate Ethereum or invest in a basket of assets on a market capitalization basis unless he or she is willing to conduct the in-depth research required to pick winners and losers. Digital assets such as Ethereum have a proven track record of outperforming Bitcoin for multiple stretches of time, but also contain more downside volatility and are a less proven, less mature market. Including Ethereum is one method of potentially generating additional alpha, but naturally involves more risk.
What Is Ethereum?
Vitalik Buterin published the Ethereum whitepaper in 2013, and the protocol launched in 2015. At its core, Ethereum is a “protocol for building decentralized applications.”3 While Bitcoin has a narrowly focused use case of storing and transferring ownership of coins on a decentralized ledger, Ethereum is the foundational layer by which anyone can program their own smart contracts. It represents the difference between simple and complex commerce, though it has nonfinancial applications such as governance, organizational management, and supply chain management. As mentioned in the previous chapter, a smart contract is essentially an IF, THEN statement. The contract is immutable and no central authority can tamper with the contract or access the funds locked in the contract as it exists on the blockchain. The contract automatically executes to release the funds or facilitate the agreement once the initial conditions are met. Developers can build entire subecosystems, such as decentralized exchanges, on this idea alone.
Ethereum has three primary applications as outlined in its whitepaper: financial, semifinancial, and nonfinancial. Financial applications involve financial derivatives such as stablecoins, decentralized lending, or subtokens that represent other assets. A stablecoin is an asset-backed, or data-feed contract that pegs the price of the coin to the price of another currency or asset. One can also represent ownership of real assets such as art or fractions of real estate through tokenization on the Ethereum network. Semi-financial applications involve money and a nonfinancial aspect. It usually takes the form of an automatically regulated agreement to release funds. For example, insurance companies can automatically process claims once a condition is met or a postal delivery service can automatically release funds once a good is delivered or returned. Lastly, Ethereum has nonfinancial applications such as decentralized file storage platforms or Decentralized Autonomous Organizations (DAOs). In a DAO, the legal framework of a company or community is set in code without the need for a hierarchy or legal team, such that decisions regarding membership, salary, and organizational direction can be made automatically using a majority of votes. Ethereum is similar to a decentralized app store on one’s phone or computer. Anyone can build an app on the network, though most projects will fail. Much of the chapter will focus on Ethereum’s diverse use cases because it helps readers better understand the asset.
Firstly, Ethereum enabled the Initial Coin Offering (ICO) boom of 2017. In the old economic model, a programmer or entrepreneur with a capital-intensive business idea needed the backing of one or more investors to gain access to the capital required to launch. With the advent of Kickstarter in 2009, potential entrepreneurs could crowdsource their project funds. If the project met its fundraising goal by the deadline, the entrepreneur received the funds and the investors gained partial ownership. If the project did not reach its goal, the investors’ funds did not get released. Ethereum automates this process through smart contracts. Coupled with a lack of regulation and a general mania surrounding cryptocurrencies during the 2016 market cycle, some nefarious actors saw this as an opportunity to take advantage of unwitting investors looking to “get rich quick” from the next Bitcoin or Ethereum. One estimate places the amount of capital raised through ICOs in 2017 at $4.9 billion. Excluding 11 projects that returned over 1,000 percent to investors, the median return of the ICO boom was −87 percent.4
Even though the craze wreaked of fraud and mismanagement, the concept behind ICOs is still rather revolutionary. Companies such as Kickstarter eliminated the requirement for banks, venture capital, or for an entrepreneur to be geographically located near a financial hub such as New York City, Silicon Valley, or London. Ethereum took this one step further by eliminating the need for centralized companies such as Kickstarter to manage the funding process. Ethereum itself was released via coin offering, raising $18.3 million in Bitcoin in the first month of its launch. The offering went on to pay developer salaries, fund future projects, pay bounties for programmers that can identify and fix bugs, and pay miners. Many projects launched through ICOs were extremely successful, though the unregulated, “wild west” nature of the mania led to investor abuse. This will diminish over time with increased regulation and increased investor knowledge. Ethereum’s role in disintermediating centralized authority from the fundraising process serves as one example of DeFi. It also disintermediates banks through collateralized lending, asset tokenization, and U.S. dollar stablecoins.
Readers should understand the difference between centralized and decentralized crypto-lending. BlockFi, SALT lending, Celcius, Gemini, and Coinbase lending programs act no differently than banks. Usually with a 50 percent loan-to-value ratio, no credit check is required. One can take a $25,000 loan by locking up $50,000 worth of Bitcoin as collateral. On a lending protocol such as Aave, Maker, or Compound, smart contracts automate the lending process. One can connect a wallet to the protocol website and take out a loan. However, as opposed to an exchange depositing the funds directly into your bank account, DeFi protocols use dollar stablecoins such as DAI, U.S. Dollar Coin (USDC), or the coin native to that blockchain to deposit funds. In addition to decentralized lending protocols, entire decentralized exchanges (DEx) such as dYdX or Uniswap exist that offer margin trading and greater token selection because they include all Ethereum-based ERC-20 tokens, not just the tokens that centralized exchanges decide to list. Currently, most users will not feel the need to use blockchain technology in every aspect of their financial life. However, with Ethereum-enabled DeFi, anyone can use a protocol to take loans and trade on margin in a trustless ecosystem.
A wide variety of dollar stablecoins exist, but they all serve the same purpose. They are digital dollars that can be used on any DeFi platform. Examples include Tether, USDC, DAI, and exchange tokens such as Binance USD. Why would anyone prefer digital dollar stablecoins over sending dollars through a bank? First, one can send any amount of dollar stablecoins on a DeFI platform or exchange instantaneously and with less fees than wire transfers. Individuals can also hold a zero-volatility asset in their wallet if they want the optionality. Stablecoins also provide a digital rail for anyone to own a dollar-pegged asset outside of a country’s financial system. For hyperinflating currencies such as the Venezuelan bolivar or Zimbabwean dollar, the U.S. dollar is a superior store of value. Using DeFi, anyone with exchange access can peg their currency to the dollar to avoid inflationist national policies or capital controls. A third use-case for dollar stablecoins involves remittance payments. Sending dollars through an international money transfer service to one’s home country will incur time and fees as high as nine percent. Sending dollar stablecoins to a digital wallet is instant and has a low, flat fee. Ethereum enables the creation of these through digital dollar pegs.
The final financial use case this chapter will examine is the tokenization of real assets, using the real estate example. Companies such as Meridio.co allow for real estate tokenization and fractional ownership. Through the Ethereum network, a commercial property owner can liquidate a portion of his or her property to fund other projects or raise capital. They do this by dividing the property into tokens that represent a certain square footage. Investors who do not have the capital to invest in large real estate projects, but have the desire to do so, can still get exposure by owning fractional shares. Smart contracts automatically distribute the cash flows from the property to all investors. Tokenizing property provides liquidity to the asset owner and exposure to the small investor in an open market. Fundraising without a venture capital firm, purchasing assets without an online broker, exchanging currency for dollars without a currency exchange, and investing in commercial real estate without a bank all represent the power of DeFi.
Ethereum in the Real World
At 2016’s Devcon2 Ethereum Conference in Shanghai, China, developers from Etherisc introduced and live-tested a decentralized flight insurance protocol. Customers would pay the application a premium and input flight details. The application would monitor the flight based on the information given, and if canceled or delayed, the smart contract would automatically execute to pay the insured traveler. Of 31 accepted policy applications, 6 experienced flight delays and received their insurance payout. In fact, an insurance payout through the protocol usually reached the traveler before official notification from the airline. The DApp underwent several updates to address critical bugs, including one that allowed insurers to input flights that had already occurred. Despite its initial bugginess, Etherisc had reached a milestone in applying smart contracts to insurance claims. Those in the audience had witnessed a self-executing insurance protocol in real time.
Since then, institutional insurers have demonstrated immense interest self-executing insurance claims. A report by Accenture indicated that the market for blockchain-based insurance will grow at a compound annual rate of 84.9 percent until 2023.5 Using smart contracts cuts down the need for human resources representatives to process claims and the likelihood of fraud. The cost-savings for insurance companies will be enormous, though it also demonstrates the disrupting effects of technology on jobs. U.S. insurance giant MetLife announced in 2019 that it would introduce a protocol on the Ethereum blockchain to streamline its claims process. Ethereum’s applications are only beginning to witness the entrenchment necessary to reach critical mass.
Smart contracts also disrupt supply chain management and identity systems. At its core, the blockchain records exchanges of value between two parties in a secure, verifiable manner. In supply chains, goods and parts exchange hands multiple times in the process that eventually leads to final delivery of a finished product. Through the Ethereum network, one can automatically track the custody of a good, determine the origin of parts, execute payment once the good is received, and maintain a transparent record throughout. Amazon Web Services patented Amazon Managed Blockchain in May 2020, using the Ethereum and Hyperledger Fabric blockchains. The Track and Trace service updates a shared ledger at every stop on the supply chain from supplier to consumer. Using Ethereum for supply chain management prevents fraud and provides full transparency. Twenty-five percent of Ethereum nodes in the world run on Amazon Web Services, and companies such as Nestle, BMW, and Sony Music manage their supply chains through the Ethereum network.6
In terms of identity verification, both Bitcoin and Ethereum can cut down on identity theft through cryptographic verification involving public and private keys. Today, governments provide proof of identity through social security cards, passports, driver’s licenses, and the like. Bad actors who get a hold of one’s personally identifiable information can easily steal someone’s identity. They can also create fraudulent government-issued identification cards. These government-issued cards and numbers make a claim that the person is who they say they are, and the only verification, if any, involves photo identification. On any blockchain network, an institution that needs to validate someone’s identity can scan that individual’s public key. The public key is then signed by the individual’s private key to confirm identity. As opposed to physical cards, anyone can have a digital ID on their smart device and sign with their private key to confirm. Cryptographic private keys held behind a firewall of facial recognition and passwords provides more security than a physical social security card or driver’s license that can easily be stolen or misplaced. In 2019, Microsoft launched its own decentralized identity tool built on top of the Bitcoin blockchain. Ethereum-based companies such as uPort and ConsenSys provide similar services.
Unlike Bitcoin that had its clearly stated use case at inception, Ethereum opened with the broad-based financial, semifinancial, and non-financial use cases. Since then, the ecosystem has taken a life of its own to power the DeFi movement and has begun migrating to solving real-world problems such as insurance claims and supply chain management. Purchasing Ethereum tokens is akin to owning a share of the protocol and betting on DApps continuing to take market share from traditionally centralized industries. Ethereum mostly challenges the financial industry. Just as Bitcoin challenges government-issued money, Ethereum challenges much of the system that custodies and lends that money.
Bitcoin Versus Ethereum
As the second blue-chip cryptocurrency, Ethereum has both advantages and disadvantages when compared to Bitcoin. Before contrasting the two, I would like to address the idea of their mutual exclusivity. Bitcoin and Ethereum tribalism would have the average investor believe that only one will survive. This tribalism manifests itself in social media, the echo chambers of confirmation bias that only amplify one’s sense of tribalism. Seeing as the two coins serve different purposes, I do not see them as challengers to one another. Bitcoin is money. Ethereum is not. Additionally, DeFi projects amplify the decentralization process that Bitcoin began. As decentralized money, Bitcoin segregated governments and banks from the value transaction process. However, adding centralized exchanges as the gatekeepers of Bitcoin, despite their support toward the asset or one’s ability to take his or her coins offline, substitutes one form of centralization for another.
The proliferation of decentralized exchanges such as Uniswap, built on the Ethereum protocol, take decentralization one step further by relying on liquidity pools instead of centralized market makers. By using Uniswap, the user must trust the code. Small bugs in code can be fixed, though users must trust that no catastrophic bug exists for hackers to exploit. By using Coinbase or a similar exchange, the user must trust the centralized server and company. Most investors interested in gaining price exposure to cryptocurrencies, seeing as they trust their online bank or online broker to hold their stocks, bonds, and currencies, will have no issue with this. However, a truly bankless, decentralized future will need to see a merge between hard money and smart contracts. Though decentralized exchanges currently only support ERC-20 tokens, several projects exist to create interoperability between blockchains. Bitcoin trading on a decentralized, Ethereum-based platform is inevitable. The concept of wrapped Bitcoin, the 1:1 backed ERC-20 token that currently trades on Ethereum platforms, is only a temporary solution.
In the bigger picture, both Bitcoin and Ethereum are changing money and finance as part of the same ecosystem. If traditional finance involves fiat dollars and traditional banks as the middlemen between value transactions, the parallel blockchain financial system involves hard money in Bitcoin and decentralized programs that reduce reliance on banks. Just as the telephone democratized communication and the Internet democratized access to information, blockchain is democratizing money and finance. Owning Bitcoin, the best-performing asset for the last decade, is the best way to capitalize on this trend and have a stake in the new ecosystem. Owning Ethereum is the second-best investment in this trend, though Ethereum is more volatile and constitutes a more risky investment for reasons that I will address later in this section.
Ethereum is disrupting the world of finance and its price relies on network effects similar to Bitcoin. The main difference between Bitcoin and Ethereum involve their use cases as hard money and blockchain application respectively. However, they contain other differences that potential investors should make themselves aware of. These include a more centralized team of developers, the proof-of-stake mechanism, and undefined scarcity. Active developers and value dilution do not exist in the Bitcoin network and add a component of risk. The second risk is the existential risk of Bitcoin-based smart contracts that programming language does not yet support but one day will. Will the future of DeFi involve inter-blockchain operability protocols that allow Bitcoin to trade on Ethereum networks? Or will it involve a Bitcoin-based smart contracts layer that makes Ethereum obsolete? The rest of this section addresses these differences and risks in order.
The 2016 DAO hack demonstrated both a pro and a con of the Ethereum protocol—the developers could quickly band together to change the protocol if necessary. As previously mentioned, a DAO is a Decentralized Autonomous Organization where a group develops smart contracts to run an organization and conducts an ICO to where number of coins represent voting rights. The DAO, one particular organization launched in April 2016, was a decentralized venture capital organization. Anyone could propose a project and the DAO would vote on whether or not to fund, how much, and even vote on specifics of their ventures. Successful ventures had profits returned to the DAO and its members in Ethereum. In June 2016, a hacker exposed a bug to successfully drain $70 million, or 3.6 million Ethereum tokens (ETH), from the organization. The price of ETH dropped from $20 to $13, as the DAO contained roughly 15 percent of all ETH.7
Days after the attack, Vitalik Buterin and the Ethereum Foundation issued a critical update, saying they had found a solution to the DAO hack. The developers created a soft fork that invalidated any transactions that derived from the DAO or the hacker’s “child DAO” through which he or she deposited the funds. Essentially, this fork froze the hacker’s assets. The soft fork failed, and hackers continued exploiting the catastrophic bug in the DAO structure to drain its assets. At that point, the core developers of the Ethereum Foundation went one step further in creating a hard fork to return the stolen funds to the DAO, with about 85 percent approval from Reddit polls. This hard fork split the network into Ethereum Classic and Ethereum—with Ethereum Classic being the pre-DAO hack network. Slowly and with controversy, users switched to the network that invalidated the hack. Only about 10 percent of users remained on the classic network.
The issue was not Ethereum itself, but a flaw in the DAO that owned a large percentage of ETH. Imagine if in the 2019 Binance hack, a group of developers banded together to return the funds and freeze the hacker’s assets. To some, this fluidity constitutes an advantage of the Ethereum network. To others, it demonstrates troubling centralization that runs counter to the spirit of DeFi projects. It also creates a “too big to fail” moral hazard. When a smaller developer writes a bad contract and loses his or her ETH, the foundation will certainly not go through such efforts to save that organization. Do I personally believe that the Ethereum foundation will undermine the network for their monetary advantage? Of course not. However, investors should know that the Bitcoin governance process involves supermajorities and multiple checks and balances for soft forks alone. The Ethereum governance process is much more centralized as demonstrated by the DAO hack.
In another demonstration of Ethereum’s trade-off between centralization and fluidity, updates to the network in Ethereum 2.0 are being rolled out in 2021 and set to complete in 2023. Ethereum 2.0 is not a hard fork and requires no change from current token holders. It provides three major upgrades to the network in an attempt to make it more scalable and secure: the beacon chain, shard chains, and docking. Ethereum 2.0 transitions from proof-of-work to proof-of-stake and reduces the hardware requirement to run a full node on the network. As mentioned in previous chapters, proof-of-stake attributes mining power in direct proportion to the number of coins held, not by computational power and energy. This makes the mining process much less energy intensive and reduces the possibility of a 51 percent attack because one needs to own 51 percent of all ETH, not mining power, to attack the network. The introduction of Ethereum 2.0 reinforces the idea that investors should think of Bitcoin as more of a finished product compared to Ethereum’s centrally driven fluidity.
Though Ethereum supporters will claim that proof-of-stake is superior because it is less energy intensive, this energy efficiency does not come without cost. As previously mentioned, proof-of-stake makes it easier for those with large ETH balances to acquire more ETH. Unlike proof of work, there are no forced sellers throughout the mining process. Large ETH holders will inevitably acquire greater voting rights and influence on the future of the protocol. I believe proof-of-stake will inevitably lead to greater centralization. This does not necessarily make Ethereum uninvestable. However, for those who see blockchain technology a wrecking ball to hierarchical structures in money and finance, proof-of-work is a step in the wrong direction. Ethereum 2.0 trades environmental palatability for centralization. For some, this constitutes a necessary tradeoff.
Another major difference between the two networks, and what oftentimes becomes an insurmountable roadblock for Bitcoiners, is Ethereum’s undefined scarcity mentioned earlier. The long-term inflation rate of Ethereum trends toward zero, but it does not have Bitcoin’s supply cap. Once the transition to proof-of-stake is complete, Ethereum will have an inflation rate between 0 and 5 percent according to its whitepaper.8 In essence, Ethereum will have an inflation rate similar to gold’s as a relatively scarce, but not absolutely scarce asset. Developers created this low inflation rate of coins in order to account for an overconcentration of wealth, lost coins, and flexibility in expanding the coin base. The irony being that wealthy ETH holders have greater staking power to begin with. To hard money enthusiasts, Ethereum developers have the power to dilute shareholder value through coin issuance, making it automatically less valuable than Bitcoin. I would argue that as money, Ethereum does not beat Bitcoin. However, one does not understand Ethereum if they are only examining its monetary qualities.
Ethereum has one major existential threat that blockchain enthusiasts will one day vote on with their wallets. Programmers are currently racing to create a programming language that allows for smart contracts on the Bitcoin network. One programming language called Sapio is built around the CHECKTEMPLATEVERIFY (CTV) code. The Bitcoin network would have to undergo a soft fork to allow for smart contract compatibility through CTV or another method. When asked about Sapio’s potential adoption via soft fork in a 2020 interview, Bitcoin contributor and Sapio creator Jeremy Rubin stated, “There are a reasonable amount of people who say it’s three years from now—at least.”9 Minsk is another programming language aimed at allowing smart contracts on the Bitcoin network. The trialing process will be extensive for both of these projects even as they reach completion.
Ethereum is also undergoing a process to allow for interoperability between blockchains. Currently, the Ethereum and Bitcoin blockchains run disparate to each other. As previously mentioned, one cannot purchase Bitcoin directly on an Ethereum wallet or DApp, but must purchase wrapped Bitcoin (wBTC), an ERC-20 token backed by Bitcoin. Other cryptocurrencies such as Litecoin and Filecoin also do not operate on Ethereum networks unless wrapped to allow for ERC-20 compatibility. In the real world, that means a supply chain manager using a public blockchain cannot accept Bitcoin as payment, only Ethereum or ERC-20 stablecoins. However, projects such as Cosmos, Chainlink, Polkadot, and Hybrix all aim at creating a network of blockchains that do not operate in a siloed manner. These projects are already launched and will likely allow for interoperability before we witness Bitcoin smart contracts.
Will Bitcoin smart contracts erase the need for Ethereum altogether? Or will using Bitcoin on the Ethereum network be the way forward in DeFi? Though no one can know the definite answer, I believe using a lens of network effects gives us an idea of the most likely scenario. Currently, most of the DeFi ecosystem exists on the Ethereum network. Uniswap reached the milestone of $100 billion cumulative transactions in early 2021. I suspect that number will be much higher by the suggested timeline of 2023 for the rollout of Bitcoin smart contracts, especially if one of the many current projects succeed to allow for greater token interoperability and selection. Will everyone on Uniswap move over to a new, Bitcoin-based decentralized exchange? While Bitcoin purists may, I believe the average user will not. The average user does not care for the mechanics underlying their operating system. They want to know if the exchange is decentralized, operates smoothly, securely, and if it offers the tokens they want to invest in.
Several examples exist to demonstrate how network effects and entrenchment will likely mean that Ethereum applications remain in place despite Bitcoin smart contracts. One example includes the Bitcoin versus Bitcoin Cash debate. As opposed to jumping to a different network altogether, Bitcoin developers upgraded the dominant coin through the lightning network. In terms of smart contracts, Ethereum is the dominant coin. I equate this to interoperability DeFi projects attempting to close the siloes between coins as opposed to the entire space moving to Bitcoin once the technology allows it. Many used the argument of entrenched carmakers introducing electric vehicles as a reason why Tesla will fail, a company that never had a full year of profitability until 2020. Porsche, BMW, and Mercedes all offer luxury electric vehicle alternatives, yet Tesla still has 18 percent of the global electric vehicle market share, with the second largest being Volkswagen at 6 percent.10 Tesla did not collapse as entrenched carmakers rolled out electric vehicles similar to Zoom not collapsing when Google made its Google Meet feature free in 2020. I do not believe Ethereum will collapse with the introduction of Bitcoin-enabled smart contracts. It certainly has consequences, such as undoing the need for centralization in Bitcoin-based loans, though I do not believe DeFi will shift to Bitcoin-only platforms. Despite this, investors should understand the risk that this technology could take significant market share from certain Ethereum’s DApps. Similar to how Bitcoin had a scalability issue that it needed to solve in 2016, Ethereum has an interoperability issue that it must overcome for mass adoption.
On Altcoins
All “alternative coins” to Bitcoin and Ethereum fall under the umbrella of Altcoins, although some will claim that the title goes to any blockchain-based digital asset that is not Bitcoin. I categorize Altcoins into four types—cryptocurrencies, security tokens, utility tokens, and DeFi protocols. Though many in the blockchain community will disagree with my characterizations seeing as DeFi protocols can be also be security and utility tokens, I believe this narrower characterization more neatly describes the ecosystem.
The first type of Altcoins are cryptocurrencies, or Bitcoin alternatives whose purpose is to make payments and store value in a secure, decentralized manner. Examples include Bitcoin Cash, Litecoin, Monero, and Zcash. Some currencies emphasize network speed for greater use in microtransactions, improving on the prelightning network limitations of Bitcoin. Others have enhanced privacy features such as Monero’s stealth addresses and Zcash’s zero knowledge-proof transactions that make them less trackable than Bitcoin’s use of public addresses. Personally, any token that advertises itself as a Bitcoin alternative is not worth the investment. Bitcoin is by far the dominant monetary network that accomplishes the primary functions of money as a medium of exchange and store of value. Institutions are not racing to provide Litecoin or Zcash services. All other coins that aim to take market share from Bitcoin will either fade into irrelevance as they fail to gain the same network effects or remain relegated into niche markets—such as illicit or private transactions that would warrant a more private monetary network.
The second type of Altcoins are security tokens. I include stablecoins under this umbrella. Security tokens are an interesting use case of blockchain technology whereby an asset becomes tokenized and ownership becomes preserved on the blockchain ledger. Though algorithmic stable-coins exist that expand and contract supply in order to maintain a certain peg, most stablecoins serve as securitized tokens of a different asset. That asset can be U.S. dollars in the case of the USDC token or exchange based stablecoins. The collateralized asset can also be commodities such as the Digix Gold token on the Ethereum network, or specific real estate markets such as the New York City Real Estate Coin or the SwissRealCoin. They can also be collateralized by other Digital Assets, such as the DAI token that is overcollaterized by ETH to maintain its dollar peg and cushion against negative volatility. Investable protocols such as Synthetix and Universal Market Access (UMA) create synthetic financial instruments to track the price of other investments using their tokens as collateral. Though they have different system designs, these are both derivative protocols. Synthetix offers short Ethereum and short Bitcoin tokens, short fiat currency tokens, or tokens such as iDEFI that inversely tracks a basket of DeFi protocols. Derivatives tokens, similar to derivatives-based ETFs, is a largely untapped market that will provide greater asset selection to investors on a decentralized exchange. UMA is set to launch an S&P 500 index token, for example. In the future, I believe all financial securities will also trade in tokenized form on decentralized exchanges. Will everyone migrate to decentralized exchanges and purchase S&P 500 tokens as opposed to the index on their brokerage account? Unlikely. However, in an attempt to avoid trade commissions, brokerage fees, mutual fund management fees, broker risk, and trade on a 24-hour basis, there will undoubtedly be a market for decentralized trading. Financial securities tokenization is an exciting aspect of blockchain technology still in its early stages.
The next type of Altcoin is the utility token. Utility tokens provide a user with a product or service, although the value of the token may increase as more users interact with a limited supply of token issuances. Tradable tokens exist to provide file storage renting, computing power renting, identity verification, digital advertising solutions, and more. Some utility tokens power a rental agreement between users while others power an entire ecosystem. Filecoin, Siacoin, and Storj are examples of peer-to-peer file storage protocols. In Filecoin (FIL), for example, miners are rewarded with coins for providing excess disc space for storage. Users can pay any miner with FIL to store their files at rates that are usually more competitive than cloud-based storage systems. The Golem Network (GNT) works in a similar manner replacing file storage capacity with excess computing power. Individual computers and large data centers alike can earn GNT for renting out their Central Processing Unit (CPU) power. In terms of ecosystem-based tokens, Civic is an identity verification ecosystem that does not rely on centralized databases to store usernames and passwords. Participants in the ecosystem get rewarded with Civic coins. The Basic Attention Token (BAT) is the native token of the Brave browser that transforms digital marketing by paying web surfers in BAT for their attention placed to advertisements. Utility tokens power a service. While the token price may appreciate depending on the popularity of the protocol, they are not collateralized securities or intended currencies outside of their ecosystem.
The last type of Altcoins, though some would claim that they fall under security or utility token depending on their use case, is the DeFi protocol. These include decentralized lending protocols such as Compound and Aave and decentralized exchange protocols such as the Uniswap token used in governance or the Bancor Network Token used as a default currency for that network. They also include tokens specific to smart contract operability such as oracle networks, which exist as third-party tokens that feed smart contracts with the external data they require. Chainlink, Augur, which specializes in prediction markets, and the Band Protocol are examples of oracle tokens that provide necessary information to smart contracts. Cosmos and THORChain are examples of protocols tackling the previously mentioned blockchain interoperability issue.
Bitcoin and Ethereum have monopolies in the digital currency and smart contracts spaces respectively. One shortfall of investing in the Altcoin space involves the nuance between protocols competing for limited market share. For example, I believe blockchain interoperability and derivatives tokens constitute two promising DeFi trends with market oligopolies. Will the oligopoly remain so? Will a current token become the dominant network in that field? Will a new token achieve the desired end-state in a manner that makes the current protocols obsolete? Unlike the blue-chip digital assets, these technologies are new and early in their adoption curves. They have the potential to become the backbones of a tokenized digital asset market that rivals traditional stock markets. They also have the potential to go to zero. An in-depth study of the over 5,000 Altcoins that exist will be a largely fruitless endeavor, especially when there is so much alpha generated in the Bitcoin and Ethereum spaces already. The subsequent chapter will examine what role, if any, Altcoins can play in a portfolio.
Aside from providing definitions, examples, and personal commentary on Ethereum and Altcoins, I hope this chapter cleared up the misconceptions many investors have. Though the precious metals analogy makes sense for Bitcoin, Ethereum and Altcoins are not the silver and platinum to Bitcoin’s digital gold. Additionally, the term cryptocurrency is a misnomer. Currencies have historically had three functions: that of a medium of exchange, store of value, and unit of account. Most digital assets were not created with these functions in mind. Each digital asset serves a unique purpose, hence why the more nebulous term digital asset fits better than cryptocurrency. Collateralized tokens have more in common with securities than currencies. Utility tokens may be the native currency of their respective networks, but exist within niche markets such as file storage and online advertising. Smart contracts, exchange governance tokens, and oracle protocols all share the use case of powering DeFi, having nothing to do with daily purchases that one would equate with a currency. Treating all these tokens as alternative currencies is a gross misrepresentation.