Blockchains, Bitcoins, and What Comes Next

When I first heard of Bitcoin and the blockchain, I was chary. I'm always skeptical of anything that calls itself "The Truth", and the ardent Bitcoin supporters weren't helping. 

Many technologies actually start like this. They seem absolutely absurd to the those who live in a world without them. To be fair, most technologies are crazy and unrealistic, but a select few advance far enough to change the world. 

So what changed, you might ask your optimistically pessimistic writer. 

The way I approach the question of disruption is not how most people do. I'm not the biggest fan of The Innovator's Dilemma, since it's too formulaic. Instead, observe the present and try to identify pain points. Let's take a recent pain point; MetroCards. Why do millions of New Yorkers have to carry around a small, easy to lose plastic card when NFC and other contactless solutions exist today? The answer is simple: it costs the city a lot of money to build the infrastructure necessary to support contactless payments in all boroughs. The project would cost billions of dollars, and would undoubtedly be inefficient as most government sponsored projects tend to be. The first company or startup to figure out an affordable solution to this clear problem will be the technology to win. The pain point is in archaic MetroCard, and the solution is a technology that affordably substitutes it. 

Banks make billion dollar bets on spreadsheets. Every single multi-billion dollar deal you see on the news - it is modeled in Excel at some stage (sometimes all stages). Corporate tax accountants, who calculate data that needs to be precise, also use Excel for most of their work. The same applies to auditors, consultants, and investment managers. Excel is the fabric on which the worlds financial data is weaved, but the material isn't very good. 

Every new release, Excel becomes more powerful and is able to handle more data. But while Excel improves rather linearly, the amount of data that needs to be processed increases exponentially. Writing about our ability to predict randomness, Nassim Taleb writes in The Black Swan:

...the gains in our ability to model (and predict) the world may be dwarfed by the increases in its complexity

The reason I included the quote above is because it's entirely how I view the state of spreadsheets. While I don't see them going anywhere for most basic to intermediate needs, their time will eventually pass for more complex financial data sets. 

Enter Chains of Blocks

At the same time that the complexity of the worlds financial data is beginning to become burdensome, a new technology shows up called Bitcoin. With it, Bitcoin brings the blockchain. 

Behind the scenes, the blockchain is quite complex (although not as complex as you think). But at the end of the day, what it provides is fairly simple (in financial applications, which I am focusing on). There are two major functions that the blockchain provides. First, it disaggregates information. Second, it allows you to trust otherwise trusted parties. These two functions bring a slew of other benefits, so they're worth discussing in more detail. 

Disaggregated Data

Currently, financial data is located in many places. For example, if you run a hedge fund, you have a copy of your data. Another copy lives with your custodian, which is usually another bank that handles your administrative tasks. Finally, there's the accounting department, which also keeps a copy of your transactions. At any point in time, there could be many reconciling items that don't match between the data you have, the custodian has, and what the accounting department has. That's not because they're bad at their jobs, but because the data is often too complex to handle. This is a gross simplification, yes, but the theory is not far from reality. 

A large part of the accounting profession is actually keeping track of this data, which is an incredibly messy process. And accountants are not so cheap. 

What the chain would allow is for that copy of financial data to exist at the hands of all the involved parties. As transactions happen, they would be recorded in the chain - and everybody involved would have access to that same chain. No reconciling items (in theory, in practice there are always some), no inefficient accounting departments, no lost financial data. 

A Brief History of Money

For the past few weeks, I’ve been reading a fascinating book, Sapiens. If you’re even a slight history geek, you should give it a read. The reason I bring it up here is because there is a chapter on the history of money, currency, and value (all synonymous terms), which put many things in perspective for me. A carefully selected excerpt:

Yet money existed long before the invention of coinage, and cultures have prospered using other things as currency, such as shells, cattle, skins, salt, grain, beads, cloth and promissory notes. Cowry shells were used as money for about 4,000 years all over Africa, South Asia, East Asia and Oceania

I’m sure you didn’t need me to tell you, my very dear erudite reader, that dollar bills did not exist when the first homo-sapiens traversed the Asia-Pacific landmass. Instead, these early humans used shells and other simplistic items as their currency. But there is a larger point I am trying to make here, and it’s the fact that our modern currency is not a constant throughout time. We assume the U.S. Dollar has been around and will be around forever. But in the grand scheme of things, it has been around a very short period of time (for the curious, the Dollar has been around circa 1786). 

So now we know two things. First, you know I’m a history buff. Second, we know what that the form of money changes through the time periods - we don’t always use the same currency. We can also make a third assumption, and that is at some point in the future, we will go from dollar bills to some other form of a store of value. What the form will be I have not the slightest clue. All I know is that it the time will come, and the best way to prepare is to explore whatever new monetary technologies sprout up. 

A Quick Aside and a Probability

If you’ve spent some time in the finance industry like me, you’ll be well acquainted with this next part. If not, you will also be well acquainted, albeit by the end of it. There are two types of analysts on Wall Street; buy-side and sell-side. The sell-side guys usually work at a brokerage firm, and gives recommendations to “buy”, “sell”, or “hold” a security (stock). What happens when they get it wrong, such as when the analysts’ report says to sell Apple stock when in fact it keeps going up for the next few years? Usually, nothing happens. There are so many sell-side opinions that get things wrong that any individual analysts opinion often gets lost in the noise. 

In stark contrast, buy-side analysts usually work at companies that buy securities rather than sell them (that might be obvious, but not if you’ve never worked in the finance industry). These companies are usually mutual funds, pension funds, hedge funds, and other companies with pools of money to invest on behalf of other people. A buy-side analyst publishes internal reports, which are not available to anyone outside the company. If they get it wrong, the limelight is on them. Thus, what buy-side analysts often do is assign probabilities to their recommendations - which tells the investment manager how strong the analysts convictions are and whether the manager should act on those convictions.

I wanted to give this brief aside because probabilities of outcomes is exactly what I’m about to give. I think providing probabilities is one of the most helpful things any prognosticator of a future event can give. When I open my weather app, I see the percentage for rain, which in turn influences my actions. If there percentage is low, I am not bringing my umbrella. If it is high, both an umbrella and a raincoat will be donned. 

With that all said, back to bitcoin, blockchains, and the future of money. What are my probabilities for each of these technologies?

Bitcoin (lower case “b”): 20%. Bitcoin the currency has too much history, and too many fanatics. That baggage weighs it down, hence the chances of it taking off are 20%.

Blockchain/Distributed Ledgers: 90%. The protocol which powers everything, the blockchain, is a form of a distributed ledger. Investments by most major players have already been made to explore this technology, and some solutions are already being offered. I’m nearly certain that most ledgers will be distributed (but not fully decentralized) within the next 5-10 years.

Money: 30%. What I mean by money is physical money. Cash money. Unfortunately, as much as I hate carrying cash and coins I doubt they will be going away in the next 10 years. The major reason for this is that cash is heavily entangled with the government, and these things tend to move especially slow. Moreover, cash solves needs that digital currencies may have a hard time solving (the ability to hide cash, for example).