The Market Ticker
Commentary on The Capital Markets- Category [Investing]
2017-06-17 08:35 by Karl Denninger
in Investing , 6695 references
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A quick primer for those who don't understand how these work.

Digital "currencies" are all basically the same.  There is a finite number of a given "coin" type at inception; each has a cryptographic "key" that must be discovered in order to "acquire" it, which the proponents argue is similar to digging it out of the ground, and thus it is called "mining" them.

However, each successive coin in a given currency is harder to "mine" than the previous one; the cryptographic series is designed intentionally this way.  The first few coins are easy and they get more difficult as the number of them mined is a greater percentage of the whole.  The designer attempts to slightly outpace the growth rate of processor capability to solve said problem so that (1) it's reasonably practical to "mine" them at the outset but (2) as time goes on it becomes more difficult at a fast enough rate that the stock of said coins is not completely exhausted at any given time, NOR does it become so prohibitively difficult that there is no point in trying.

The "coins" are designed to be "self-proving" through a technology known as "blockchain" in the generic sense.  In order to confirm your coin is valid (and owned by you) others must reproduce your published "signing" result on the coin you claim to have mined.  In addition to prevent your "coin" (which is just a series of bits -- that is, a number) from being duplicated (counterfeited) whenever you exchange it with someone else they have to sign the "coin" and that transaction has to be published and the signature verified by some number of others before the "spend" is considered to be good.  Once it is considered good then ownership of said coin has passed to the new person.  Though this mechanism the transfer of a given coin from its mining onward can be irrevocably traced and it is thus impossible (in theory anyway) for someone to duplicate (counterfeit) said coin.

Digital "coins" are divisible and such divisions are just as valid as an original, but again a division must be confirmed and signed as well.  Thus you can spend 1/10th of a coin, the person who has 1/10th can spend half of that (or 1/20th of the original) and so on.

The design of these systems, however, is intentionally deflationary.  That is, not only is it harder and harder to "mine" more coins but any coin in which the signature cannot be confirmed because the person who last signed it loses their signing key is irrevocably lost.

There are nuances between all the different "coins" but they all share a common set of problems:

  • While the number of a given coin is distinct, discrete and finite there is no limit to the number of competing digital "coins."  If you don't like the ones that are present today you can set up another one and nothing prevents you (or someone else) from doing so.  This means that the common chestnut of there being a "finite supply" is false.

  • A deflationary "currency" over time ultimately becomes extinct and valueless.  In order for something to have a price it must in some form or fashion, for some period of time store value.  The creators of digital currencies try to insure this through their deflationary design.  The problem is that in order to get the value out of a non-physical thing that thing must be a medium of exchange.  That in turn requires wide acceptance by various individuals and firms transacting in that coin in some fashion.  As the number of coins in circulation inevitably decreases due to its deflationary design it ultimately must lose individuals and firms willing to transact in same.  At some critical mass point it becomes crippled sufficiently in terms of exchange that the alleged "value" collapses.

  • Alleged "exchanges" have no clean business model.  A valid exchange must exist solely on fees charged for transactions.  The problem is that a distributed authentication model, which is what makes "blockchain" work, inherently has no means for the validating nodes to charge back the work of validation to the transacting parties.  This results in those nodes having to exist via some other means (e.g. mining), and that means is usually speculating on the coins themselves!  If you want to know why these exchanges seem to have a record of absconding with your coins (or "losing" them), this is the reason -- they have no legitimate business model to otherwise pay for the continuing daily costs of validating and transacting between parties.

  • ALL such "digital currencies" are by design and intent a means to separate you from wealth and give it to whoever founded said "currency."  They are for this reason all effectively a pyramid scheme.  This will inevitably lead to the seizure and closing of all such systems -- if and when governments figure it out.  The reason is simple: With a finite and ever-more-difficult means of mining each successive coin the effect on value for participants is exactly the same as it is in any pyramid scheme.  Since nothing of physical existence is created or dug out of the ground there is no utility value and thus no floor price, unlike gold or silver (both of which have industrial value due to the metallurgical properties.) The person who "invents" such a system gets to "mine" many coins at very low cost (in electricity or whatever.)  He then watches the "value" of said coins escalate as each one becomes harder to "mine" and as hype takes over, and can convert that "wealth" into some other form, whether it be a fiat currency, real property or otherwise.  The founder always makes a grossly outsized "profit" in this fashion with the available profit dropping exponentially and ratably in every single case simply based on the number of participants.  At the beginning recruiting others who also make money is easy because mining the coins is easy.  However, over time recruiting others becomes harder and harder. This is exactly identical to what happens in a traditional pyramid scheme -- the founder gets a cut off all the sales from everyone under him.  The next layer who all find the field "unmowed" with lots of customers make a lot of money too, but always less than the first group and so on.  But since the number of customers is finite, just as is the number of coins, with each successive layer of participants it gets harder and harder to find others to transact in sufficient volume to turn a profit because the acquisition of each new (coin or customer) becomes exponentially more-difficult.  It is thus impossible on a mathematical basis for any such design to be self-sustaining since it relies on an exponentially more difficult act in a finite world.  ALL such systems are inherently ponzi schemes whether we are talking about digital currencies or the alleged sale of products.

This doesn't mean you can't try to speculate in such "currencies", because you certainly can.  However, you must recognize a few things before doing so.

First, it is my contention that you are probably participating in an illegal scheme, albeit one that is not currently recognized as such by the authorities.  No matter the instance, design, product or service any exponentially more-difficult (with time or number of "wins" or "participants") system is inherently a pyramid scheme.  That is it will always result in less return for the second participant than the first, for the third than the second, and so on.  Eventually the return will always become negative at which point the scheme collapses.  This is mathematically provable and is why such schemes are supposed to be illegal everywhere.  Part of your risk profile assessment thus must include whether such digital currency schemes will be ruled an illegal pyramid scheme by governing authorities somewhere (or everywhere) and if it is whether you will simply lose all the money you put into it or worse, potentially be criminally prosecuted.

Second, because blockchain inherently records every transaction for each "mined item" back to its point of origin the risk of that loss through said action never disappears.  Cryptographic signatures are admissible evidence since they are very close to being absolutely tamper-proof and as a result if such an outcome occurs the risk of a forcible unwind of any transfer out of said "currency" into some other form of money or property never expires.

Third, any attempt to evade paying taxes on any gains you make in such "currencies" is idiotic because your ownership and the exact P&L on your transactions is not only trivially able to be determined it is published in the blockchain and visible to anyone who cares to look!  If you don't declare every penny of such gains and a government decides to look they can trivially nail you and since there is no statute of limitations on intentional tax fraud in the United States (only on errors) you can get hammered retroactively literally for the rest of your life.

Fourth, because there is no means of payment to the validators of transactions from those who do transact due to the distributed design any "coins" you have at an exchange are subject to being lost or stolen if said exchange is unable to fund itself, and many of those exchanges, if not most, must be presumed to be speculating on the increasing price of said "coins" as their primary means of funding.  With the "miners" being validators (which is true for, I believe, all existing systems) this adds a second level of risk in that they can quit too since they don't get paid for validating -- only for discovering "new" coins. This exposes you to an insane amount of business risk over which you have no control.  In addition you must contend with all the other risks associated with third-party custody of anything such as theft or destruction.  Since a coin is non-duplicable and if stolen, spent and validated (or worse deleted) it is irretrievably gone such risks are exactly the same as those involved in holding a bar of gold or stack of $20 bills.  We have existing insurance systems for physical storage of various items of value for other things, but I am aware of none that are worth a bucket of spit when it comes to digital currency exchanges.  This may change in the future but for now it makes any holding of such "coins" by a third party extremely risky.

Fifth, because all such systems are self-extinguishing in that they are deflationary by intent and eventually either run out of coins to mine or cost more to mine one than the value that can be obtained through their exchange the number of persons willing to continue to provide validation of transactions as an uncompensated "part of their operation" (that otherwise makes money, e.g. by mining) eventually falls to zero.  Along with this the ever-increasing size of the transaction chain that must be maintained this makes the computational cost of validation as coins are divided and subdivided become ever-larger. Ultimately this forces some sort of payment model into the validation system but that's not a solution either as the larger and larger size of said chain causes the cost to continually increase without boundary.  Somewhere well before there are either zero validators or the cost of validation exceeds the marginal value of your proposed transaction you will lose the critical mass necessary to validate transactions in a reasonable amount of time and with reasonable certainty at which point said "digital currency" becomes worthless.  Nobody knows exactly where this "knee point" is for any given instance but that this problem exists by design in every case is a fact.

So go ahead and play if you wish folks, but just recognize that you're riding a ponzi scheme -- and that all of them, without exception, eventually collapse.

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