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The Exchange: The Road Ahead for Crypto
From left: Scott Duke Kominers and Charles C.Y. Wang
(Image by John Ritter)
Cryptocurrencies have been edging their way out of the periphery for the last decade and proliferating as they go: About 18,000 digital currencies currently exist and hit a total market cap of $2 trillion before major losses in June. Will crypto overcome the challenges on the road to mainstream adoption? What’s standing in its way? HBS faculty members Charles C.Y. Wang, who has written about public firms’ investments in, and accounting for, cryptocurrencies, and Scott Duke Kominers, who advises crypto businesses and holds an expanding personal collection of NFTs, sat down with the Bulletin last spring to talk about trust and transparency, and what a crypto future could look like.
Scott, in the article “Bitcoin and Beyond,” you and coauthors Christian Catalini and Ravi Jagadeesan (PhDBE 2020) make the point that it took centuries for paper currency to evolve from a concept to reality. Meanwhile, bitcoin has been around for about a decade. Can you help situate us in the lifetime of this technology?
Scott Duke Kominers: One of the points we make in that article is that a currency gains value only once many people have all agreed that it has value. Dollars, or other established fiat currencies, are useful because lots of people are willing to exchange them for goods and services. Which means that if you’re holding a dollar, you’re pretty certain you can trade it to somebody else for something they might want to sell you.
Cryptocurrencies have not yet reached that state. Digital financial transactions are commonplace now, but cryptocurrency, per se, is not something very large numbers of individuals or businesses are willing to trade for goods and services. In many cases, they don’t have the right sort of technology with which to do that, even if they wanted to. We’re already seeing the current implementation of the Ethereum network have trouble managing the number of transactions people are making, such that transaction fees can be much more than the cost of many of the goods people might want to buy. We’re also seeing environmental costs with the energy usage of certain bitcoin architectures. Meanwhile, digital wallets that people use to hold cryptocurrency don’t have many of the protections people are used to and expect from other forms of digital financial services, like online banking. There’s a long way to go in terms of consumer protection.
Charles C.Y. Wang: Aside from the logistical issues that Scott has mentioned, a couple things stand in the way of mainstream adoption. For people to use cryptocurrencies to transact, it will be important to have a somewhat stable value. But they are riskier than the stock market, so cryptocurrency markets are dominated by speculators or traders. Another constituent is the long-term investors, who take a long-horizon macro view on these assets being a less-dumb form of liquidity than holding cash. But if you believe that the value’s going up in the long run, there’s no reason to spend it now. You don’t want to be the guy who bought two Papa John’s pizzas with 10,000 bitcoins way back in 2010. So what’s less clear to me is how—and how long it will take—to arrive at a place where cryptocurrency prices are sufficiently stable and where there’s a critical mass of people who are actually using these currencies for transactional purposes, rather than speculation.
Kominers: You raise a good point. If this stuff does become backbone transaction infrastructure, I think that will happen through stablecoins, central-bank digital currencies, or other uses of the blockchain technology that aren’t built around the same features that potentially make some crypto assets attract speculation. And as Catalini, Jagadeesan, and I discussed in another paper, crypto introduces a tension: For something to be useful as a medium of exchange, it has to have a reasonably stable value, but you also need it to be liquid enough that people will use it. At the same time, if a cryptocurrency becomes super liquid, there could be potential security implications: Somebody could acquire a lot of liquid tokens and potentially subvert the network. So you need some people treating the currency as a store of value as well.
And, incidentally, these sorts of dynamics don’t just play out with general-use cryptocurrencies. They also show up in individual tokens, like NFT projects. If a utility token in a game ecosystem is too valuable, nobody wants to actually spend it, so no one’s playing the game, which then destroys value. And if it’s too liquid, then there’s suddenly too much of it in play, it loses all the value, and the game’s economic system collapses. It’s a very careful balance to strike. And the more decentralization you build into the system, the harder it is to manage that balance.
Wang: We talked about bitcoin. And Scott, you mentioned stablecoins, but there are other altcoins and tokens, as well. What are the differences?
Kominers: Bitcoin was the original cryptocurrency, and its underlying architecture is the original blockchain. That’s a ledger of transactions maintained by a decentralized network of computer systems that validate and cross-validate the transactions. Stablecoins are a different type of crypto asset. They use the same underlying blockchain technology, but instead of comprising an asset that could fluctuate in value, they try to define an asset that will hopefully keep a very specific value, often by associating it to a currency reserve. A stablecoin might have a value that’s pegged to the dollar, for example, or the euro. Often the way to make that happen is to hold a reserve of dollars, or euros, so people buy into the coin and cash out of it in more or less the same way as you would with deposits at a bank.
Wang: And the reason this is desirable is presumably that it’s a superior system for transparency and trust.
Kominers: It’s very transparent and—when done correctly—very fault tolerant. And it reduces your need to place trust in any individual centralized institution. In bitcoin, people submit transactions to the system, just like you might tell your credit card company to send money to a merchant. All the computers simultaneously try to process transactions, and they do this by solving a very computationally difficult task. The first one that solves the task basically gets a cryptographic certificate that says, “You solved this task.” These certificates are hard to construct but easy to verify. So all the other computers then say, “Okay, great. We now know that this set of transactions has been added.” And then they move on and start trying to add the next block, and in doing so they form this chain of transaction history.
Wang: Banks have ledgers that help them keep track of who owns what, and we get paper statements to help us make sure that they’re not making some mistake. The difference here is that the blockchain brings transparency and trust in this ledger: No one person controls it, and the public can see what changes happen. Now, if we extend this idea to a fiat currency system, let’s say one run by Scott, one worry is that he could go to the back office at the end of the day and just print a bunch of “Scott Kominers coins” for himself. Nobody would ever know because people don’t have the ability to scrutinize Scott’s ledger. This type of worrisome transaction would not be possible with cryptocurrencies because the creation and transfers of currencies are recorded on the blockchain.
Kominers: Yes, but at the same time, because the system is decentralized, you don’t have the same recourse you would have against a bank. If the bank just took half of my checking account and gave it to you, I could bring a lawsuit, and the bank would have to respond. When the system is decentralized, there’s no owner, and often not even a central legal institution wrapped around it. If the system somehow decided to take half of my bitcoin holdings and give them to you, there’s nothing I could do about it.
“While the technology is technically transparent, it’s still very opaque for the average consumer.”
A big part of what makes these systems work is that the code itself is transparent, so you can trust the software that’s running because you can read it, and you know it will always run as claimed. That’s the substitute for institutional trust, and while it’s powerful, it limits what you can do in these systems to some degree, because you have to design software that can be trusted in this way. That’s the reason for these very hard computational problems, to manage the transaction flow in this context.
I take your word that the code is transparent, but it’s not at all clear to me. To what degree is the inherent complexity of this technology a factor in mainstream adoption?
Kominers: One of the many ways in which this stuff is not yet ready for widespread use is that while the technology is technically transparent, it’s still very opaque for the average consumer, or even for the very sophisticated consumer. This shows up in the extent to which even very sophisticated actors are having their crypto assets stolen. And on the onboarding side, it’s still very complicated even just to get a crypto wallet.
I think for many applications, a lot of this technical complexity is eventually going to get submerged. NBA Top Shot is a system for trading digital NBA video “moments” and is one of the most popular NFT trading platforms: They submerge nearly all of the crypto-ness under the hood, and the fact that it’s managed on a blockchain is just how they make the architecture work.
The thing that will be helpful for consumers is the fact that, with these crypto technologies, you yourself have control over your digital assets in a way that you didn’t in previous incarnations of the web. And more important, the platforms actually have a strong incentive to educate consumers and help them understand. Because once you own your digital assets, you can carry them with you from place to place. As an analogy, it’s really hard to close an account at one bank and move the money into a different bank. That’s a multistep, very complicated process. By contrast, if you have a digital-asset account, you have the ability to decide which platforms you engage with and why. Which means the platforms themselves are incentivized to build systems you want to use and educate you about how those systems work.
It’s still early days. But you could have said similar things about the early internet, when it was really hard to navigate to information. Certain platforms made a lot of that initial effort for us, by identifying key consumer-use cases and then making it very intuitive and simple, like the original Google home page. I think a lot of the innovation today is around trying to understand the core consumer-use cases and the needs that crypto technology can really address, and how to make the technology intuitive in addressing those problems.
Wang: Beyond the advantages that Scott has mentioned, imagine you’re in a country where the currency is more volatile than cryptocurrencies, or where it’s highly risky to be carrying around cash. Cryptocurrencies can be extremely valuable in such countries, and these use cases are not likely to go away anytime soon. So far, two countries have declared bitcoin as legal tender: El Salvador and the Central African Republic.
Kominers: You raise a really important use case, which is financial inclusion. In some places, the transparency and security afforded by crypto assets can be a huge feature, because the institutions around currency and banking are not nearly as strong as they are in the United States or elsewhere.
I think we’re likely to see a lot of crypto technologies stick around. We might see them stratify by use case. In general, there’s going to be a lot of space for competition, even at the infrastructure layer and in terms of all the smaller tokens that are used for very specific use cases. We’ll have lots of them. People will have digital wallets to manage them, in the same way that you have a phone full of apps for lots of different use cases.
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