James J. Angel is a renowned professor with nearly three decades teaching finance in the USA. We had the chance to speak with him about how cryptocurrency is shaping the world as we know it. During our interview, he broke down technicalities of Bitcoin into manageable pieces, in what we consider to be a comprehensive seminar of what everyone should know about Bitcoin.
Good day James, and welcome to Fyggex. Could you tell us a bit about your finance background?
My name is James Angel. I am an associate professor of finance at the McDonough School of Business at Georgetown University. I study, among other things, how financial markets work in detail. I have been following cryptocurrencies for many years now and, in fact, I called for the US fed to issue the US dollar in digital form. So, I am a big proponent of crypto and digital technology, even though I am a bit sceptic about the prospects for Bitcoin 1.0.
Bitcoin 1.0. Can you elaborate on that?
Bitcoin 1.0 was a brilliant prototype, but one that can be and will be superseded by other applications. We don’t use prototypes indefinitely in most technology areas. We are not using Altair computers or flip phones anymore. We use more modern ones. Technology does progress. Today, there are many blockchains which are better, faster, and cheaper than Bitcoin 1.0. And I think those will be the applications that we will end up using.
You have a lifetime of experience in the academic field as an educator. What led you to move from traditional finance to cryptocurrency?
I started off as an engineer and I got my engineering degree at Caltech. I have always been interested in that interface between practicality and understanding how things work. I am in the business school because I like to see the practical applications of the things I work on. Because of my engineering background, I still have a lot of friends from the Caltech engineering community. And when I heard them starting to talk about this new thing called Bitcoin many years ago, it piqued my interest.
I long ago switched from engineering to finance, and I have studied a lot of economics along the way. And my first instinct was “Oh, they’re trying to start a new money”. Guess what? If you study the history of money, you will notice there is a long history of national governments, squeezing out private money. And for very good reason: creating money is very profitable.
The people who created Bitcoin and the early miners and whales are now very, very rich. If the rest of the world were to adopt Bitcoin as a monetary standard, which it will not, it would just exacerbate the inequality that we are dealing with now. You would have a few whales with all the bitcoins, and everyone else with nothing.
Our use of Bitcoin is different from its original purpose. What are your thoughts on that?
In his original white paper, Satoshi only mentions currency once, and he mentions payments over a dozen times. Bitcoin 1.0 was designed as a payment system, not as a store of value. With payments you have a thing called network economics, and this is where any new payment system has a big problem. With network products, the more people use it, the more valuable they become.
Imagine you had the only telephone in the world. It would be a useless paperweight because there would be nobody to talk to. But the more people connect to a phone network, the more valuable that phone becomes. Similar th happen with crypto. Bitcoin now has many nodes and many people with wallets, but people are mostly speculating with it. There are very few real-world applications where people are using it in a day-to-day sense.
I spent a lot of time, over the last several years trying to come up with a method for valuing Bitcoin and other cryptos. To value Bitcoin, we must figure out what are you going to use it for. And the original use case of payments does not really work well.
When I am teaching about Bitcoin, I always love to ask the audience “has anybody here ever bought or sold anything with Bitcoin?”. Occasionally, some students buy fake IDs, some people do online gaming sites, and one time a business owner who had been hit by ransomware, paid the ransom with it. And this is the real problem with Bitcoin 1.0. Apart from speculation, the primary use case has been in the underground economy.
Do you think that is the reason for regulation?
In the early days, crypto anarchists though “We’re going to create a brand-new monetary system without any of that ugly government involvement”. There are good reasons why every country on this planet has strong regulation of its financial sector.
You want to make sure that the money in your wallet is not being stolen, that you are not being defrauded or that the economy is not going to collapse in instability. That is why we have a lot of financial regulations that make sure the system does not collapse. And the idea of a world jumping onto a hard money system that is brittle and that nobody can change, is just delusional.
Bitcoin just broke an all-time high. Again. Did you see this coming?
From a technical perspective, after passing the old all-time highs and after breaking through the 20,000 resistance, Bitcoin could find a new price level. But its volatility shows why it is such a poor store of value. Think about something like gold. You know that the price of gold is bounded from below by its industrial uses. You can make very pretty jewelry out of it or use it in semiconductors. In other words, people can use gold for other things than sticking it in the ground. Its price is bounded above by its marginal mining costs. So, you can fairly predict, within a factor or two, where the price of gold is going to be. Now, with Bitcoin, that does not happen.
When it comes to Bitcoin, the dominant narrative right now is store of value. In other words, you are talking about acquiring an insurance to protect your purchasing power. Well, I got bad news for you, friend: insurance costs money.
Think about the insurance you buy for your car. The insurance company expects to profit from it. They know the law of large numbers and they know roughly how many claims they are going to get. On the other hand, we, the consumers, expect on average to lose money. At the end of the year, we are happy that we did not get into an auto accident and must put in a claim for the automobile insurance. But we are also happy that, when a tree falls on the car, we have got that coverage (this happened to me this year).
The notion that you are buying insurance against the collapse of civilization and the monetary order, is inaccurate. If your worldview is the collapse of civilization (which is not my view), there are probably better things to do than buying crypto, like becoming a prepper with your food supply for example.
With this view of Bitcoin not being a proper way to store value, do you think it is still smart to utilize crypto to hedge against hyperinflation?
It is one of many possible hedges. Yet again, hedging is costly. If you are in the middle of a hyperinflation scenario, and you are desperate seeing the local currency depreciating in front of your eyes, then crypto is a potential tool. But it is an expensive tool.
One of the things you see floating around is a graph of the purchasing power of the US dollar since 1913, when the US Federal Reserve was created. One of the talking points is that the US dollar has lost more than 90% of its purchasing power since 1930. Well, nobody is going to take green pieces of paper and bury them for a century. On the other hand, if they had put the money into US Treasury bonds and kept rolling over the interest in reinvesting, it would have been worth more, and they would have had positive returns over that century even after inflation. From an investment perspective, most people do not want to lock up their purchasing power for decades.
I have seen plenty of speculative bubbles in my day. And I have seen plenty of times where a new generation of investors comes in saying that “this time is different”. You really need to focus on what are the fundamental use cases for Bitcoin. And yes, you can use it to get around a failing economy (if you were in the middle of one). It is one tool of many, but it is a very unstable tool.
Do you think we are in in the middle of a crypto bubble?
Some of the big bulls come saying that “bitcoin is going to be worth a trillion dollars, someday. Therefore, you should buy it from me today!”. But they do not really provide any good justification for why it is going to be worth whatever big number they have. The best I have seen are some notions saying that the world’s gold stock is worth 8 trillion and, since this is the same as gold, Bitcoin should have a market cap of $8 trillion. That would mean that each coin is worth $200,000!
If there were a Nobel Prize in marketing, it should be given to Satoshi Nakamoto. Nakamoto (or whoever he/she/they are) created the most viral marketing scheme around. Bitcoin was started in the computer community by a bunch of very smart people who really were unencumbered by economic history. They did not realize that governments had this long record of suppressing private money. I am just enough of an economist to know that there have been many situations where people tried to start their own money and governments basically shoved them aside. That is one of the reasons why I have been a bit sceptic.
Once people buy into Bitcoin, either they have bought into a bubble and afterward they will look foolish, or everybody else drinks the Kool Aid, and they look brilliant as early adopters. Put simply, once you buy Bitcoin (or once you make an investment in some Bitcoin related business), the only way to make it worth anything, is to go out and proselytise to the world that this is the biggest thing ever to happen on the planet, so others would buy.
As a result of this practice, Bitcoin has become a massive multiplayer online speculation game. That is what we see when you look at the exchanges and their wide variety of activity there. It is basically people gambling.
About speculation, in your social media you claim that the speculative gambling nature of Bitcoin is one of its features. Should we be worried about that?
People are looking at gaming as an entertainment activity. The problem with gaming is “How do you deal with the people who are addicted to it, so it does not cause problems for them and the rest of society?”. Nevertheless, if people want to speculate, they should have the right to do that.
Knowing what we know now about Bitcoin, should we include it in our investment portfolios?
When you are designing an investment portfolio what you want to know is “What are the expected returns that you will get from various asset classes?”. In other words, “How much do you think you will be able to get from equities, the stock market, bonds, or real estate?”. But what is the expected return on Bitcoin and other crypto assets? What is the expected risk? And most important, how correlated is that risk with the rest of your portfolio?
In general, investors want things with positive expected returns that help to bring down the risk. you want a well-diversified portfolio. In other words, do not put all your eggs in one basket.
Over the last few months Bitcoin has had generally a low correlation with other asset classes. Not negative but slightly positive. When you run the math, crypto is only going to belong in a portfolio if it has a high enough long term expected rate of return to overcome a volatility of over 100% per year. As for me, I am trying to figure out how to come up with that long term expected return. I am viewing it as a hedge asset. And once again, hedge assets cost money.
What makes Bitcoin so different from other asset classes?
Bitcoin is not like a piece of real estate that throws off cash flow. It is not like a stock in a productive enterprise, where you can point to how much money they are making. In fact, it is like taking a hunk of metal and burying it in the ground, hoping to sell it again someday at a higher price. So far, Bitcoin seems to be good in the short run, as a speculative play. In other words, you expect many other people to drink the Kool Aid soon. But what is going to happen when they get tired of this speculation game and move on to something else?
A lot of people follow certain stocks for a period of time. Then, they get bored with them and move on. I would not be surprised to see the same thing happening with a lot of crypto assets.
You claim that crypto is here to stay and that this new form of finance is not going anywhere. Can you elaborate on this?
I am a big fan of crypto technology and its role in finance and other areas. When you think about the stocks and bonds we trade, those are securities that do not do much. They are “dumb contracts.” But having a smart-contract-enabled-securities that allow us to do much more than we can do right now, makes me think we are on the edge of a tremendous amount of innovation in the financial sector.
We are in the midst of a great intellectual revolution. People who have the courage and the creativity to go out and try new things, brings us forward as a society. But that does not mean that every coin is going to be a success. In fact, hundreds if not thousands of coins have already failed by now.
What factors could cause Bitcoin to fail?
I think for many reasons that Bitcoin 1.0 is not going to become the monetary standard of the world. If for nothing else, its tremendous impact on the environment. It is a simple calculation. Start with the current hash rate, which you can easily get from many websites or derive from the current level of difficulty. Then look at how many tera hashes .
Commercial miners can do in a second and how much energy they use. That allows you to calculate how much electricity is needed. Bitcoin 1.0 has got a theoretical capacity of seven transactions per second, but on average stands around three or four. If you run the numbers, what you see is we are basically having about 7000 million watts of electricity to do three transactions per second. This is the equivalent of about seven Chernobyl power plants, running around the clock!
The marginal fuel on this planet is still carbon based. If you care at all about the planet, you are not going to want to see Bitcoin 1.0 being the monetary standard. At least in its present form.
Crypto has been scrutinized because of its irreversibility. Imagine that we can sort the environmental impact of Bitcoin and make it feasible. Do you think we could overcome the irreversibility issue?
The problem is one of finality of settlement. The thing about Bitcoin is that you transfer it from address A to address B, and once it is confirmed in a block, it becomes almost impossible to change it or reverse it. This brings up the whole issue of consumer protection. If I make a mistake and send some Bitcoin to the wrong address, I will not see it again.
Bitcoin is just like cash that you send to some cyber address with no way of even contacting the owner. This is a problem that instant payment systems have. How do you deal with the fact that we humans make mistakes? With Bitcoin 1.0, there is nobody doing customer service. If you make a mistake, maybe you can go to your wallet provider. Maybe.
We have seen plenty of examples of hacking and stealing private keys. If somebody steals my credit card number, the bank will treat me as a victim of fraud and make me whole. But there is nobody in the Bitcoin space who can do that for you, which means there is a whole lot less consumer protection there. And that is one of the many reasons why I think Bitcoin 1.0 really does not work well as a payment system.
Do you think that this is the reason why most people worldwide are not yet in Bitcoin?
I think we can point that at the cost of using it. It is too expensive to do Bitcoin transactions. For instance, if you look at the fees that are currently being paid, it is not worth to buy a cup of coffee. The merchant is not going to pay a $5 or $10 or $20 fee to sell you a $5 cup of coffee.
A lot of people are having high hopes for things like the Lightning Network to have a side chain to do it. But again, how do you jumpstart a payment network, especially at the retail level. That is a hard and expensive thing to do.
In your opinion, what are the biggest threats of Bitcoin whether you use it as a cash payment system or trade with it?
Firstly, the biggest issue is cyber security, in the sense of how do I know that my Bitcoins are not going to be stolen by some hacker. Again, there is no place to go to complain if that happens. The second level of threat is regulatory, as in what kind of tax or other implications am I going to run into.
People demand financial regulation. The notion that you can get away without being regulated is delusional. The real question is what kind of regulation we want.
The biggest risk to widespread adoption comes from the traceability of the Bitcoin blockchain. Law enforcement could say to Bitcoin holders that those coins came from a ransomware attack, and anyone who holds them is holding stolen property. And if it has gone through a mixer, they could say that anything that comes out of it is deemed to be illegal. If this is taken as an assumption, authorities could look at your public keys and basically confiscate your coins.
I believe that there is going to be a widespread fear about holding certain Bitcoins. In other words, every coin will be “colored”, in one way or another.
About regulation. What should we expect?
What I expect to see is governments applying control in all the entry and exit points of the digital world. Whether you are a wallet provider or an exchange, countries will demand that you comply with their regulations. I would see it happening in the same way employers are required to withhold taxes from employees. They will go to businesses that accept cryptocurrencies and say “Oh, you are receiving cryptos. Guess what, you are going to have to withhold taxes on them”.
In your opinion, which countries do you think are more advanced when it comes to regulation of Bitcoin and crypto assets?
Well, the easiest thing to say is the US is behind. I mean, our regulators are very slow. Some places like China, Bahamas or Lebanon are already launching their own digital currencies. So, on the central bank digital currency front, those countries are ahead of the US.
In other areas of regulation, many countries have FinTech laws. However, it is always hard from a distance to see how effective those laws are.
Nowadays, the fashion in regulation is to have a regulatory sandbox so new FinTech applications can launch easily. But in some countries, it is quicksand rather than a launching pad. Local regulators think like regulators: they put so many restrictions on the sandbox that nobody wants to use it.
This happened in the US with crowdfunding. Our regulators could have let crowdfunding happen with our existing regulatory authority. Only that, they did not, so our Congress passed a law forcing them to do it. Then, the regulators made the implementing regulations on crowdfunding so painful that few people did it.
What is the sweet spot for a regulation to enable crowdfunding in a more feasible way?
The sweet spot is to have intelligent regulators, who understand the business, have the power to do what is needed, and the flexibility to adapt to circumstances. Alas, there is no perfect system. At the end of the day, regulators are only human.
What we really need are people who understand that there is a fantastic technology here, with great potential, and who wants to make sure it works. What we do not want are regulators, like we have in the US, who are so focused on the old school regulation that they do not understand that this technology is different and that needs to be approached in slightly different ways.
New technology needs new approaches. Can you put an example?
If you walk into a taxicab in New York City, there is a big bulletproof screen between you and the driver. There is a history of drivers being robbed at gunpoint and, consequently, that screen makes sense. Now, with Uber, the company knows who the passenger is, and who the driver is.
Drivers are not carrying any cash, which means that there is really no risk that they are going to be robbed at gunpoint. So, you do not need to put a bulletproof shield between them and the passenger. Now, regulators would say “we have a rule that says you must have a bulletproof shield”. But it is unneeded there because ride sharing is actually a very different technology from the old-fashioned taxi and, therefore, should be treated differently.
Similarly, Bitcoin is a new technology that does a lot of the similar things of stocks and bonds. But it is also doing things in a different way, with different communication and custody channels. So, we need to rethink regulation. We want to protect consumers from fraud, grow the economy, and maintain financial stability. We need regulators who understand the principals involved to achieve this.
Crowdfunding. Raising capital with traditional methods is hard. Angel investors, VC, rounds of investors, and so on. You point at ICOs as the biggest game changer when raising capital. Can you elaborate on that?
I am a big fan of the idea of ICOs. It reminds me of the South Sea’s bubble several hundred years ago. There was this brand-new invention called the joint- stock company in England. What followed was a wave of initial public offerings in the early 1600s, and many of them were fraudulent enterprises that basically went nowhere. As a result, the government responded basically by banning joint- stock companies.
I think the joint stock corporation was one of the greatest inventions of the Industrial Revolution. It really made it possible to raise capital from a wide variety of people, and a way to fund the development of the large-scale enterprises that make our lifestyle possible. I view the crypto space as a similar innovation in two respects. Crypto is easy to trade and, most importantly, has created a whole new distribution channel for raising capital.
Now, this causes regulators to have nightmares. One of the reasons why raising capital is so regulated is because of the widespread history of fraud. And we saw what happened in 2017 with the ICO boom: plenty of frauds came to light.
We have this opportunity to create securities that are far more advanced than the stocks and bonds we trade today. But we also need to make sure that we have fraud prevention built in. That is going to be the real key. How do we protect investors and make sure they get the information they need? How do we make sure these markets are not being manipulated? We want to take advantage of the tremendous opportunity that is there.
Which one is your favorite coin?
The next one (he laughs).
Where do you think you would be if it were not for blockchain and crypto?
I enjoy what I do: teaching and doing research. I even read regulatory rule filings for entertainment! If the crypto revolution had not occurred, I would be visiting trading floors and examining the minutiae of the nuts and bolts of how security markets operate.
Thank you, James, for taking the time for this interview and for sharing your story and expertise. We wish you all the best of luck for all your current and future projects.
— Fyggex (@fyggexchange) August 12, 2020
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