Duke University and NBER Innovation and Cryptoventures Cryptovaluation Campbell R. Harvey Duke University and NBER January 27, 2018

Campbell R. Harvey 2018

Money Purposes of money: Primary Unit of Account: A way to compare the value of various goods and services Medium of Exchange: Allows for non-barter transactions. Secondary Store of Value: Allows value to be retained – even if partially – rather than complete decay (e.g. storing food). Transfer of Value: Ease of transfer of value and to defer value. Original vision of bitcoin was for a technology that would make transactions more efficient (the transfer of value motive) Campbell R. Harvey 2018

Acquiring Cryptocurrency Three ways to obtain an existing cryptocurrency Win a block. Receive a gift or be paid for goods or services Buy on an exchange Currently 109 exchanges that trade bitcoin You can also obtain cryptocurrency through an Initial Coin Offering (ICO). New currency can also be obtained via a hard fork. Campbell R. Harvey 2018

Exchanges https://www.coinhills.com/market/exchange/rank-for/btc/ Campbell R. Harvey 2018

Exchanges Will have more to say later about Coincheck https://www.coinhills.com/market/exchange/rank-for/btc/ Campbell R. Harvey 2018

Exchanges Beware of exchanges Largely unregulated. This is the reason that the SEC has blocked the formation of ETFs based on “physical bitcoin” Exchange often holds your keys and they pool all the keys – acting like a bank. In a usual crypto trade, every transaction generates a new private key. If “off-chain”, then private keys are shifted between owners in the exchanges’ database. Holding the keys invites hacking attacks. We have already talked about the 850,000 BTC theft of Mt. Gox *In the future, exchanges may become more distributed. An atomic swap is a cross chain transaction. https://www.cryptocompare.com/coins/guides/what-are-atomic-swaps/ Campbell R. Harvey 2018

Exchanges Beware of exchanges There are advantages to these off chain transactions. They can be done instantly and at every low cost (no miners no delay in writing to a blockchain). This is what Coinbase.com does. Their exchange is GDAX. Many worry that exchanges are a centralizing force In the future, exchanges may become more distributed. An atomic swap is a cross chain transaction* Campbell R. Harvey 2018 *https://www.cryptocompare.com/coins/guides/what-are-atomic-swaps/

Exchanges Beware of exchanges: Bitfinex Approximately 10% of all bitcoin trading; registered in BVI History of multiple hacks. May 2015: 1,500 BTC stolen. 2016: 119,756 BTC stolen – customers forced to take a 36% haircut on deposits; Bitfinex does not use fiat currency wire transfers – it uses a cryptocurrency called Tether (USDT) Campbell R. Harvey 2018

Exchanges Beware of exchanges: Bitfinex Tether is supposedly backed 1:1 with USD; capitalization is $1.6 billion Campbell R. Harvey 2018

Exchanges Beware of exchanges: Bitfinex Tether hacked in November 2017 for $30 million. Once you have a tether, the value is stable and you can use that on many different exchanges to quickly trade (wire transfers could take days) If you receive a tether, one dollar is deposited in your vault https://www.coindesk.com/tether-claims-30-million-stable-token-stolen-attacker/ Campbell R. Harvey 2018

Exchanges Beware of exchanges: Bitfinex Supply of tether has increased dramatically https://qz.com/1149772/the-murky-relationship-between-bitfinex-and-tether-is-raising-suspicions/ Campbell R. Harvey 2018

Exchanges Beware of exchanges: Bitfinex Tether based in British Virgin Islands How do we know that the dollar deposits match the outstanding tether? November 21, 2017 Nathaniel Popper of NYT breaks story that Bitfinex and Tether are operated by the same people. This was revealed in the Paradise Papers. Why is this an issue? https://www.nytimes.com/2017/11/21/technology/bitcoin-bitfinex-tether.html Campbell R. Harvey 2018

Exchanges Beware of exchanges: Bitfinex First, Bitfinex was not transparent about its relationship with Tether Second, read the fine print for tether https://www.nytimes.com/2017/11/21/technology/bitcoin-bitfinex-tether.html Campbell R. Harvey 2018

Exchanges Beware of exchanges: Bitfinex Third, if not fully collateralized, it is possible that Bitfinex is creating money that could artificially increase the price of cryptocurrencies like bitcoin. “Bitfinex appears to be creating Tether coins out of thin air and then using them to buy Bitcoin and push the price up.” https://tether.to/wp-content/uploads/2017/09/Final-Tether-Consulting-Report-9-15-17_Redacted.pdf Campbell R. Harvey 2018

Exchanges Beware of exchanges: Bitconnect Begins in January 2017 Launches with Bitconnect Coin (BCC). You needed to send bitcoin to the exchange and they would convert it to BCC With the BCC, you were guaranteed “up to 120% return per year” and users were earning interest by holding their coin for “helping maintain the security of the network” https://cointelegraph.com/news/bitconnect-ponzi-scheme-no-sympathy-from-crypto-community Campbell R. Harvey 2018

Exchanges Beware of exchanges: Bitconnect Campbell R. Harvey 2018

Exchanges Beware of exchanges: Bitconnect Coin rises to $437.31 Campbell R. Harvey 2018

Exchanges Beware of exchanges: Bitconnect Coin rises to $437.31 Campbell R. Harvey 2018

Exchanges Beware of exchanges: Bitconnect Social media campaign attacks Bitconnect Campbell R. Harvey 2018

Exchanges Beware of exchanges: Bitconnect Blows up January 17, 2018 Campbell R. Harvey 2018 https://twitter.com/3PSboyd/status/954140748135383040

Exchanges Beware of exchanges: Bitconnect January 17, 2018 exchange closes following warnings from Texas and North Carolina regulators. Drops 87%. https://cointelegraph.com/news/bitconnect-closes-virtually-its-entire-operation-bcc-token-drops-87 Campbell R. Harvey 2018

Exchanges Beware of exchanges: Bitconnect Current price = $18 Campbell R. Harvey 2018

Exchanges Beware of exchanges: Bitconnect Campbell R. Harvey 2018 https://bitconnect.co/system-news/95/bitconnect-update-regarding-the-changes-to-lending-and-exchange-functions/

Cryptocurrencies: Trading Beware of exchanges: Bitconnect Campbell R. Harvey 2018 https://bitconnect.co/system-news/95/bitconnect-update-regarding-the-changes-to-lending-and-exchange-functions/

Exchanges Beware of exchanges: Bitconnect https://youtu.be/kbR1SXIje1U Campbell R. Harvey 2018

Exchanges Beware of exchanges: Bitconnect https://www.reddit.com/r/Bitconnect/ Campbell R. Harvey 2018

Exchanges Campbell R. Harvey 2018

Exchanges Campbell R. Harvey 2018

Exchanges Only bitcoin??? (Thanks Nikhil Arun) https://coincheck.com/ Campbell R. Harvey 2018 https://coincheck.com/

Exchanges https://www.wsj.com/articles/cryptocurrency-worth-530-million-missing-from-japanese-exchange-1516988190 Campbell R. Harvey 2018

Exchanges Campbell R. Harvey 2018

Exchanges Campbell R. Harvey 2018

Exchanges Mechanics of the hack Website says that bitcoin is held in cold storage (off line and untouchable via the Internet – and considered safe from hacks) However, each exchange also has a “hot wallet”. Think of this as float. It allows for very fast and cheap transactions It was the hot wallet that was exploited and the details are unclear Campbell R. Harvey 2018

Exchanges Campbell R. Harvey 2018 https://cointelegraph.com/news/coincheck-stolen-534-mln-nem-were-stored-on-low-security-hot-wallet

Exchanges Mechanics of the hack (some analysis from Marc Toledo) Coincheck uses “smart hot wallet system” which was exploited Supposedly, they used a machine-learning based dynamic hot wallet based on volumes of transactions, for easier access and faster transactions Hackers gained access to the server where the keys were and stole all the NEM via unauthorized transactions Campbell R. Harvey 2018

Exchanges Mechanics of the hack (some analysis from Marc Toledo) Speed was important. It happened in a couple of seconds. NEM is known for being one of the fastest blockchain platforms Within Coincheck, everything appeared to be operating as usual Coincheck signaled thumbs up for 250,000+ transactions 8 hours later they discovered the hack Campbell R. Harvey 2018

Exchanges Campbell R. Harvey 2018

Exchanges 532m NEMs stolen 260,000 customers affected Promised to return 90% of the value Company has the address where the funds went http://www.bbc.com/news/world-asia-42850194 Campbell R. Harvey 2018

Exchanges Heist larger than Mt. Gox which was $450 million NEM (coins) were lost (other cryptos were not lost) NEM short for New Economy Movement Launched in 2015 and similar to bitcoin but less energy intensive. They use “Proof of Importance”. Campbell R. Harvey 2018

Exchanges Proof of Importance (PoI) Certain “supernodes” exist with considerable computing power Each account as a PoI score. If you account has 10,000 NEM or more and is “vested” holding that amount of a few weeks, you can lend your PoI score to a supernode and that increases the chance that the supernode “harvests” a block Harvest includes coinbase plus transaction fees Campbell R. Harvey 2018

Exchanges Proof of Importance (PoI) They argue PoW gives advantage to those that have the most computing power – and there is an excessive amount of energy spent They argue PoS gives advantage of “coin hoarders” – more coins the more you earn. Campbell R. Harvey 2018

Exchanges Proof of Importance (PoI) looks at three factors (see pages 34-35 of technical document): PoI only counts coins that are in the account for a number of days 10% of the unvested, vests every day The higher number of vested coins the higher the PoI score Need a minimum of 10,000 vested coins to start harvesting https://nem.io/wp-content/themes/nem/files/NEM_techRef.pdf Campbell R. Harvey 2018

Exchanges Relatively little impact on NEM price – because the hack was not a hack of the NEM blockchain Campbell R. Harvey 2018

Exchanges History of exchange hacks: Mt Gox 2011 Mt Gox 2014 $350m NiceHash December 2017: 4700BTC Bitfinex $72m The DAO $70m Parity Wallet $30m Bitstamp $5m https://cryptonews.com/news/coincheck-hacked-more-than-500-million-xem-stolen-1093.htm Campbell R. Harvey 2018

Exchanges Not all tokens associated with exchanges are fraudulent but we always need to be aware of security. Supports about 50 coins Extremely low fees https://en.bitcoin.it/wiki/Comparison_of_exchanges https://techcrunch.com/2018/01/25/free-cryptocurrency-trading-app/ Campbell R. Harvey 2018

Exchanges Announced January 24, 2018 allows trading of BTC and ETH from Feb 2018 No-commission stock trading app Buy and sell bitcoin and ethereum without any added transaction fees. Other coins to be added. Not much information on security but recently they added information. Campbell R. Harvey 2018

Exchanges Campbell R. Harvey 2018

Exchanges Campbell R. Harvey 2018

Cryptoassets Asset or Commodity or Currency or Collectible Asset : Asset generates or is expected to generate cash flows in the future. Commodity: A commodity derives its value from its use as raw material to meet a fundamental need, whether it be energy, food or shelter. Value can be established looking at supply and demand.  Currency: A currency is a medium of exchange that you use to denominate cash flow. Currencies have no cash flows and  cannot be valued, but they can be priced against other currencies. BTC is a currency and ETH is a commodity? Description from Aswath Damodaran, Finance and Valuations professor at NYU Stern School of Business http://aswathdamodaran.blogspot.com/2017/10/the-bitcoin-boom-asset-currency.html https://www.cnbc.com/2018/01/10/dean-of-valuation-buffett-paints-cryptocurrency-with-too-broad-a-brush.html Campbell R. Harvey 2018

Cryptocurrencies: Valuation Very challenging Most assets valuations are fairly narrow For example, to value the stock you need a forecast of future cash flows and a sense of the risk (discount rate). There could be disagreement – but the range of disagreement is usually narrow For fiat currency (which is closer to cryptos given there is no official collateral), we usually look at the relative expected real GDP growth in two countries and the relative expected inflation. Again, there is disagreement but range is narrow. For cryptocurrency, the disagreement is extreme. Many believe the value is zero. Others might believe the value is $1 million. Campbell R. Harvey 2018

Cryptocurrencies: Valuation Many “theories” Scarcity. The idea is that just because something is scarce it must have value. Bitcoin can be thought of as algorithmic scarcity (given the supply of bitcoin is capped at 21 million). To me, this theory only makes sense if there is a usefulness for the asset. Campbell R. Harvey 2018

Cryptocurrencies: Valuation Many “theories” Assumes the cryptocurrency to be an asset i.e., cryptoasset Quantity theory of money. It is claimed that “There is a fixed supply of tokens. As demand for the token increases, so must the price”. However, this is problematic because it ignores the velocity. The key equation is MV=PQ. Let PQ be Total Transaction Volume. So Average Network Value = (Total Transaction Value)/Velocity. However, velocity is very high with cryptocurrencies. This high velocity means that the Average Network Value should be small. Chris Burniskie treats Cryptocurrencies at Crypto-assets https://multicoin.capital/2017/12/08/understanding-token-velocity/ https://medium.com/@cburniske/why-i-like-the-term-cryptoassets-ab6b76e1ee33 Campbell R. Harvey 2018

Cryptocurrencies: Valuation https://www.forbes.com/sites/laurashin/2017/10/17/how-to-value-a-crypto-asset/ Chris Burniske, partner at crypto asset venture capital firm Placeholder Ventures, who just came out with a book, "Cryptoassets: The Innovative Investor's Guide To Bitcoin And Beyond," Burniske previously worked at ARK Investment Management, which was the first public fund manager to invest in one of the only securities to offer exposure to Bitcoin, the Bitcoin Investment Trust in September 2015 and put GBTC, the Bitcoin Investment Trust, into two of ARK’s ETFs Campbell R. Harvey 2018

Example : Simple Valuation Model of Storj Year From Launch 2017 2018 2019 GB of Storage Available in the World Each Year (GB) 6,444,290,465,101 8,106,917,405,097 10,198,502,095,612 Price per GB via Storj ($) 0.18 0.144 0.115 TAM for Storj ($) 1,159,972,283,718 1,167,396,106,334 1,174,867,441,415 TAM Growth 25.80% %Share of market addressed by Storj 0.0001% 0.0002% 0.0003% GB that Storj is storing each year (GB) 1,440,000.00 2,165,760.00 3,257,303.04 Amount required in Storj ($) 259,200.00 311,869.44 375,241.31 Utility value of Storj simulation Number of new storj issued/yr 2,000,000 5,000,000 Number of Tokens issued 52,000,000 57,000,000 62,000,000 Consumption value ($) 0.00 0.01 StorJ is platform that provisions users HDD to store data By estimating Total Addressable Market for Data Storage and assuming Storj’s market penetration (Blue Cell), we estimate dollar of Storj required and given the Storj token in circulation , we arrive at a Consumption value for the token. Once we Discount the future Consumption value, we can arrive at a Net Present Value and compare it against the current market Speculative value The market penetration assumption is crucial. This is completely simplistic model for the purposes of the class. An example of a complete model can be found here : https://docs.google.com/spreadsheets/d/1ng4vv3TUE0DoB12diyc8nRfZuAN13k3aRR30gmuKM2Y/edit?usp=sharing http://bit.ly/storjchainalysis https://medium.com/@cburniske/cryptoasset-valuations-ac83479ffca7

Cryptocurrencies: Valuation Many “theories” Replacement for Gold. Many similarities to gold: No centralized supply Costly to mine World currency Also, there are some advantages to cryptos: Easy to transport Cheap to store Not susceptible to a supply shock However, gold has direct usefulness (jewelry, technology, dental) Campbell R. Harvey 2018

Cryptocurrencies: Valuation Many “theories” Mining cost benefit equilibrium. This mixes some of the other theories. The idea is that people will not mine bitcoin unless it is profitable to do so. So the cost of the marginal miner is the floor for coin price. If price drops, then mining decreases as it is not worth buying a mining machine and paying the electrical cost However, in contrast to gold, decreases in hash power simply cause the difficulty to decrease (it does not impact the coinbase supply) Campbell R. Harvey 2018

Cryptocurrencies: Valuation Many “theories” Bubble mentality. A bubble is an asset that has value because people believe that it has value. Large speculative demand for cryptocurrencies is typical of bubble behavior. “As investors join the bandwagon, they create their own truth – for a while.” Warren Buffett Important. Bursting of a bubble does not necessarily take you to zero. Consider history of bubbles like the housing bubble, tech bubble, … Campbell R. Harvey 2018

Data from Aug 2017 when Bitcoin price ($4,000) Bitcoin Bubble is growing Dotcom Bubble bursts Housing Bubble bursts Bitcoin bubble is much bigger than any we have seen In 2016, 54% of Coinbase users were “holding” not using it to transact Figure (6) https://medium.com/@cburniske/cryptoasset-valuations-ac83479ffca7 https://www.marketwatch.com/story/heres-how-bitcoin-is-dwarfing-housing-and-dot-com-bubbles-2017-08-30 Data from Aug 2017 when Bitcoin price ($4,000) Campbell R. Harvey 2018

Cryptocurrencies: Valuation Many “theories” Relative value. The idea is that you fit a regression model to the price of the crypto versus other cryptos. The model delivers a fitted price. If the fitted price is greater than the market price, then the crypto is relatively “under valued” The key word is relative. It is possible that both are over valued or both are undervalued Campbell R. Harvey 2018

Cryptocurrencies: National Central bankers have finally come to the realization that they must create their own cryptocurrencies, like Fedcoin. It is obvious that “paper” money will be a historical relic – in the near future. The advantages of a crypto are substantial: Technology makes it far more difficult for criminal activity. 79% of all US currency is held in $100 bills – yet the average person does not carry a $100 bill nor do retailers accept them. Crypto eliminates counterfeiting. Crypto allows for the efficient collection of taxes. You eliminate the “I prefer to take cash” tax evasion. It is also straightforward to implement both a Value Added Tax (VAT) and a Border Adjustment Tax (BAT). Efficient implementation of these types of taxes combined with the decrease in evasion, would make it possible to substantially cut income and corporate taxes. Campbell R. Harvey 2018

Cryptocurrencies: National Central bank cryptocurrency: Crypto allows for many people that are unbanked to become banked. There are two billion unbanked in the world and, as a result, they have trouble accessing the modern world such as internet transactions. Crypto eliminates all of the costs associated with printing, distributing and securing, paper currency. Crypto allows monetary authorities to implement negative interest rates. Today, negative rates are hard to implement because why would anyone buy a bond with a negative interest rate when you can hold paper cash with a 0% interest rate. Crypto retains all of the flexibility of the current system such as central banks deciding how much currency needs to be “printed”. Campbell R. Harvey 2018

Cryptocurrencies: National Venezuela's cryptocurrency will launch within days and be backed by 5.3 billion barrels of oil worth $267 billion The launch is a bid to offset a deep financial crisis, the socialist government said on Thursday https://www.cnbc.com/2017/12/29/venezuela-oil-backed-cryptocurrency-to-launch-in-days.html Campbell R. Harvey 2018

Cryptocurrencies: National Central bank cryptocurrency: Sweden http://www.newsbtc.com/2017/10/16/sweden-cryptocurrency-technology-cashless/ Canada https://www.coindesk.com/bank-canada-demos-blockchain-based-digital-dollar/ India https://economictimes.indiatimes.com/news/economy/policy/another-experiment-with-currency-rbi-is-looking-at-its-own-bitcoin/articleshow/60710700.cms Singapore http://www.trustnodes.com/2017/10/08/phase-two-tokenizing-singaporean-dollar-ethereum-blockchain-completed-monetary-authority-singapore Israel http://mashable.com/2017/12/27/israel-cryptocurrency/#rhDwvLfMuOqn China https://futurism.com/china-becomes-first-countrchina-becomes-first-country-in-the-world-to-test-a-national-cryptocurrencyy-to-test-national-cryptocurrency/ Russia https://www.coindesk.com/official-russia-to-introduce-cryptocurrency-regulation-bill-next-week/ Campbell R. Harvey 2018

Cryptocurrencies: Digitization of Other Assets In principle, any asset can be tokenized RMG is a collaboration between the Royal Mint Group and the Chicago Mercantile Exchange Each RMG is backed by one gram of gold held in the Royal Mint’s vault Campbell R. Harvey 2018

Cryptocurrencies: Digitization of Other Assets In principle, any asset can be tokenized RMG has the volatility of gold (about 15% per annum) Direct competitor to an ETF – fees are lower for RMG Ability to hold very small quantities and use gold to pay for regular transactions Why not consider other assets? https://dinardirham.com/blog/overview-commodity-backed-blockchain-assets/ Campbell R. Harvey 2018

Cryptocurrencies: Education Challenges: Nobel Laureate #1 DECEMBER 28, 2013, 2:35 PM  Bitcoin Is Evil Campbell R. Harvey 2018

Cryptocurrencies: Education Speaking of mind-bending, economics professor Cam Harvey of Duke University did a presentation this afternoon on the blockchain, which is the foundation of Bitcoin. I have been friends with Cam for many years, but it has been an online friendship. He was the first to do research and analysis of the inverted yield curve, and I’ve learned a great deal from talking and writing with him. Cam came over when the day session finished, and we began to talk about some aspects of blockchain technology. Harry Markowitz, the Nobel Prize laureate who created Modern Portfolio Theory, walked over; and after a few minutes he began to challenge Cam on the mathematical impossibility of what he thought Cam was talking about. It was fascinating watching these two genius professors talk about math and ideas, and eventually Harry got a handle on the process Cam was describing. But I will confess a small pleasure at watching one of the greatest mathematical economists of our time wrestle with the concept of the blockchain. I have to tell you it took me a while to get my head around the concept, too, and it took Harry only five minutes. Cryptocurrencies: Education Challenges: Nobel Laureate #2 Campbell R. Harvey 2018

Cryptocurrencies: Education Challenges: Nobel Laureate #3 https://www.bloomberg.com/news/articles/2017-11-29/bitcoin-ought-to-be-outlawed-nobel-prize-winner-stiglitz-says-jal10hxd https://cointelegraph.com/news/regulate-it-out-of-existence-stiglitz-and-swiss-bank-bash-bitcoin-at-davos Campbell R. Harvey 2018

Cryptocurrencies: Education It is important for educators to open the black box and to show students and the general public how blockchains work Campbell R. Harvey 2018