A decade in, blockchain and cryptocurrencies remain a source of confusion

In January 2009, when the first bitcoins were mined, few had heard the term “cryptocurrency.” For their first year in existence, no one traded the bits of code that purported to be digital cash, effectively putting their price at zero.

Just nine years later, the market capitalization of all cryptocurrencies had swelled to exceed that of Facebook, Microsoft and Google. The price of a single bitcoin had reached $19,926.

Cryptocurrencies were worth more than the combined estimated gross domestic product of the world’s 67 smallest countries by purchasing power parity.

As an investment class and as a new category of technology, cryptocurrencies and blockchain have captured the attention of retail and institutional investors, entrepreneurs, financial institutions, and businesses.

But along with the hype came confusion about how the technology works and what value many of the new assets hold.

Terms like “tokens,” “distributed ledger,” “ICO” and “blockchain” swirled as the new asset class made colossal returns for early investors.

As valuations drop in 2018 and with regulators taking a closer look, VCJ has prepared a primer how blockchain technology works, different categories of coins and tokens, and the difference between digital assets that are securities and those that are not.

The beginning

Cryptocurrencies didn’t become mainstream until 2017, but their roots date back nearly a decade to October 2008, when an unknown person or persons using the name Satoshi Nakamoto published a white paper containing the code for an “electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.”

Second Opinion
A man with the name Satoshi Nakamoto is surrounded by reporters in Temple City, California, March 6, 2014. The reclusive Japanese-American man, at one point thought by some to be the father of Bitcoin, emerged from his Southern California home and denied any involvement with the digital currency. Reuters/David McNew.

The white paper describes a way for strangers to send digital “coins” to each other over the internet securely, quickly, without fear that the funds have already been spent, and without need for a third-party intermediary like a bank.

The paper never uses the term “blockchain,” but the underlying code based on a cryptographic proof describes an immutable chain of transactions recorded in units called blocks.

Although previous researchers had developed similar systems, the nine-page anonymous paper was the first to solve a conundrum called the double-spend problem and is considered the first blockchain.

The coins, which are themselves a chain of digital signatures, are the first cryptocurrency, or electronic cash.

Nine years of expansion

The code for the original bitcoin blockchain is open-source, meaning anyone can share and modify it. In the years since bitcoin’s release, it has inspired a multitude of cryptographic systems based on its immutable blocks of transactions.

At this writing, Coinmarketcap.com lists 1,514 different cryptocurrencies, including bitcoin. In 2017, the number of cryptocurrencies listed on the site more than doubled, with on average roughly two added each day.

AngelList lists 1,675 blockchain companies, many of them working in sectors like payment services, healthcare, insurance, cloud infrastructure, compliance, identity, security, gambling and prediction markets.

Nor is the interest in cryptocurrencies and blockchain technology limited to startups or enthusiasts hoping to make a quick profit. Well-known businesses with established brands are experimenting with the new technology.

IBM has developed a blockchain platform for a network of businesses, and it has partnered with shipping giant Maersk in a new venture to digitize supply chains using the blockchain. The company is also involved in the Hyperledger consortium, an open-source project that aims to standardize commercial blockchain technology.

Walmart, working with IBM and Chinese retailer JD.com, is using the blockchain to track food and ensure its safety in China. And Microsoft has released a product to develop and deploy blockchain applications.

Beyond the business sector, cryptocurrencies have begun to play a direct role in countries’ economies and international security crises.

Amid Venezuela’s economic crisis, President Nicolas Maduro in December launched the petro, a cryptocurrency system backed by the country’s natural resources. Some have criticized the move as a ploy to skirt economic sanctions.

And some suspect that North Korea has been mining bitcoin, using bitcoin ransom attacks, and hacking exchanges to steal digital assets as a way to fund its nuclear program.

Uncertainties remain

As the interest in blockchain surges, regulations and standardization follow.

With myriad teams working in the sector, terms for distinct concepts in the blockchain sector are often used interchangeably.

For example, the term “cryptocurrency” is often used to refer to true cryptocurrencies, cryptocommodities and digital tokens alike. “Distributed ledger” is often used synonymously with “blockchain.” And bitcoin is written in lowercase and uppercase. Some tokens that are securities are marketed as “utility tokens,” as a way to skirt regulations. And some initial coin offerings are not coin offerings at all but token-generation events.

Beyond the etymological confusion are more fundamental questions about the technology.

Are private blockchains useful or will they die out as intranets did in the face of the public internet? What exactly makes bitcoin valuable? And does a blockchain need to have a coin at all?

At their most basic level, blockchains consist of peer-to-peer networks that employ agreed-upon rules for how transactions are approved, with valid transactions immutably linked to each other in a chain of blocks that can be viewed by anyone with access to the network. The rules are the blockchain’s protocol. Blockchains that anyone can view and contribute to are public. Others restrict access to those with permission.

Instead of a centralized entity, like a bank, keeping track of all transactions, the code enables multiple people to share and contribute to a decentralized database where all the transactions are recorded, or distributed ledger. A blockchain is just one type of distributed ledger, although the two terms are often used interchangeably.

A consensus protocol is the agreed-upon set of rules by which network members choose to validate transactions. In the case of bitcoin, the consensus protocol is called proof-of-work, but there are other methods to obtain consensus. Either way, once a transaction is approved and recorded in the blockchain, it cannot be reversed.

The distinction between a blockchain network and the assets or coins that transact on it often is unclear. Many in the sector use the uppercase term “Bitcoin” to refer to the underlying protocol and network, while the lowercase “bitcoin” refers to the currency itself, but this distinction is often overlooked.

Blockchain layers

The most prominent blockchain-related protocols include those used by Bitcoin, Ethereum, Ripple, Hyperledger and R3. The former two are public blockchains, while the last two require permissions, meaning that only people or institutions approved by the networks’ creators can view or make changes to the blockchain. Ripple offers both the public XRP Ledger and the permission-based xCurrent protocol.

While public blockchains are like the internet, in that anyone can access them, private or permission-based blockchains bear similarities to corporate intranets.

Some have argued that private blockchains are likely to fade in comparison to public blockchains, in the same way that private-company intranets are less influential than the public internet.

On top of a public protocol, developers may build decentralized applications, or dapps, that target various markets and users.

Perhaps the most popular protocol for building dapps and holding token sales is Ethereum. This enables smart contracts, or programs that allow for funds to be automatically transferred among users under predetermined conditions.

ICOs and token sales have also been built on top of other blockchain protocols, including Waves and Stellar.

Often, the difference between the underlying protocol layer and the dapps built on top of it is unclear and can easily lead to a blurring of terms. For example, coinmarketcap.com, which lists the trading price of cryptocurrencies, divides the assets it lists into “coins” and “tokens.”

A coin is a cryptocurrency that can operate independently, the site says. Coins that are native to the underlying protocol layer would include bitcoin, ether, and Ripple’s XRP.

A token is a cryptocurrency that depends on another cryptocurrency as a platform to operate. Popular tokens include eos, tron, and tether.

But by those definitions, many initial coin offerings, or ICOs, issue not coins but tokens, since they depend on other cryptocurrencies like ethereum to operate.

The term ICO is used broadly to include token offerings or token-generation events.

Cryptocurrencies, digital commodities, and utility tokens

Another way to assess digital assets is by what they do, rather than by what layer of the blockchain infrastructure they reside in.

Only a few cryptocurrencies are intended to be used as currencies at all, while others aim to be digital commodities or have a limited use within a particular platform.

A few cryptocurrencies, like bitcoin, bitcoin cash, and zcash, aim to be electronic cash. These currencies have little value outside the fact that people ascribe value to them, much like fiat currency that is not tied to a standard like gold.

Other digital assets derive their value from their service as digital commodities. Ethereum enables developers to build smart contracts, or codes that allow transactions to be implemented without a third party. Filecoin and Storj make decentralized storage networks. IOTA allows for microtransactions on the Internet of Things.

Lastly, certain assets aim to be utility tokens, which perform specific functions within particular platforms or dapps. These operate in much the same way that arcade coins do. The Brave Browser uses the Basic Attention Token, which improves the efficiency of digital advertising. And online-gambling blockchains use utility tokens for wagers.

While the majority of blockchain systems operate with some type of currency or token to transact, not all do. The financial consortium R3’s distributed ledger Corda, the Hyperledger Fabric project, and the blockchain platform Monax all operate without tokens or coins.

And while the distinctions above are important from a technological standpoint, the only distinction that matters from a regulatory perspective in the U.S. is whether the digital assets in question are securities or not.

SEC investigates ad hoc

The SEC has refrained from making sweeping claims about cryptocurrencies. Instead, it has investigated individual companies and token offerings and case by case declared them to be securities.

Depending on how any offering is issued or used, it could fall under the purview of U.S. securities laws.

Already, the SEC and state securities boards have halted alleged ICO scams like PlexCoin, MuncheeAriseBank and Bitconnect.

Instead of crafting new laws aimed at digital assets and cryptocurrencies, the SEC has relied largely on the Howey Test, developed in a 1946 U.S. Supreme Court ruling that presents criteria for determining whether an asset counts as a security or not.

The agency has also warned against token issuers who try to overemphasize an asset’s utility to reduce the chance it would be considered a security.

Some token issuers are trying to comply by issuing their asset or token as a security.

And some investors are exercising caution by avoiding investing in coins that could be securities and instead investing exclusively in utility coins.

Volatile valuations

Valuations roared last year and have deflated significantly in 2018.

On Jan. 1, 2017, the total market capitalization of all cryptocurrencies was $18.3 billion, according to coinmarketcap.com. On Jan. 1, 2018, that figure reached $612.75 billion, a factor of 34.

But the year has been rocky. On Jan. 7, 2018, the market capitalization of digital assets reached a record of more than $833 billion. By Feb. 6, the figure dropped by two-thirds to less than $282 billion.

Some have predicted that the value of bitcoin and other cryptocurrencies will go to zero.

But while prices of cryptocurrencies and tokens remain volatile, development continues on the companies utilizing the underlying technology.

There is no guarantee that any of the cryptocurrencies and tokens trading today will survive. But work on blockchain technology applications shows no sign of slowing.

Download Data: Most active venture firms with blockchain focus

Disclosure: Kaitlyn Bartley and her husband own cryptocurrencies, including Ripple’s XRP.

Photo of cryptocyrrencies Bitcoin, Litecoin, Ethereum, dogecoin with traditional money courtesy of yesfoto/iStock/Getty Images.