This is my second essay in a series of love letters to cryptocurrency maximalists. It is not investment advice. Take with a grain of salt. The views expressed in this article do not represent the view of my employer.
In the 1990s, the Internet brought the democratization of information. In the 2010s, breakthroughs in distributed ledger technology brought us the democratization of money. Anyone can now unleash crypto-assets that compete for mindshare and adoption in a free market.
Innovation has accelerated at a breakneck pace and we now have multiple decentralized networks and digital assets competing for public mindshare. In this article, we’ll look at two potential digital stores of value: A fungible, provably scarce settlement token called Bitcoin and a non-fungible, provably scarce digital manifestation of the species Felis catus, the Generation Zero CryptoKitty.
Unfortunately, objective analyses are hard to come by these days. Because human nature dictates it, the cryptocurrency field has split into warring tribes. It’s like a super-charged version of PC vs. console or bodybuilding vs. CrossFit, amplified by social media bubbles and vast economic stakes. In this article we’ll take a peek beyond the fog of war to uncover the hard (socio-)economic facts.
What is a Store of Value?
A store of value is an asset that is scarce, durable, and maintains a stable price over time. Commonly used stores of value in the real world are currencies, bonds, precious metals and real estate. Some stores of value, such as gold, have proven their consistency over time and are therefore highly popular. However, besides the usual suspects, a whole lot of other things are being used to store value, including fine art, watches, collectibles and even social reputation.
Digital Scarcity and Modes of Production
For an asset to be useful as a store of value, there must be limited supply of the asset as well as consistent demand. In the case of gold, supply is limited by the amount of gold that can be feasible mined from the Earth’s crust. In the world of decentralized digital ledgers, the rules for generating more of an asset are enforced by code and cryptographic algorithms. Assuming that everyone agrees on running the same code, it is impossible to inflate the supply of a particular asset beyond the limits set by its protocol.
To the layman, Bitcoin and CryptoKitties couldn’t seem more different: CryptoKitties are fluffy animals while Bitcoins are gold coins with a capital B imprinted on them. However, in essence they are both scarce digital assets that can traded peer-to-peer over the Internet.
New Bitcoins come into existence via a process called “mining”. In Bitcoin mining, Chinese factories compete to solve cryptographic puzzles using highly specialized integrated circuits. Whoever wins gets to add a block of Bitcoin transactions to the blockchain and can reward themselves with some newly minted Bitcoin.
The number of new Bitcoins generated per block decreases geometrically over time, with a 50% reduction every 210,000 blocks. As a result, the total number of Bitcoins in existence will never exceed (slightly less than) 21 million. This can be verified by reading the source code of the Bitcoin Core client.
Just like real felines, CryptoKitties are expressions of genetic sequences. The genetic code of each kitten is stored on the Ethereum blockchain. New kitties are generated by sexual intercourse between existing ones. Kittens can be mated at the owner’s leisure and can produce an unlimited amount of offspring. However, the number of kittens at the root of the evolutionary tree is limited, making those special kitties a scarce commodity. For the remainder of this article, I’ll be referring specifically to “generation 0” CryptoKitties (KITTY0).
The rules that govern the mating and evolution of CryptoKitties are enforced by an Ethereum smart contract. By inspecting the source code, we can see that two constants were set during initialization that restrict the maximum amount of KITTY0 to 50,000 (further down the code you’ll see that attempts to create any kittens beyond that limit will fail).
Bitcoin and CryptoKitties differ not only in appearance and maximum supply but also in value proposition and technical details. Metaphorically, Bitcoin more closely resembles gold, while generation 0 CryptoKitties resemble rare collectibles. Salient features of the two assets are compared in the table below.
2018 will go down in history as the year of the bear. In an environment of pessimism and negative market sentiment, most crypto-assets lost 90% or more in value. Many previously hyped projects exit scammed or ran out of funds. Let’s see how Bitcoin and CryptoKitties fared in this merciless environment.
To assess the performance of Generation 0 CryptoKittes (KITTY0) we’ll look at the monthly average price of KITTY0/ETH throughout 2018, as well as the corresponding KITTY0/USD rate considering the average ETH/USD exchange rate for each month (data sources are listed at the end of this article).
As can be seen on the graph, both KITTY0/ETH and KITTY0/USD peaked in February 2018 and dropped sharply as the wider crypto bubble popped. Starting in July however, the KITTY0/ETH price starts to trend upwards, crawling up back to yearly all-time-high by December. Interestingly, this rise in ETH valuation compensates for the drop in ETH fiat value over the same period.
Let’s now see how well BTC and KITTY0 held up during the bear market by tracking an investment of $1,000 over the second half of the year:
KITTY0 has retained 100% of its USD value while BTC has retained only 47.7%. It stands to reason that KITTY0 has outperformed BTC as a store of value during this period.
The cryptocurrency market is still in a nascent state and crypto-assets are far too young to serve as a reliable store of value. That being said, past data shows that generation 0 CryptoKitties offer better stability than Bitcoin in relation to the US Dollar. All else being equal, it appears that organic demand for virtual feline companions is less prone to market cycles than demand for speculative settlement tokens.
Past performance however doesn’t predict future results. Investors face the usual dilemma: If I was to invest $1,000 right now, am I more likely to become rich by putting it into BTC or KITTY0 (and more importantly, am I going to kick myself for not having invested in either one in ten years)?
This is of course impossible to answer because current prices are determined almost entirely by speculation. Many chaotic factors may influence the price of a given crypto-asset. Over the next decades, network effects, hype, real-world adoption, yet-to-be-discovered use-cases, major hacks and even completely unforeseeable developments (say, Satoshi rising from the grave and dumping his early stack of Bitcoin on the market) could turn the world of cryptocurrencies on its head many times over.
The best we can do is to assess the fundamental value proposition of each asset and judge whether it will hold up in the future.
Fundamental Assessment of Bitcoin (BTC)
The latest fashion in the BTC camp is to proclaim Bitcoin to be an improved digital version of gold, a vision that has been made wildly popular by Saifedean Ammous’s book The Bitcoin Standard. In this view, Bitcoin (BTC) is the ultimate form of sound money, a scarce liquid asset that is resistant to government meddling and primarily used for international and online settlement. Its proponents ensision the Bitcoin blockchain to become a settlement layer that will see transaction fees rising to $1,000 and more.
This value proposition has a few problems. Firstly, it requires all rational actors to eventually acknowledge the supremacy of Bitcoin. Given the emergence of many cryptocurrencies with vibrant communities and the rapid pace of innovation in the space, this seems a little far-fetched. A multi-currency future (e.g. described Andreas M. Antonopoulos’ excellent The Internet of Money) appears far more likely. As there’s nothing about Bitcoin that makes it fundamentally different from competing currencies (except for the fact that it is Bitcoin), there is no reason why it should remain the most widely used digital currency for storing value or any other use-case.
The second problem is that given the high transaction fees predicted by Bitcoin-as-a-settlement layer advocates, the vast majority of people will be not be able to access real Bitcoin. Most trade and usage will be relegated to second-layer representations and “Paper Bitcoin” (ETFs, Futures). In such a scenario, it would be naive to assume that all virtual Bitcoin in circulation will remain fully backed by actual Bitcoin. As is the case in the gold market today, it is likely that supply and demand for actual Bitcoin will not play a role in determining the price of Bitcoin — instead, Bitcoin will inherit its price from its secondary markets. Bitcoin’s sole remaining value proposition as “hard money” will be then be diluted by inflation via Bitcoin derivatives and fractional reserve.
Applying Metcalfe’s law with respect to daily active wallets and trading volume indicates that Bitcoin is currently overvalued relative to other cryptocurrencies, indicating that market valuations are lagging behind fundamentals. My personal thesis is that as Bitcoin fails to adapt in a rapidly evolving environment, and investors increasingly demand real-world use-cases, Bitcoin’s network effects will keep eroding.
Fundamental Assessment of Generation Zero CryptoKitties (KITTY0)
Cats have been common in human households around the world for tens of thouands of years. Evidence of mummified cats being buried with their owners goes back 8,000 years, but the cat domestication may date back to about 12,000 years ago. It is fair to say that humans have shown a consistent preference for cats and that’s not likely to change anytime soon. I therefore predict KITTY0 prices to remain at leas fiat-stable or possibly gain in value as “the original” blockchain collectible.
Objectively speaking, BTC and KITTY0 stand out from the crowd in one (and only one) particular way: Being the first of their kind. Bitcoin is the first successful peer-to-peer, provably scarce digital currency, while CryptoKitties are the first successful provably scarce digital collectible. Considering historic price data and intrinsic properties of both digital assets, it would appear that generation 0 CryptoKitties represent a safer and more stable store of value as well as a more promising speculative investment. Evens so, it is always wise to diversify!
Full Disclosure: I own three generation zero crypto kitties by the names of Catniss, Muzi and Luke Purrwalker.