I am a big believer in the potential of blockchain technology. But, I have to admit that Charlie Munger and Warren Buffet have 100% valid criticisms against cryptocurrencies.
Once you evaluate their way of thinking, it isn’t too hard to see why they strongly oppose Bitcoin and other cryptocurrencies. Let’s peer into the brain of Charlie Munger and see why.
In the book Poor Charlie’s Almanack, there is a speech Charlie gave to the Economics Department of the University of California, Santa Barbara, titled “Academic Economics: Strengths and Faults After Considering Interdisciplinary Needs.” It focuses on how academic economics is prone to making mistakes because there is a lack of knowledge across the many interdisciplinary fields that are involved in economics.
It hit me that cryptoeconomics is even more interdisciplinary than economics alone. There are cryptographers, distributed computing engineers, game theorists, and open source developers working together. None of them are inherently trained on how to run a business. Then there are the marketing, sales, and other business employees in every blockchain project who fill the roles to run a business, but may not understand the technical details of how blockchains work.
I’ve taken 5 of the criticisms of for economics that Charlie had, and related them to the cryptoeconomics of blockchains. By being able to identify some of these criticisms, it will help us to accurately identify which blockchain protocols are building tools we truly need.
“When given a hammer, every problem looks like a nail.”
In a space as new as blockchain, it can be unclear what technology we need to build. This confusion can cause teams to focus on metrics that are completely unconnected to the success of their product. Along with social proof, some of these metrics can appear to be important milestones to hit. We end up collectively overweighting what is easily measured.
Overweighting whitepapers for their marketing value
Whitepapers in the blockchain space have become unconnected from their main purpose. They are meant to describe an issue to the reader, and present a technology that solves the issue. The Bitcoin whitepaper is an example of a good whitepaper. It is short and to the point, and much of the technology had already been developed. The network went live less than three months after the whitepaper was released.
Sadly the last two years whitepaper’s have become focal points for raising money through ICOs or private investing. Teams end up focusing their efforts into crafting a perfect whitepaper, rather than building software. It is easy to write a whitepaper to tell a compelling story as to why your product will work. It is much harder to deliver on a product that people will actually use.
Because of this shift, it is important to view whitepapers for what they are, and not get too excited about the narrative the whitepaper is telling. Whenever you can, look for the technology that backs up whitepaper before taking a project seriously.
Overweighting the importance of easy-to-measure values
Community building is an important metric for every blockchain. But, it can be hard to measure. Open source code contributions, product user engagement, and the decentralization and diversification of the Miners and Validators of a blockchain are crucial pieces of information that can indicate how well a community is functioning. But these metrics are hard to obtain, and take effort to get meaningful data to draw conclusions.
What is easier to understand is a simple number, such as a Telegram chat room membership size. Blockchain protocols are notorious for showing off their Telegram membership numbers, and today some are reaching the 100,000 mark.
The large number is very misleading, as it isn’t a good indicator of community engagement. It is easy to temporarily inflate this number with some good marketing, such as a free airdrop. But having a group of 50,000 members doesn’t allow for a good communication channel between the company and the community. The chat room will have so many messages coming through, that it becomes hard to follow, and often degrades into a glorified troll box.
Comparing one Telegram group to another is an easy metric to measure. But as investors and community members, we shouldn’t let ourselves be convinced so easily. We should pay attention to the harder to obtain metrics, like open source contributions.
For blockchain protocols, there is a social pressure to follow the herd and build a large Telegram membership. But the best teams will focus on building a community for developers to get involved, and will have productive communication channels with the end users of their product.
Poor resource allocation that should be dedicated to tech R&D
Even though the legal status of ICOs is still a grey area, there is a certain level of responsibility that has been ignored in the cryptocurrency space.
Greed took the best of many companies, causing them to raise millions of dollars without doing their due diligence. Now they are worried about retroactively being classified as a security.
The companies now have to focus time and money on trying to convince everyone their blockchain was a decentralized protocol from day one, and not a security. This wastes resources that could be spent building the product. Losing these resources can be categorized as bad management, or lack of taking responsibility, which isn’t a valuable trait for a startup. Needless to say, lawyers are loving their new revenue stream for blockchain consulting.
There are better ways to raise capital responsibility. Balance, an Ethereum wallet project raised $1.2 million USD through crowdfunding. This is a reasonable amount of money to get a start up on their feet. They can now focus on building a great product, rather than watching their backs for the SEC. Doing a crowdfund was the perfect balance (no pun intended!) of obeying the law and finding a way to allow the general public to invest . It’s what the blockchain space is all about, and it shows a level of responsibility that you want to see from a founding team.
Munger coined the term “Febezzelment, ” which refers to identifying embezzlement using simple algebraic functions. Blockchain investors are guilty of ignoring simple algebra, as billions of dollars are appearing out of thin air.
Forked blockchains creating money out of thin air
Let’s take a look at Bitcoin Gold (BTG). The team behind Bitcoin Gold decided to fork bitcoin, and simply change the mining algorithm to be better suited to GPU mining. The development work for this appeared to have started on September 5th 2017, and the launch date of Bitcoin Gold was November 12th, 2017.
They also decided to premine 200,000 BTG to be sold for 20,000 BTC on the market to fund development. Around late October 2017 when Bitcoin Gold launched, 20,000 BTC would have been worth about $120,000,000 USD. With just over two months of development work by a few developers, the team was able to create millions of dollars out of thin air for themselves.
Let’s examine the simple algebra that investors are guilty of ignoring. Before Bitcoin Gold was forked, it had no community, and no proprietary code. You could write the equation down as follows:
$0 worth of BTG = No community and code
After two months of development, Bitcoin Gold was released, and eventually peaked at a market cap of almost $8 billion. The equation then looked as follows:
$8,000,000,000 = Two months of development work
Clearly, this equation is not balanced. And it is a perfect example of why Charlie doesn’t trust cryptocurrencies. Let’s investigate ICOs next.
ICO’s creating money out of thin air
A typical ICO can have investors expecting to double their money in a few days, which is just not sustainable. For example, let’s say a team creates a whitepaper and a website. They then run an ICO, and they raise $10,000,000 in Ether. A day later the tokens the investors received can be sold on the market for a 200% return.
Looking at the chart, it is clear that $20,000,000 was created out of thin air, and all that we have is a whitepaper and a website. We can’t keep tricking ourselves, eventually this false math will blow up in our faces. Expect tokens to drop to $0.
Every investor can only blame themselves, but we must also point fingers at the teams raising more money than they truly deserve. It is too easy to raise money without repercussion. This is because ICO’s are a poorly designed incentive system.
To draw a comparison of a badly designed incentive system, let’s consider employees that take advantage of workers compensation benefits. If workers compensation is too easy to abuse, employees will do so. If a doctor’s note is all it takes to get a paid month off, you can bet that fake injuries will be reported. It will end up costing the company serious monetary and operational costs. This is a poorly designed incentive system because it incentivizes lying about injuries to get money, at the cost of the company. ICO’s are poorly designed incentive systems because it incentivizes marketing, hype and manipulation to raise money, rather than building technology that people can use.
It is often talked about how EOS raised $4 billion dollars for their ICO. What is less talked about is the fact that they raised 7% of all Ether. Ethereum is the biggest smart contract platform with the most open source developers in the world, and it is now 7% owned by block.one, the company behind EOS. It begs the question, what did they do to deserve it?
Sadly, what they have produced so far is not worthy of 7% of the total supply of Ether. What they have done, is gamed the incentive system better than anyone else. They are like the employee who gets hurt, goes on workers compensation, and sues the company for 7% of all their assets to go start their own competing company. EOS is simply the greediest project in the blockchain space. It is unlikely they will ever build software that is worthy of all the capital they raised. 100’s of other blockchain startups could have been funded with $4,000,000,000, which would have created many more jobs and a more competitive and diverse landscape.
Charlie talks about how focusing on macroeconomics is an easy way to hide how things work at the microeconomic level. We have a very similar problem in the blockchain space. Blockchain protocols boast about their platform taking down the big bad centralized entities, without ever mentioning how they will obtain user adoption.
A great example is the idea of decentralized storage protocols (Filecoin, Storj, Sia) competing with Amazon Web Services, which is a multi-billion dollar industry. When looking at it through this lens, these protocols appear to be extremely attractive investment opportunities.
However, we are seeing very few teams actually provide information on the micro level details of their protocol. How will a decentralized protocol, with decentralized developers, and decentralized service providers be able to compete on end user price, against the economies of scale that AWS has with their super central, super organized services that continue to make it more affordable?
Blockchain projects either miss this point completely, are vaguely aware of it, but choose to ignore it, or they are purposely hiding it behind the macro mission of their protocol. A billion dollar opportunity is a sexy story that can blind many people to the finer details that matter. Such as the cost of user acquisition, and the fine details of how decentralized services will be more affordable that centralized services.
Decentralized storage may compete with Amazon one day if the network can reach mass adoption. But mass adoption is still very, very far away.
Second and higher order effects are hard for people to understand. But when you are raising millions of dollars to fund a blockchain company, you’d hope the founders could pull off some second order thinking.
Second order effects of increasing transaction speed
When it comes to the topic of increasing blockchain transaction speed, the second order effects are often ignored. There is the simple tradeoff of security, scalability, and decentralization. Increasing one of them will end up decreasing one of the other two. It can be illustrated by the triangle below, tweeted by Vlad Zamfir:
This is a simple, yet not well understood fact to many investors and people in the blockchain space. Many blockchain protocols deliberately claim high transaction speed, while choosing not to mention the sacrifices they make in security and decentralization.
Second order effects for Decentralized Applications (dApps)
Second order effects are too often ignored when it comes to dApps being used in the real world. It is true that internet companies and governments are controlling and selling our data, and this is a worrisome fact. Decentralized networks need to be built to give us another option for interacting outside of centralized control.
But the truth is, for the foreseeable future, this will be a slower, more expensive, and less user friendly experience than what established centralized entity can provide us today. Before raising money, every blockchain protocol should be considering the following questions:
How many people care enough about being in control of their own data to use your dApp over a centralized application in the next few years?
Most protocols will conclude that there will be a subset of people who are willing to pay extra money for privacy. But this subset is small. No matter how well you design your dApp, it is going to be very hard for it to overtake a similar, centralized application, for reasons completely out of your control.
There is also the fact that many of these services that require you to be in control of your own data, also require you to protect it. You need to make sure your personal computer doesn’t get hacked, otherwise your digital identity and assets could be stolen. Individuals using decentralized networks have to invest their own time into protecting themselves.
Centralized entities streamline these protection services to make our lives easier. This leads to another question dApp teams should ask themselves:
How many people are willing to put up their own time and money to secure digital identities and assets, without the help of centralized services?
Once again, there will be a subset of people who want to do this. On a 20 year trajectory, decentralized services might be as cheap and easy to use as a centralized services. So it is reasonable to think there is a future for this, and the only way to get there is to put in the work. The problem is the lack of evaluation by blockchain protocols and investors into realistic short term user adoption.
The most virtuous thing to come out of the blockchain space is the invention of Bitcoin. An anonymous creator built a digital currency, which gave people a new way to own assets with no involvement of centralized entities. It is an extremely powerful idea, and it was given to us for free.
It also pathed the way to many vices — ICO Scams, private key theft, pump and dumps, exchange hacks, and market manipulation. This has lead to pain for many investors. The system won’t get fixed until there is a punishment system created for committing these acts.
Some of these punishments will come through government legislation, which will be a good thing as long as they don’t abuse their power and stunt innovation. But even in the normal economic world, almost nobody went to jail for the 2008 financial crisis. So the law will be unable to fix this system on its own.
We need a better way for blockchain protocols to be held accountable for the resources they are commandeering. Because right now, founders are transferring all the risk to the investors. An ICO can raise $10,000,000 with no blood, sweat, or tears endured by the founders. That is a recipe for an unreliable startup, as the founder’s haven’t endured that hardships that are usually required to secure funding.
An eye for an eye, which is rooted in old religious law, is a simple technique that could fix this problem. The existence of the law provided skin in the game for both parties in agreement.
It would require that when an ICO raises $1,000,000, the founders also put in $1,000,000 of their own money. That shows some real investment, and people would be much more inclined to trust that the founders will put in the work needed to succeed.
However it is unrealistic to expect a team to match their funding round. A million dollars is a lot of money. What you want to see from a team is a working product that took them months or years to develop, so that you already know they are significantly invested themselves.
Vitalik’s DAICO fundraising model is also a step in the right direction, as it allows for ICO funds to be slowly released over time. It gives the investors the ability to take back the funds if they feel the team is not spending the money wisely.
Charlie Munger is an extremely intelligent and experienced investor. It is common for the blockchain community to ridicule the comments he and Warren Buffet make towards cryptocurrencies. But they have decades of experience, and when you start to understand the way they think, you recognize some of the big red flags they see.
These criticisms are valid, and we should take Buffet’s and Munger’s opinions seriously. But, we should also be optimistic about the long term benefits that blockchain’s and decentralized networks will provide. Even at the beginning of the stock market, there was rampant fraud and trickery. But it has matured into a reliable system that allows people to feel safe with investing their money.