Explain Crypto Like I'm 5

by Overheard Wall Street

Outline:
  • Intro
  • What Exactly is Crypto?
  • Crypto Universe
  • How to Play Crypto?
    • Bitcoin
    • Ethereum
    • Tether
  • Bull Case
  • Bear Case
  • Conclusion

Intro

Cryptocurrency has been getting slammed this year. Even though we are on the cusp of summer, Crypto winter is still raging. Does this spell the end for crypto though? Maybe, maybe not! What we do know is that crypto has completely changed our world in just a few short years.

But why?

In 2011, Marc Andreessen said that “Software is eating the world” – and he was right! Look at the biggest and most prominent companies today: Apple, Microsoft, Google, Meta. These are all software companies that dominate our world. Crypto is in the same boat. The technology underlying cryptocurrency, the blockchain, is eating the world.

Understanding cryptocurrency is a bit more complex than trying to figure out how Amazon or Google made money last year. Not too long ago, cryptocurrency was something only a few knew even existed. Those who lived in online forums knew what they were talking about but the rest of us had no clue what a “Bitcorn” was. 

Nowadays, it feels like you can’t even go a day without hearing about some newly minted crypto-millionaire or another hacking scandal. Just last month, Elon Musk hinted that Dogecoin could be used to purchase gear from the SpaceX gift shop! Do people actually want that?

   

This type of hype and excitement only brings crypto further into the light and deeper ingrained in our lives. Everyone knows someone who made a huge pot of money on crypto. And similarly, everyone knows someone who lost it all (or a significant amount) and got out of crypto for good. The space is growing every day and the more stories we hear, the more normal this whole world becomes.

   

What Exactly is Crypto?

The challenge here is to not bore everyone who reads this by going way too far into the details of the technology, but rather explaining the basics in order to better understand the landscape.

At the foundation is blockchain technology, which we can think of as an accounting ledger handled entirely by computer programs, rather than the 22-year old recently graduated CPA in the back closet “office.” This does not mean that one is better than the other, but it does mean that computer programs will not come into your office every 15 minutes asking what a “debit” is or how they can account for “accrued depreciation for this or that client.”

AKA it’s efficient.

   

Blockchain technology is an immutable (read: unchangeable, permanent) digital ledger that allows transactions to be completed and verified securely without a central authority (our recent CPA). Through this technology, transactions can be completed in a much more efficient and secure manner, while also being free from manipulation by bad players (anyone read Spider Network?).

At this point, I imagine you are wondering: “How does a ledger change the world exactly..?”

   

As an example, think about how much everyone relies on their credit card, or bank account, to live their lives. Rent payments, utilities, groceries, gasoline, mortgage, loan payments, restaurants… The list is endless. You need to pay for just about everything in the world today. And that requires the use of a middle man: your bank (or credit card company). These central authorities process all of your transactions, taking a small fee along the way, and providing some amount of security and safety to hold your accounts.

But what if you didn’t need to rely on a bank to process all of your transactions? What if a whole network of computers were processing your transactions almost instantaneously and with no human interaction? That would be pretty nice, right?

Imagine a world where you can send money overseas, across borders, down the street or to your favorite newsletter without relying on some middle man to approve your transaction. No one checks to make sure you have enough money in your bank account, instead that information is available directly on the public blockchain and can be verified instantly. No concerns for geopolitical tensions or one company not accepting a certain currency. An end to currency borders.

This is the end goal of the blockchain technology and cryptocurrency facilitates that goal. While blockchain technology is the rail line that all information is built upon, cryptocurrency is the Rolls Royce C Range engine (the train) running on the tracks.

Crypto Universe

There are many aspects to cryptocurrency right now, some of which will be explained in how we can play the market below, but to put some context on the size of the space, according to Pitchbook there are over 1,600 private companies focused on Blockchain technology with over $42 billion dollars of Venture Capital money raised as of March 7, 2022.

   

The space has grown exponentially in the last few years as more companies are finding ways to utilize this technology and build new applications that have potential use cases like crypto trading, crypto exchanges, blockchain gaming, decentralized finance, real estate, insurance, healthcare… the list goes on and on. And this is just the private company space – the list of actively traded cryptocurrencies, or liquid tokens, is over 1,500 strong right now with a market cap hovering around $1.3 trillion.

The top 100 tokens make up the vast majority of this total market cap and each token has a different function:

   

What makes cryptocurrency so different from publicly traded companies is that your ownership share can have multiple functions. For example, holding the token MKR (MakerDAO) gives the right to vote on governance issues such as interest rates, collateral amounts, and general business operations. Holding USDT, the Tether stablecoin is purely used for transactional purposes and as a stable store of value - there are no voting rights associated with ownership there.

How to Play Crypto?

The biggest areas within this space right now are Liquid Tokens like Bitcoin, Ethereum, Dogecoin and Tether. There are other more nuanced areas of cryptocurrency that can be explored, but that might require a post longer than anyone is willing to read right now. So, let’s dive into liquid tokens for now and see what we can learn!

Liquid Tokens

Liquid tokens are the mainstream area of cryptocurrency that we hear about daily on Twitter, CNN, Fox News and Short Squeez – Bitcoin, Ethereum, Tether, etc. It’s the token/cryptocurrency that is actively traded on the blockchain. Anyone with a Coinbase or Robinhood account can actively trade these tokens. The main reason to differentiate them as liquid is that now the private coin market space has grown so much that there are tokens being created by private companies that are only accessible as an insider, these are non-liquid tokens.

Within the liquid token space, there are a vast number of interesting and unique tokens that each accomplish something different. A few of the bigger names: Bitcoin, Ethereum, and Tether, each have a different function and a different purpose.

    

Bitcoin

Bitcoin is considered “digital gold” or the most likely to operate as a store of value asset. In the early days, some people tried to transact with Bitcoin, like this champion who spent 10,000 bitcoin on pizza (today the equivalent of ~$330 million dollars), but due to the cumbersome nature of its blockchain, Bitcoin is better served as a store of value investment. In other words, it takes so long, compared to other chains, for a bitcoin transaction to settle due to how large the chain has become, that transactions cannot be verified and posted instantly like we would expect to see when transacting regularly for things like groceries or pizza. They can take up to a few minutes, sometimes longer.

Imagine showing up at your local pizza joint, scanning your bitcoin wallet to buy some pizza, and waiting 10-30 minutes for the blockchain to verify your transaction and post it. That’s not very efficient.

Bitcoin is better considered a store of value asset – meaning that it serves no direct purpose other than as an investment vehicle that can be relied on to still be there in the future. It is the original cryptocurrency and so far has survived and thrived amidst all the ups and downs.

There will only ever be 21 million Bitcoin in existence - so the fear of more coins being mined every day and destroying the value you hold, should be mitigated. There is a set schedule in place that shows how all 21 million Bitcoin will be fully mined and in existence by 2030 - after that, no more Bitcoin will be created. That scarcity of supply facilitates some of the value attributed to the asset by investors.

Unfortunately, it can be tough to see Bitcoin as a “store of value” asset when it has such dramatic price volatility. While equity markets have experienced significant drawdowns, they are generally not quite as often, or extreme, as those for Bitcoin:

    

Ethereum

Ethereum, often referred to as the “World Computer” is the ultimate heavyweight in the crypto world. Ethereum is the foundation that almost all other cryptocurrencies are being built on today. The main reason for this is that Ethereum brought into existence smart contracts. Contracts that can be executed automatically through computer programs without a necessary middleman. Sound familiar?

Imagine having a contract with a supplier to pay only upon delivery of the asset. The asset is delivered and logged on the blockchain and instant payment is made without your lawyer calling their lawyer to confirm all the conditions are met.

Ethereum has a somewhat easier time transacting than Bitcoin, although the bigger difference is that there is no limit on Ether like Bitcoin. The way that scarcity is maintained in Ethereum is that with each transaction, a fee is paid in the form of Ether that burns/destroys a small portion of the token - these are called gas fees. All transactions pay a gas fee on the Ethereum blockchain and the amount paid is determined by the volume transacting in the market at that time.

When major events happen, like the ConstitutionDAO initiative to form a collective that purchased an original copy of the Constitution, gas fees were as high as ~$250 per transaction. When the Bored Ape Yacht Club dropped their virtual real estate rights deal, gas fees were north of $1,000 per transaction.

Ethereum has laid the foundation for Decentralized Finance, NFT’s, and other emerging areas of cryptocurrency through this smart contract functionality. The explosion in innovation over the last few years since the 2018 Crypto Winter can be traced back to Ethereum. Smart contracts have provided functionality and potential that are just now starting to be unlocked - look at Axie Infinity.

Axie Infinity is an online game that pays gamers in the native token, AXS, based on in-game functions and scores. Players create teams, battle other teams, buy and sell characters, all for actively traded cryptocurrency. This level of innovation has given recently laid-off workers a chance to make a living for their families in many countries.

    

   

Tether

Honorable mention to the supposed “stablecoin” that imploded not long ago. Pour one out for the Terra/Luna algorithmic stablecoin.

Now that we’ve paid our respects – Tether is a more traditional stablecoin. Stablecoin means that it is tied to a “real world” asset that has some value in order to keep the price of the token as close to $1.00 at all times. The purpose of this is that stablecoins can be thought of as the gateway to cryptocurrency. Less of the price volatility of Bitcoin and more easily understood from the traditional finance lens.

Tether has pegged their token 1-to-1 with matching assets in order to provide this $1.00 stable price. This means that your Tether token has some asset, held in a vault somewhere, that backs the token’s value of $1.00. It can be exchanged at any point in time for a dollar. 

A few years back, there were concerns over the assets backing Tether. Some said that there was no vault holding billions of dollars to back billions of Tether floating around. But since then, transparency has only gone up and you can see that Tether regularly updates and confirms their asset base to justify the stable value:

   

  

Sure, in Coinbase you can purchase Bitcoin by linking your bank account and paying with USD, or EUR, or any other currency. But when you go farther and start to transact directly on the blockchain, you will need a native asset that can be logged on the blockchain. Enter stablecoins.

If you have $1,000 you want to invest in a more niche cryptocurrency, you are going to need to do so in your MetaMask wallet, or through another hot wallet. But if you are doing this, you don’t necessarily want to put your $1,000 in Bitcoin in order to convert it to another cryptocurrency at a later time – what if BTC falls by 10% overnight? You want to invest the entire $1,000 into this niche token.

Stablecoins allow for this level of functionality. They allow for the conversion of assets between different chains without losing their value (apart from transaction fees).

On top of this, stablecoins also provide a service to the cryptocurrency space in general that is well-rewarded: liquidity. Everyone needs liquidity. Markets definitely need liquidity. And for those that want to hold stablecoins and provide that liquidity, they can be rewarded for that action through the form of a yield sometimes as high as 20%.

Just remember to use your head – if the yield sounds too good to be true, it probably is. *Another moment of silence for the Terra Luna gang*

Bull Case

Everyone knows someone who bought the dip at the right time and made out like a bandit. Whether it was your quirky brother who spends way too much time in the basement doing who knows what, or your favorite uncle who loves to talk about abolishing the government at Thanksgiving.

  

The compelling nature of cryptocurrency is that it seems like anyone can become the next “Bitcoin Billionaire.” The access is there for someone to take the time to learn more about it. Nothing is guaranteed in this business, but high-flying returns draw everyone in for a closer look.

The level of innovation and improvement in the space in the last few years is matched only by the internet craze in the late 90’s. We have gone from Long Island Iced Tea Blockchain crazes to political officials getting paid in cryptocurrency and entire sovereign governments adopting cryptocurrency as legal tender. It seems like the innovation in this space will never end. Smart contracts solving flight delays, insurance claims, mortgage lending… the list seriously goes on and on.

This space is exciting and unique. It is drawing in all sorts of investors who may not have cared a whiff for buying stock in a car manufacturer, but tell them they can buy a token with a picture of a cute Shiba Inu on it, and they are all in.

Bear case

Remember that friend that bought the dip and made out like a bandit? Yeah, most of us did not experience that. What we experienced was more akin to losing our shirt and giving up.

  

There is so much innovation and things are moving so quickly within the realm of cryptocurrency that losses are just as common, if not more so, than gains at this point.

So many projects have a great story, but little development, or little security, and can end up costing investors more than they bargained for.

Two great examples of this are Terra/Luna and the Squid Games token.

Squid Game was a silly example – the Netflix show was so wildly popular that someone created a SQUID token purely for fun, without much of an explanation as to what it would be used for, or why. People thought it was awesome and of course, they loved watching Squid Game, so they bought in.

Not long after, the creators stole all $2.8 million that was invested and left everyone in the dirt wondering what happened.

Security is key, but regulation is nonexistent at this point, so investors need to be aware of the fact that they have to do their own due diligence first. And just because a token has a fun name, or is attributed to a popular show, it probably is not the place to bet the farm.

Terra/Luna is a more nuanced example because at one point Luna was a top 10 token! It had been around for a long time and the people behind it were clearly not crooks (at least, no one thought that a few months ago).

Luna was a token created to algorithmically keep Terra, a stablecoin, pegged to $1.00. Instead of a full treasury vault backing up the value of the stablecoin like Tether, Terra was backed by an algorithm that was buying and selling LUNA in order to keep the value of Terra as close to $1.00 at all times.

Unfortunately, since both of these tokens were so closely linked as one started to fall in price, the other followed suit and what commenced is called a "Death Spiral." As Terra dropped, more LUNA was used to stabilize the value of Terra, but to facilitate that LUNA needed to be sold. As LUNA price fell, so did Terra, and on and on. Because each is so inextricably linked, there was no stopping this fall and $40 billion was essentially wiped from the face of the earth. (Here is a video you can watch for a more fulsome explanation)

This was not a scam (at least, it doesn’t appear that way yet) but it does showcase the fact that just because a token has extremely wide adoption does not mean that your investment is “safe.”

Conclusion

As with everything in investing, there is no get rich quick scheme. If you think you have found it, most likely you are the one others are getting rich off of.

Right now, crypto is providing an exciting opportunity for investing in unique stories and world-changing technologies. They may not be able to take care of every aspect of your life (sorry pup, we still can’t find anyone to walk you 3x a day) but they are providing some incredible opportunities for investors to make a lot of money.

Play in this sandbox only if you are willing and able to lose 100% of your investment. There are no guarantees here - even the names that carry a lot of weight are not necessarily safe places.

      

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