Prices of Cryptocurrencies, especially Bitcoin, are soaring since the inception of Bitcoin and the underlying distributed database type nowadays known as „Blockchain“. Let’s discuss what it means in a short and long term perspective...
-Florian Glaser is Head of "Electronic Markets & User Behavior
" at the Karlsruhe Insitute of Technology
Prices of Cryptocurrencies, especially Bitcoin, are soaring since the inception of Bitcoin and the underlying distributed database type nowadays known as „Blockchain“. Let’s discuss what it means in a short and long term perspective while taking the evolution of the underlying technology into account.
Soaring prices usually imply a substantially higher demand than supply. That is, there are way more people who want to buy cryptocurrency than people who want to sell cryptocurrency.
What is the intention of the people who are buying Bitcoin? Two cases are reasonable: Cryptocurrency for Payments
, or the belief it could serve a payment SystemCryptocurrency as a Speculative Asset
The fees (costs) for a user to trigger a transaction on the Bitcoin Blockchain has to be set by the sender of the transaction. At the time of writing this post, a transaction on the Bitcoin blockchain costs around $6 of direct fees (bitcoinfees.info, bitcoinfees.earn.com). A SEPA transaction within the European Union costs close to nothing. Who would be willing to bear these costs when frequently paying (rather cheap) goods with Bitcoin? Besides high direct transaction costs, who is about to pay with a currency that might increase in value by 70% within the next week?
Even if people ignore these costs and lost return opportunities, if Amazon would bring its 35 orders/second  on the blockchain, the network could technically process only a fifth of the orders assuming no other users besides Amazon clients are actively using the Bitcoin network.
In summary, paying with Bitcoin is far from being a rational choice and would not be possible at a large scale. Unless you have other requirements like pseudonymity and the reduced traceability of Bitcoin transactions. In the future, assuming millions of active users, the costs for transactions will rise dramatically due to transactions on a blockchain being a sparse and hence costly good.
There are people working on solutions of the scalability problem (as I do myself). But the purely technical problems which need to be addressed are several decades older than the blockchain technology. They have been extensively studied by computer scientists, but are often hiding in the complexity of the technology. What is rather novel is the direct entanglement of technical and economic incentive issues at a large scale . One promising solution is to perform transactions aside the blockchain without losing the trust properties of a blockchain . Another promising solution is, for example, to split up ecosystems into many interoperating chains while each chain caters a certain business domain. Given this perspective and the fact, that we are only at the beginning of blockchain technology evolution, it seems most likely that the currently running, first generation of systems won’t be part of highly specialized and fragmented technical solution in the future.
What are the expectations that people are investing into? The mutual believe into rising and, hopefully, stable prices of the highly speculative asset at a later point in time. The alternative are false expectations nurtured by a mix of technological complexity and ongoing, exaggerated public appraisal.
Participation in Blockchain Projects via Initial Coin Offerings (ICOs)
ICOs promise the buyer to participate in profits earned by a product that is (yet to be) built by the sellers of a digital, cryptographic token. There are three types of tokens sold through ICOs: (1) a token implemented by a smart contract on the Ethereum blockchain alongside a system of services that are also implemented as smart contracts on the Ethereum platform. (2) a new blockchain network is launched, the product is built on top of that newly launched system and a share of the new blockchain’s inherent tokens is sold. (3) a token is implemented by a smart contract in the Ethereum blockchain, used to represent shares of an offline project. This implies that people participating in an ICO assume that there will be some product, which provides value to others when used on the blockchain or used offline. This can be considered similar to the listing of a share of a company on an exchange and its issuance in the process of an Initial Public Offering (IPO).
The European Financial Market Authority (EMSA) and the German authority BaFin raised strong concerns regarding ICOs in November 2017 [1,2]. Both warn investors that those products often don’t exist, may not function properly, are complex to understand (inadequate information), might be faulty or degenerate on purpose (flaws in technology), or might never be build (vulnerable to fraud). The prices of tokens are also very volatile and options to exit the investment are often lacking altogether.
While one or multiple of these concerns might be valid for many of the ICO financed products, an even more crucial factor regarding type (1) tokens is – again – scalability of the underlying blockchain. In the case of smart contract-based products (Decentralized Applications – DApps), Ethereum is the chain of choice, because it is the only public blockchain that provides smart contract programming as an intended design feature. In contrast, the Bitcoin blockchain allows complex smart contracts only in the form of a workaround, which is painstaking and error-prone from a technical perspective.
All DApps require interaction with users in form of transactions. That means, DApps only work if users send transactions into the Ethereum blockchain to trigger smart contract services. Each ICO token is striving to acquire hundreds or thousands of users. Although the Ethereum blockchain is capable of 3-4 times more transactions per second (25tx/s on average) than Bitcoin, millions of users using thousands of smart contracts cannot be served due to technical limitations.
For type (3) tokens, the service is not built on the blockchain itself, that is, developers are only raising cryptocurrency funds to realize the project. Nonetheless, the dependency on the technical functioning of the public Ethereum Blockchain and the valuation of the token by the public remains. Due to the lack of control and regulation, no one knows or can control what a company - which might exist only in form of a website - is actually going to use the money for. Once the Ether is turned into a „real world currency“, the invested value has left the trusted realm of the blockchain system. This implies that investors have to trust into the company as an interface to the tokens sold in the ICO. But the trust-free environment of the underlying blockchain is no longer relevant or useful as a guarantee .
What about the large companies investing in Blockchain technology?
If a company identifies any use for an advanced and customized version of a blockchain, such as Ethereum, Bitcoin, or any other Blockchain system won’t be relevant for or related to the success of this technology. The profit through technological progress will be reaped by the companies using it, either by reducing costs of their processes/services, by making users pay for participating in their blockchain ecosystem or by licensing the technology to third parties for internal or inter-group usage.
Blockchain technologies indisputably are very fascinating software systems. There are promising, domain-focused use cases and many more to be discovered in a more digitized and digitalized future. However, blindly investing into the first generation of public networks is only paying off for the first movers. I am curious who will be second, won’t be able to sell when the bubble bursts, and eventually pay the bill of the excess. Only time will tell if the public crowd of investors is less greedy than the financial institutions that were often blamed by the public for their excessive greed prior to the financial meltdown a decade ago.
 Financial Times (2017), https://www.ft.com/content/ed6a985c-70bd-11e2-85d0-00144feab49a
 ESMA (2017), https://www.esma.europa.eu/press-news/esma-news/esma-highlights-ico-risks-investors-and-firms
 Bafin (2017), https://www.bafin.de/SharedDocs/Veroeffentlichungen/DE/Meldung/2017/meldung_171109_ICOs.html
 Glaser, F. (2017), “Pervasive Decentralisation of Digital Infrastructures: A Framework for Blockchain enabled System and Use Case Analysis
“ Hawaiian International Conference on System Sciences (HICSS).
 Glaser, F. et al. (2014) “Bitcoin – Asset or currency? Revealing users’ hidden intentions.
” European Conference on information Systems (ECIS).
 Engelmann, F.; Glaser, F.; Kopp, H.; et al. (2017), “Towards an Economic Analysis of Routing in Payment Channel Networks