Joel Telpner (BBA78/JD83), special counsel and chair of the fintech and blockchain practice group at Sullivan & Worcester, LLP in New York City and chief legal officer of the blockchain company IOHK
Professor Erik Lie, Amelia Tippie Chair in Finance, Tippie College of Business
EL: What is blockchain and what is cryptocurrency? Because we hear about them all the time, but it’s still hard to grasp a good understanding of the technology and applications.
JT: I think that's a great starting point because people do use the terms interchangeably and they're actually very different.
Blockchain is in its simplest forms a new way of managing, storing, sharing, and verifying data and transactions that require the use of data. They are types of what are called distributed ledgers.
If we look at how we have historically managed and stored data and transaction information, we started off on clay tablets, then paper, then computers and servers, then cloud-based—all convoluted methods of trying to reconcile different systems and move data back and forth seamlessly and without error.
The concept of blockchain arose out of the question: What if you had a universal database that everybody had access to?
Blockchain is a distributed ledger or database where, in effect, all you have to do is open your laptop to access the virtual common database. It can be completely open, permissioned, or quasi-permissioned. Everybody can access it and everyone owns it, but nobody owns it at the same time.
The question is, how can you add data to that database and do it in a way where people can actually verify and be comfortable with the validity of the data is being added. By taking a distributed ledger and combining with cryptography, now we create a methodology by which new data can be added that we trust, without even knowing the party that has provided that data.
There are different methodologies for verifying data. There are many different approaches people are experimenting with, but all blockchains in common use some type of puzzle, algorithm, and/or cryptography combined together in different ways.
For example, the Bitcoin blockchain uses a process by which to add a new piece of data, you have to solve a mathematical puzzle. Anybody can propose a new piece of data. When they do, there are computers and people all over the world that immediately start engaging in complex mathematical computations in order to verify that that piece of data is actually valid.
EL: Just a question before we get to crypto—Would it be possible for a hacker to come in and manipulate any of this data in the blockchain—part of it or, or the whole system?
JT: Theoretically, yes, but not easily. If we get into quantum computing, all bets are off, but for now, depending on the type of blockchain and cryptography that's being used, there are ways to potentially attack and hijack data and create false data.
For example, there is a 51% issue that people talk about where if a number of people that are working on these mathematical puzzles decided to collaborate together, they could manipulate and create a false positive verification. But you'd have to find all of the anonymous people around the world that are working on the mathematical puzzle simultaneously and get them to somehow come together.
The reason why it's called the blockchain is every piece of data has to tie back to the proceeding piece of data. It's almost like a jigsaw puzzle—you have to find the one piece that can attach to the prior piece. Part of the mathematical process that is being used is to verify the entire chain back to the beginning. So hacking is theoretically possible, but practically speaking, it’s very unlikely and the amount of computer power required would be immense.
Most of what we hear about hacking involves individuals who lose access to their keys or crypto wallets as opposed to the blockchain itself being compromised.
EL: And what is cryptocurrency?
Cryptocurrencies are a software application that run on top of a blockchain.
Bitcoin blockchain was the first cryptocurrency. We don't know who created it. They used a pseudonym—Satoshi Nakamoto. He/she/the group published a white paper suggesting how the Bitcoin blockchain could work and it took off.
With a blockchain that just exists without a central company, party, person behind it, the question is: How does it keep going? That was the most interesting and novel part of the Bitcoin blockchain—it created a system where solving these mathematical puzzles is incentivized. If you solve it, the next piece of data is verified and you're rewarded—the Bitcoin blockchain automatically generates a new Bitcoin that you receive. Other blockchains use a fee mechanism.
Now, if nobody perceived Bitcoin to have any value, it wouldn't matter anyway, but the whole notion was to create an artificial concept of money and create a limited supply, where there is a total number that can never be exceeded. With it, we have a potential scarcity economic model where demand exceeds a supply, and the value of Bitcoin goes up.
Cryptocurrency, just like dollars or any fiat currency, has value to the extent people think it has value. It's all faith.
Fiat currency: government-issued currency that is not backed by a commodity such as gold.
If this new currency has perceived value, people can use to pay for goods and services. Some retailers are now willing to accept Bitcoin. The state of Ohio was allowing you pay your income taxes with Bitcoin. There’s even a region in Arkansas that's trying to become a tech hub and are offering people $10,000 worth of Bitcoin to relocate there.
So people started saying, well, wait a minute, let's take this concept. And now you have a whole bunch of variations that have been created. Hundreds of cryptocurrencies are competing for potential people to buy and hold it and are proving that it’s a valuable thing. We will probably not continue to have hundreds because a lot of them will prove to be worthless and disappear.
You don't need a cryptocurrency for blockchain, but the way blockchains have evolved, in many cases, that cryptocurrency is part and parcel to it.
Another aspect of cryptocurrency is tokens, or digital representations of an underlying asset. Non-fungible tokens (NFTs) are asset-backed tokens digital representations of an underlying asset—a piece of art. It’s like a digital title of ownership.
Non-fungible: a unique digital identifier that cannot be copied, substituted, or subdivided that is recorded in a blockchain and is used to certify authenticity and ownership.
There are also tokens that are used to get access to goods and services. For example, online gaming platforms that run on blockchain and require you to use the games’ native token. It’s like going to the old arcade where you had to use physical tokens.
Another specialized token that I’ve worked with involves farmers directly requesting proposals for crop insurance in the form of a weather derivative. People could bid on providing that coverage to the farmer. It’s all done on a blockchain using smart contracts or a token for purposes of creating that particular weather derivative contract and transaction.
EL: We spend a lot of time at Tippie teaching students how to value securities. Often the way that we do that is to discount the cashflow generated by these securities. We are stumped by these currencies because they don't generate any cashflow, per se, unless you’re a miner of these coins. How is it that these cryptocurrencies derive their value? Where's that value coming from?
That is one of the most interesting questions in this space. My cynical answer is: Who the hell knows!
JT: We have long had a methodology by how we value equity securities. It's very complicated, but people have been doing it and teaching it for a long time. There are different models and approaches. But when it comes to crypto, problem #1 is that no two pieces, coins, or tokens are the same.
In the world of equity, we know that common stock is common stock. There can be some variation in rights among classes of common stock, but in general, the common stock of one company gives you the same rights as the common stock of another company, so that we're able to not only value within a particular company, but we're able to compare values across companies.
So, problem #1 is that every token or cryptocurrency is unique, as far as its attributes, rights, and features. What it gives holders is not necessarily the same. For example, tokens can represent an ownership interest in the company and a right to profit, just like an equity security, but the vast majority of tokens don’t give the holders an ownership interest. They may just give you the right to play games or buy a cup of coffee.
I think the only way to even start to think about how to value tokens is by looking at the fact that most tokens are created with a fixed maximum supply. You can look at economic models where once there is a demand you can start to measure it and see if that demand is growing. If people really want the coins or tokens they’re going to have to go out into the marketplace and try to buy those tokens from other holders, and it drives up the price. You can create a valuation model like that, but I think that valuations right now for most tokens are throwing darts against a dart board.
The value of Bitcoin is based primarily on faith, just like the value of the dollar, but every other crypto coin out there seems to go up and down in fairly close correlation to Bitcoin's prices. Bitcoin is the gorilla in the room. We're still waiting to see other crypto that can truly break out and break away from Bitcoin where the valuation is truly independent.
EL: I teach a class on wealth management. One of the topics is asset allocation—how much to invest in bonds, stocks, and so on. The issue arises now, how much crypto, if any, should be included in one’s retirement portfolio. What’s your view on that?
JT: I've sat on some panels with a man named Ric Edelman, he's an interesting guy. His view is, you'd be crazy not to allocate at least 1% of your portfolio to crypto. His view is that if you completely lose value at 1%, so what, but because of how it’s performed historically, you'd be crazy not to have at least some allocation. So, I would say that unless you are very wealthy and have a high-risk appetite, having more than deminimis exposure to crypto probably doesn't make sense, but having no exposure also doesn't make sense.
Deminimis: too trivial or minor to merit consideration, especially in law.
We've seen some people that have become billionaires through their activities in crypto. But just like in any tech cycle, you have some early adapters who become hideously wealthy, and then the vast majority of people that jump in lose everything because it crashes and burns. I think the early examples in the blockchain and crypto space are no different, but that said, we are starting to see a maturity. I think the way to think about it is to start to look at where some of the asset classes are going. We're now seeing ETFs, we're now seeing a small but growing futures market in Bitcoin. As those types of investment products come online, I think that is a further argument that it is worthwhile to have at least a small portion of your portfolio in crypto.
EL: We started off talking about blockchain versus crypto. Similarly, when we think of investing, can we think of potentially investing in the underlying technology versus the coins themselves?
JT: I think that's a really good point. Investing in blockchain is very different than investing in crypto.
Regulators are still trying to figure out what crypto is—an asset class, security, commodity, or currency. But there are all kinds of things that people are doing with blockchain technology.
I think a great example is the supply chain, which right now is a mess. Even before the current supply chain disruption, supply chains were always very complicated because they involve a number of different hands that touch something, from when it's manufactured or grown until it finally ends up on the retailer shelf. Historically, every time a product goes from one party to another, you’ve got a lot of paperwork and the title has to move from party to party. The problem arises again about the kinds of databases and servers needed to have a common language to make sure the goods are moving and tracked through the supply chain.
If you take the supply chain and put it on a blockchain, now everybody involved in a product from its inception to the store shelf all have access to that common distributed database. Everybody can add their piece of information, and everybody can track where that good is throughout its life cycle. On that common database, we have created a much more efficient system for managing how we move goods from inception to store.
Lots of companies are looking at how to better automate supply chains with blockchain, how to better automate the creation, storing, and sharing of medical records, and how to better automate the process by which we verify people have graduated from a certain school. Companies that are using blockchain to simply make things more efficient is what I find really interesting and what I look at for investing.
When you're looking at where to invest—and maybe where not to invest—another interesting aspect to consider about blockchain is that it disrupts a lot of legacy type operations and could possibly make them irrelevant.
Take securities—you could digitize them and then trade them on a blockchain. In our present world of trading securities, the clearing house plays a critically important role. You've got go from a broker dealer to a clearing house to another broker dealer. You've got all these intermediaries that touch a security, which is why it takes a couple days for that security trade to settle and clear. But on a blockchain, theoretically, you could trade your security and have virtually simultaneous trade and settlement.
EL: Slightly different topic, there's a bit of an energy crisis in Europe these days—electricity prices are sky high. In the midst of this, servers are working on these underlying blockchain calculations, consuming mass amounts of energy and probably contributing to the higher prices and maybe the carbon footprint.
JT: I’ve heard that the Bitcoin blockchain uses the equivalent energy of a medium size country. But there's a new generation of blockchains. Bitcoin style blockchains are called “proof of work” blockchains—meaning that you're working on or performing these mining functions or complex mathematical calculations using massive computer power in order to add data the blockchain.
But there are other types of blockchains out there that are gaining in popularity. The most significant is what are called “proof of stake” blockchains, where instead of using computational power to verify the next block, they use a validation mechanism called staking, where holders of a cryptocurrency are required to be willing to lock up and/or forego X amount of the coin or crypto they're holding as a way to validate a piece of data that gets added. It's a different way to prove a new piece of data that uses a tiny fraction of the energy.
EL: So what you’re saying is I should sell any Bitcoin that I might have?
JT: Look, there are still those who are very bullish on Bitcoin because they’re looking at all the creative ways that people are trying to use renewable energy to do their mining activity. And there are arguments that computer calculations will continue to get more efficient over time. So… who knows?
EL: Looking into the future, how will this field of currency shake down and what kind of impact will the underlying technology have on our daily lives and society?
JT: That’s a great question. There are two elements to it—the crypto side and the blockchain side.
On the crypto side, somebody I work with just made this point yesterday. He said, “If you look at the history of the monetary system in the U.S., particularly before the Civil War, we didn't have a national currency, per se. Every bank had its own currency, and the currency was backed by whatever gold or silver it had in its vault, but there were hundreds of competing currencies.” Of course, that didn't last and crypto is probably the same. A lot of the crypto out there that is trying to compete directly with Bitcoin as a form of payment or a store value probably won't last.
On top of that, you've got a lot of governments that are very concerned about crypto—particularly the category called stablecoins. They don't want to see these cryptocurrencies competing with traditional fiat currencies, because if they do, governments worry about losing control over monetary policy. Governmental regulatory pressure will probably grow to the extent that the use of crypto continues to grow.
Stablecoins: a type of cryptocurrency that relies on a more stable asset as a basis for its value. Most commonly, people refer to stablecoins as linked to a fiat currency, such as the U.S. dollar, but they can also have value linked to precious metals or other cryptocurrencies.
Central banks are also exploring creating digital currency, which would challenge the ongoing viability of a lot of the crypto out there. Over time, I think that we'll still have cryptocurrency, but we won't have the hundreds that we have now.
Now, the other aspect of your question is about blockchain technology. Because a lot of blockchains are not public or permissionless, they are blockchains that are created for specific users. Going back to my supply chain example, Walmart has created a proprietary blockchain that they are starting to require all of their vendors to use. And FedEx is a big proponent of using blockchain to create a much better way to manage how they track and move all of their packages around the world.
Over time, using blockchain technology to make various businesses and business activities and applications more efficient will to continue to happen in the same way that the internet is now integral to every business around the world that uses it as part of how they function. Nobody talks about the internet at as a separate component, it's just how they conduct business.
If you look out 20 (or maybe even 10) years, blockchain applications and uses within businesses is going to be as common and not discussed as the internet.