Bot, and Paid For.

Headline: Bot and Sold

Date: 4/23/2033

Body:  The key to cryptocurrency, and what keeps me up at night if I owned any, is the extreme volatility of the prices.  This is nothing new to readers of my blog and readers of any kind of article about cryptocurrency.   But, the reasons why this extreme volatility exists might not be so visible.   In the stock market, there was an arms race of who could get their orders fulfilled the fastest, and year after year, firms would invest millions of dollars to get a foot closer to the servers closing the deals.   In terms of timing, this advantage was measured in nanoseconds or less, literally.

So, should it be any surprise that when dealing with something even more abstract, like cryptocurrency, the arms race begins on an even higher level?  I hope that your answer was NO!!  Back in the halcyon days of trading “real” stocks, there was a brief period (measured in microseconds) between a large institutional investor, say CALPERS, placing an order and getting that order filled.   Some computers, were they fast enough, could “see” this large order coming and order the same stock first.   This would guarantee them a lower sales price than CALPERS was getting, and then, microseconds after the big sale, they could sell their stock back at an inflated price, and pocket the difference.  This is the essence of “front running” and in the realm of cryptocurrency, this has taken on Olympian proportions: perhaps that’s an understatement because, it is physically impossible for any human to do this accurately. (There is a great book about this called Flash Boys.  Great read.)  Enter the “bots.”

The bots are essentially small pieces of code that “see” a potential change in prices upcoming and try to take advantage of it.   As you can probably guess, this army of code pieces adds significantly to the volatility in pricing of cryptocurrency.  In fact, some experts have made this exact point.

“Under the surface of every transaction that finds its way to the blockchain, there are fierce wars over every bit of profit,” said Manuskin. “If you happened to come across an arbitrage opportunity, or even notice an error in some contract, it is very likely that it will be hard to extract this value without either operating a bot yourself to fend off the front-runners, connecting to and paying a miner to conceal your golden goose transaction, or making the transaction complex enough for the front-runners to not notice.”

This is hard to believe.   Is there proof that these bots exist?

Good question.   Researchers looked at this very question, in fact.   They put together a large transaction that was engineered to be attractive to a bot like this.  The Ethereum based contract was pending for about 3 minutes.  Then in the same transaction block (before the engineered bait transaction) a similar transaction took place.   Why did the Ethereum miners prioritize this transaction?   The bot paid them 0.0001111 more gwei.   (This is a currency paid for the miners to substantiate a transaction.   This payment is also called “gas.”)  The researchers engaged the services of an Analytics company and figured out that the bot had been used since 2018, and it had taken profits amounting to $10,000.  Not quite enough to live on near DC, but, one single person can operate MANY different bots, and the results can multiply quickly.      In the next stage, researchers hid their transaction behind a proxy server, and even with this protection, there was a different front-running bot that was not fooled.  Arms race has officially begun!

So, we know there are front-running bots, so we can avoid them, right?

No such luck, I’m afraid.    Said one researcher, “Each [bot] operates differently and might be triggered by different factors of the transaction,” he said. “The bots themselves are in competition with each other over who gets the reward. This is only the tip of the iceberg in the full picture of the bots out there, which makes it even more interesting.”

Enter the Flashbots

Of course, somebody out there put together a free, open-source “kit” from which you (or somebody with nefarious intent) can assemble your own bots, set to be attracted to the transaction parameters of your choosing, with instructions personalized to that bot.  But, the stereotyped 19 year-old guy with thick glasses who lives in a used camping trailer under a highway bridge is not the only one who can do these shenanigans.  The miners themselves can make choices about which transactions to put before other transactions, so, the arguments against these bots often fails at this point.  Most experts seem to agree that the current situation is not ideal, but it has the potential to improve the system drastically, over time.

Has there a reaction to these Flashbots?

Binance is a well-known cryptocurrency exchange, and has put together a policy statement on how they will fight these Flashbots.  Their defense is organized around the following areas:

Defense	Comment
Fast matching of transactions within blocks.	If the transactions are verified and executed quickly, these bots have a much smaller window of time in which to operate.
Transparent Match Engine	The rules for matching and executing transactions are known by all participants, and anybody can “replay” the verification of a block, to ensure that the prioritization rules have been followed.
Periodic Auction Matching	When the Auctions are Matched later, the bots work perfectly, too perfectly.  So, these can be traced back to individuals, and there can be consequences.

This is not a perfect defense mechanism, but it does seem to work pretty well.

The Verdict

Whenever anything new under the sun is trotted out, there is one and only one thing that can be counted on: The crooks WILL try to take advantage of this new mechanism to enrich themselves.  So, given this, we seem to have 2 choices to remain safe.  The first alternative is to not play in the cryptocurrency sandbox at all.  This would prevent any front-running bots completely.  But, we would have to forgo the potential benefits too, and that could be substantial.  The second is to choose your cryptocurrency exchange very carefully. 

REFERENCES

https://www.coindesk.com/tech/2020/12/29/new-research-sheds-light-on-the-front-running-bots-in-ethereums-dark-forest/

https://www.bloomberg.com/news/articles/2021-09-23/crypto-trading-how-flashbots-work-to-front-run-ether-and-other-coin-purchases

https://docs.binance.org/anti-frontrun.html

https://www.morningbrew.com/daily/stories/ethereum-gas-fees

Editor’s Note: Please note that the information contained herein is meant only for general education: This should not be construed as Tax Advice.   Personal attributes could make a material difference in the advice given, so, before taking action, please consult your tax advisor or CPA.

Research is Currency

Headline: Methods to Research the right kind of Crypto to Invest in

Date: 3/26/2022

Body:

Investing guru Peter Drucker is quoted often.   One of his most famous quotes is, “You should be able to illustrate their business model with a crayon.”  Cryptocurrency is simply a different type of investment, so it stands to reason that you should be able to illustrate the value proposition “with a crayon.”  To be able to simplify such a complex decision to such a level, requires significant research.  When researching stocks of companies, you can go to the corporate website and peruse the 10-Q and 10-K statements (paying extra attention to the actual financial statements) and then scan the commercial press to find articles indicating a good future is probable, or the reverse.  With a cryptocurrency, this process is not possible because the same statements are not required by the Federal Government.  But, be of good cheer, there are things that you can do to ensure that you are making the best investment possible, for yourself.  Recognizing that nobody has a perfectly functioning crystal ball, these research ideas cannot and will not  provide guaranteed wins.   But, they will significantly increase your odds.

First, understand what it does and how it functions.

To do this, please be sure to download the whitepaper that is behind the currency you are thinking of investing in.  Before a cryptocurrency is launched, the team behind it will  create a whitepaper that introduces the currency to potential investors.   It will outline the purposes of the currency, introduce the management team and brief you on some of the major policies that the currency follows.  I know that this can be tiresome, but, reading and digesting this document is part and parcel of your investment.  But, if you don’t, what could happen?    I mean, nobody has had a disastrous blind date before, did they?    But, this potential partner has some of your money, so, it’s a bit more serious.

Please pay serious attention to the market capitalization of the currency you’re considering.   If it is too small, it could be a very illiquid investment that is hard to exit.  Also, pay some attention to how much currency will be held by the founders.

Second, scan the press (i.e. Google) and see if it is active

Currency isn’t worth the metal it’s minted with if you can’t turn it into something else of value, and crypto has no metal to it.  So, look to see if it seems to be actively spoken of in the internet.   Look to see if the website works well.   Look to see if there is an active community.   Look to see if people are actively developing apps to add functionalities to the currency.  Be sure to stop at CoinGecko or some similar site to get general information on price fluctuations and how your currency compares to others.

Third, check out the competition

OK, so you want to invest in Bitcoin.   But then you look at Ethereum and realize that the functionality might be better, and there are several metaverses that you might like that run on its infrastructure.   Be aware of how good or bad the competition is.

Fourth, do some research on your own situation

Do you have an emergency fund set up?   Are you currently contributing to a retirement account?  Do you have enough money to cover normal expenditures absent this money you’re about to invest?  Be very frank and honest with yourself, and if you said “no” to any of the foregoing questions, perhaps you should consider it a red flag.

Are there common scams to avoid?

There are some common scams to avoid.  Fortunately, if you use good research practices, they can be identified.

First, if something seems too good to be true, it probably is.   This is true in the realm of cryptocurrency as well.   If somebody is promising to make you 10X your money within a quarter, be very skeptical.   Sliding away from them is probably a good move too.

More specific to the internet, shilling and sybil attacks are quite common.   If watching a video or reading a website, the line between “educational material” and “promotional material” can be razor thin or less.   (Trust me, I have taken a very large variety of workshops where they explain techniques and tricks to make this work.  That’s why I never charge for these blogs or have advertising on my site.)  Sybil attacks are related, only instead of one “voice” giving you “educational material”, a user with an agenda will open several websites and try to appeal to multiple audiences, and make it appear that there are several people with this point of view.  This chorus can be quite convincing: your only option is to put plenty of wax in your ears, strap yourself tight to the mast, and ride it out.  (Sorry for the long-winded Odyssey reference.)

The Verdict

Wait a minute… this is all supposed to be fun, right?  Well, no.    This is supposed to be a way for you to hopefully make some good money, and that requires work.   If you were hoping to make money and have fun risking it, you’re probably better off to go to a real casino.    On the other hand, if you’re truly of the stripe to do this investing, you will find this researching to be enjoyable.  Just be sure to remember to keep things in perspective.

REFERENCES

https://www.fool.com/the-ascent/cryptocurrency/articles/your-7-point-checklist-to-crypto-research/

https://academy.binance.com/en/glossary/do-your-own-research

https://www.thebalance.com/how-to-invest-in-cryptocurrency-5078408

https://www.experian.com/blogs/ask-experian/how-to-start-investing-in-cryptocurrency-beginners-guide/

https://www.cpacanada.ca/en/news/canada/2021-11-30-crypto-investing

Editor’s Note: Please note that the information contained herein is meant only for general education: This should not be construed as Tax Advice.   Personal attributes could make a material difference in the advice given, so, before taking action, please consult your tax advisor or CPA.

Be Careful to not Contribute to the Delinquency of a Miner.

Headline:  What does a Crypto-Miner do?

Date: 3/28/2022

Body:  The usual bitcoin miner is unlikely to wear a helmet or carry a pick.   He or she is much more likely to wear shorts and sandals and carry a laptop.  Why shorts?   This is important because on “the rig” it gets REALLY hot.

Think of the movie Star Wars, Episode I.   In this film, we see Anakin for the first time, and he is flying a pod.  (basically a blocky little passenger compartment connected  by cable to two ridiculously, ludicrously over-sized engines.)  In this example, the little cockpit is the laptop controlling the “rig”.   This rig (the engines in our illustration) is essentially a tacked together supercomputer.  On second thought I quite like this illustration because both generate a tremendous amount of heat and they occasionally explode.  When we are speaking of bitcoin mining, this is the image I want you to have in mind.

OK, so what do they DO?

A bitcoin miner tends to this machine.  The machine is tasked with verifying the transactions on the blockchain by solving ridiculously complex mathematical functions called hashes.  In return for this verification, the miner is given some quantity of bitcoin.  (The first miner to get the right answer is given the most reward, but several other miners can get lesser prizes for being 2^nd , 3^rd or 4^th.  )  As each block is solved, it is added to the blockchain, which is the publicly available ledger for the entire network.  The algorithm organizing Bitcoin will alter the complexity of the hashes, and currently one new block of transactions is added, about every 10 minutes.

To even get started is some sort of journey.  They need a cryptocurrency wallet, and this is no problem.    Mining software can be downloaded at no cost.  But, the hardware with the graphics processing units or the Application-specific integrated circuits can easily cost over $10,000.  Once set up, the miner has to have some impressive investors lined up to pay the electricity costs because they can be extreme!!  They must also have an incredibly stable and unlimited connection with their Internet provider.  All of these things can be obtained in an economical manner only if the price of Bitcoin remains elevated.

Lest we forget, the mining rigs improve in speed every year.   So, you have to upgrade your rig to stand a chance against the newest ones.   This is a REAL arms race here.   This represents real expenditures that must be made.  

One new approach is to join a mining pool.   True that you don’t have the enormous hardware costs anymore, but you have to split the reward money with a lot of people, and there are membership fees charged.   These are still interesting enough that there will likely be an entry about them on their own.

So why should I consider NOT being a miner?

This is actually a simple question, then a philosophical one.   It’s true that you can make some money, but that requires some major investment of time, energy and money and with the volatility of Bitcoin pricing, this can easily become prohibitive.    More along the global concerns, the carbon footprint is HUGE!!  Crypto-mining accounts for more than 91 Terawatt-hours of electricity annually.  If you need some perspective (I did) each Terawatt-hour is equivalent to 1,000,000 kw/h and according to Digiconomist, a single Bitcoin transaction takes 1,544 kWh, which is equal to 53 days of power for an average US household.   This is a LOT of power!)  Much fossil fuel has been consumed and pollution created to make this happen.   Do you want to be one of the people responsible for this, just for a chance of making a little money?  Not judging, this is your call.

We are really slinging some Hash here.

We spoke of hashes above.   These totals represent 64 digit hexadecimal numbers which must be computed to make a block accepted for the Bitcoin blockchain.  (They are simply inconceivably complex.)  But wrong answers don’t matter, only the right one does.    So, the strategy is for your rig to throw out as many “guesses” as possible as quickly as possible.  The speed of your rig is therefore known as the hash rate.  A “good” rig can push out 100 hashes per second.   In order to stand a chance in this realm of computing, you do essentially need a supercomputer, or at least the distributed version of a supercomputer.

The Verdict

Well, my landlord would be very upset if I set up a mining rig in his house.   I suspect yours would too.   Joking aside, to do this right requires an industrial-scale facility, with some massive cooling equipment to keep the computers from melting into expensive slag.  If you can join a pool, or find a patron who will open a very large checkbook for you (regularly) I guess this could work for you.   But, you’d better be good, because this will be your job and your life, and sleeping will become negotiable.   This is not the life I would choose, maybe you would.  Just be careful to do this with open eyes and understand your competition.  Goodnight, and good luck!!

REFERENCES

https://www.pcmag.com/how-to/how-does-bitcoin-mining-work

https://www.thebalance.com/how-does-bitcoin-mining-work-5088328

https://money.usnews.com/investing/term/bitcoin-mining

https://www.coinbase.com/learn/crypto-basics/what-is-mining

Editor’s Note: Please note that the information contained herein is meant only for general education: This should not be construed as Tax Advice.   Personal attributes could make a material difference in the advice given, so, before taking action, please consult your tax advisor or CPA.

KYC, here we come!!

Headline: What are Know Your Customer restrictions and how do they relate to Anti-Money-Laundering efforts

Date: 3/30/2022

Body:  KYC, kind of sounds like a Midwest city with big ambitions.  But it’s not.  In the context of cryptocurrency, KYC is “Know Your Customer” or “Know Your Client.”  Even though cryptocurrency aims at a decentralized transactions, the exchanges still have to try to moderate the potential of money laundering.   Enter the KYC requirements.   Before you can open an account for some party, there are some details you need about them to ensure that they are a real entity, and they are the entity they purport to be.  This is all in an effort to minimize potential for money laundering and tax evasion.  If you refuse to give this basic information to the exchange, they could decide not to setup an account for you, or throttle you back as to how much cryptocurrency you can have in your account.

What will they ask me for?

They ask, generally, for the basics like birthdate, TIN or something similar.   They are also quite likely to ask for a government issued ID card.

What if I don’t want to identify myself?

If this is your preference, there are options.   There are Bitcoin ATMs, and you could use these.    The other option is a decentralized exchange (DEX).   The author used an apt comparison, DEX is kind of like Craig’s List for cryptocurrency.  You’re never really sure who you’re dealing with, and you are really trading at your own risk.

Another option is an AMM.   In these exchanges, no identity verification is required, but they can only trade one form of cryptocurrency for another.   They do this trading by executing computer code in the form of smart contracts.  While AMMs don’t require identity verification, you need to already have a crypto wallet with funds to trade. You can’t buy crypto using cash on these platforms. Many users opt to buy crypto with cash on a centralized exchange first. Then, they transfer that to a crypto wallet and connect it to an AMM to have access to a wider selection of cryptocurrencies.

What is the history of KYC?

For many years, the Federal Government has had rules, telling financial services companies that they must help to detect and prevent financial crimes. In 2001, as part of the USA PATRIOT Act, the United States Department of the Treasury detailed specific KYC processes that financial services firms must have in place.  In 2013, the Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN) published interpretive guidance FIN-2013-G001 that declared that administrators or exchangers of virtual currency are money services businesses under the Bank Secrecy Act and FinCEN regulations. (What is a money services firm?  Think money services businesses like quasi-Banks.  Examples would include check-cashing services and casinos.) Money services businesses are subject to the AML and KYC requirements of the Bank Secrecy Act.  In 2016, the Treasury elaborated on and applied these regulations to the FinTech sector.  (Don’t be put off by “FinTech.”   This is just a “cooler” way to include all the services that make online trading and other electronic services possible.)

So, What Is KYC?

AML regulations usually leave the specifics of the KYC process up to the regulated entities, using a risk-based determination of what rules are appropriate. These KYC programs generally include the following three basic components:

1. Customer Identification Program (CIP): OK, first thing that an exchange has to do is identify you as you.  They will at least take your name, DOB, and physical address.     Some might ask for a SSN, driver’s license or passport.   Often, they will have a KYC template and the customer will simply enter all of the requested data there.
2. Customer Due Diligence (CDD): This due diligence has but one purpose: determine the level of fraud risk you bring to the exchange.  More or less, this is a background check.
3. Ongoing Monitoring/Risk Management: Essentially, this is looking for large, unusual or questionable transactions made by the customer, and yes, it is constantly on-going.  The idea is to catch any malfeasance early, and contain damages, both financial and reputational. 

How does crypto AML work?

The Financial Action Task Force (FATF) sets the standards for AML laws globally. FATF began publishing guidance on cryptocurrency AML in 2014, and policymakers in FATF’s member jurisdictions quickly took action; today, FinCEN, the European Commission, and dozens of other regulatory bodies have codified most of FATF’s cryptocurrency AML recommendations into law. 

From there, the baton gets passed on to virtual asset service providers (VASPs)—a group that FATF defines to include cryptocurrency exchanges, stablecoin issuers, and, on a case-by-case basis, some DeFi protocols and NFT marketplaces. These businesses do the heavy lifting to stop money laundering by employing compliance officers, requiring know-your-customer checks, and continuously monitoring transactions for suspicious activity.  When suspicious activity is observed, VASPs report this information to relevant regulators and agencies, which then use blockchain analysis tools like Chainalysis Reactor to investigate the flow of funds and link illicit activity to real-world identifiers.

By implementing a mandatory eKYC policy, crypto exchanges can guarantee a few things. The first and most important is that one singular account can be created per person.   This is important because each individual person has only one true character.   They might have (validly) several different addresses, but despite some changes, their character remains the same.  (This is made a little more complex in Europe where there is a “right to be forgotten.”   This is the idea that after a certain period of time, data about you should drop off the internet.  Under this law, the company can only retain these records online for a set period of time, and then the only copy allowed is an encrypted version held in cold storage, offline.)

The Verdict

Money laundering is a very large problem in today’s world, and deserves attention.    While it is true that we have very sophisticated computers to track transactions, these transactions can now go worldwide, in less than the blink of an eye.  This puts an onus on the financial regulators in all of these countries to work together as money laundering almost never stays within one jurisdiction.  This is made even more difficult because each financial institution involved desperately needs the revenue from customers, and those looking to launder money often have more than enough financial resources to make them appetizing targets for hungry banks.  Perhaps the pandemic taught major countries that it is possible to work together to protect citizens of this world: We can only hope.

REFERENCES

https://www.gemini.com/cryptopedia/kyc-meaning-know-your-customer

https://www.fool.com/the-ascent/cryptocurrency/articles/what-is-kyc-and-why-do-crypto-exchanges-require-it/

What is AML and KYC for Crypto?

https://www.forbes.com/sites/forbesbusinesscouncil/2022/02/17/why-kyc-is-one-of-the-keys-to-cryptos-longevity/

https://www.nasdaq.com/articles/lets-admit-it%3A-to-ward-off-crypto-scams-kyc-is-a-must-2021-09-29

Editor’s Note: Please note that the information contained herein is meant only for general education: This should not be construed as Tax Advice.   Personal attributes could make a material difference in the advice given, so, before taking action, please consult your tax advisor or CPA.

My Analyst Keeps Talking about Regression…

Headline: Is the valuation of cryptocurrencies correlated to the performance of the stock market?

Date: 3/23/2022

Body:  Who cares?   Why do we care if the value of cryptocurrency is correlated with the performance of the stock market?  Cynic.   Well, actually, a good question.   Typically, we are looking at cryptocurrency to serve as a diversifying agent for our portfolio.  Assuming that it’s a largely stock-based portfolio (often it is) then our other investment should ideally not do really badly when our stock portfolio is tanking too.  This is why we should care.   If your investment is not correlated with the performance of the stock market, you can sleep a little better knowing that most likely as one investment or a few go down in value, the other ones are going up or staying even.   But, if they are highly correlated, then adding cryptocurrency does not achieve the diversification you are looking for.

OK, sorry for the flashback to Statistics…

Just as a reminder, if 2 things are uncorrelated (perfectly) the correlation will have a value of 0.  If there is a perfect positive correlation (as one increases in value, so does the other) the value will be 1.  If there is a  perfect negative correlation (as one increases in value 10%, the other decreases in value 10%) the value is -1.  Any other relationship between the two valuations slip somewhere betwixt the 1.00 and -1.00 values.  The value of bitcoin seems to have a slight correlation with the stock market (the value appears to be from .2 to .3 based upon what index is used.)  That being said, sometimes when there is a huge loss in  stocks, there is also a huge loss in value for cryptocurrencies.   Why does there seem to be a tie binding the two, and how can I either take advantage of it or account for it?

What Do Analysts Say?  

Good analysts don’t say much… ooh… sorry, wrong analysts.    There are 2 main hypotheses for this seeming correlation.   And, yes, they do interact with one another.

1.  Some analysts suggest that people get into stocks and cryptocurrencies for similar reasons: Namely, they wish to add some risk to their portfolio so that their chance of reward increases.   For this reason, as some people adjust their risk up with stocks, others adjust their risk with cryptocurrencies, often at similar timescales.   For this reason, there appears to be a correlation.
2. There is a large consultancy called Datatrek, and their analysts seem to suggest that investing in cryptocurrency is being normalized.  Per the analysts, “Since investors have only one brain to process risk, they will make similar decisions about cryptocurrencies and stocks when they see price volatility in the latter.”  So, when the butterflies in their stomachs become too great within the stock market, they also pull their investment in cryptocurrency. 

What is likely to happen down the road?

OK, we have to step back a bit here.   Per the Tabb Group (another consultancy) institutional investors (think pension funds etc.) represent up to 88% of trading volumes, and right now, they are reticent to jump into cryptocurrency.  But don’t be fooled: They probably will (and my guess is soon) and when they do, they will jump in with both feet.  This means, for little investors like us, that the volatility will likely dampen, and that’s probably good.

Just last week, President Joe Biden signed an Executive Order, instructing several government agencies to begin conversations (and publish reports) related to how they are likely to be best involved in the cryptocurrency markets.  This added regulation will likely help to dampen volatility.  President Biden’s executive order on crypto regulation is a “huge milestone” for crypto and further enhances “the legitimacy and long-term outlook of the space, which bodes well for Bitcoin, which is still king, at least for now,” says Brian Goldblatt, CPA and industry leader of digital assets at Prager Metis.

If a picture paints ten thousand words…

Bitcoin is meant to be an uncorrelated asset and this is/was a positive. However, it is clear that right now bitcoin correlates with stocks very closely:

Bitcoin and stocks are moving in sync

 CREDIT: ADVFN

From just a cursory inspection of this graph, it is pretty clear that the value of these two asset classes can be highly correlated over the short term.   I suspect this is likely due to emotions.  (Behavioral finance is a fascinating area of study.)  It does seem important to note, however, that this correlation seems to weaken over the longer span of time.

The Verdict

Small investors (like us) should probably limit their holdings in cryptocurrencies to 1% to 3% of their portfolio, since it could “lose a lot of its value in a short amount of time,” says Alex Chalekian, CEO of Lake Avenue Financial in Pasadena, California.  If you want to get a punch from cryptocurrency without being kicked by it, you might want to consider a different approach.   There are several ETFs that invest in Bitcoin and other cryptocurrencies.  These ETFs are easy to purchase and probably will do better than you buying random cryptocurrencies.  Alternatively, you could invest in stocks that make extensive use of cryptocurrencies (e.g. Coinbase Global, Paypal and MicroStrategy.)   In this way, you benefit from the aggressive earnings of the crypto world, but, you are not held prisoner to the craziness at full volume.  Investors need to view Bitcoin as a “very good vehicle for someone who is truly a speculator – either a bull or a bear,” says Robert Johnson, a finance professor at Creighton University. BTC could rise exponentially in value, collapse again or do both repeatedly. Investors can only speculate on the future price of Bitcoin because it has no intrinsic value, unlike gold, he says.

Whatever approach you choose, all I have to say is, “May the forks be with you…”

REFERENCES

https://www.marketwatch.com/story/is-bitcoin-an-uncorrelated-asset-these-stocks-and-funds-boast-correlations-higherand-lowerthan-coinbase-11622826320

https://www.investopedia.com/news/are-bitcoin-price-and-equity-markets-returns-correlated/

https://www.forbes.com/sites/investor/2020/05/13/bitcoin-and-stocks-correlation-reveal-a-secret/?sh=46277ddb12c2

https://www.fool.com/investing/stock-market/market-sectors/financials/cryptocurrency-stocks/is-cryptocurrency-good-investment/

https://money.usnews.com/investing/cryptocurrency/articles/is-bitcoin-worth-investing-in

Editor’s Note: Please note that the information contained herein is meant only for general education: This should not be construed as Tax Advice.   Personal attributes could make a material difference in the advice given, so, before taking action, please consult your tax advisor or CPA.

Making a Statement

Headline: Decrypting the words

Date: 3/9/2022

Body:  OK, deep breath, because news of all types is coming at us right, left and center.  One of the top stories today.  In the midst of news of very real violence in Europe, there is a pretty significant thing happening at home.  Just today, President Biden signed an Executive Order to investigate the possibility of having an official U.S. digital currency.    Brian Deese, the director of the National Economic Council, and Jake Sullivan, the president’s national security adviser, said in a statement that the order “will help position the U.S. to keep playing a leading role in the innovation and governance of the digital assets ecosystem at home and abroad, in a way that protects consumers, is consistent with our democratic values and advances U.S. global competitiveness.”  This seems to be the way to say, it’s about time.

Is digital currency really a big deal?

Yes.   The value of digital assets has risen above $3 Trillion, up from $14 Billion just 5 years ago.  This is the main impetus for the Executive Order.

What is the sequence of events that led to this Order?

In January, the Fed released a long-awaited report on central bank digital currencies.  Per the government, this report was meant to generate comment and conversation. On Wednesday, after news of the executive order, the Fed’s official Twitter account noted that it had “made no decisions on whether to pursue or implement a central bank digital currency” and invited the public to continue commenting on issues raised by its report.  The Chairman of the Federal Reserve commented that with such a digital currency, the stablecoins might be deemed less relevant.  Others are also weighing in on this topic, such as the Secretary of the Treasury, Janet Yellen.  “As we take on this important work, we’ll be guided by consumer and investor protection groups, market participants, and other leading experts,”   She went on to say, “Treasury will work to promote a fairer, more inclusive, and more efficient financial system, while building on our ongoing work to counter illicit finance, and prevent risks to financial stability and national security.”

The EO is produced at an instance of escalated national security concerns.  Chief among them is the question of whether or not Russia will utilize these cryptocurrencies to launder money and disguise the source of funds.  (They might want to do this if they are cut off from Western finance systems.  Spoiler alert: They were.). A senior  administration official  claimed that work on it had predated the Ukraine war.President Biden’s order sets an 180-day deadline for the reports to be prepared.

What did the EO specifically setup into action?

Specifically, the Executive Order calls for measures to:

• Instructs the Treasury Department (and partners) to develop a protocol for dealing with digital assets and cryptocurrency and render recommendations.
• Directs agencies to work with international partners to develop an internationally cohesive approach to cryptocurrency.
• Produce a report on how technological solutions can be harnessed to better serve underbanked populations.
• Directs the Federal Reserve to continue researching the feasibility of a U.S. Central Bank Digital Currency.Commodity Futures Trading Commission Chairman Rostin Behnam has also urged Congress to give his agency a leading role in regulating digital assets.

The Verdict

Eswar Prasad, a professor of trade policy at Cornell University and the author of a book called “The Future of Money,” said the order would put the United States in “pole position” to set global standards and move closer to what he said was “the inevitable digitization of the world’s pre-eminent currency.”  So, I guess that the good old Greenback was always destined to be replaced by the good new Screenback.  Whatever happens with the digital currency of the United States, it will  be interesting to watch.

REFERENCES

https://www.whitehouse.gov/briefing-room/statements-releases/2022/03/09/fact-sheet-president-biden-to-sign-executive-order-on-ensuring-responsible-innovation-in-digital-assets/

https://www.reuters.com/business/finance/biden-sign-executive-order-cryptocurrencies-this-week-source-2022-03-07/

https://www.washingtonpost.com/business/2022/03/09/biden-crypto-executive-order/

Editor’s Note: Please note that the information contained herein is meant only for general education: This should not be construed as Tax Advice.   Personal attributes could make a material difference in the advice given, so, before taking action, please consult your tax advisor or CPA.

What is a Smart Contract?

Headline: What is a “smart contract?”

Date:2/25/2022

Body: Have you ever seen a contract?   I mean a real contract?   I work for the Federal Government, and I have seen a few, and they are fearsome documents indeed.   There are dozens of terms that are explicitly defined, there are endless specifications spelled out and a plethora of detailed statements about what would happen if certain events happened.  It would seem so much simpler and easier if we could simplify these documents and have a simplified enforcement paradigm, similar to the consensus model.   Enter the smart contract.

What is a Smart Contract?

In the end, this is a series of computer code.    But, smart contracts are not completely new within the realm of contracts.   For a long time, there has been something called a unilateral contact wherein Party A does something valuable (takes an action) for Party B, and then Party B now owes something valuable to Party A.  The new wrinkle is that the exchange terms are already written, and the 2 actions are immediately taken, and the consensus function makes sure that the actions were taken correctly.  This is a very efficient mechanism, but, if there is a bug in the code, correcting errors is impossible.

An example follows.   Janus wants to learn to dive.   He goes to Tortuga and contracts with Ahab’s Diving school to train him and certify him for SCUBA diving for the total of 52 Dogecoin.  Janus deposits the 52 Dogecoin, and then, when the transaction is validated as complete, the Dogecoin are released to the diving school.

When did Smart Contracts get to be so important?

In 1994, Nick Szabo, a legal scholar, and cryptographer realized that the decentralized ledger could be used for smart contracts, otherwise called self-executing contracts, blockchain contracts, or digital contracts. In this format, contracts could be stored as computer code and easily executed and supervised.   In this paradigm, no middlemen were required.    Clearly, this would be more cost-efficient and a good solution.   This architecture would also allow for excellent internal control.  But, the seed of smart contracts was just blowing in the wind.

When Bitcoin started in 2009, smart contracts were technically feasible.     But, it was the advent of Ethereum when the smart contract became really important.   As Ethereum continues to evolve, smart contracts also continue to evolve.  In the not-so-distant future, it seems likely that Banks might begin issuing mortgages that incorporate smart contracts.   They will soon be ubiquitous.   

Are there certain blockchains that are better or worse for smart contracts?

Blockchain Mechanism	Comment RE: Smart Contracts
Bitcoin	Very limited facility for adding documents to payment processing.
Side chains	These have been developed adjacent to Bitcoin blockchain and allow more flexibility to handle smart contracts.
NXT	This is a public blockchain with templates for contracts.  If your contract doesn’t fit one of the templates, you could be out of luck here.
Ethereum	Offers a lot of flexibility for smart contract construction, but, they will make you pay ETH coin for that complexity you require.  This transaction fee is called “gas” and the more complex your transaction, the more gas is required.

Before we get too “down” on the Ethereum network for charging “gas” fees, you should consider the regulatory mechanism.   By charging this fee, the network is able to discourage overly-complex transactions, and thus keep the network free-flowing.

Are there types of transactions that smart contracts are best suited for?

Yes.   Smart contracts are, right now, best suited for very simple transactions of 2 types:

1.  Ensuring payment of funds upon certain triggering events.  (e.g. when the inspection is done and accepted by the buyer, and all taxes have been paid, the remainder of the sales price is transferred to the Seller’s account or wallet.)
2. Ensuring that if conditions are not met, there is a financial penalty (e.g. if the attributes are not met within 30 days, there will be a 5% decrease in selling price.)

Please note that on a nearly daily basis, the networks are improving in efficiency, so in the near future, it is likely that contracts with significant complexity will be accommodated.

Are these smart contracts enforceable?

There is no authority at the federal level to allow for enforcement.   At the state level, requirements differ among jurisdictions.  But, stay tuned.  The federal government installed the Uniform Commercial Code (UCC) to facilitate interstate commerce, so it seems likely that something similar could be done to facilitate smart contracts.

As for now, the key difference seems to be the difference between the terms “contract” and “agreement.”  States seem to largely stay away from the word “contract” because that implies that there is a Court-appointed process for adjudication, in case of disagreements.   That said, many states seem much more amenable to using these smart contracts as agreements.  The states also seem more likely to support simpler smart contracts, as the “vending machine” example is often brought up.  Given that there are a variety of Electronic Data Interchange agreements even today, it seems likely that these wrinkles will likely be ironed out, in time.  There also seems a likely role for insurance companies to make a few dollars here, insuring that the code works as expected, so it becomes even more likely that the states will fashion some type of agreement.   Stay tuned.

What if the contract requires information that cannot be pre-written into the code?

Nobody has a crystal ball (If you do, we REALLY need to talk.)   So, there is likely a circumstance where outside information must be applied before the contract is executed.  Think about an example.  A farmer has drought insurance and for the money to be disbursed, he or she must have some sort of proof that the precipitation is 30% less than normal conditions.  Might the contract look to the National Weather Service?   Maybe AccuWeather data would be used to substantiate the drought?  These are called “oracles” within the smart contract paradigm, and there is an active debate about how to best define the oracle that will be consulted.

Given the developmental stage of these smart contracts, what are the Best Practices to follow?

With the caveat that we have relatively little track record to go on, we can still suggest some best practices.

1.  Though code-only contracts are most easily enforced in many states, the parties should give significant consideration to using a hybrid approach.   This allows for some text to be included, and that can be used to explicitly prescribe which oracle is to be consulted, and explicitly define terms that are central to the contract.
2. The parties should consider risks due to a possible coding error.   Perhaps each would have to pay for a portion of an insurance contract.  
3. The text portion should clearly spell out the law under which the contract is being executed, and the order of priority between text and code in case there is a conflict between the two.
4. The text agreement should incorporate an acknowledgement by both parties that they have reviewed the code and that it reflects the terms in the text agreement.    (This is where insurance companies might come in.)  This acknowledgement is not enforceable per se, but it is a good idea to be careful in the execution of the contract.

 The Verdict

Here’s how Jeff Garzik, owner of blockchain services Bloq, described smart contracts:  “Smart contracts … guarantee a very, very specific set of outcomes. There’s never any confusion and there’s never any need for litigation.”  Assuming that you’re not a hungry attorney, these words probably bring you some comfort.  But, this comfort currently comes with a lack of ability to go to a Court and get the contract evaluated and enforced, and this might be a significant brake to financial transactions like these.  Perhaps in the future, we will figure out technical and social structures that will allow us to reap the benefits of smart contracts and mitigate the deficiencies.   But, for now, it would appear most wise to stick to simple transactions, and remain aware of the possibilities for the future.

REFERENCES

An Introduction to Smart Contracts and Their Potential and Inherent Limitations

https://www.gemini.com/cryptopedia/crypto-smart-contracts-explained

https://www.bankrate.com/glossary/s/smart-contract/

https://blockgeeks.com/guides/smart-contracts/

REFERENCES

Editor’s Note: Please note that the information contained herein is meant only for general education: This should not be construed as Tax Advice.   Personal attributes could make a material difference in the advice given, so, before taking action, please consult your tax advisor or CPA.