SumZero Q&A

What Professional Investors Should Know About Bitcoin Note: Winklevoss Capital Management is an investor in SumZero, Inc. Disclaimer: The opinions expressed within this interview reflect those of the contributor(s) and not SumZero, Inc.

As an asset designed to replace gold, and a protocol to replace modern payment platforms, Bitcoin is a subject of considerable relevance to the entire investment community. Dissatisfied with the current state of reporting on the matter, we ask: What must members of the fund industry know about bitcoin and its growing role in the economy? Today we offer this deep-dive into one of today’s most controversial and yet broadly misunderstood subjects: Bitcoin.

To be clear, we officially have no opinion on Bitcoin at SumZero. We recruited award-winning journalist Morgan Housel (Wall Street Journal/Motley Fool) to identify the most important questions and to seek the answers directly from one of the most well-known backers of Bitcoin, Tyler Winklevoss of the newly-launched Gemini platform, a fully-licensed, NY-based bitcoin exchange which Tyler formed along with his twin brother, Cameron Winklevoss. Their in-depth interview follows below:

Some people I know are bullish on digital currency, but not necessarily Bitcoin. They use the analogy of Napster. Napster showed the world that digital music was clearly superior to physical sales, but the company itself essentially failed. It took a decade or so for a more established organization, Apple, to really solidify the business of digital music sales with iTunes. Napster's idea and vision won, but it itself failed. Could this be a reasonable scenario for Bitcoin?

Tyler Winklevoss, Co-Founder & CEO, Gemini: The comparison to Napster is apples and oranges. Napster was a company with a headquarters, centralized servers (though it had elements of a peer-to-peer network) and a software client that a lot of people used at one time for file-sharing that consequently violated existing laws. It may have helped people wake up to the limitations of buying music in analogue format (e.g., tapes, CDs), something no doubt fueled by the “free” music Napster offered, but the paradigm shift in music consumption was more a function of the invention and superiority of digital formats (i.e., MP3) to non-digital formats (i.e. tapes, CDs) as opposed to a company that willingly turned a blind eye to rampant digital copyright infringement and, as a result, was eventually shut down.

Napster’s idea and vision did not win. It’s devil-may-care attitude towards digital rights management (DRM) and the thumbing of its nose at the record industry became a cautionary tale of what not to do and what invariably happens when you work outside of the law rather than within it. It’s predecessors like Apple iTunes (and the new Apple Music) and other services such as Spotify exist today because they learned from Napster’s missteps. Had Napster not made this fatal blunder, I see no reason why it couldn’t still be here today.

But I digress. Napster, Apple, Spotify are/were companies, Bitcoin (capital “B”) is a protocol and bitcoin (lowercase “b”) is the only digital asset in in the world that currently can be transferred over this protocol. It is not a company; it has no headquarters, no CEO or central servers, rather, it is a decentralized peer-to-peer network, the infrastructure of which is collectively maintained by a decentralized user base and it enjoys legal status in the United States and many other jurisdictions around the world. A more apt music industry comparison would be comparing Bitcoin as a money format to MP3 as a music format, not a company. That being said, Bitcoin is open-source, which means unlike MP3 (which is an open standard encumbered by patents that require deep pockets and permission to make contributions), it can be endlessly improved upon and evolve in a crowdsourced, permissionless manner.

Napster should really be juxtaposed to Bitcoin companies, not the actual Bitcoin protocol. Bitcoin companies that fail to take regulation and anti-money laundering laws seriously will get fined and/or shut down. We’ve already seen this happen. The companies who get regulation right and emphasize compliance will succeed, while those that don’t, won’t, just like Napster.

Comparisons aside, Bitcoin is the first protocol of its kind, and in general, first-moving protocols win the day. What sets Bitcoin apart is the size of the network that secures it. The integrity of a decentralized network’s ledger (i.e., its blockchain) is directly proportional to the computing power dedicated to solving cryptographic math problems using its canonical transaction data (i.e., it’s hashrate). The greater a network’s hashrate, the more costly it is for a bad actor to co-opt it, and therefore, the greater its security. The Bitcoin network today is ~77,000 times more powerful than the world’s strongest computer and 5-10 million times more powerful than the world’s next biggest decentralized cryptocurrency network, Litecoin. As a result, the Bitcoin network is orders of magnitude more secure than any other comparable network in the world.

For this reason alone, a new entrant, when faced with a decision tree, will always choose to build on the Bitcoin blockchain regardless of whether or not he or she is a Bitcoin stakeholder. There very well may be other digital assets in the future, but it is more likely that they will borrow or piggyback on the security of the Bitcoin blockchain rather than try to recreate it from scratch. What we will see is an Internet of inter-operable parallel blockchains all harnessing the security of the Bitcoin blockchain. If this is the case, then bitcoin the asset will become the global digital reserve currency -- there is no such thing as the Bitcoin blockchain without bitcoin.

Morgan Housel, Wall Street Journal/Motley Fool: I buy a lot of stuff online. I have nothing to hide, but care about my privacy. I really have no problems with the current payment system. My biggest question about Bitcoin is that I'm still not sure what problem it solves for me. Where am I wrong?

Tyler Winklevoss, Co-Founder & CEO, Gemini: People had the same questions about the Internet 20 years ago -- how is this going to affect my life? The truth is, in the short-term it very well may not, but in the long-run, it will in more profound ways that any of us can imagine.

Bitcoin is Internet money, it is money purpose-built for the internet. Credit cards and ACH on the other hand, are payment systems that were invented in the 1950’s and 60’s before the Internet even existed. Using them on the Internet is like trying to fit a square peg into a round hole. Bitcoin is a money protocol that has transformed money into packets that now travel over the Internet, not the balkanized rails of the legacy banking system. If we look at how other protocols have impacted our lives, we can start to see a glimpse of Bitcoin’s potential. Think for instance about how email protocols such as IMAP and SMTP changed the way we send mail or voice protocols like VoIP changed the way we make phone calls. You send an email today instead of a postcard or make a call around the world on Skype virtually for free because of the invention of these protocols.

Bitcoin’s utility lies in the eye of the beholder. In the first world, Bitcoin will make its first dent as a settlement mechanism, not as a payment system that helps you buy a cup of coffee. Bitcoin’s ability to settle at the atomic level will metamorphosize clearing operations and the blockchain will rethink chains of custody. Paper, middlemen and cumbersome back office operations will go the way of the dodo.

In other parts of the world, Bitcoin will have a different immediate meaning. Payment systems may not appear “broken” through a first world prism, but they are by no means efficient and borderless. Try sending money to someone in Sri Lanka for instance. Credit cards are only really popular in about 8-10 developed countries and expanding the existing network is costly and infrastructure-heavy. Similar to how developing countries leapfrogged the installation of telephone poles and landlines with the adoption of cellular phones, Bitcoin will allow them to skip forward to a next generation, Internet-centric payments network (that enables among other things micropayments) without waiting for legacy networks to arrive that have little interest and/or ability to service them anytime soon.

In countries like Argentina, where the national currency is habitually debased, bitcoin (the asset) will be seen as a better store of value and celebrated for its gold-like qualities. For citizens looking to circumvent draconian capital controls in search of greener pastures, bitcoin will represent their chance to exit or opt-out. In countries like Cyprus, where there is precedent and/or risk that government-insured deposits will not be honored (as was the case during the 2013 banking crisis bail-in), bitcoin will mean disaster insurance.

Ultimately, however, Bitcoin will fundamentally change the way humans and machines exchange value. Computers can’t open up a bank account at Wells Fargo, but they can plug into protocols. This, in addition to the fact that it is practicable to transfer fractions of pennies (i.e., nano-payments) over the Bitcoin network or other blockchains built on top of it, will enable lightweight economic transactions that the existing payments system will never be able to facilitate let alone contemplate. As a result, Bitcoin will create new avenues of human to machine (i.e., H2M) and machine to machine (i.e., M2M) trade that were previously not possible and usher in the first forms of artificial life.

In the future, you will summon an autonomous agent (e.g., self-driving car, drone) to pick you up and take you to your destination. You will be able to pay your fare in bitcoin which an agent will happily accept, and you will also use bitcoin to pay other agents such as roads for road-space or other self-driving cars to move out of your way if you want to go faster. It’s fun and easy to come up with endless examples of what is now possible. Bitcoin will bring the Internet of Things to life, making devices not just smart but also intelligent (i.e., rational economic actors). As the invention of money itself fundamentally evolved the circuitry of the human brain, programmable money (i.e., Bitcoin) will rewire the neurological pathways of the Internet forever.

Morgan Housel, Wall Street Journal/Motley Fool: What are Bitcoin's biggest problems right now, and how does Gemini solve them?

Tyler Winklevoss, Co-Founder & CEO, Gemini: Bitcoin’s biggest bottleneck right now is a lack of regulated on-ramps. In most jurisdictions, it is clear that Bitcoin (and bitcoin) itself is legal, yet at the same time, it is unclear how Bitcoin companies themselves can become licensed. In some regions, Bitcoin companies have been allowed to slot into existing regulatory frameworks, while in others, they have had to wait for entirely new regimes to be built (e.g., New York’s BitLicense) or standby indefinitely as regulators remain silent on the issue altogether.

This conundrum has put the majority of Bitcoin companies in an awkward state of regulatory limbo. Companies that want to comply, can’t comply, because they haven’t been told how to. Such uncertainty is arresting in the financial world and has severely limited the traditional economy’s ability to interact with the Bitcoin economy and help grow it. Refining this idea further, the world’s leading economies tend to be also be of the most regulated, and as a result, their financial institutions (i.e. hedge funds, banks) simply can’t or won’t do business with businesses that are not yet fully regulated (i.e., Bitcoin businesses). The large exception to this trend is China, where Bitcoin companies have to date been able to integrate with the traditional financial system. Unsurprisingly, and to my point, 80% of all bitcoin trading volume today is happening in China.

The Chinese paradox aside, the regulatory landscape in many financial capitals of the world has thankfully and (ever so) slowly become more tractable for Bitcoin companies to navigate. New York’s department of Financial Services has lead this charge and it is no coincidence that New York is also the city where we chose to headquarter Gemini, our next generation pure-play bitcoin exchange.

When we founded Gemini over a year ago, our vision from the start was simple; build a bridge into the Bitcoin economy that both individuals and institutions can use. Our principles were, and still are, pretty straightforward; 1) become licensed in the US under a regulatory framework that allows us to service both individual and institutional customers, 2) do not operate until such licensing has been achieved (i.e., ask for permission not forgiveness), 3) establish a US banking relationship so customer fiat funds are eligible for FDIC insurance and never leave the country, 4) build our tech stack with a security-first mentality from day one, 5) hire only the A-team, and 6) keep hiring only the A-team.

We believe we have stayed true to our principles and as a result think Gemini stands to be a significant long-term Bitcoin catalyst. If Bitcoin is going to go mainstream on a global scale, Bitcoin entrepreneurs are going to have fill in the critical pieces of the Bitcoin infrastructure puzzle. We think we’ve started to do that with Gemini and look forward to helping build the future of money for many years to come.

Morgan Housel, Wall Street Journal/Motley Fool: What are your thoughts about Bitcoin's price volatility against the dollar?

Tyler Winklevoss, Co-Founder & CEO, Gemini: Bitcoin’s price volatility is largely a result of the bitcoin market being a young market. Youthful markets tend to be thin (i.e., few bids and asks), small in market capitalization and low in trade volume -- which is to say they are less liquid. As a result, they are less capable of absorbing intrinsic and extrinsic variables responsible for price impact and are, therefore, more prone to volatility or price movements.

Bitcoin’s largest volatility events have been for the most part attributable to news events. Such events have involved bitcoin companies, global macroeconomic crises, law enforcement actions, regulatory developments and so on. The most notable of these have been the Mt. Gox collapse, the arrest of Silk Road creator Ross Ulbricht, the U.S. Marshall’s auctions of confiscated Silk Road bitcoins, and the clamp down on Bitcoin by the Chinese government and subsequent loosening of restrictions.That being said, volatility is a complex matter and plenty of bitcoin price action remains unexplained and poorly understood even after you factor out news events. As the bitcoin market continues to mature and become more liquid, both attributable and unattributable volatility factors will have much less influence on price.

Long-term volatility reduction will occur once supply chains are denominated in bitcoin or whenever there is a significant volume of forward contracts in the market, which is essentially a more abstract expression of the same thing. Supply chains denominated in bitcoin will incentivize price stability because otherwise there will be arbitrage opportunities within the supply chain itself. Just as inter-exchange arbitrage keeps all of the exchange prices shoulder to shoulder after taking into account counterparty risk, the same will extend back to the supply chain and vice versa. Until then, it will be really hard to say what the price of bitcoin “should” be. As a result, individuals operating with their own utility functions are likely to cause more or less random fluctuations as their needs for liquidity change. Once price gets averaged over a whole supply chain, it will be more likely that price movements will be a factor of changes in the supply and demand profile for goods, rather than supply and demand profile for bitcoins themselves.

Morgan Housel, Wall Street Journal/Motley Fool: Realistically, where is Bitcoin 10 and 20 years from now? What's the bullish stretch scenario, and what probability do you put on this being a fad?

Tyler Winklevoss, Co-Founder & CEO, Gemini: In 10 or 20 years from now, bitcoin will replace gold. In the scheme of the universe, gold and other precious metals are not even remotely finite. In fact, there are asteroid databases that estimate the composition and profit of mining over 600,000 asteroids in our solar system and it turns out that earth’s chemical elements are quite abundant when you look at the larger picture. Once we achieve cheap access to space, which seems like a real possibility in the next decade or two, gold will no longer be scarce. The only fixed, commodity-like asset with money-like qualities left will be bitcoin.

Today, bitcoin is already a better gold. Taking into account the 9 characteristics of money -- scarcity, durability, portability, divisibility, verifiability, storability, fungibility, difficulty to counterfeit, and adoption -- bitcoin matches or beats gold across the board in every category. The only thing gold has on bitcoin right now is a 10,000 year first-mover advantage -- but there is no divine reason why gold couldn’t eventually be replaced in the free market by a synthetic digital gold that was engineered to have superior qualities. That being said, first-mover advantages are powerful so it may take until asteroid probes confirm empirically and incontrovertibly that gold is in fact plentiful (which may not be that long from now), for bitcoin to unseat gold.

Not only could bitcoin replace precious metals in an investment portfolio, its upside potential might be even greater. Bitcoin is not just an asset, it is also a protocol and a global network similar to the Internet itself but for exchanging value. If you own bitcoin, you own a piece of the entire Bitcoin ecosystem. Its like owning an asset that tracks the entire Bitcoin market. This is not the case if you own gold, you do not also own a piece of the mining and services sector for instance. This was also not the case with the original Internet, you couldn’t go out and directly buy a piece of it. Bitcoin is very different, you don’t have to bother sorting the winners from the losers, there is little chance a Bitcoin company succeeds and bitcoin doesn’t. Owning bitcoin is not just owning a better gold, it is also like owning a call option on the most exciting technology space and innovation in the world today.

The probability of bitcoin being a fad seems low. Right now, the Bitcoin blockchain is the most secure, trustless, permissionless, decentralized public ledger in the world. Anyone presented with the choice will chose to build and entrust their data on the Bitcoin blockchain because it is leaps and bounds more secure than the next most secure blockchain of its kind. As a result, there are significant network effects and first-mover advantages at play here in favor of Bitcoin. If it is a winner-take all landscape, which it is looking like it increasingly is, then the Bitcoin blockchain could be the core foundation on top of which most digital currencies and digital currency applications are built. If this is the case, then bitcoin (the asset) will become the global digital reserve currency.

You can argue whether or not bitcoin or some other digital currency or blockchain will be the winner, but you can’t argue with that fact that blockchain-based cryptocurrencies are the future. There’s a certain inevitability about Bitcoin that has always fascinated me. Bitcoin or something like it would have been included in the early proposals for Internet standards long ago if it had been technologically feasible. It took until 2009 for the computer science breakthroughs to occur to make an Internet money protocol possible. Bitcoin was never an if, it was always a when -- Bitcoin was always going to happen.







Note: Winklevoss Capital Management is an investor in SumZero, Inc.

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