We’re here with David Yermack
chair of
the finance department at NYU Stern, a
colleague and the catalyst behind a fin
tech specialization that was the first
in graduate education, wasn’t it, can you
talk a little bit more about that?
We offered our first course in Bitcoin in
digital currency back in 2014 and
basically due to student interest and
demand from industry, we’ve scaled this
up. We now have a specialization in the
stern MBA program. Let’s start with the
basics. Please explain what a cryptocurrency is. A cryptocurrency is a
currency that is driven by computer code.
It’s also sometimes called an
algorithmic currency, but rather than
being issued by government, it’s issued
by a computer network with code that is
usually very transparent so that people
can understand when coins will be
created and at what rate and how they’ll
be stored and so forth. So you’re putting
your faith not in a central bank, but in
the integrity of the computer code
itself. How does it maintain value though,
how do you create confidence that
you’re gonna have scarcity
such that, why don’t people just keep
mining it over and over and explode,
start printing more currency if you want?
Well, the rules of the code that govern
the currency usually prohibit that, so in
the case of Bitcoin, which is by far the
best known, there’s a certain rate at
which Bitcoins are competed for every
ten minutes that at current rates
there’s going to be twelve and a half
Bitcoins entering the network every ten
minutes. People compete for them, but all
you can do is hope to win that prize and
the supply will not expand
beyond the constraints set by the
network. When you say “compete for them”
how do you compete for them?
What happens in the case of Bitcoin is
that you have to essentially guess
random numbers in a way that completes a
set of computer codes and solves the
block, as it’s called, so there are people
all around the world with supercomputers
trying to enter this contest because the
prize at the moment is very valuable and
whoever can complete the block in a
certain way the quickest, wins the 12 and
a half Bitcoins that are up for bid
every ten minutes. So, it’s not a
fixed amount, it’s just increasing at
a very slow rate? Yeah, the current
rate of increase is twelve and a half
coins
per 10 minutes and the software behind
Bitcoin cuts this in half roughly every
four years. So, in the year 2021 it will
be cut to 6 and 1/8 bitcoins – or 6
and a quarter bitcoins – and so forth
until it eventually tapers off to zero
in the year 2140. All of this is
transparent to the people on the network
so you can see the rate of money
creation which is very different than a
central bank which uses its judgment but
will change it from time to time
whenever it ultimately concludes that it
should. And there’s some mythology here who
gave birth to to Bitcoin, how did it
start, who originally got the money for
this, who initially
cashed the first check for the first
Bitcoin? Well, the way it began is still
something of a mystery – we know that late
in 2008 somebody using the name Satoshi
Nakamoto posted a white paper on a
cryptography bulletin board on the
internet and at first, almost nobody
noticed this except a small clan of
people who frequented these kinds of
places, but the ideas spread by word of
mouth and volunteers helped Satoshi code
this up. It went live on January 3rd 2009
and it took a while, it wasn’t until May
of 2010 that the first bitcoins were
actually spent on anything and this was
two pizzas for 10,000 bitcoins and very
slowly, other merchants began to accept
Bitcoin and network of companies grew
that somehow participate in the industry
and it’s been completely organic from
the bottom up, there’s no sponsor, no
investor who launched this and Satoshi
Nakamoto vanished after a couple years –
we still to this day don’t know who this
person is – but they haven’t been involved
in the project since some time around
2011, 2012 . OK, so two
pillars of a cryptocurrency – one you have
to convince people that there’s a
mechanism for regulating supply and then
you have to get people to accept it as a
store of value, right? So, it sounds
like Bitcoin’s been able to do that. What
are some of the other cryptocurrencies
that have been able to do that? The
strong number two in the market right
now is called Ethereum,
and Etherum is rather different from
Bitcoin. Bitcoin was really intended to
be a general use currency that in
principle could be spent anywhere that
people would accept it, but Ethereum is
internal to the Ethereum Blockchain and
it’s used just to execute smart
contracts within a closed system. So, some
people would call Ethereum not even a
currency, but a token since it’s a single
use type of asset, but there’s no
question it’s valuable that lately
Bitcoin’s total market value has been
somewhere in the neighborhood of 65
billion and Ethereum has been trending
between 20 billion and 30 billion so a
lot of people put value in these. Are
those the two primary ones? There are
some others, there’s more than 1,100
currently. Ripple would be the strong
number three, which has had a value
approaching 10 billion lately and
there’s an offshoot of Bitcoin called
Bitcoin Cash which at the moment is
among the big four in terms of value, but
I think there are as many as 15 or 20
that have values north of a billion
dollars if you look at their total
market capitalization. So I’m already
trying to think about ways to game this –
if you were Walmart, Home Depot, the
biggest retailers or the biggest
airlines and you said we’re
gonna buy a lot of this and then in
uniform announced that we take this as a
currency thereby dramatically increasing
the value, isn’t there all sorts of
opportunities for bad behavior and
market manipulation here? There might be
and whether you could ever hold anyone
accountable for this in many ways turns
on where it fits legally in the legal
system. If Bitcoin were a security, you
might worry about people manipulating it
and being liable under the securities
laws, but it’s hard to make the argument
that it really is. Bitcoin doesn’t have
voting rights or dividends, you know, the
other things that you would typically
associate with the security and some
people have said maybe it’s a commodity,
but again you don’t see many of the
characteristics of a commodity present
in this virtual asset that doesn’t even
exist physically. I think it’s a new type
of property and exactly what regulations
might apply to it is far from certain
and you’ll get different
answers in different countries about
that. So, a baseline understanding –
Bitcoin, Ethereum, Ripple – now explain what
feels like the building blocks, if you
will – I don’t know if it’s the paper of
the currency – a blockchain. What is
blockchain? What’s the technology?
What role does it play in all of this? A
blockchain is simply a database, but it’s
a very different type of database than
we’ve historically used for financial
data. So, typically you would have a
ledger with debits and credits and a
balance sheet with assets and
liabilities – it’s a whole system of
double entry bookkeeping that came in
during the Renaissance and has been
really for 600 years the backbone of
capitalism – the blockchain is totally
different.
It puts records into a sequence and it
links them together using something
called a hash code where if you change
one entry in the ledger, it throws off
all the future entries. What this means
is that it’s very easy to spot fraud –
much easier than in double entry
bookkeeping in fact – so, blockchains not
only are very transparent in that you
can see when they’ve been changed, but
typically with these crypto currencies,
they distribute a copy of the blockchain
to everybody, which allows you to
crowdsource the auditor function. So it’s
not just that a mistake would be obvious
if somebody changed the ledger, but
everybody on the network would be able
to see it at once. You wouldn’t have to
rely on an auditor, investigator, whatever,
to find it. You would see it in real time.
So, this sounds as if it strikes or could
potentially be an innovation or around
credit card fraud or one of the – and these
are good problems – but one of
the pain points in my life is wiring
money and then having the institution
call me and ask me questions that even I
don’t know because they need to
validate it. What you’re saying puts
the validation in the form of several
thousand people that creates multiple
points of security check or barriers. So,
are all these things up for disruption
in terms of credit cards, wiring fees?
I think you understand this very well
that the real achievement here
is not Bitcoin, but the application of
the blockchain technology and basically
anything tracked on a database
can probably be tracked more
successfully on a blockchain than on the
databases that we’ve used for a long,
long time. So, blockchains hold out the
promise of defeating cyber fraud and
hacking, of making international payments
much simpler without all the levels of
credit checks and redundancy and so
forth that have to go into that. The
Economist magazine called the blockchain
a trust machine because the cryptography
is such that you can unconditionally
rely on it once it reaches you at the customer level. So, it has the
potential to really revolutionize
financial markets and if you want to
sell shares of stock or bonds or the
title to your home or automobile titles
or send money around the world, any
financial transaction could be recreated
on a blockchain at potentially greater
security, more savings, faster
transmission, all kinds of benefits that
have been long sought-after in the
financial markets for a long, long time.
So, what’s the link between Bitcoin and
blockchain? Bitcoin resides on a
blockchain and the blockchain – probably
dates from 1991- seems to have been the
first time it was really proposed and
discussed, and the authors of the
original paper imagined it as a registry
for intellectual property, like recording
ownership of digital tracks of music and
things like that and it wasn’t until 17
years later that Nakamoto wrote his
paper and proposed putting these
bitcoins onto blockchains – and this
turns out to be the first compelling use
case where blockchains were really
applied on a large scale – was for Bitcoin
and all of the eleven hundred other
currencies that have imitated Bitcoin
each has its own blockchain and this is
essentially an architecture, a data
structure that seems to be in many ways
superior to what the world has been
using up to now. The real breakthrough is
the blockchain. And can the blockchain be the underlying trust
engine of not only Bitcoin but other
more traditional currencies? It seems
like one of the applications often
discusses that central banks may want to
take the bills and banknotes, withdraw
them from circulation
and just put the national currency into
an electronic blockchain so you would
have a digital dollar a digital pound
and so forth. It would give the central bank much closer control over the money supply and
it would defeat things like money
laundering and tax evasion very simply. I
think it’s a matter of time, it’s not
a question of if, but when a country will
do this and my expectation is that the
benefits will be so large that all of
the other countries will quickly follow
suit, that ten years from now you’ll see
many central bank digital currencies
like this. So, Bitcoin’s value has
skyrocketed. I read an article by Robert
Shiller, the Nobel prize-winning Yale
economist, saying that one of the reasons
that explains bubbles is there’s an idea
epidemic, that people latch onto a
narrative and then pump something up
beyond a kind of a rational
price and that the idea epidemic behind
Bitcoin is that people have lost faith
in governments, but they still recognize
the need for store value transfer
payments and here we have a currency
that’s no longer dependent upon a
government and the governments can’t
control and the governments can’t screw
up by just – every fiat currency
I think over time has eventually gone
out of business, so to speak – what’s your
view on what are the things driving the
two, three hundred percent gains we’ve
seen in in crypto currencies? You know,
first of all, I think the introduction of
Bitcoin could not have been better timed
because it’s launched in January of 2009,
which is right at the bottom of the
financial crisis, so it catered to a
belief by many people that central banks
around the world had failed in their
mission and it made people consider
whether money wouldn’t be better issued
on a decentralized computer network than
by sovereign governments who had done a
very poor job of overseeing the
stability of their financial systems. Now,
what accounts for the rise in value? I
think recently you can actually point to
a couple of precise factors. One is that
Bitcoin, for a couple of years now, has
had a backlog where more and more people
wanted to use it, but it wasn’t growing
in storage capacity enough. Basic supply and
demand. Right, and you had some choke
points and bottlenecks only very
recently in August after a
couple of years of delicate negotiations, was a
solution actually implemented. So, I think
this was actually quite important that
the anticipation of this, and then
finally the the achievement and the
implementation caused the price to rise
considerably, but a lot of it has also
been tied to the introduction of initial
coin offerings that really just in the
last six months you’ve seen a flood of
new assets into the market and to buy
these initial coin offerings, to be a
customer, typically you have to pay
either an ether, which is the Ethereum
currency or in Bitcoin and so many
people think that the demand for Bitcoin
and ether is really derived from the
demand for these new tokens and that
they’re using Bitcoin and ether really
just to bid in the auctions for this new
wave of speculative assets. So, initial
coin offerings – walk us through that.
Instead of issuing stock in exchange for
ownership rights to board seats, a
company does an initial coin offering –
what’s the difference? It’s sort of like
forward selling the revenue and using it
for product development. So, tokens are
meant – at least they’re represented to
the public – as a similar thing. It’s a way
of a company to raise startup capital,
but it doesn’t give any kind of
ownership right to the person who buys
the token. Do your customer rights enable
you to cash flow? Not really, no,
it doesn’t seem like it. So, what’s
– and this is where my
my mind starts circling and it goes
nowhere – what’s the benefit then and
why are these initial coin offerings
raising so much money if you don’t have
a right to future cash flows? Is it just
that you’re creating something that
supposedly has currency and creates a
synthetic where other people will buy it
for more or is it just pure speculation? With
these tokens, it’s hard to see why
privileged access to the product in the
future may be so valuable and I think
the motivation of many of the people who
buy them is to flip them quickly, really
as short-term speculative investments up
to now this is kind of work, that there’s
been so much capital flooding into the
market that a number of these things, as
a round trip investor you can make a
quick killing in a matter of minutes or
days. Obviously, this can’t go on
indefinitely. Of the three things we’ve talked
about – cryptocurrencies, blockchain, and
initial point offerings – the thing that
sounds the sketchiest and the scariest
is initial coin offerings, but
the other observation is that because
it doesn’t represent ownership,
there’s no potential it doesn’t warrant
oversight by the SEC or any other
regulatory agency. The regulators around
the world wish they could regulate this
and you look at a company raising
capital you say well, this is a security
under the securities laws, but the people
who’ve designed these have designed them
very carefully to get around the
classical test that we have for
securities laws, and regulators have been
pretty flummoxed by this. We had an event
at NYU just last week where the head of
the SEC was here and said he was very
interested in these, but to date, the SEC
has only taken a position on exactly one
of these and the one that it issued the
letter about was probably most like a
security of all the ones that they might
have picked, but I think the people who
designed the coins not only have
cleverly maneuvered around the
securities laws, but they’ve been careful
about geography.
Many of them have ruled out investment
from people in the US and physically
they’re typically not located anywhere
so that it’s hard to say who might have
jurisdiction when they exist only in the
cloud in cyberspace. So, it sounds – I’ll put
out a thesis – if you’re advising
different stakeholders involved in
initial coin offering – if the company can
raise money off the initial coin
offering, I see very little downside to
creating a synthetic – I don’t know why you
wouldn’t do it. It sounds like a great
idea, let’s do an initial coin offering.
For the person who’s sophisticated and
has a stomach of steel – and risk
capital for 30 seconds or less and
hoping to flip – it it sounds like on a
risk-adjusted basis an interesting way
to make a living. For anybody
else, this sounds awful. I would not
recommend these as investments, I
would use a great deal of
caution, learn what you’re buying. All of
these are a little bit different and one
or two of them may have value in that
they are connected to a product or
a service that will be scarce and your
access to it may be valuable in the
future, but I think for most of them this
is probably a long shot. Do your homework,
don’t jump into the
market and expect to be able to flip
them quickly because sooner or later
these things end. It’s an application of
what we call – in finance – the greater fool
theory – that I know I’m a fool for buying
it, but there’s an even greater fool than
me who I’m going to unload this on. Do you
think this technology or
cryptocurrencies assuage risk in
the financial markets or increase it? I’m
not sure that they actually interact
with the regular financial markets. I
wrote a research paper early on that
showed that Bitcoin is completely
uncorrelated with other currencies and
with gold, and it just seems to be a
risky asset out there all by
itself and in that sense if Bitcoin does
well or does poorly, it doesn’t really
affect macroeconomic variables like
interest rates or the stability of the
money supply, or anything like that. I
think it’s a curiosity and at this point
it’s really so small that it can’t be
much trouble one way or the other for
the real financial system. So, this isn’t
long-term capital management 2.0, you
don’t you don’t see a scenario where
potentially the next financial crisis,
the epicenter, is crypto currencies? No,
because the total value of all the money
in the world in crypto currencies is on
the order of a hundred billion dollars
and that’s just tiny relative to the
size of the capital markets in the world.
It’s fun and it’s a curiosity,
but the real value of this is the
technology behind it and how it’s
probably going to be integrated into the
mainstream economy so I think Bitcoin is
of historical importance for bringing
this technology to our attention, but I
don’t think Bitcoin is either the money
of the future nor is there any risk of
Bitcoin destabilizing the currency
markets. But it sounds as if you’re
zeroing in on blockchain versus Bitcoin
or initial coin offerings, that the
innovation here and the thing likely to
stand the test of time is blockchain?
That’s absolutely right and that’s why
we put blockchain right into the title
of our course and what we talk about are
very mainstream problems like
international remittances, supply chain
management, logistics, managing the flow
of collateral and letters of credit
among banks that secure goods in transit,
settling trades on the stock
exchange – these are very big markets and
applications that can probably be done
much better on a blockchain than they’re
done with the old technology that’s in
use now and that’s the real
promise and the real source of value. You
see the companies beginning to apply
this as vendors, serve people like IBM
and Microsoft that are recruiting blue
chip clients like Maersk and Walmart and
so forth to integrate this directly into
supply chain management, working capital
management and so forth. How do you
invest in and make money potentially in
blockchain? It’s an interesting question
because you do have basically a
disruptive technology here, but this is
open source technology that anyone can
access for free. It’s really a way of
designing a ledger or a database. I think
the best way to make money on it is
probably to identify companies that have
been especially aggressive and
forward-looking at bringing it to the
market and investing in their stocks and
this requires some equity research. I
think some firms are rather secretive
about what they have going on from a
research point of view, but in the long
run I think some financial firms will
adopt this quicker than others and
companies who are in the shipping or the
transit business – also, industries like
Electric Power, healthcare and so forth –
there seem to be clear applications for
it, and I could see someone starting, for
instance, a mutual fund called the
blockchain fund, that would identify
companies that were very forward in
their adoption of this and then you
could invest – at least indirectly – in the
technology by owning that basket of
company stocks that had bet long on this
technology. So, companies that you feel
are good at this – of all
the bulge bracket or all the financial
institutions, the JP Morgan’s, the
Goldman’s, the UBS’s – do you see any
standouts that seem to be doing the
best job or kind of get this? It’s
interesting that JP Morgan Jamie Dimon
gave a speech just a day or two ago denouncing Bitcoin, saying it
was a fraud and that he would fire
anyone who he caught trading in it. Now,
he wasn’t specifically denouncing the
blockchain, but the the message, I think,
to the Troops, was pretty clear that JP
Morgan is not that company that’s going
to be forward-looking. I’m
reluctant to pick out any one bank, simply
because so many of them are looking at
it at this point. Many of them are really
reacting from a defensive posture that
they realize this is a technology that
cuts out the middle man. You know, if you
do international remittances, you can do
it with Ripple and maybe not need the
network of banks on the Swift Network, so
I think many of the people in industry
are trying to do what I would call the
bare minimum to co-op this into their
business models in such a way to protect
the franchises they have. The problem
the banks have is that all of them have
to comply with existing regulations in
their current lines of business and as
soon as they start moving assets on the
blockchains or dealing in virtual
currencies as investments, they open a
can of worms about whether they’re still
in compliance and for a start-up that
doesn’t have the burden of the overhang
of regulations for their existing
business, you have a lot more freedom in
this space. So at a retail level, how is a
consumers life going to change with the
innovations around blockchain,
cryptocurrencies, etc.? I think first of
all, physical money will disappear almost
entirely and for most people that’s
already happened that we use not only
credit and debit cards, but mobile
payments like Venmo and I think that
trend will only accelerate. I think the
biggest change that you may see is that,
if central banks issue digital
currencies, you won’t have branch banks
engaging in fractional reserve banking
anymore. In other words, your paycheck
wouldn’t be deposited into the Bank of
America or JP Morgan Chase, it would go
into an account at the Federal Reserve.
Everyone would just bank at the central
bank; branch banks would disappear, so
your point of interaction with a
financial system may be just through one
giant national blockchain run by the
central bank and this would
fundamentally change the way that you
handle your personal finances because
you wouldn’t be interacting with the
consumer banking system that you have
grown up with and that you have been
using for now, and this wouldn’t
necessarily be a bad thing. I mean, it’s
worth remembering that these banks all
failed multiple times and required
taxpayer bailouts and you wouldn’t have
to worry about any of those kinds of
disruptions in the future, either
taxpayer or as a customer. So, banks go
away, reduction in fees, more confident or
secure that you won’t be a victim of
hacking and/or fraud? That’s the big
benefit is that the security of your
financial data should be much higher in
a blockchain so you’re not going to wake
up and learn that 143 million social
security numbers have just been hacked
from a credit bureau or that, you know,
somebody opened a bunch of accounts and
your name by taking your information. All
of that, hopefully, will be in the past if central banks are able to
co-op the blockchain technology and use
it as a line of defense against what is
a huge problem with cybersecurity. So, the
legacy players might get hurt and might
shed value because they don’t want to
risk their current businesses by running
afoul of regulators and it sounds like
Jamie Dimon pooh-poohing, you know, that
reminds me a lot of retailers in the 90s
saying no one will ever buy anything
online.
It sounds like they might collectively
lose market capitalization or value.
Startups gain because they’re too
stupid to know they’re gonna fail and
they can be crazy and aggressive and
really go after stuff. Do you see
any legacy industries that will likely
increase in value or do you see any big
winners in existing marketplace from
this technology? Not obviously, in fact, I
think the best analogy is to consider
the peer-to-peer economy and the example
I usually bring up at the start is the
music business. So, you must remember
Tower Records and Sam Goody. I know Tower
Records – I used to go to the Tower Records
on Westwood Boulevard – I love Tower Records!
Yeah, and it’s not there anymore and that
is what is really going to happen to the
banks of the brokerages, that you’re
going to move to much more of a
peer-to-peer interaction between savers
and investors to send international
remittances you won’t need a chain of
four or five banks on the Swift Network,
you’ll just send a Ripple token with the
transfer attached to it. So, it’s not so
much that banks are going to gain or
lose, it’s that they’ll just become
unnecessary. That sounds
like a loss. Well, yeah, I mean they’re
just gonna be gone like Tower Records.
You think large
financial complexes will disappear?
I think they will be greatly reduced,
they will preserve some parts of their
businesses but you’ll see many defensive
mergers and consolidations of the
financial services industry, banks
brokerages, exchanges, and so forth, and
many of these things recreating
themselves on a peer-to-peer basis using
blockchains as a substitute for the
trusted third party the payments process
or the Clearing House, the bank – the whole
point of the technology is to make the
middleman disappear and, I think one by
one, you’re going to see this happen in
different product lines and financial
services. So, in finance – one of the
basic tenants of Finance or investing
is diversification across a bunch of
asset classes – do you recommend that
cryptocurrencies be part of someone’s
portfolio as an asset class? Maybe a
very tiny amount. There still very, very
small, relative to the community of
investable assets, you know, well below 1%,
and it’s a little funny because they’re
not a hedge for anything. You would think
that they would move inverse to some
industries or provide some insurance
against the sovereign currencies in the
market, but they seem to be out there by
themselves as a type of pure risk, so I
think the case for an investor to hold
these is pretty minimal and I wouldn’t
advise holding the currency. I would
advise learning about the blockchain
technology and thinking how it may
change different industries. Do you own
any cryptocurrencies? Absolutely not, it’s
very risky.
Professor David Yermack, chair of the
finance department and the catalysts
behind our FinTech specialization. We
appreciate your time. Thank you, Scott.