Evaluating Zcash (ZEC) as an investment

Let me preface this discussion by stating that I am not a Bitcoin maximalist, nor am I here to either endorse (plug) or disparage any particular crypto or development team. As a matter of fact, I am super excited about the proliferation of altcoin projects - this is truly a phenomenal example of how freedom, innovation and properly aligned economic incentives work to maximize payoff for everyone involved.

What I am setting out to do in this post is to illustrate a method of evaluating any alternative crypto currency, using Zcash as an example, - with a view to a long-term investment, aka "value investing" (as opposed to pure speculation).

Most professional investment managers make frequent use of the so-called "modern portfolio theory" or MPT which essentially provides a mathematical framework for evaluating and combining assets into a portfolio that has a well-defined risk/reward profile. MPT operates with a rather easy-to-understand formulation - the net expected return of a portfolio is the sum of individual portfolio instruments' expected returns weighted by their relative proportion in the total portfolio basket.'

Total Expected Return  = Sum( Expected Return  x weight )

Given this simple underlying framework, one can analyze portfolio return variance (tied to the correlations between assets in a portfolio - a hugely underestimated critical metric in the crypto space, as most crypto currencies are highly correlated with either bitcoin or Ethereum), portfolio volatility (and thus possible portfolio draw down) and diversification strategies that would minimize these while maximizing return. Now, in traditional portfolios risk is pretty much synonymous with historical volatility, which, in turn is derived from historical price variance. I am going to suggest that this is NOT a proper metric when dealing with crypto currency startup. There are two reasons - 1) there is often not enough history to go on, and 2) crypto volatility is often driven by "pump and dump" mechanics, not underlying expected return. Thus, I personally tend to completely disregard PRICE fluctuations, and instead, focus on risk as a measurement of underlying fundamental factors that could drive VALUE in the long term.

Given all the current hype in the crypto currency space it is easy to see what is happening from a social psychology angle - eager amateur investors who understand technology, but lack even rudimentary economic skills, flock to the promise of unlimited gains, their analytical skills lulled to sleep by confirmation bias and wildfire-like crowd euphoria. Is it any wonder that so many are wildly overestimating reward and underestimating risk (if they take it into account at all), thus skewing the real picture towards the ever higher probability of sub-optimal returns (or losses).

Due to this inherent bias to disregard risk, I believe it is more valuable for me to focus on the risk assessment, and leave reward evaluations for a later discussion. Risk comes in two primary flavors - systematic risk and specific risk. In our context we can think of systematic risk as being a bet on outcome of the crypto currency paradigm in general, whereas specific risk will be associated with a particular crypto currency being evaluated. Additionally systematic risk will include things like a lack of market liquidity, closing down of an exchange (by authorities or a DDOS attack) or any other adverse condition that affects the entire crypto currency space.

Regardless of the genuine sense of excitement for a particular crypto currency, an astute investor never loses sight of the presence of systematic risks.

Armed with some of these preliminaries, let us take a look at the particular crypto currency, - Zcash, - to illustrate what analysis of specific risks might look like.

Technology

Algorithms

Obviously, in this space, technology is half the game. Ideally technology is both innovative (disruptive) and solid - meaning it has a proven track record, extensive peer review history. In case of mathematical algorithms it needs to have a formal proof that it works (and remember, proofs themselves can be shown to be wrong years later). Case in point - Zcash utilizes a novel mathematical paradigm of zero-knowledge proofs (zk-SNARKs) which allows completely anonymous (and yet verifiable) transactions. Innovative? Yes. Proven? On a scale from 1 to 10 - probably a 3. This should be a concern to an investor, regardless of the "coolness" of the zk-SNARKs algorithm. The technology may just too new to be "tested in production". With your money. (See the video below for more on this, starting at 29:00)

Another big concern with the current implementation of the algorithm is that it relies on initialization parameters, the so-called "toxic waste" which the founders supposedly had discarded upon Zcash inception. This is concern - not just technically, but politically (see more on this in Team).

Scalability

As we are all aware of by now, delays in the Bitcoin network have really underscored the importance of tackling scalability issues early on. How does Zcash fare on this front? Actually not so great. A side effect of implementing zk-SNARKs is that verifying transactions takes orders of magnitude longer than verifying transactions in bitcoin today. This is the difference of minutes vs days to confirm a block at the scale of Bitcoin. This means that unless a completely new approach is found, Zcash simply could not scale as a primarily privacy-centric crypto solution.

Decentralization

The whole value of crypto currencies rests on the premise of decentralization as one of the core values that gives credence to the whole idea of an egalitarian, censorship-free money. Without this aspect, the whole edifice falls flat. Zcash claims improvements in this area as its Proof-of-Work (POW) algorithm - Equihash - is supposed to be ASIC-resistant, however their claims appear to be based on outdated assessment of the hardware landscape (see https://petertodd.org/2016/cypherpunk-desert-bus-zcash-trusted-setup-ceremony#equihash-proof-of-work). In short, they do not offer any significant improvements in this area.

The technical decentralization is overshadowed by the financial one. The founders of Zcash have retained 20% control of the currency to be issued. This is a huge stake in terms of % share of the network and could make 51% attacks much more feasible than if the currency had been distributed in a more equitable fashion.

Team

The second most important aspect of assessing specific risks is evaluating the team - the founders and principal engineers who are responsible for initiating and maintaining the project. Ideally you want to see wide community support, a growing pool of developers with expertise in relevant fields such as cryptography, distributed computing, hardware optimization. The interests of the team should be aligned with the interests of the community at large. Any existing or potential conflict of interest should be a red flag and should be reflected in overall risk assessment.

Talent

This is where Zcash really stands out. It has an impressive listing of PhD's associated with the guts of the underlying algorithm and the software. There are a lot of smart people working on this project and that definitely helps one's confidence that the team could potentially overcome some of the hurdles it currently faces.

Governance/Conflict of Interest

Unfortunately, much of the shine from the team itself is overshadowed by the ownership structure of the project. Zcash is a commercially owned product - a trademarked product of the ZECC which is a US-based entity subject to the rather arbitrary rulings of SEC and FinCEN.

I mentioned under the technology heading that one of the disturbing features of Zcash is the inherent need for the "toxic waste" - the initialization parameters used to "seed" the network. Despite the widely publicized "param ceremony" wherein the founders supposedly destroyed all of these seed parameters, the suspicion of a backdoor looms heavily in the mind of a cautious investor. Access to the seed parameters would allow the founders to issue new ZEC coins without anyone being able to detect fraud. This is highly disconcerting especially in view of the founders' control of 20% of the currency supply.

With a little imagination one could foresee a potential "perfect storm" of trying to reconcile privacy, having to comply with US AML/KYC laws, having a potential back door to the code, and being tied to the 20% of the currency valuation. Not a good situation from a risk perspective.

Competition

As with any startup business, an important aspect of evaluating potential risk is understanding the competitive landscape that a newcomer is attempting to establish itself on. In case of Zcash there are a few contenders that might gain an upper hand. The most formidable of them is probably Monero which has established itself with a solid technology, a respectable market cap and wide adoption. Another competitor to Zcash might be ... Bitcoin. Yes, that's right. There are several proposals being drafted that would allow near-perfect anonymity to be achieved on the existing Bitcoin network. One such proposal was published by Tim Ruffing in 2015 in his paper titled "Mixing Confidential Transactions: Comprehensive Transaction Privacy for Bitcoin". While we are still a long ways off from the implementation, one can see how adoption of SegWit could lead to a variety of improvements in the protocol.

Ok, so this sums up our sample specific risk analysis using Zcash. We have looked at technology profile, the team, and competition. While there are many other areas for analyzing risks - these three tend to dominate the outcome. What can one do after performing such a feat? Presumably one could introduce a risk scale for determining an unacceptable levels of risk. Looking at different aspects of the investment, one could use a point system to see if the threshold is exceeded or if the risks are acceptable.

When evaluating risks - always look for dominating factors.

As always, systematic risks should always be accounted for in addition to evaluating specific risks, especially before one runs off to invest his retirement money into a new shiny crypto coin. Have fun!