The 99 Chains Newsletter Issue #2: 0x Investment Breakdown — The 5 Key Blockchain Project Valuation Techniques to Know
This week I take a look at what makes 0x attractive as a potential investment — and why I invested several thousand $USD in the project. Keep in mind that when evaluating a crypto project as a potential investment, the key metrics — from the growth rate to how value is created in a network — differ from those of mainstream investments. Here are 5 key metrics I use.
What is 0x (the ZRX token)?
“0x is an open protocol that is designed to offer a decentralized exchange as part of the Ethereum blockchain. 0x is made using a protocol that involves Ethereum smart contracts that allow those around the world to run a decentralized exchange. The team behind 0x strongly believes that in the future, you will find thousands of tokens from Ethereum and that 0x can provide an efficient and trustworthy way to exchange them. 0x is designed to be different from both centralized and decentralized exchanges, providing the best possible combination of features.”
#1. The Mafia Effect
You can have a mediocre product and a great team and do well, but a great product and a mediocre team is a hopeless endeavor. Blockchain is tricky because it’s such a new industry. There are no real “experts” in the same way that there are pros in computer science, neuroscience or any other established field that’s been around for at least a couple of decades. This makes assessing the team in a blockchain project a challenge.
Look for Startup Experience
That said, it’s possible to identify transferable skills. If the founders of a project have successfully started and exited companies in the past, or have been part of a startup team, this gives me some reassurance that they know how to handle a fast-paced, chaotic startup environment. On the other hand, if the founders have only worked for Microsoft or Apple and suddenly decided to ride the blockchain wave, jumping into a startup with zero startup experience, I would be more cautious. I’d check whether they have good external advisors or other employees with startup experience.
The early players in any vertical in any industry can have a sort of “Mafia effect.” Most famously we had the Paypal Mafia, whereby several employees from Paypal left and started their own ventures that ended up becoming ultra successful. Former Paypal employees include Elon Musk (SpaceX, Tesla), Peter Thiel (Palantir), Reid Hoffman (founder of LinkedIn), Steve Chen (cofounder of Youtube), Yishan Wong (CEO of Reddit), and quite a few more. Ripple/R3 are their own mafia — Ripple managed to recruit Ben Lawsky, a former NY regulator responsible for creating the infamous BitLicense, onto their board. Talk about an inside edge!
Give Extra Points for Crypto Space Bench Strength
Coinbase could be sort of a Paypal Mafia of the crypto world. Perhaps, it’s still too early to tell. At the very least, many companies have external advisors from Coinbase, and a few employees have left Coinbase to join new ventures. The 0x (ZRX) project was one that stood out for this reason. Three of the co-founders of 0x were previously at Coinbase.
While Coinbase is a centralized exchange and doesn’t exactly live up to the libertarian ideals of a decentralized marketplace, it provides necessary market liquidity and is a key player in getting bitcoin trading to the masses. It’s also the largest crypto exchange in the U.S, has $225 million in funding, is based in Silicon Valley, and was #1 in downloads on the iTunes App Store for quite some time. They are doing something right. So when employees from Coinbase leave to start a company or join another business, it’s worth raising your eyebrow.
What is most intriguing to me is the nature of the 0x business — it’s a decentralized exchange, which is exactly the opposite of Coinbase. Why did these three people from Coinbase leave and join 0x? Perhaps it’s a disagreement about ideologies (centralized vs. decentralized), or perhaps they know something we don’t and have a hunch about the future of blockchain. Regardless of the reasons, the benefits of having ex-Coinbase members on your team are numerous — chiefly, the know-how they bring from a crypto startup team.
Being in the know in Silicon Valley and one of the first cryptocurrency exchanges in the U.S. provides clear advantage. There’s also the potential that, if 0x is on good terms with Coinbase, maybe the ZRX coin gets listed on Coinbase. And what do you know — as of me writing this, it has been announced that the coin is being listed on Coinbase Pro (which will almost certainly create more liquidity and an increase in price). Other members of the team include engineers from Google, Facebook and Apple who have worked on digital products. While they are not blockchain projects, again, they bring tech expertise in a fast-moving industry.
#2. Metcalfe’s Law/Network Effects
Metcalfe’s Law states that as the number of nodes in a network increase, the value of that network increases. One telephone is useless, but when you have two you can communicate. When you have 100, then things get really interesting. This applies to blockchain projects. And your product doesn’t even have to look pretty, it just has to work well (amongst other factors). Craigslist didn’t have the best website, but it had the most users for a classified site. eBay had a pretty basic website too, but it had a first-mover advantage, captured many users and was able to dominate its market.
Hundreds of coins are ERC-20 based coins, meaning they are built on top of the Ethereum Blockchain. Blockchain startups choose ERC-20 tokens because they run on the most reliable smart contract platform, which is led by a great dev team. As the number of projects increase, the value and necessity of Ethereum to the smart contract ecosystem has increased with it. This explains the several-thousand percentage price increase in ether between 2017 and 2018. Many blockchain projects have the potential to do the same.
Any project that captures a certain vertical — say online gaming, could move on to become the dominant token or platform used by gamers. Of course just because it can doesn’t mean that it will. A lot of other factors have to be just right, like timing, the team, the tech, and of course a bit of luck.
Assess Traffic Flow Growth
The 0x project, a decentralized open source protocol, plans to light up network nodes by solving a lot of the problems associated with decentralized exchanges. It’s technically not an exchange, but can be used by anyone to create a decentralized exchange. The transaction fees are practically zero. Unquestionably, demand will be huge for decentralized exchanges in the coming years.
Since the average consumer is still wrapping their heads around Bitcoin, they will flock to Coinbase or Bittrex to buy bitcoins and do little else. As crypto investing goes mainstream, a protocol like 0x will be the backbone for many of these decentralized exchanges, and that’s a good spot to be in.
Following Metcalfe’s Law, the value of the 0x protocol is quite low at this point in time since there are few nodes in the network — that is, not many companies or people using it. Even if it is traded as a coin on Coinbase, what is the actual utility beyond speculation? The true value won’t be realized until there are actual applications and projects (and many are already being built). But once that happens, 0x has, in my opinion, the potential to add significant value to the ecosystem. From this perspective it’s not a good short-term investment, but a mid-to-longer term one. And because it’s longer term I’m willing to accept drawdowns on my investment of 30–40%.
#3. Price Psychology
Follow Your Own Research, Not the Herd
How the market currently thinks about a certain technology can obviously impact its price. Market psychology is largely about the media, and social media has taken us to a new level of information dissemination. Even individual investors like the eccentric John McAfee (there’s a great documentary about him on Netflix) can shill a coin on Twitter, causing massive fluctuations in price.
This is herd mentality at its finest. During the big hype cycle in late 2017, early 2018, we saw many cryptocurrencies pop off the charts, making unreasonable gains with wild valuations.
Many friends asked me how to buy bitcoin and when they should sell. I can’t make those decisions for anyone but myself. This was risky territory and I always tried to dissuade them from putting up any amount that they wouldn’t be willing to lose. One comment I got frequently that scared me was,“I don’t want to buy bitcoin because it costs so much.”
More disconcertingly, many people didn’t understand the very basic technology. Nor did they understand that they could lower their risk by purchasing a few satoshis (1 Satoshi = 0.00000001 BTC), that all these currencies are divisible. You don’t have to buy one bitcoin, you can buy any fraction that suits your current situation and goals.
Beware of Media Hype and the Ripple Effect
Fortunately, or unfortunately, this is how a market is created; people in the know vs. people not in the know. This is how money is made. That and a bit of luck. Now, another interesting example comes from Ripple (XRP), whose price multiplied more than 4x over the span of a couple of weeks in late 2017 and early 2018. This resulted in the coin topping the charts in the top five cryptocurrencies. It stood at around $1 for one XRP for several days. Looking at the chart at this time, Bitcoin was hovering over $10,000, Ethereum over $1,000, and Litecoin in the several hundred dollars.
Many investors who didn’t understand even the basics of how market capitalization works saw Ripple as “cheap.” It only costs $1! CNBC picked up on this and started talking about how to buy Ripple. When major media starts instructing the average consumer how to buy, you know you’ve reached the top of the market and should be very cautious. It came crashing down pretty quick, and then CNBC ran another special on “how to sell Ripple.”
While I expect people have learned from their mistakes, I don’t think we’ve reached market saturation or mass consumer adoption. Plenty of newcomers will start using cryptocurrencies in the next few months and years. Even day traders and professional traders are not immune to these psychological traps & tendencies.
The 0x protocol has the ZRX token, which has hovered between #40–80 in total market cap in the latter part of 2018, fluctuating between 60c and $1. When we think about market cycles in terms of bull and bear, I like to ask myself, “Which coins will people flock to in the next bull cycle?” Surely the ones that get media attention, but also the ones that seem ‘cheap’ and have nice round, emotional numbers. I think 0x falls into that category (under $1 and hasn’t had a big 10–20x market pump).
#4. Opportunity Cost of Other Investments
Whenever we make a decision to focus on a particular investment, we forego other options. Investing in 0x, for example, means that I can’t use that money elsewhere. It means that I should be fairly confident and have good reasons for choosing this one and not another. Of course, you can choose several investments depending on your appetite for risk, the amount of risk capital you’re willing to invest, and how you choose to split your portfolio.
When I first started trading cryptocurrencies I took the popular “shotgun” approach and bought several coins in the hopes that one or two would make disproportionately large gains. I was just starting out and didn’t know what I was doing, so figured this was a good strategy.
During a bull market, it almost doesn’t matter what you choose. The majority of altcoins made very large gains in 2017, and if you had randomly selected to invest in any of the top 30 projects on Coinmarketcap, you would have done very well. That said, many of the coins also fizzled out. Many of the projects and ICOs were scams and retraced to 90% of their price within a year. That means you could’ve also lost most of your money if you didn’t withdraw/cash out in time.
Find an Information Edge
At this point, most people would advise you to diversify. There are many reasons people diversify their investments, but it’s primarily to avoid having all of your eggs in one basket and getting wiped out. I also think it’s because people don’t know what they’re doing. Those are Warren Buffett’s words, not mine.
Most people don’t spend hours and hours researching, nor are they actively involved in the industry they are investing in. They diversify because they don’t know how to make more informed choices.
But if my friend the hydroponic farmer tells me about his investment in a new hydroponic tomato company, I am going to listen. There is informational asymmetry — he knows something about the industry that most people probably don’t — and that’s valuable. So when evaluating why ZRX might be in a good position to do well, compare it to other projects and, remember, the most valuable information is expert information.
Seek High Growth Crypto
Many large blockchain projects have already been through several boom and bust cycles. They’ve ICO’d, 10x’d their prices, dropped back down to the ICO price, went back up, and then tapered off at current prices. It’s certainly possible that some of those coins will continue to gain in value, but it’s unlikely that they will increase 10x or 100x in price again in the next bull cycle. At least in the world of cryptocurrencies, the newer projects that haven’t had their “time to shine” tend to take off and gain traction.
In other words, there’s more upside potential for newer projects than some of the older projects that have already seen incredible price increases. While Bitcoin can be a “stable” investment, do you think it’s likely to pop off and make a 20x or 30x gain in a month vs. a project that hasn’t had a single bull cycle? I think not. I believe ZRX is an interesting coin for this reason because it has significant traction in the market, support on major exchanges, great tech, a great team, and the many other reasons I’ve stated above, but it hasn’t seen the ridiculous gains that we’ve experienced with other coins. It has room for growth.
#5. Long-term Survivability
There are generally two types of projects to choose from, coins or tokens. The majority of tokens are ERC-20 compliant and based on the Ethereum blockchain. Yet many tokens don’t fair so well because, while they use Ethereum’s tech, they are very centralized around their own figureheads (projects that aren’t open source and centralized could easily fall apart if the lead developer or founder suddenly left).
Many haven’t delivered on any significant projects, while others have completely dissolved, the recent case of Cofound.it (CFI) being a good example. The crowdfunding platform for blockchain startups was basing its service around ICOs, which are dying out. As ICOs began to be crowded out of the market by a new form of crowdfunding (see Security Tokens), the founders shut the business down and redistributed all the coins.
Invest in Coins With Strong Network Effects
Even if a few developers leave, Ethereum will likely continue to thrive. Like Windows OS, it has established itself as a platform that so many others depend on, yet different from Windows, the Ethereum Blockchain hosts ecosystems with powerful network effects amplified across platforms by cross-compatible ERC-20 tokens.
Ethereum won’t die even if Vitalik does (that’s a big IF, as it’s possible he’s an extraterrestrial sent to save the human race). It makes sense to accumulate coins that have their own ecosystem, at least as one measure. Decent (DCH) is one example, as is Tezos (XTZ), and of course ZRX. 0x is an open source protocol that allows DApp ecosystems to interoperate. As long as there is traction in the early stages, use cases and strong community support, then it’s less likely to be shut down even if some of the core members leave.
Avoid Obscure Exchanges
One final related point — there will always be risk of low liquidity when you’re trading low market cap coins. It’s largely unavoidable, but as long as the coin is listed on at least one big exchange, your risk can be significantly reduced. There are other newer projects with great teams that I’m also interested in investing in, but they’re riskier because they’re not liquid or on obscure exchanges. Even if they do make a 10x gain, or worse, if they lose 50% of their value, what happens if I can’t sell? Personally, I’m not going to put 10k USD into one, high risk coin that I won’t even be able sell in the case of an emergency. ZRX is listed on major exchanges including Bitfinex and Coinbase (which is a good sign) and has yet to see a big price increase like many other projects. I think for this reason it’s undervalued and makes for a very interesting project.
Rogue Developers and Further Commentary
There are several shortcomings to using Metcalfe’s Law and no method is perfect. On the blockchain, volume will flow to second layer solutions and sidechains making volume calculation harder to accomplish and Metcalfe’s Law less accurate.
Like any investment, there are certain considerations to keep in mind and it’s important to keep an eye on the project in case there is a good reason for me to divest. So, what would trigger me pulling out of 0x?
At the time of writing this, there was a hard fork in the 0x protocol, whereby a few developers from a big decentralized exchange built on top of the 0x protocol decided to rewrite the code and go their separate ways. At a first glance, you might conclude that the future of 0x is uncertain. Forks can happen very naturally and are an important part of progress in the ecosystem, so this could actually be a good thing, but from an investor’s perspective it is a red flag as the fork could render the current 0x token worthless.
Upon digging deeper, though, we find evidence of a struggling DEX (decentralized exchange) going rogue in a bear market over a couple of disagreements, and their decision to fork coming from a position of seeming desperation rather than choosing to double down with their current resources. The “exodus” only involved a couple of developers from one decentralized exchange.
Ultimately I don’t see any cause for alarm. What would give me pause is if we saw several of the core developers start to leave and work on other projects, with nobody picking up the slack. If the Github repository was dead for months and no new projects were being built on top of 0x, I would reassess the business and decide whether or not to pull out or stay in the game.
Thanks for reading and see you next week!
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