The 10 minute Guide to Investing in Crypto for Family Offices

Credit: Morgan Stanley: Bitcoin Decrypted

In this article I will attempt to provide an overview that is readable in 10 minutes or less on the current crypto market with a lens towards how a CIO in a family office would want it detailed.

As show above we seem to be entering a new paradigm with several tier 1 institutions such as Morgan Stanley (which classified crypto recently as a “New Institutional Investment Class”) and Fidelity launching (‘FDAS’) adding validation to the asset and technology. Many question remain in terms of custody, regulation, valuation and more but a rational investor, in this authors opinion, would want to narrow the information asymmetry gap now before any alpha gets diminished. (*please note, this should not be deemed investment advice; please consult the proper internal or external staff before making any investments in this asset class).

Contents:

  1. TAM v SAM
  2. How mature is the market?
  3. What product/s are currently available to invest in
  4. What valuation schema are currently available?
  5. What are the risks associated with this market?

What’s the TAM/SAM

As we know TAM can be defined as a global total (even if a specific company could not reach some of it) or, more commonly, as a market that one specific company could serve (within realistic expansion scenarios). The inclusion of constraints such as competition and distribution challenges then modifies the strategy to frame it with realistic boundaries, reducing the market down to the serviceable available market (SAM), the percentage of the market that can actually be served (either by that company or all providers) out of the TAM. This is occasionally referred to as PAU (Potential Active Use).

I will touch on two verticals cryptoassets aim to disrupt & displace their incumbents: internet & money.

Now, think of every internet based product, platform or tool you know…take a minute and look at your phone to see what you use every day — Google, Amazon, Lyft, AirBnB, Facebook, Venmo, etc.

These are all built upon centralized systems — server farms big as O’Hare airport that have created a single point of attack. It’s useful to see the difference in centralized architecture v decentralized visually:

As George Gilder writes in his book “Life after Google”: “Centralization tells thieves what digital assets are most valuable & where they are. It solves their most difficult problems. Unless power & info are distributed throughout the system peer to peer, they are vulnerable to manipulation and theft from the blenders at the top.”

We’ve seen this play out and it’s been rather ugly:

The cost of the failures of centralized system is rather significant as stated by a Bloomberg article from two years ago. “Cyber threats are ever-evolving and may come from sophisticated adversaries,” the CEA said in its report. “Due to common vulnerabilities, instances of security breaches occur across firms and in patterns that are difficult to anticipate.”

Everyday the companies in your portfolio, whether liquid (equities) or illiquid (direct, private equity, venture), from the new emerging start-up’s to legacy, family run business are ever increasingly susceptible due to their architecture (and yes that does also mean those built on AWS). The costs (financial and reputation) associated with not leveraging new systems built via cryptographic architecture and technology is becoming a real data point.

Now, switch gears and think about money.

“Add in checking accounts, savings accounts, money-market accounts — not quite physical money, but you can make a bank transaction digitally and use that as money”; the total amount of money easily accessible in the world economy grows by several multiples. This is called broad money, and according to the CIA World Factbook, the global total is in excess of $80 trillion.

Yes the global TAM/SAM is potentially THAT big — maybe not today, maybe not next year but in 5,10–15 years it is. Currently if you’re in any of these countries the SoV (store of value) and the censorship resistance features of Bitcoin are far better than your regional currency:

Here is a list of the five countries with the highest inflation rates in the world:

  • Malawi (19.78%) — Population: 18.62 million
  • Angola (33.68%) — Population: 29.78 million
  • Suriname (67.11%) — Population: 563,402
  • South Sudan (476.02%) — Population: 12.58 million
  • Venezuela (475.61%) — Population: 31.98 million

Total population affected: 93.52 million

This belief that cryptoassets has the ability to disrupt and displace legacy incumbents in the internet and money system is not being dictated by anarchists or fear mongers trying to destroy governments and banks — it’s being driven by people like Abigail Johnson, CEO of Fidelity who have over $7T in Assets under Administration, when announcing the launch of Fidelity Digital Asset Services (‘FDAS’) said: “FDAS’ goal boils down to making digitally native assets, such as bitcoin, more accessible to investors. She continues on by saying that she expects for her firm to continue experimenting with this “emerging asset class,” alluding to her belief that there are long-term prospects for the blockchain innovation.”

How mature is the market?

In terms of where we are in the maturation cycle one could look to the total size (in $$) of the current market to where it was five years ago and the analogy of crypto’s growth vs. the early days of the internet.

Credit: Morgan Stanley

Now if we look back to see the overall size of the market cap just 2 years ago we glean some insight:

As discussed in great length by many we saw a torrid increase of capital flooding the cryptoasset market in 2017, especially in Q3-Q4 driven by retail speculators chasing a dream of hitting the crypto lotto jackpot; this in turn led many ICO’s and teams to be able to raise excessive amount of capital which in turn distorted the entire market cap (see Nov ‘17-Jan ’18) instead of a more smoothed out J-curve. One possible explanation for this occurrence in this authors mind is that many retail investors stayed on the sidelines during the prolonged equity bull market and missed the proverbial bus — they didn’t want that to happen again and plowed heavily into an asset they were not educated on.

In terms of crypto’s growth vs the internet a great visual is provided by Chris McCann, formerly the Community Lead @ Greylock Partners and now founder of @CryptoWeekly

As Chris correctly writes: “You can see we’re actually tracking quite closely with the early days of the internet. If you think cryptocurrencies is going to follow a similar trajectory as the internet, we look like we’re in about year 1994 compared to the internet.”

What product/s are currently available to invest in?

As we wind down 2018 we have been witnessing a change in the investment products being offered; in 2017 all the talk was the “ICO” and in the latter parts of 2018 we’ve been hearing about the “STO” (securitized token offering). Direct investments, in lower middle market private equity style and venture capital deals, have been on the rise in family offices for the past five years, in due part due to the lack of performance, high fees and lack of customization that institutions and funds have been offering. As discussed in valuation schema below, it is complex to value many crypto private deals currently by leveraging pre-existing models. For that reason, plus the lack of bandwidth many family office CIO’s already deal with, it may be worthwhile to initialize exposure to the asset class via funds.

Credit: Morgan Stanley

As we see there has been a surge of fund creation over the course of the last two years. As I discussed in a prior Medium post: “Guide: Crypto Fund Diligence Checklist for Family Offices” there are several aspects of evaluation one should consider when reviewing crypto hedge funds — custody solutions, counterparty risk (i.e. exchanges they trade with, liquidity risk issues) and what assets are they in fact trading (are they trading the top 10–50 tokens or are they venturing out in the abyss).

In terms of evaluating crypto venture funds this author believes strongly that funds that have engineers as advisors provide a great element (not necessary but very helpful) in diligence of projects and in origination. I also believe strongly in those managers who deploy a business development approach to the projects they work with — hands on approaches to help the founders ramp up development and testing of their platforms.

A quick note about “STO’s”: Recently Templum Markets successfully provided investors access to one of the first STO’s. What is an STO though: An STO is similar to an ICO in that an offering is made by a business to the crowd, in which consumers purchase crypto tokens built on a blockchain, but the two do not share many similarities beyond that. Whereas ICOs are the sale of coins, purported utilities or even currencies, STOs are the sale of securities. STO participants are investors, not users, who pay and receive a security (i.e. equity, debt, revenue share, etc) that is represented by a token. In order to sell securities to the crowd, a company has to register the offering with the SEC (difficult and expensive) or use an exemption from said registration. (thanks to Howard Marks, co-founder at Activision/Blizzard).

Valuation schema currently available

There is debate about this topic everyday in the crypto community; some incredibly thoughtful and smart investors have been weighing on this topic as we’ve seen models from from Chris Burniske’s MV = PQ model to Haye’s discussion on costs associated with mining.

Credit: Lanre Ige @ Mosaic.io

The verdict is still out on which model or models is right but the amount of work being done of this subject is coming fast and daily. An investor, Brendan Bernstein from Tetras Capital believes: “The key to ascertaining fundamental value in crypto is an understanding of [1] economic activity — transactional usage of the token + the store of value component and [2] velocity — how frequently the token changes hands.

In this authors opinion the court is still out; I do believe in some form of valuation being extrapolated from the “sunk costs” of participating as a node/validator on the network/s. One must purchase ASICS or GPU’s and use significant amounts of energy in order to solve complex cryptographic puzzles to be awarded Bitcoin or other alt coins. Additionally network effect is something I think could be used; quantifying an additional user of a good or service has on the value of that product to others. When a network effect is present, the value of a product or service increases according to the number of others using it. However, negative network externalities can also occur, where more users make a product less valuable i.e network congestion that we saw with CryptoKitties.

Risks associated with the market

There was a point in time, about 2 years ago, that the idea of Bitcoin going to zero had some degree of probability (whether minor or significant can be debated). While it certainly still does, the probability from 0–1, whereas 1 denotes an act most definitively happening, has diminished in this authors opinion for a few reasons. First, as denotes above, the current market cap of crypto is approx $200B, of which Bitcoin accounts for roughly +50% of that — that’s $100B of investors money sloshing around — that’s $10B of family office money locked away in military style vaults from the likes of Xapo. Does this remove any probability of a total loss of capital from this asset class, no…but the quality of investor (i.e. retail to more institutional) does.

Two, new market entrants: as discussed above the recent news from Fidelity, Goldman, Nomura, NYSE/ICE, TD Ameritrade and others in the traditional finance system is quite promising. We have recently also seen more conservative institutional investors, as as Yale Endowment, entering into the asset class.

Other risks include custody of the asset/s & regulation.

Credit: Steven Zhang, The Block (theblockcrypto.com)

Custody: As detailed above from Steve Zheng from TheBlock the custody solution space is ever growing and maturing whereas a year ago there was just a handful of solutions. Recently Goldman Sachs and Mike Novogratz’s Galaxy Digital Ventures contributed about $15 million to BitGo’s Series B fundraising, which brought in a total of $57.5 million. The endorsement from two firms with strong Wall Street roots may help BitGo attract more institutions and wealthy investors as customers. With solutions from Coinbase, BitGo to Casa there has been a tremendous amount of movement & capital being provided to solve the problem.

Regulation: over the course of the last year there has been numerous meetings with federal and state regulators and politicians to determine how this asset class will be treated. Just last week more than a dozen members of Congress sent a letter to SEC Chairman Jay Clayton Friday, joining calls from the cryptocurrency industry for a clearer picture of how the agency views the digital asset class. The letter comes days after a four-hour meeting in Washington, where representatives from Wall Street and the crypto industry pleaded for more regulatory guidance. This is an ever evolving aspect of the asset class and one that requires regular monitoring.